Deep Dive: Alcoa (AA)
Attractive industry demand & supply, sound balance sheet, cash flows, and improving returns to shareholders
Which versatile metal is positioned to enjoy strong secular demand over the coming decade from vehicle electrification, renewables, and other de-carbonization use cases? We think investors should become familiar with aluminum.
This report will explain our thesis on Alcoa - the largest North American aluminum producer - with a focus on understanding the aluminum industry fundamentals and supply & demand dynamics. Commodities have regained the spotlight since the start of the year, as investors scrambled to understand whether we are in a world headed towards a structurally higher pricing environment. If you are looking for ways to gain exposure to commodities in your portfolio, perhaps this may be a good place to start.
We think aluminum has attractive medium to long-term fundamentals, and believe the recent pull-back in prices is a good opportunity to accumulate on weakness. Aluminum is positioned as the metal of the future, benefitting from broad-based demand growth driven by de-carbonization trends. Demand is just one side of the equation however, as commodities investing cannot produce good returns without orderly supply to support prices. We take a close look at the major aluminum producing markets and examine the structural constraints to global supply. Building on top of the industry discussion, we highlight the case for an investment in Alcoa by examining the company’s assets, operations, optionalities, and valuation.
Table of contents
Aluminum Industry fundamentals
Industry 101 to get you up to speed in 10 minutes
Production process, industry structure, energy use & emissions, aluminum pricing
Global demand and supply
Long-term demand growth drivers - examining usage across industries including EV and de-carbonization demand
China’s significantly lower supply trajectory expected in the coming decade (a marked departure from the past)
Structural constraints in other markets (Europe, Russia) - will not resolve in the near-term
US aluminum industry
Overview of the current state - industry players, domestic production vs. imports, policy
Decline of the US aluminum industry, its strategic role and opportunities in re-shoring
Alcoa
Global smelting portfolio, including the economic significance of renewables power source conversion
Recent operational highlights - capacity curtailments, restarts, expansions
Optionalities, including ELYSIS joint venture
Alcoa’s investment cases summarized
Valuation
Alcoa’s P&L forecast at different LME prices
Calculating the enterprise value
Scenario-based approach
Historical and peer multiples
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Aluminum industry fundamentals
First, we cover some basics of aluminum production, supply chain, industry structure, and pricing that are prerequisites for understanding the business.
Extraction, refining, and smelting
Bauxite, a reddish brown rock mined just meters above the surface of Earth, is the main source of aluminum containing about 15-25% aluminum content. 90% of global supply of Bauxite comes from tropical/subtropical regions, most notably Australia, Guinea, Vietnam, Brazil, and India. There are 29 billion tons of known bauxite reserves on Earth, and at the current rate of extraction the reserves can last more than 100 years. But there are also reports of vast undiscovered reserves that may extend it to 250-340 years and beyond. As an element, aluminum is abundant.
Bauxite is fairly widely distributed across the globe, and because it also sits close to the surface, extracting it is also relatively straightforward. The bottleneck with aluminum is not in the extraction, but in the production (refining and smelting). Production involves two main steps: alumina refining, which converts bauxite ore into aluminum oxide (called “alumina”), and aluminum smelting, which converts alumina to pure aluminum. Four tons of bauxite is refined into two tons of alumina, which is then smelted into one ton of aluminum. To give you a sense of the value-add during each production stage, the prices (Alcoa’s third-party realized prices in 2Q) were $3,864 for a ton of aluminum, $442 for a ton of alumina, and $46 for a ton of Bauxite.
Bauxite is refined into alumina with what is known as the Bayer Process. Bauxite is crushed, grounded, then mixed with heated solution of caustic soda, creating a hot slurry. It is then filtered and dried to produce Alumina in the white powdered form (illustrated below).
Aluminum is then created by running huge amounts of electricity through alumina solution in a smelter. For the scientists out there, alumina (aluminum oxide or Al₂O₃) is just aluminum atom bonded to oxygen. To get aluminum in its pure form, oxygen needs to be separated by electrolysis, and that’s where the need for electricity comes in. The energy requirement during this step is enormous, typically running at about 30-40% of total production cost. It is this massive energy requirement that is the industry bottleneck. The most important thing for Aluminum smelters is being located in a region with powerful and stable, yet low cost, and preferably renewable source of energy. This is important, and will come up again and again in this report.