INVESTMENT DECISION IN BASIC MATERIALS/ ALUMINUM INDUSTRY: ALCOA VERSUS ALCAN
Introduction
Alcoa and Alcan are the selected NYSE-listed companies to be analyzed. They are the top-two companies in terms of market capitalization and total revenues. They are also among the leaders in short-term and long-term growth. For these reasons, comparative analysis of financial position and performance is on relative equal-footing and the findings will allow potential investors to pursue a more lucrative portfolio. Simply put, when Alcoa and Alcan are the sample companies, investors are assured that they are the benchmark within the market leader’s criteria. It is also useful to note that the business experience of the two firms is also comparable as they are working and polishing the business and the industry as a whole as far as the mid-1880s. Financial data are based on the recent Yahoo! Finance listings and 3-year financial statements of the two firms.
I. Profitability
Alcan exceeded Alcoa with 1.79 points in terms of return on stockholders equity (i.e. in general). The former is more effective in allocating and using the funds of its shareholders. This happened despite Alcoa’s big face value amount in its earnings in 2006. One reason is the multiple growths in earnings of Alcan where Alcoa has only doubled the account. This is concretized by the stable growth of their total equity. It is also observable that financing activities of Alcoa is in continuous decline during the last three years while Alcan is on the reverse direction. On the contrary, Alcoa is pouring its funds on investing activities. In this view, Alcoa may be investing in underperforming or possible growth assets while Alcan is focusing on debt management. As their performances are within the industry average, their difference on this specific ratio has insufficient investment basis.
In terms of net profit margin, Alcan exceeded Alcoa by 0.16 of points. The former has a larger margin that makes its total revenues more relevant to the bottom-line or the amount those investors especially shareholders can receive. Although 2005 provided margin difficulties for both companies due to higher cost of business, they have managed to substantially improve their profit after income taxes (PAIT). However, Alcan obtained the upper-hand because it succeeded to reduce its 2006 cost of sales with increasing sales. Alcoa incurred rise in cost sales. Even so, both companies exceeded the performance of the industry. In terms of the profitability of regular operations, Alcoa overtook 1.39 points from Alcan because of the latter’s move to reduce interest payments for some uncertain motivation.
Investing wise, Alcoa is more profitable in its portfolio that Alcan garnering 0.51 points upper hand in return on total assets. This is a useful finding because both companies have exhibited growth in PAIT, total assets and cash investments and proved that one company has more sound investment decision than the other. Return on common equity, however, is higher for Alcan exceeding Alcoa with 0.80 points. In conjunction with return on stockholder’s equity above, this upper hand of Alcan showed that even if its net return on assets is smaller, it assures that common shareholders (i.e. and preferred stock holders) will receive higher returns insensitive to underperforming investments. This also indicated that Alcan can provide more returns to common stockholders even if preferred shareholders are prioritized.
Earnings per share (EPS) has different scenario between in the two firms. As observed in three-year computation, Alcoa has a more stable and growth of EPS while Alcan substantially jumped to .47 EPS in 2006 compared to .33 and .69 in the last two years. This latter situation is possible for Alcan because it had a drastic increase in earnings in 2006 while Alcoa merely doubled this account. Further, the number of common stockholders of Alcan is reduced from 2005 level to 2006 level by at least 5,000,000 outstanding shares. The net effect, therefore, was stronger that affected EPS. However, even with such substantial increase in EPS, Alcan has the same dividend pay-out ratio compared to Alcoa at 23%. Therefore, Alcan afforded to invest a lot in 2006 due to increase in available operating cash than Alcoa. Even if the dividend payout ratio is the same the share of Alcan shareholders to earnings rise.
II. Liquidity
Alcan’s ability to meet its current financial liabilities is higher than Alcoa having the difference of 2.6 points. Since 2004, the two companies exhibited similar movements wherein the increase/ decrease in current liabilities led to increase/ decrease of current assets. This is an indication that they are financing some of their current assets with current liabilities. Also since 2004, Alcoa and Alcan exhibited continuous decrease in financing activities while increasing its investing activities. Such trade-off is reflected in the relationship of its current assets and current liabilities. Both of the companies derived most of their current assets/ liabilities in trade receivables/ payables and inventories/ short-term borrowings which suggested the vitality of inventory turn-over and collection efficiency. Such weight is concretized by low-levels of cash/ cash equivalents and short-term investments exemplified in the balance sheet of both companies.
The heightened sales performance of Alcan in 2006 is showed by 1.6 advantage over Alcoa in quick ratio. The former inventories are relatively easily sold than the latter; therefore, it did not have to rely much on inventories to pay short-term obligations. This finding assigns to Alcan the initial impression that it has relative strength in coping short-term liabilities. However, in evaluating the aggregate three-year performance of both firms, the Alcoa has higher quick ratio in 2004 and 2005. With this, it can be thought that Alcan’s 2006 performance derived the biggest “disturbance” in its high earnings growth relative to past two years. Such also affected lower inventory levels and higher quick ratio. Further, the increase in trade payables and trade receivable are seemingly related to each other. If this suggests that the payment for trade is derived from receipt of receivable, collection and payment efficiencies should be managed properly.
III. Efficiency
In collection efficiency, Alcoa consistently exceeded Alcan with 2006 figures separating the two companies with 7.3 points. The comparative figures mean that Alcoa receives the actual payment for its credit sales approximately 37 days from the day of invoice compared to Alcan who lagged at approximately 44 days. As a result, the upper hand of Alcan’s in liquidity ratios is tarnished by faster conversion of Alcoa of its inventories to cash. If any, Alcan benefits from having a higher trade receivable account but not on cash and cash equivalents. On the contrary, Alcan has longer grace period in paying for its short-term obligations compared to Alcoa with average payment period upper hand of 51.63 points (i.e. days). As a result, the former situation compensated its relative inefficiency in collection. In this view, the preposition that payment for trade receivables are used to finance existing liabilities grain ground.
For Alcoa, low average payment period (i.e. even below the collection period) can mean two-things; namely, it can have substantial free cash flows or it has risky short-term obligations due to shorter grace periods. The former cannot be supported by liquidity ratios because Alcan took-over the advantage. However, the 2006 reductions in receivables and increases in prepaid expenses and other current assets can reflect that Alcoa has enough cash to pay for its obligations (i.e. even in advance) despite low levels of receivables. However, for the investors, the inability of the company to bargain payment extensions from capital suppliers can adversely affect their returns. This is evidenced by minimal financing activities of Alcoa in 2006 (i.e. from 4 Million to Million) where payments in dividends remained constant since 2004 while long-term debt repayments have a three-year all time low. The funds could have been diverted to pay short-term obligations had diminished the chance of shareholders to receive higher dividends.
In inventory efficiency, Alcoa maintained the 14.4 points edge contrary to Alcan. This means that the former sold more inventories as percentage of total sales. This ratio showed that the substantial increase in sales of Alcan in 2006 did meet the growth expectation of the company leading to inventory surplus, thus, lower inventory turnover. On the contrary, the modest and consistent sales of Alcoa aided the company to accurately forecast the demand for the coming year. Due to this difference, Alcoa maintained higher inventory turnover even if it incurred considerable rise in COGS probably due to volatile price movements of raw materials and prices of its products. The three-year performance of the two firms also showed that Alcoa is consistent on having efficient inventory turnover compared to the near competitor Alcan.
In terms of efficiency in utilizing their assets, the two firms are at par with one another as no difference is derived in asset turnover. Due to this, the need for economies of scale and scope in the industry is evidenced as companies are using this benchmark to sustain substantial costs in heavy industries. However, by digging deeper in asset efficiency, Alcoa exceeded 14.4 points in fixed asset turnover compared to Alcan. This ratio is helpful in showing the manufacturing capabilities and value-adding resources of the firm that investors may view as precious in their decision-making. Alcan may have significant wastage in product defects or its machines have relative shorter performance lives. Labor productivity is also a crucial factor to consider in evaluating fixed assets because the low fixed asset turnover of Alcan can be supported by more skilled and motivated workforce. However, since the industry is capital-intensive, such admonition is difficult to assume rather should be based on actual findings (e.g. fixed asset ratios).
IV. Financial Stability
As Alcan exceeded the debt-to-equity ratio of Alcoa by 0.56 points, it is more leveraged and has higher financial risk. Due to this, the higher financing activities of Alcan can be presupposed to come from debts that it had afford to increased investments and financing activities at the same time. Compared to the same situation of Alcoa also with increased operating cash flows, cash that are used in financing activities have substantially reduced from 2005 levels. This mean that Alcan is using is debt on a rather strategic way while Alcoa can experience relative reduction in sales growth due to minimal financing and investing activities. As both of their ratios are injected with almost the same levels of debt and equity, the financial risk being more attributable to Alcan is justified by effort to increase returns (i.e. bigger/ smaller risks will result to bigger/ smaller returns). Alcoa may be on the brink of undercutting the debt edge.
Even though Alcoa has lower debt-to-equity ratio, its times interest earned or coverage ratio is higher by 3.13 points compared to Alcan. This is a bad signal for the latter because as it is more leverage than the former it would require the ability to pay the interest in order to prevent demise of credit worthiness and even face litigation. Such scenario is apparently avoided by Alcan as it posted a huge difference in financing activities compared to Alcoa. The former used most of its cash from its operations for debt repayments while the latter hardly pay for such account. This approach is consistent with the fact that Alcan undercut interest payments in 2006 compared to 2004 and 2005 while the less indebted Alcoa even intensified its interest payments. The seemingly opposite debt payment strategies of the two companies are eminent. With this, Alcan is on the risk of inability to borrow from creditors which can limit long-term growth of the firm.
V. Horizontal and Vertical Analysis
The initial boost of Alcan’s stocks in the first quarter of 2007 is combined results of good earnings in 2006, increased in aluminum prices, plant expansions, more leveraged business model and European exposure. Due to these factors, such trend is expected to remain over the year and that will offer potential investors above average returns. On the other hand, Alcoa only received a pinch of price increase as it announced divestment of one of its low- margin business area. However, as showed in ratio analysis above, this will trim down the inefficiencies lurking in COGS particularly in 2006 that pulled its net profit margin behind Alcan even with higher sales in absolute amounts and year-on-year growth. Further, most analysts suggested that Alcoa’s price outlook can be directed to a more positive scenario if its assets and investments are less diversified. Due to this, the stake of the company in pharmaceutical and other consumer products are on the verge of re-assessment to assure business success in the future which could undermine its substantial capital expenditures implemented in 2006.
According to corporate leaders of aluminum companies, the industry will have a balance market in 2007. However, the growth in demand will fall from 6.8% in 2006 to 6.7% in 2007 and overall supply will risk 7.8%. As a consequence, even though the supportive status of market indicators, aluminum industry will post less growth in the current year except perhaps from industry-specific strategies and situations. In the vertical industry like steel and iron, a growth company Steel Dynamics can trigger the consolidation trend for steel/ iron and metal industry. Steel/ iron industry is regarded as efficient industry while most of the companies have lower debt-to-equity ratio. As a result, most firms are acquiring diligently using minimal debt financing rather rely on growth revenues to finance them. The implications to the aluminum industry is that it can have customers shifting to steel/ iron and metal industries due to substantial economies of scale and scope. As a result, aluminum companies such as Alcoa and Alcan are expected to intensify the dependence of their customers on their products through continuous innovation and cost-efficient operations.
VI. Portfolio Decision
In profitability, Alcoa has more consistent performance than Alcan making the former more safe investment destination. The substantial increase in sales of Alcan and subsequent increase in costs of Alcoa in 2006 have underpinned the positions of two companies. However, as the industry merely receives positive impact of increase in aluminum price in the 2006 while Alcoa is improving its portfolio, Alcoa is more profitable in the long-term and less risky compared to the short-term and cyclical direction of Alcan. Consistency is also implied in liquidity ratios exemplified by Alcoa where Alcan only took the upper hand in drastic sales success in 2006. Efficiency in collection, inventory and bargaining is payment are also attributed to Alcoa, although as shareholder, it is more advantageous to haggle payment periods of creditors. The plant efficiency of Alcoa also surpassed Alcan even if there are still inefficient areas to develop. Lastly, financial stability is afforded in Alcoa relative to Alcan due to less leverage and higher coverage ratio. As a result, Alcoa is also ready for consolidation threats of the steel/ ore and metal industry as the latter industries are also less indebted.
Appendices
Appendix 1: Manual Computation of Unsearchable Financial Ratios
FINANCIAL RATIOS
AA
AL
2006
2005
2004
2006
2005
2004
I. Profitability
Return on Equity
0.154
0.092
0.162
0.013
0.024
Return on Total Assets
0.060
0.037
0.062
0.005
0.008
Net Profit Margin
0.074
0.048
0.076
0.006
0.010
Gross Profit Margin
0.126
0.090
0.112
0.033
0.037
Earnings Per Share
2.57
1.40
1.49
4.47
0.33
0.69
Dividend Pay-out
0.233
0.425
0.150
1.736
0.864
II. Liquidity
Current Ratio
1.258
1.163
1.284
1.101
1.017
Quick Ratio
0.735
0.711
0.751
0.625
0.580
III. Efficiency
Average Collection Period
37.571
37.345
44.928
41.458
47.505
Average Payment Period
32.200
34.547
83.835
82.772
85.486
Inventory Turnover
2.051
2.034
1.907
1.842
1.877
Asset Turnover
0.817
0.759
0.817
0.763
0.748
Fixed Assets Turnover
2.051
2.034
1.907
1.842
IV. Financial Stability
Total Debt to Total Assets
0.558
0.563
0.614
0.635
0.664
Times Interest Earned
7.938
4.811
6.945
7.356
-0.077
0.673
Credit:ivythesis.typepad.com
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