Alumina: Result 2013

For yet another year, Alumina has presented a dire set of full-year accounts. Net profit of just US$0.5m compared favourably with last year’s US$56m loss, but it's hardly a great outcome.

Reported profits, however, are a misleading measure of progress for the business. Alumina’s sole asset is a 40% stake in the world’s largest producer of bauxite and alumina, AWAC, and its reported profit is a messy affair, with operating performance obscured by accounting adjustments for derivatives, currency movements and other non-operating items.  

At its simplest, Alumina accepts dividends from AWAC and pays them to its shareholders. When needed, it makes cash contributions to capital expenditure and, with two of five seats on AWAC’s board, has input into the strategic direction of that business.

Although cash dividends from AWAC rose 16% to $100m last year, Alumina paid no dividends. The company expects to earn another $100m this year from AWAC but is again unlikely to pay dividends. That’s not a lot of cash to support Alumina’s current market capitalisation of $3.5bn.

Yet valuing Alumina on the dividend stream alone is a mistake. A 40% share of the assets and profits of AWAC should ultimately be reflected in the value of Alumina. For the moment, with bauxite and alumina prices low, those profits are tiny. AWAC reported a 66% decline in earnings before interest, tax, depreciation and amortisation (EBITDA) to about US$270m and a net loss of US$243m, suggesting Alumina’s share of the loss was about $100m. Yet AWAC owns some of the best bauxite and alumina assets in the industry. Financial performance will improve when the cycle turns.

While most of the industry continues to wallow in losses, lower costs and a new pricing mechanism for alumina are working to improve outcomes at AWAC. (For more information see Alumina: lousy business, hot opportunity? (Speculative Buy – $1.44)). The new pricing mechanism is yielding higher prices than the old one, and AWAC has now moved 65% of sales onto the new formula. Profits in future will be both higher and less volatile.

Low-cost producer

In a year when the aluminium price fell, AWAC reported a 45% increase in operating margins to US$45 a tonne. Although total production volumes remained around 16m tonnes, higher-cost production has been replaced by lower-cost output, reinforcing AWAC’s status as one of the lowest-cost producers in the industry.

Unprofitable production across the industry is being closed, the new pricing mechanism is working as intended and Alumina’s balance sheet is in better shape than it ever has been. Our investment thesis is on track. That isn’t reflected in the results but pessimism about the business is less dire now; the share price has risen 91% since its lows in Alumina: For the bold and the patient (Speculative Buy – $0.645) and 23% since our last update on 26 Aug 13 (Speculative Buy – $1.00).

With Alumina’s enterprise value now 1.2 times the value of the equity in its AWAC stake, Alumina is no longer a dirt cheap bargain. It is, however, a poor-quality business that demands a considerable margin of safety. With prices breaching our recommendation guide, that margin is diminished. We’re downgrading to HOLD.