This is part two of my recent commentary on Alcoa. The first part was Alcoa and its CEO. In this part, I will concentrate on the conference calls from 2009 to 2010 and see what direction the business has been taking since the financial crisis.
To better understand the situation, let me put here the chart for Alcoa and Aluminum prices.
Fig 1. Price of Aluminum
Fig 2. Alcoa, stock chart.
Something which immediately jumps from these pictures is the similarity of the graphs above. It is not very far-fetching to assume that this similarity is not going to go away at the moment. But for now, let us not get side-tracked by tangential discussion.
The year 2008
Looking at the 2008 shareholder letter by the then chairman and retired CEO Alain JP Belda we see how the precipitous drops in the Aluminum prices effected Alcoa during 2008. The Aluminum market soared to an all time high in Jul 2008, followed by the fastest drop in price and customer demand in history.
The smelting process for Aluminum is very power intensive. To put it in perspective, one tonne of aluminum requires the same amount of electricity as an average family uses in 20 years. It is very important to have cheap electricity and the best way to do it is to produce it yourself. Hence, the immediate action for Alcoa was to secure power and that too cheaply. Alcoa succeeded in doing this and 80% of the smelting power was either self generated or covered by contracts that lasted at least through 2028.
Alcoa exited the packaging and the consumer business (one of the trademarks of the new CEO of getting out of low margin ventures). It acquired two high growth fastener businesses and got out of one of its non-core soft alloy extrusion business by swapping it with two smelters in Norway, making it the largest aluminum producer in the world (once again).
The CEO letter additionally gives us a clear vision of Alcoa from his own eyes. Kleinfeld thinks that producing Aluminium is a great business with high growth (nearly 6%) and he supports it by several statistics. In particular, the population growth, need of lightweight transportation, and infrastructure development.
We also see that the CEO wants to concentrate on generating cash from Alcoa. As we saw in the first article, Alcoa’s cap spending was out of sync with its operating cash flow and Kleinfeld recognized that Alcoa cannot do this for long. It must use the money it generated to fuel its expansion. We will start seeing the results in 2009 and later.
The year 2009
In the year 2008 Alcoa had an OCF of $1.2 billion and cap-ex of $3.4 billion. This leads to a negative FCF of around $2.1 billion. Comparing it to 2009 we have a OCF of $1.36 billion and cap-ex of $1.6 billion. The FCF is only a negative $257 million. The improvements were achieved by cutting down on several fronts at once.
The first target was to reduce the procurement costs (in obtaining raw materials, equipment and supplies to the site) by $2 billion until 2010. Out of this, $1.5 billion was to be reduced in 2009. Alcoa saved $1.998 billion in 2009 itself.
The second obvious place is to reduce the cap-ex and bring it to something which is more in line with the OCF. The management looked at the CapEx into two parts. The sustaining CapEx is the expenditure in managing and upgrading the currently owned facilities, while the growth CapEx is for acquisition or building of new facilities. The target was to bring the sustaining CapEx to $850 million. In 2009 the sustaining CapEx for Alcoa was $1.25 billion. Which compared to 2008 is a great achievement. The effect on the balance sheet of Alcoa can be seen in the figure below.
Fig 3. Alcoa’s debt and equity
The year 2010
From Q1-2010 conference call.
I’ll remind everybody that we’ve got a target to be free cash flow positive in 2010. All of our cash sustainability initiatives are centered on driving free cash flow and structurally improving our ability to drive bottom line growth.
In 2010, we also hear the management talk about China a lot more. In Q1, China was producing more aluminium than it was consuming. The management expects that this is only temporary. With the growing urbanization in China the electricity is a scarce resource and Chinese will try to not have too many smelters running.
What we’ve seen here with China in the worse of all downturns, they have been very, very good in managing their supply and demand balance and they’ve been very agile and very, very fast in responding here. So, I would be very sure that this surplus is really only temporary.
We also hear about how the management thinks of the Aluminium business and the growth in it.
I think that when you look at reports, there is almost a consensus in the world that you will have probably over a long period of time 6% annual growth. If you have 6% growth in this market, this would actually mean that we would have or somebody else would have to build 2.3 million tons per year of new capacity. This would mean three new modern smelters per year. This would mean four new Sao Luis expansions per year; it will mean 20 new gas turbines per year or for those of you who love hydropower two new Hoover dams built every year and it would means equal 30 billion that would have to be put into the ground as infrastructure investments.
By looking at that, I am pretty confident that the supply/demand situation is heavily biased towards the tight situation, because it’s not very likely that this will be doable in this world, right? Therefore, I am pretty convinced that we will continue to see pressure on the prices here going forward.
In Q2 the prediction of the management about China is already coming to fruition. China’s surplus has been reduced from 400,000 tons to 200,000 tons. The company acquired Traco which is a manufacturer of windows for commercial buildings and fitted nicely with Alcoa’s construction portfolio.
Alcoa’s Russia segment is now having positive after-tax operating income for the first time and China facilities are increasing production.
Let's now review our progress against our 2010 operational improvement targets. Procurement, our target $2.5 billion; we are at $1.4 billion now. Overhead, target $500 million; we are at $311 million now. Total CapEx, target of $1.250; that includes $250 million for Ma'aden, we've spent $514 million.
In Q3, the CEO talks about the value driver.
The next value driver that is really well underway is Ma'aden. This will be the lowest lost refinery that exists. It will start by end of 2014. It's, as I said, well underway. We expect the project financing to be completed by the end of this year.
Alcoa in this quarter changed the pricing structure. A small discussion from the conference call is below. The end result being that Alcoa stopped hedging its Aluminium contracts for better transparency. This will further drive the stock price to closely follows the price of Aluminium.
We said that we are changing the pricing mechanism and we do that as we speak. I mean to the spot index and I talked about Platts and I talked about the first contract that we have concluded, which basically are a monthly average stock price based on a number of indexes and we use a basket of indexes. We believe that that really better reflects the different cost structures that we have in Alumina and with caustic, ocean freight, oil and gas and coal in there compared to what we seen in LME. It gives more pricing flexibility. It's more reflective of the short-term volatility. The concept I think is very well understood by our customers. In the mean time, we are concluding business on that basis, and really – I mean, it's good that Platts has added this index. On a daily reporting it's even more differentiated than what we currently use, it was very transparent to that. But at the same time, I think, you have to be very clear. Every pricing change takes a while until it gets done. We have about 20% of our volume coming up and really take that as an about number, 20% of all volume in alumina coming up every year. So it will take a while until this will ripple through the system, but we are concluding contracts as we see on that basis.
From the CEO letter of 2010, Alcoa met all cash sustainability targets (Fig 4). The liquidity positions continue to strengthen and for the first time since 2004, Alcoa is FCF positive again (Fig 5).
Fig 4: Cash targets
Fig 5: Improvement abound
At the same time, Alcoa did not compromise on values and safety. I will let the CEO have the final summary.
So, one other thing that makes me really, really proud and I'm pretty sure that I speak for all Alcoans that in the downturn it's so easy to compromise your values and that didn't happen. And the safety side, the safety performance is probably a very decent indicator. I've just pulled out here on the left hand side one indicator is the lost workday incident rate and as you can see there, I mean, the performance is really good. I mean, we improved another 20% from an already very low base in the year before. I mean, to put that in perspective, 82% of all Alcoa locations had no lost workday in 2010, never had that before and actually it's, I mean, I applaud everyone who runs those locations for the continuous focus on safety. This also means that 48% of all of our locations had no recordable incidents.
In the next article I will look at the year 2011 and the current plunge in the price. I will also have more details on the profitability of the company, its balance sheet at the moment and the shareholder returns.
Additional disclosure: The data and some of the quotes are taken from the conference call and the annual reports of Alcoa.