Formed in 1888, Alcoa Inc. (AA), a Pennsylvania-based corporation, is among the world's leading producers of primary and fabricated aluminum and alumina. It involves the technology of mining, refining, smelting, fabricating and recycling of aluminum. The company runs about 350 facilities in approximately 41 countries.

The principal business of Alcoa's Flat-Rolled Products segment is the production and sale of aluminum plate, sheet, foil and hard alloy extrusions. These products serve the packaging and consumer, transportation, building and construction, distribution, aerospace and automotive markets. The company's Engineered Products and Solutions segment is engaged in the production and sale of titanium, aluminum and super alloy investment castings, forgings and fasteners, aluminum wheels, integrated aluminum structural systems and architectural extrusions. These products serve the aerospace, automotive, building and construction, commercial transportation and power generation markets. The company also has bauxite-mining interests in Australia, Brazil, Guinea, Jamaica and Suriname. It has a collaboration agreement with CIMC Vehicle (Shandong) Co. Ltd. to design and develop an aluminum fuel tanker trailer for the Asian market, besides a strategic cooperation agreement with the Peoples Government of Henan Province in China to jointly establish projects for the fabricated and primary aluminum industry.

Acquisition and Divestures

Alcoa World Alumina LLC (AWA LLC), a majority-owned subsidiary of Alcoa and part of Alcoa World Alumina and Chemicals, acquired a BHP Billiton (BHP) subsidiary that holds interests in four bauxite mines and one refining facility in the Republic of Suriname. This acquisition strengthens Alcoa's presence in Suriname and supports its overall growth strategy. In this transaction, AWA LLC received the direct ownership of the BHP subsidiary and added 993,000 tons of alumina refining capacity to Alcoa's global refining system.

Alcoa also owns 100% of Elkem's aluminum business. Elkem is one of Norway's largest industrial companies, and one of the world's leading suppliers of metals and materials. Elkem includes aluminum smelters in Lista and Mosjoen, Norway, with a combined output of 282,000 tons and the anode plant in Mosjoen in which Alcoa already holds an 82% stake. The addition of the two smelters and the anode plant (supporting the Norwegian and Icelandic operations) strengthen Alcoa's leading position within the aluminum industry.

Alcoa recently divested its wire harness and electrical portion of the Engineered Solutions business to Platinum Equity. The wire harness and electrical portion generated sales of $1,114 million in 2008 and, at the time of the divestiture, had operations in 13 countries employing approximately 16,200 employees. Alcoa has also divested its Global Foil and Transportation Products Europe businesses in order to streamline its portfolio.

REASONS TO BUY

Alcoa should benefit from the improving outlook for aluminum and alumina prices. China and India are undergoing rapid industrialization. Both of these factors are positive for underlying aluminum demand. We expect aluminum demand to increase over the next three years, outstripping supply growth. As a result, the aluminum market is likely to see deficit for a prolonged period. This provides a backdrop supportive of high alumina and aluminum prices.

Alcoa's downstream business volume has rebounded, due in part to higher U.S. capital spending, particularly in the aerospace, commercial vehicle and non-residential construction markets. We expect the combined effect of higher price realizations and rising shipment volumes of downstream products to boost growth. The company is also committed to acquiring downstream assets in faster growing economies. Alcoa has recently started a flat-rolled product facility in Borhai, China to serve the Chinese domestic lithographic, transportation, electronic and packaging market. In Russia, Alcoa has commissioned the high-quality coated sheet line in the Samara facility to serve the packaging market. Alcoa is the only domestic can sheet producer in Russia.

We are impressed by Alcoa's ability to stay focused on its cost reduction target. Alcoa's cost-cutting efforts have resulted in overhead cost savings of $375 million and raw material procurement savings of $1.61 billion in the first nine months of 2009. We believe that cost reduction efforts are, to some extent, offsetting the negative impact on profitability from higher energy and raw material costs. Additionally, the company is making good progress in divesting underperforming assets through its restructuring program. For the current fiscal year, Alcoa has indicated that the company is likely to generate $320 million in cost savings by eliminating 22,200 positions globally.

We are also optimistic about Alcoa's long-term growth projects in China, Australia, Jamaica, Suriname and Brazil. Demand from these countries is expected to increase its alumina and aluminum production capacity while lowering operating costs. The company is expanding its Alumar Refinery, north of Brazil, which has a capacity of 2.1 million tons of alumina. The Juruti mine in Brazil would produce about 2.6 million tons of bauxite, post-expansion. We expect such expansions to drive Alcoa's top line.

REASONS TO SELL

The aluminum industry generally is highly cyclical, with prices subject to worldwide market forces of supply and demand and other influences. Alcoa is subject to cyclical fluctuations in LME prices, general economic conditions and aluminum end-use markets. The greatest risk to our Neutral recommendation would be a further deterioration in aluminum price. If there is any significant decline in aluminum prices in 2010, Alcoa is likely to fall short of our expectations. If the global economy worsens further, demand for aluminum and aluminum-based products would also likely slow, thereby pulling down Alcoa's shipments and revenues.

We expect rising energy and raw material costs to continue constraining margin expansion. The company will pay more to purchase important supplies of oil, natural gas, caustic soda, carbon and resin. Higher-than-expected input costs or unplanned outages could negatively impact Alcoa. If the company is unable to execute its restructuring plans and proposed cost cuts successfully, this could also have an adverse impact on the share price performance.

Beyond cost concerns, currency issues are negatively impacting Alcoa's operating results. Management believes Alcoa's operations in Australia, Canada and Europe will be negatively impacted by the appreciation of these home currencies versus the U.S. dollar.

Alcoa's free cash flow position is likely to worsen considerably due to higher capital expenditure on growth projects. While these projects could have longer-term benefits, they have depressed Alcoa's return on invested capital (ROIC) in the interim. The company reported negative return on equity during the last six-month period. Alcoa's net cash position (long-term debt including current portion less cash) is a deficit of $9.2 billion or $9.4 per share as of September 30, 2009.

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Buy Rationale:

Alcoa ended 2008 with $26.9 billion in sales. Today, it trades with a market cap of around $4.8 billion and enterprise value of $13.6 billion (equity value plus long-term debt). In today's market, $5.6 of sales can be had from a $1 of invested capital. In 2003, it cost $1.55 per share to buy a single $1 worth of sales. Nearly nine times more sales can be had today for an investment in Alcoa's business than just a little over five years ago. Now I don't know about you, but I've recently started some businesses and let me assure you driving sales is no small thing. It costs money. Lots of it. When that amount of sales can be acquired on a stock exchange (no work required on my part other than a few mouse clicks), I get interested. Now I'm not naive enough to believe that given the slowdown in the economy that Alcoa's sales going forward, at least for this year, will resemble anything near 2008 levels. But even if they are cut in half, you are still getting a couple of dollars of sales for every dollar invested. In "ordinary" times (say...a growing economy), it is rare to come by even a dollar of sales for a dollar of invested capital.

In 2003, Alcoa had a market cap of $32.4 billion on sales of $21.5 billion. Long-term debt at the time was $7.22 billion. Since then, LTD has risen $1.55 billion to $8.87 billion. FFO were $1.2 billion and interest expense is $407 million a reasonably comfortable 3 to 1 ratio. Most debt covenant's interest coverage ratios are around 1. With gross margin running around 17%, even if sales declined to 2003 levels, Alcoa would still more than likely meet their interest obligations on long-term debt. Yet the stock is trading at a price that is roughly 16% the share price it was trading at in 2003.

In 2003, Alcoa had a net tangible book value (book less goodwill) of $5.6 billion giving the company a price to book ratio of 5.8X. At the end of 2008, it stood at $6.1 billion or a price to book ratio of 0.80X.

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