Operating Segments that Comprise the Bulk of Alcoas Business - Assignment Example

Alcoa Assignment Question Return on Equity a) The Return on Equity (ROE) is calculated as Net Income Average Shareholders’ Equity b) This ratio can be decomposed into three elements by the DuPont Analysis as below (Healey and Palepu, Chapter 5). Return on Equity (ROE) = Net Profit Margin x Asset turnover x Financial Leverage, which is Return on Equity (ROE) = [Net Income / Sales] x [Sales / Assets] x [Assets / Equity] These ratios have been calculated in the chart below prepared from the Alcoa financial data given as part of the case study document. ( in $ millions) 4Q-06 2006 1Q-07 2Q-07 3Q-07 4Q-07 2007 Sales 7,789 30,379 7,913 8,082 7,371 7,349 30,748 Net income 359 2,248 662 715 555 632 2,564 Assets 37,183 37,183 38,803 38,803 38,803 38,803 38,803 Shareholders Equity 14,631 14,631 16,016 16,016 16,016 16,016 16,016 Net Income / Equity 9.81% 15.36% 16.53% 17.86% 13.86% 15.78% 16.01% Net Income / Sales 4.61% 7.40% 8.37% 8.85% 7.53% 8.60% 8.34% Sales / Assets 83.79% 81.70% 81.57% 83.31% 75.98% 75.76% 79.24% Assets/Equity 254.14% 254.14% 242.28% 242.28% 242.28% 242.28% 242.28% Notes to the above chart: i. The quarterly sales numbers are taken as the total third party sales for the six product segments. The total of these third party sales numbers differs slightly from the reported annual sales number. The difference does not make a significant difference to the ROE analysis. ii. The increase in assets from 2006 to 2007 is from Property, Plant and Equipment. Data for quarterly additions are not available. In the chart, the year end assets are applied to each quarter. iii. The increase in shareholders’ equity from 2006 to 2007 is from retained earnings. In the chart, the year end shareholders’ equity is applied to each quarter. c) The ROE for Alcoa has improved in 2007 to 16.01% from 15.36% in 2006. This improvement is from the higher Net Profit Margin of 8.34% in 2007 compared to 7.40% in 2006. However, the assets utilization ratios have become worse. d) The quarterly Net Profit Margins in all quarters of 2007 are significantly higher than the fourth quarter of 2006. The calculated ROE is consequently higher though the assets utilization ratios are worse in 2007 than 2006. e) In the third quarter of 2007, the sales figures are lower than in the previous two quarters. This is due to lower third party sales of all product segments. This has impacted the ROE. Sales in the fourth quarter are at about the same level as the third quarter. The reported net profit for the quarter is higher due to the restructuring adjustment from the agreement to sell the packaging and consumer business of the company. f) The Balance Sheet data shows that the increase in assets is due to major additions in Properties, Plant and Equipment which suggest a major increase in production capacity. Current assets and in particular receivables and inventories are lower in 2007 compared to 2006. Data on capacity utilization would therefore be relevant. Question 2 – Net income of 3 Q- 07 compared to 3Q – 06 Alcoa’s sales in the 3Q – 2007 were significantly lower at $ 7,379 million compared to the previous two quarters which were both around $ 8,000 million. Since Net Profit Margin from sale of products is the main driver for the company’s ROE, the stock market would take the reduced sales figure as the signal of lower ROE for the year. In the previous quarters Alcoa’s stock prices must have gone up on the higher sales numbers from the corresponding quarters of the previous year. Question 3 – Operating segments that comprise the bulk of Alcoa’s business The chart below shows the share of each of the six product segments of Alcoa in total sales and profits.   2006 2007 Sales Value % Value % Total third party sales 30,993 100% 30,715 100% Alumina 2,785 9.0% 2,709 8.8% Primary Metals 6,171 19.9% 6,576 21.4% Flat-Rolled products 8,927 28.8% 9,171 29.9% Extruded & end products 4,419 14.3% 3,246 10.6% Engineered solutions 5,456 17.6% 5,725 18.6% Packaging & Consumer 3,235 10.4% 3,288 10.7% ATOI         Total ATOI 3,551 100% 3,174 100% Alumina 1,050 29.6% 956 30.1% Primary Metals 1,760 49.6% 1,445 45.5% Flat-Rolled products 255 7.2% 200 6.3% Extruded & end products 60 1.7% 109 3.4% Engineered solutions 331 9.3% 316 10.0% Packaging & Consumer 95 2.7% 148 4.7% a) Primary metals with 21.4% of third party sales in 2007 and flat rolled products with 29.9% of sales make up the bulk of Alcoa’s business. Primary metals contributed 45.5% of Alcoa’s after-tax operating income (ATOI) in 2007. This segment is therefore the most important for Alcoa. Flat-rolled products had an ATOI of only 6.3% in 2007. b) The reconciliation between ATOI and Net Income for Alcoa shows that the company’s profits are continually impacted by restructuring and other charges. These have fluctuated between quarters and have distorted the reporting of the company’s real earnings. Question 4 – Alcoa’s pricing limitations for their products a) From an economic perspective Alcoa’s upstream products Alumina and Primary Aluminum are affected by the demand supply equilibrium. Both are commodity products and one supplier can be easily substituted by another. Global aluminium demand rises gradually whereas new capacities are added in major steps. New capacities cause a short-term oversupply position with prices dropping. An economic recession causes the demand for aluminum to drop and prices come under pressure. Since aluminum capacity addition is a long gestation project, Alcoa would have early information on the potential changes to the demand-supply equation and would be able to plan ahead. Alcoa would also have some flexibility in pricing in certain parts of the world to the extent of the transportation costs from the production centers to the markets of consumption. b) The downstream products such as Flat-rolled products, Extruded & end products, Engineered Solutions and Package & Consumer have the economic characteristic of a perfectly competitive market with many suppliers each with an insignificant market share. The investments needed to manufacture these downstream products are low in comparison to the upstream smelting facilities to make alumina and primary aluminum. Alcoa’s ability to price their products would be limited by the competition. Alcoa would have little flexibility in pricing the downstream products. Question 5 – The basis for Alcoa’s ability to compete Alcoa’s ability to compete is based on the industry structure. The upstream alumina and aluminum production is a commodity industry but with high barriers of entry due to high investments, access to raw materials and technology. The downstream products such as flat-rolled or extruded products and engineered solutions and package & consumer products have many competitors and low entry barriers (Healey and Palepu, Chapter 2). Alcoa’s ability to compete in the upstream alumina and primary aluminium production would be based on driving costs of production down. The major elements of cost in this industry would be the royalties for bauxite ore extraction, the amortization of capital costs of the smelter plant and access to low cost energy which is a major component of the cost of aluminum production. Alcoa due to its size and dominant position in the industry would be able to secure long term mining rights at favorable prices to control the cost of bauxite ore. This ore can be beneficiated (concentrated) and transported to the smelter site which would typically be sited where a low cost energy source is available. Alcoa would continuously invest in upgrading efficiencies at the smelter by modernization. The Aluminum smelting process causes environmental pollution issues and Alcoa can lobby with local governments to prevent competitors from setting up smelters close to their own locations. To compete against competitors such as Rusal with access to low-cost Hydro energy, Alcoa would have to depend on the transport costs to consumers being higher and the risks associated with a distant supply source. For downstream products, Alcoa’s ability to compete would be dependent on their offering products different from their competitors. These could be in the form of aluminum alloys better suited for specific applications such as automobile bodies or food packaging. For the building construction industry Alcoa could offer more intricate extrusions or sections with higher strength than their competitors. Alcoa could also focus on long term supply contracts with customers such as the auto body industry or the beverage can industry to lock out the competition. Reference: 1) Healey, P.M. and Palepu, K. G., (2012). “Business Analysis & Valuation: Using Financial Statements”, 12th Edition, Cengage Learning. Read More