The current recession is only one problem for Alcoa Inc (ticker: AA). To anyone looking at Alcoa's financials over the past 10 years, a disturbing trend in free cash flow can be observed. The good news is that the current recession seems to have lit a fire underneath the feet of management. It appears as though Alcoa is working to improve things going forward with a focus on free cash flow.
Management is keeping closer tabs on cash flows created from operations and through better management of capital expenditures. These are the two line items used to calculate free cash flow. The premise is that cash flow from operations needs to be maximized while capital expenditures minimized. This article addresses the past, present and potential future of Alcoa.
The past 10 years:
Alcoa has one big thing working against it. That is capital expenditures. capital expenditures from 1999 to 2003 (inclusive) totaled $5.36 billion. This is an average of $1.07 billion each year. But capital expenditures over the past 5 years (2004 to 2008 inclusive) have totaled $13.56 billion. This is an average of $2.71 billion in capital expenditures each year. In terms of percentages, this represents an increase of 153%.
Things have been even worse over the past 3 years. Over the past 3 years (2006 20007 and 2008), capital expenditures have averaged $3.43 billion.
Cash flow from operations have been fairly consistent over the past 10 years. Over the past 10 years, cash flow from operations have averaged $2.26 billion. Cash flow from operations did fluctuate over those 10 years, but when looking at the 10 years, things have been fairly constant. This is not an immediate concern, but cash flow from operations should be growing over many years, not shrinking.
Capital expenditures have been running out of control. To see what capital expenditures are doing, observe the following chart. Cash from operations(CFO), capital expenditures(cap ex) and free cash flow(FCF) have been normalized by using their 3 year trailing averages. By doing this, it is easy to observe how cash from operations has been fairly constant and how capital expenditures are having a great effect on free cash flow.
Recent events:
Between July 2008 and December 2008, the price of aluminum on the London Metal Exchange tumbled 56%. In response to this and the overall changing economy, Alcoa began to reduce their workforce, reducing output at the least efficient smelting facilities and froze share repurchases. They also reduced capital expenditure spending to only those things that are required by law or needed to fulfill customer contracts.
In January of 2009, the Cash Sustainability Program was created. The goal of this program is for cash flow from operations to be neutral at worse. The focus of the program while it is ongoing is to keep a close eye on overhead, procurement, working capital, operations and transactions. Alcoa does admit that these are short term focuses. These are focuses that Alcoa should make part of their culture. Hopefully that proves to be the case when the economy improves.
For the first 3 Quarters of 2009, cash flow from operations came in at $241 million. This meets Alcoa's goal of the Cash Sustainability Program. Capital expenditures also seem to have been reigned in a bit. For the 3 reported quarters of 2009, cap ex comes in at $1.25 billion. That is greatly improved over the $3.43 billion average we have seen over the past 3 years.
Valuation
For this valuation, a Discounted Cash Flow model is used. There is no simple way to value Alcoa so three views will be taken. One that assumes zero free cash flow for many many years. The second will use the 10 year average for Free cash flow as a basis for future free cash flows. And a third view will be an optimistic view that assumes that management can better control capital expenditures going forward.
Both approaches require a share count. As of the latest 10-Q, there are 974 million shares outstanding (974,377,851 to be exact). However, there are convertible notes which could dilute the current share base. There is the potential for 89 million additional shares through these convertible notes. So for valuation purposes, assume 1.063 billion shares.
- valuation 1
The simple approach is to use the $13.2 billion in shareholder equity that is on the books. This will serve as the minimum valuation of Alcoa. This is about $12.42 per share. This valuation is simply a discounted cash flow analysis that assumes that no free cash flow for all future years.
- valuation 2
So long as management is steadfast in their actions for the long term, shareholders could very well be rewarded. This in large part means that management needs to continue to tightly control capital expenditures going forward just as they have during the current recession. Without tight controls on cap ex going forward, this valuation may be overly-optimistic. Having said this, the average free cash flow for the past 10 years is $364 million. This will serve as free cash flow for year one in this valuation. A low free cash flow growth rate of 4% is used with a discount rate of 9%. These future free cash flows discounted to current value (at a rate of 9%) yield value of about $4.4 billion. Or $4.14 per share. Add this to the $12.42 previously calculated and an intrinsic value of $16.56
- valuation 3
This is the valuation which shows the true potential for Alcoa. This assumes free cash flow of $1 billion for FY2010. It will then grow at 6$ for 10 years and 4% for the 10 after that. A discount rate of 9% is used again. By doing this, a value of $26.9 billion is calculated. This is $25.32 per share.
- valuation conclusion
Alcoa closed at $13.40 on Friday. At a bare minimum, Alcoa is worth $12.42 per share. More realistically, Alcoa is probably worth at least $16.50. And the optimistic view is that Alcoa is worth 25.32. There seems t be only upside potential here.
Management is keeping closer tabs on cash flows created from operations and through better management of capital expenditures. These are the two line items used to calculate free cash flow. The premise is that cash flow from operations needs to be maximized while capital expenditures minimized. This article addresses the past, present and potential future of Alcoa.
The past 10 years:
Alcoa has one big thing working against it. That is capital expenditures. capital expenditures from 1999 to 2003 (inclusive) totaled $5.36 billion. This is an average of $1.07 billion each year. But capital expenditures over the past 5 years (2004 to 2008 inclusive) have totaled $13.56 billion. This is an average of $2.71 billion in capital expenditures each year. In terms of percentages, this represents an increase of 153%.
Things have been even worse over the past 3 years. Over the past 3 years (2006 20007 and 2008), capital expenditures have averaged $3.43 billion.
Cash flow from operations have been fairly consistent over the past 10 years. Over the past 10 years, cash flow from operations have averaged $2.26 billion. Cash flow from operations did fluctuate over those 10 years, but when looking at the 10 years, things have been fairly constant. This is not an immediate concern, but cash flow from operations should be growing over many years, not shrinking.
Capital expenditures have been running out of control. To see what capital expenditures are doing, observe the following chart. Cash from operations(CFO), capital expenditures(cap ex) and free cash flow(FCF) have been normalized by using their 3 year trailing averages. By doing this, it is easy to observe how cash from operations has been fairly constant and how capital expenditures are having a great effect on free cash flow.
Recent events:
Between July 2008 and December 2008, the price of aluminum on the London Metal Exchange tumbled 56%. In response to this and the overall changing economy, Alcoa began to reduce their workforce, reducing output at the least efficient smelting facilities and froze share repurchases. They also reduced capital expenditure spending to only those things that are required by law or needed to fulfill customer contracts.
In January of 2009, the Cash Sustainability Program was created. The goal of this program is for cash flow from operations to be neutral at worse. The focus of the program while it is ongoing is to keep a close eye on overhead, procurement, working capital, operations and transactions. Alcoa does admit that these are short term focuses. These are focuses that Alcoa should make part of their culture. Hopefully that proves to be the case when the economy improves.
For the first 3 Quarters of 2009, cash flow from operations came in at $241 million. This meets Alcoa's goal of the Cash Sustainability Program. Capital expenditures also seem to have been reigned in a bit. For the 3 reported quarters of 2009, cap ex comes in at $1.25 billion. That is greatly improved over the $3.43 billion average we have seen over the past 3 years.
Valuation
For this valuation, a Discounted Cash Flow model is used. There is no simple way to value Alcoa so three views will be taken. One that assumes zero free cash flow for many many years. The second will use the 10 year average for Free cash flow as a basis for future free cash flows. And a third view will be an optimistic view that assumes that management can better control capital expenditures going forward.
Both approaches require a share count. As of the latest 10-Q, there are 974 million shares outstanding (974,377,851 to be exact). However, there are convertible notes which could dilute the current share base. There is the potential for 89 million additional shares through these convertible notes. So for valuation purposes, assume 1.063 billion shares.
- valuation 1
The simple approach is to use the $13.2 billion in shareholder equity that is on the books. This will serve as the minimum valuation of Alcoa. This is about $12.42 per share. This valuation is simply a discounted cash flow analysis that assumes that no free cash flow for all future years.
- valuation 2
So long as management is steadfast in their actions for the long term, shareholders could very well be rewarded. This in large part means that management needs to continue to tightly control capital expenditures going forward just as they have during the current recession. Without tight controls on cap ex going forward, this valuation may be overly-optimistic. Having said this, the average free cash flow for the past 10 years is $364 million. This will serve as free cash flow for year one in this valuation. A low free cash flow growth rate of 4% is used with a discount rate of 9%. These future free cash flows discounted to current value (at a rate of 9%) yield value of about $4.4 billion. Or $4.14 per share. Add this to the $12.42 previously calculated and an intrinsic value of $16.56
- valuation 3
This is the valuation which shows the true potential for Alcoa. This assumes free cash flow of $1 billion for FY2010. It will then grow at 6$ for 10 years and 4% for the 10 after that. A discount rate of 9% is used again. By doing this, a value of $26.9 billion is calculated. This is $25.32 per share.
- valuation conclusion
Alcoa closed at $13.40 on Friday. At a bare minimum, Alcoa is worth $12.42 per share. More realistically, Alcoa is probably worth at least $16.50. And the optimistic view is that Alcoa is worth 25.32. There seems t be only upside potential here.
