AA - Alcoa: Hold This Major Aluminum Producer

2023-12-26 15:39:51 ET

Summary

• Alcoa is a vertically integrated aluminum producer with facilities across five continents.
• The aluminum market is expected to be balanced in 2023-2024, with strong consumption growth in the green energy sector leading to a market deficit.
• Alcoa's total revenue is projected to decline in 2023 but increase in 2024, driven by a recovery in aluminum prices.

Investment Thesis

Alcoa ( AA ) is one of the largest international vertically integrated aluminum producers. The company's facilities are spread across five continents. The main production of raw materials (bauxite) is located in Guinea and Australia, while refining takes place in the USA and Northern Europe.

We expect the aluminum market to be balanced in 2023-2024, and then, strong consumption growth in the green energy sector will lead to the market deficit without a substantial hike in aluminum prices. We expect aluminum prices to be at $2 294/t (-15% YoY) in 2023 and $2 438/t (+6% YoY) in 2024. The company's total revenue in 2023 will decline by 16% YoY to $10 431mln due to lower raw material prices, while in 2024 the revenue will be $10 987mln (+5% YoY).

We expect the company to report a 70% YoY drop in EBITDA to $676 mln in 2023 and a 111% YoY increase to $1 425 mln in 2024, driven by a recovery in aluminum prices. Rating is hold .

The Industry Outlook

Before looking at the industry and Alcoa company, let's briefly review how aluminum is produced.

The process of making pure aluminum is divided into 3 steps:

• Bauxite mining. Bauxite is a type of sedimentary rock that contains aluminum particles (aluminum is not found in pure form in nature).
• Production of aluminum oxide via the Bayer process (a method of producing alumina from high-quality bauxite). To separate aluminum oxide from bauxite, the sedimentary rock is exposed to caustic soda at extreme temperatures.
• Obtaining aluminum from aluminum oxide through Hall-Eru technology (electrolysis process). This extraction method is based on the fact that when aluminum oxide is dissolved in molten cryolite, pure aluminum is settled by electrolysis. The aluminum is drained, then fluxed and degassed in a reflection furnace and poured into molds as slabs.

The main global production of aluminum comes from China, which accounts for more than 60% of the global metal market. Significant increase in production occurred at the beginning of the 21st century, due to the active growth of the Chinese industry.

However, despite the acceleration of smelting in 2022, China will be the main constraint on production ramp-up after 2030 due to the 45 mt of annual aluminum production limits imposed by environmental regulations.

In turn, the major demand for metal is concentrated in the development and transport sectors.

And demand will slightly exceed supply, CAGR of supply is estimated at 2% until 2029 against demand growth of 3% annually. The major increase in demand will come from transport (substitution of vehicles from internal combustion engines to EVs) and electricity grids due to the upcoming renovation cycle.

According to the latest data from Fitch , demand for aluminum outside China was not as strong as previously expected. In addition, China continued to ramp up aluminum production due to capacity recovery resulting from improved energy supply amid a significant reduction in electricity costs and sufficient water levels in reservoirs. As a result, we expect the aluminum market to be balanced during 2023-2024, and thereafter, strong consumption growth from the green energy sector is likely to lead to a market deficit without a proper increase in aluminum prices.

We expect aluminum stocks to be at 5.9-6.2 if measured in weeks of consumption in 2023-2024. Then stocks are likely to deplete without substantial growth in aluminum production.

We maintain our aluminum price forecast at $2 294/t (-15% YoY) for 2023 and $2 438/t (+6% YoY) for 2024. In the event of balance, we expect average producer margins at the 80th percentile to be 15% and producers at the upper end of the cost curve to operate at ~0 margins.

Alcoa

Alcoa - is one of the largest international vertically integrated aluminum producers . The company's facilities are spread across five continents. The main production of raw materials (bauxite) is located in Guinea and Australia, refineries - in the USA and Northern Europe.

The company's main revenue is derived from the sale of primary aluminum (>50% of revenue), and it also sells aluminum oxide, bauxite, and electricity from its own power plants in South America and North America.

As we mentioned earlier, primary aluminum production is located in the EU and the US, with production facilities in Australia, Brazil, and Canada. The total metal production capacity including effective ownership interest in the projects for the last 2 years totaled 2968 kt per annum. However, in early 2023, the company announced the permanent closure of the Intalco plant in Washington State with a nominal capacity of 279kt per annum. Therefore, we expect total nominal capacity to remain at 2,689kt per annum (including ownership interests) over the forecast horizon.

The company almost never deploys all of its metal production capacity, leaving room for ramp-up in high-demand conditions. The average capacity utilization of the plants from 2017 to 2022 is 72%. In the forecast period, we expect capacity utilization to remain consistently above the 5-year average due to the ever-increasing demand for metal, and the resulting increase in shortages over the entire forecast horizon. Thus, we expect 2023 output to reach 2062 kt (+2.6% YoY) and 2024 output to remain at 2062 kt. The growth in capacity utilization is also due to the disposal of Intalco.

In turn, the company is selling everything it produces and is actively reducing its inventories. We expect total sales to third parties to reach 2 447 kt in 2023 (-5% YoY) and 2 575 kt in 2024 (+5% YoY) on the back of metal demand recovery.

Historically, the company has sold raw materials at a market of $300/t-$450/t, but during the heightened political situation in Eastern Europe, the premium widened to $735/t in 2022 as consumers switch to aluminum from Western players. However, we expect the premium to return to its historical level as early as 2024, reaching ~$535/t in 2023, before declining to $356/t in 2024 amid a resumption of aluminum commodities purchases from Russia due to increasing supply shortages.

Hence, we expect the division to generate revenues of $6827 mln (-23% YoY) in 2023 and $7 194 mln (+5% YoY) in 2024 amid demand recovery as well as expected price growth.

In contrast to finished product capacity, the main component for smelting the metal - alumina - is produced in Australia, Brazil and Spain. The company has no plans to launch new projects or increase effective ownership stake in existing mines, so we expect nominal effective aluminum oxide production capacity to remain at 13.8 mt per annum.

In contrast to the aluminum smelting segment, Alcoa showed nearly 100% mine utilization due to the ability to sell aluminum bauxite to more efficient players when prices are low.

As we stated earlier, Alcoa is vertically integrated and is sourced from its own mines. The company sells surplus aluminum oxide to companies with low resource base. We expect shipments to reach 12.6 mt (-4% YoY) in 2023 and 12.7 mt (+1% YoY) in 2024 as the company increases aluminum smelting at its facilities.

The cost of aluminum oxide for both third-party and intersegment sales is close to the market price. We expect average selling prices to third parties to decline by 6% YoY to $360/t in 2023, and in 2024 we expect a recovery of 10% YoY to $396/t.

The cost of aluminum oxide for both third-party and intersegment sales is close to the market price. We expect average selling prices to third parties to decline by 6% YoY to $360/t in 2023, and in 2024 we expect a recovery of 10% YoY to $396/t.

It is also worth mentioning that since the beginning of 2023, the company has combined the segments of aluminum bauxite and aluminum oxide production. ~90% of the bauxite produced is used for internal production of aluminum oxide and the rest is sold, which accounts for ~16% of revenue from aluminum oxide sales.

Financial Forecast

Thus, the company's total revenues will decrease by 16% YoY to $10 431 mln in 2023, and the 2024 revenue will be $10 987 mln (+5% YoY).

The total costs of the aluminum business are made up of 3 main components: aluminum production costs, aluminum oxide production and aluminum bauxite mining costs, and other operating costs.

In order to forecast costs it's necessary to examine the components of aluminum production. The main input for aluminum production is aluminum oxide, which requires ~1.9t per 1t of aluminum.

In terms of cash expenses, we also observe that aluminum oxide accounts for more than 30% of costs. We should not forget that non-ferrous metal production is an energy-intensive process, which is also reflected in the cost structure (electricity accounts for 22% of cash costs).

We expect the average cost of aluminium oxide for Alcoa to be $402/t in 2023 and $418/t in 2024. The electricity cost forecast was taken from the EIA, which forecasts an average industrial electricity cost to be 8.1 cents/kW in 2023 and 8.2 cents/kW in 2024.

Thus, aluminum production costs will average $2607/t (-8% YoY) in 2023 and $2587/t (0% YoY) in 2024 due to the stabilization of aluminum oxide prices. The company will continue to operate at a relatively low gross margin level (3-5%) in the forecast period.

In order to forecast costs we determine components of aluminium oxide production. The main input for aluminum production is aluminium bauxite, which requires about 3t per 1t of aluminum oxide.

In terms of cash expenses, we see that aluminum bauxite and caustic soda account for about 40% of the costs. We should not forget that, like aluminum production, aluminum oxide production is an energy-intensive process, which is also reflected in the cost structure (gas and electricity account for 24% of the cash costs).

Aluminum oxide production costs will average $399/t (+19% YoY) in 2023 and $373/t (-9% YoY) in 2024. The company will continue to operate at a fairly low gross margin level (3-5%) during the forecast period, as well as in the aluminum segment.

Due to the high level of production costs, it will exhibit a low gross margin of 7% in 2023 and 13% in 2024.

We expect the company to show a 70% YoY drop in EBITDA to $676mn in 2023 and a 111% YoY increase to $1425mn in 2024 due to aluminum price recovery.

We expect the company to report an FCF loss of $70 million in 2023 due to continued low aluminum prices and ongoing business restructuring costs and then expect the company to gradually enter FCF earnings as early as 2024.

Valuation

Rating - hold . Target price - $36. Our valuation of the company is based on 2025 due to the expectation of price stabilization in the global aluminum market. The target price of $36 was derived by discounting the 2025 fair value at a 13% annualized rate of return.

Alcoa stock is a bet on aluminum price movements. The fair value of the company's shares changes is following small movements in raw material prices due to high operating leverage. We have provided a sensitivity table for aluminum prices and Alcoa's target share price on the valuation page.

Conclusion

Alcoa is the largest aluminum and aluminum oxide holding company. The Company successfully balances the phases of aluminum demand cycles by increasing or decreasing its effective ownership on its facilities/fields.

Alcoa is another raw materials case that could be a winner as a result of an active energy transition and depletion of existing world reserves.

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Alcoa: Hold This Major Aluminum Producer