Alumina: For the bold and the patient

Alcoa’s second quarter results confirmed what everyone has long suspected; the aluminium industry is in dire form. Alcoa reported a small quarterly loss after restructuring costs. On an underlying basis, the world’s third largest aluminium business made just US$61m in quarterly profit on revenue of more than US$6bn. Even in a very capital intensive industry, it’s an awful result.

In an almost desperate plea for clemency, Alcoa continues to remind the world that global demand for aluminium is rising; it’s expected to grow 7% this year. But as the tumbling price of the metal attests, supply growth is even stronger.

Whereas most commodity producers acknowledge the rise of China with joy, it has provoked only tears for aluminium producers. Explosive growth in Chinese supply is largely to blame for a global glut of aluminium. Alcoa’s appalling result is a reflection of that supply glut.

Alumina punished

If it’s aluminium in turmoil, why did investors push Alumina’s share price lower? Alumina’s sole asset is a 40% stake in Alcoa Worldwide Alumina and Chemicals (AWAC), the world’s largest bauxite and alumina business (the remaining 60% stake is owned by Alcoa).

Weak aluminium prices have clearly savaged the profits of aluminium producers but, for the moment, it’s also impacting AWAC’s profitability. Sales have historically been linked to aluminium prices and although this is changing, it will take another three years to complete the transition to alumina based pricing. So far, a third of sales have been moved to the new method successfully.

That leaves two-thirds fully exposed to the weak aluminium market. Since dividends from AWAC are Alumina’s sole source of cash, it’s in the firing line. Alumina received just US$40m in dividends for the quarter compared with US$70m this time last year. Cashflow is being impacted, explaining why the share price has fallen 33% since 15 May 12.

With no signs of aluminium prices changing course, dividends from AWAC will remain weak. This leaves Alumina in a cash squeeze. Net debt of about US$460m needs servicing; last year Alumina spent about US$30m on interest payments and while it can comfortably cover interest now, cash for dividends and future capital expenditures is tight.

Although there are no large projects to fund in the near term, a business like AWAC will always need to spend money maintaining its asset base. That expenditure can be delayed, but it can’t be neglected. Cash might be tight, but the need to spend it hasn’t disappeared. A capital raising at some point is now more likely. The falling share price suggests the market is already anticipating one, so set some cash aside to participate (see box: A capital raising?).

If a capital raising is likely, does that mean you should sell? No. The short term might bring more pain, but there is evidence that the investment thesis is playing out as expected. Although aluminium prices fell 18% for the quarter, alumina prices were flat. As AWAC successfully links sales to alumina-based prices over the next three years, profits will improve.

That an 18% fall in aluminium prices can translate into a near 50% fall in cashflow for Alumina demonstrates the high operating leverage. In times of falling prices, it’s a weakness. We've lowered the prices in our recommendation guide to account for lower than expected aluminium prices and the risk of a capital raising. If prices increase, however, the upside could be explosive.

Cheap but risky

This remains a risky situation and, in the short term, investors must endure some pain. Yet AWAC still controls the largest, lowest cost bauxite and alumina production in the industry. It is the custodian of strategic assets that have more value than what today’s share price implies.

Today’s price implies a value of just US$300 a tonne for Alumina’s share of output. To build new capacity in the western world would be five times as costly. Even the cheapest Chinese production would cost twice as much. Inverted, Alumina’s output is being valued at about half its replacement cost.

Further signs of cheapness can be gleaned from the balance sheet; Alumina trades at just 70% of the implied equity value of its AWAC stake. Today’s shareholders aren’t guaranteed success, but they are buying cheap.

The time to buy cyclical businesses is when the gloom seems never-ending and the upside forgotten. This is an opportunity that favours the bold and the patient. SPECULATIVE BUY.