Alumina: Down then up?

Since recommending Alumina on 05 Oct 11 (see Alumina: lousy business, hot opportunity? (Speculative Buy - $1.44) the share price has fallen 34%. The drop may be rollercoaster-steep but it’s neither irrational nor unwarranted.

The main culprit is the alumina spot price, which has fallen from over US$400 a tonne 12 months ago to about US$300 a tonne today (see Chart 1). Aluminium prices, which still determine prices for the bulk of production, have similarly declined from over US$2600 a tonne 12 months ago to US$2000 a tonne today.

Unsurprisingly, this has hurt the industry. With a glut of aluminium and rising energy costs, structural change threatens profitability in the aluminium sector. As explained on 05 Oct 11, structural change for the alumina market also looms. This time the shift could be a force for good.

China’s demand for aluminium has created a new, traded bauxite and alumina market which AWAC, 40% owned by Alumina, dominates. AWAC holds the best bauxite and alumina assets in the industry. Yet all metrics of profitability suggest this is a lousy business; return on equity, for example, is just 4%.

In lean times, a capital intensive and cyclical business is no bad thing. To build new bauxite or alumina capacity requires immense amounts of capital because, as with coal and iron ore, infrastructure is needed to bring new supply to market. Low prices and capital intensity join forces to restrict potential supply.

Cyclicality, a terrifying prospect during booms, offers salvation in the bust. Low prices are forcing supply shutdowns that will eventually result in higher prices.

Alcoa announced it would cut 390,000 tonnes of production immediately and Norsk Hydro has also cut back. More producers are likely to follow. More than half the industry is losing money on every tonne of alumina they sell.

With operating margins of US$35 a tonne, AWAC is faring better than most. Less than six months ago, operating margins were twice that and, during the peak of the boom, they exceeded US$100 a tonne.

This highlights the great boon awaiting Alumina shareholders: Just as AWAC has huge operational leverage to lower alumina prices, so it does to higher prices.

Prices to rise

With aluminium capacity continuing to expand without corresponding increases in bauxite or alumina capacity, alumina prices should rise. Alumina has traditionally been priced as a percentage of the aluminium price. There’s been little incentive to invest in additional output because prices reflected aluminium costs, not alumina costs.

That’s now changing. With alumina priced according to its own demand and supply fundamentals,  prices must increase to encourage new supply. That was the premise of the original investment thesis and it remains sound.

The best way to value Alumina is with reference to its ‘look-through’ value. The company’s sole asset is a 40% stake in AWAC. Alumina therefore has a notional call on 40% of the equity in that business, currently worth US$3.3bn.

Short term pain

Adding net debt of $470m to Alumina’s market capitalisation of $2.3bn delivers an enterprise value of $2.8bn. That means Alumina is trading under the equity value of its AWAC stake, suggesting a degree of scepticism regarding the value of the asset or the returns from it.

Scepticism in both cases is unwarranted. AWAC operates in the lowest cost quartile in the industry (see Chart 2). It is the single largest producer of bauxite and alumina and stands to gain enormously as alumina prices disconnect from aluminium. Returns today reflect low prices, but they should rise with alumina prices. These assets, irreplaceable and strategic, are worth more than book value, not less.

The best time to invest in a business that is capital intensive and cyclical is when the industry is struggling to make money, output is being cut and investors aren’t interested. Alumina fits that recipe to a tee. The short term may prove painful but patience, that most useful of tool to genuine long term investors, should be rewarded.

Alumina remains a speculative situation so allocate no more than 2% of a risk tolerant portfolio to it. SPECULATIVE BUY.