Alcoa Split Doesn't Change Our Valuation

After weighing the financial implications of

First, based on the announcement of the split alone, we see no justification to change our long-term profit forecasts for Alcoa. During the related conference call, CEO Klaus Kleinfeld alluded to potential dissynergies that are likely to arise. In aggregate, the two new entities' operations are likely to be supported by a modestly higher degree of selling, general, and administrative expenses relative to current spending, but not enough to inspire a fair value change.

Second, this development supports our view that headwinds facing the upstream businesses have spoiled the appeal of the midstream and downstream segments. We assert that the separation of these entities will attract a new class of investor who will now be able to tap into Alcoa's midstream and downstream growth story without taking on the uncertainty associated with the commodity-facing operations. Unlike an investment in Alcoa's current share class, purchasing shares of the value-add business will allow investors to sidestep China-related concerns, including weak aluminum demand via decelerating fixed-asset investment growth as well as the country's role as a growing net exporter of aluminum.

Third, we caution that investors shouldn't dismiss the potential attractiveness of upstream operations as a long-term, deep-value play. Although Alcoa maintains a middling position on the global smelting cost curve, it occupies an enviable first-quartile position on the cost curves for bauxite mining and alumina refining. With alumina and aluminum prices currently well below our long-term forecasts, the upstream business could be a rewarding turnaround story for contrarian investors with a longer investment horizon.

Spin-Off Set for Later Next Year Alcoa is a fully integrated producer of alumina, primary aluminum, and aluminum products for a variety of end markets, including packaging, automobiles, aircraft, and construction. The company is involved in every step of the aluminum production process, from bauxite mining to the sale of specialized aluminum products.

In September, Alcoa announced that it will split into two companies. The upstream company will include Alcoa's upstream bauxite, alumina, aluminum, casting, and energy operations, and the value-add company will include Alcoa's global-rolled products, engineered products and solutions, and transportation and construction solutions. Management expects the tax-free spin-off to be completed in the second half of 2016.

Although the upstream units have historically generated the lion's share of operating income, Alcoa's management team has made sizable investments to expand the midstream and downstream businesses. This has softened the company's sensitivity to aluminum prices and provided exposure to end markets with more attractive growth opportunities.

When selling primary aluminum, Alcoa's realized average selling price is a function of the prevailing London Metal Exchange spot price as well as a premium to that spot price that is dictated by storage costs associated with the underlying metal. The longer the metal is stored before being delivered, the higher the premium that is ultimately paid by the purchaser.

To further improve its position on the industry cost curve, Alcoa has invested in a Saudi Arabian aluminum production complex as part of a joint venture with the Ma'aden mining company. A fully integrated operation that is believed to be the lowest-cost aluminum production operation in the world, the Ma'aden complex capitalizes on a low-cost natural gas supply to generate meaningful cost savings, as energy represents about one third of Alcoa's aluminum production costs.

Some Cost Reduction, but Not Enough for a Moat Although Alcoa is a low-cost producer of alumina, this is not enough to offset a middling cost position for aluminum production. Additionally, aluminum prices must appreciate significantly for the company to generate positive economic profits. Because aluminum price appreciation depends on Chinese smelters starting to behave more rationally, we don't have enough confidence in Alcoa's ability to generate positive economic profits to award the company a narrow economic moat rating.

Encompassing every phase of aluminum production, which involves the mining of bauxite, the refining of bauxite into alumina, the smelting of alumina into primary aluminum, and the fabrication of primary aluminum into various products for end markets, Alcoa enjoys full vertical integration. The company retains little pricing power, as its core products, alumina and primary aluminum, are largely undifferentiated commodities sold into cyclical end markets. On the cost side, however, Alcoa does appear to have an advantage in bauxite mining and alumina refining. Currently situated at the 25th percentile of the industry cost curve associated with alumina production, management expects the company will graduate to the 21st percentile by 2016 via curtailments of high-cost facilities.

Alcoa has not been able to generate the same degree of cost savings with regard to aluminum smelting, the electricity-intensive process by which primary aluminum is extracted from alumina, although management says its smelting operations should move from the 43rd percentile to the 38th percentile on the industry cost curve by 2016. This improvement is slated to be achieved via productivity gains and the new smelting facility in Saudi Arabia, which is the lowest-cost smelter in the world.

Although Alcoa has made progress reducing costs, the dynamic industry cost curve has also been moving lower. Mainly driven by the closure of high-cost Chinese smelters that make up the high end of the cost curve, China's aluminum industry is gradually becoming more globally competitive. Legacy high-cost facilities in eastern China are being replaced with new facilities in the northwest part of the country that take advantage of low-cost electricity available there. Therefore, as company-specific progress will be partially offset by cost reductions across the entire industry, we do not envision a material change to Alcoa's competitive positioning in the years to come.

Leveraged to Aluminum Pricing Alcoa is highly leveraged to its all-in realized average selling price for primary aluminum. This all-in price is a function of the London Metal Exchange spot price and a regional premium that is a function of how long the underlying metal is stored before delivery. The impact of aluminum pricing volatility on Alcoa's earnings is smoothed to some degree by the fact that while primary aluminum is the output of the primary metals segment, it is an input cost for the global rolled products and engineered products and solutions segments. As a result, although higher aluminum prices are always beneficial for the company as a whole, low aluminum prices benefit Alcoa's downstream segments in a healthy demand environment.

Given that Alcoa enjoys full vertical integration, it is able to exert a greater degree of control over its supply chain than many of its competitors that must secure factors of production from external sources. Recent improvements in the company's downstream operations coupled with enhanced companywide efficiency measures have helped offset weakness in the upstream businesses to produce more stable financial results. Although pro forma adjusted leverage remains high for a cyclical company, we believe Alcoa has sufficient liquidity and borrowing capacity to manage its ongoing debt-service requirements.