What's the point of Alumina?

Mike Ferraro is the CEO of Alumina Limited, which is the company that owns 40 per cent of AWAC, the Alcoa subsidiary that produces alumina. Now, it yields at the moment, on a trailing basis according to last year's dividend, 13.7 per cent, although analysts have got the dividend coming down this year a bit. So on a forward basis, the yield is probably more like 10 or 9.5 per cent. But still, that's a high yield. 

There's a couple of questions for Mike. How volatile is the yield likely to be? Is it really a safe and secure income stock as it appears to be and really should be? And the other question, which I've always wanted to know is, what is the point of Alumina? I mean, why do we want to invest in AWAC, the Alcoa subsidiary, through this other listed company that owns 40  of it? Also, what does he do all day, Mike Ferraro? I mean, they’re passive investors in somebody else's alumina operation. What does he do? That's the question and I put it to him. 

Here's Mike Ferraro, the CEO of Alumina.

Well Mike, perhaps we can start with answering a question I've always had, which is probably a stupid question.  But what's the point of Alumina Limited?  Why is it better to have 40 per cent of AWAC owned through a listed vehicle called Alumina, than having 40 per cent actually just listed directly and having AWAC listed on the ASX?  What's the point of having Alumina Limited?

Well, at the moment, the way the ownership structure is is in the context of our co-own, not us.  Put us to one side, Alumina Limited.  You would not be able to have an AWAC-listed entity on its own on the stock market.  I don't believe that Alcoa would be supportive of that whilst it’s got downstream operations that are on a semi or integrated basis.  So it's not feasible.  From our perspective, as a 40 per cent direct interest in AWAC, it's the only entity outside of China that an investor can get access to the income stream and an interest in both bauxite and alumina, without having any significant exposure to aluminium.  Whereas any other combination at the moment would include a significant exposure to aluminium.

Including Alcoa itself, of course?

Correct.

Tell us about the shareholder agreements you've got and how shareholders in Alumina are protected, being a minority shareholder in AWAC?

Sure, the arrangements were renegotiated in 2016 when Alcoa de-merged as an enterprise, which resulted in a lot more rights being granted to Alumina Limited.  Those include any capex US$50 million and above requires our approval.  Previously, it was US$1 billion, so a sharp contrast.  There's also major supply agreements need our approval and cash distributions, and this is important from the dividend perspective for shareholders, have a great a deal of certainty in place.  Any cash within the AWAC joint venture, over and above US$150 million, needs to be distributed to its shareholders on a quarterly basis.

Just sort of moving along to the point, obviously, the purpose or the people investing in Alumna Limited obviously see it largely as an income stock and the one kind of negative about it has been over the years the potential volatility of the dividend stream, which is a bit more volatile perhaps than a bank dividend stream.  What's changed lately to make it less volatile?

That's a good question, Alan.  What's happened over the last seven or eight years since the GFC is that a number of high-cost refining operations, including some of our own, have been shut down or curtailed.  And at the same time China has changed its policy from overproducing certainly in alumina, moving towards more of a policy of self-sufficient, in addition, combined with environmental constraints designed to clean up its air quality and water and so forth. 

What that has resulted over the last eight or nine years and where we are today is that the demand-supply dynamics are finely balanced.  At the moment you could argue that either the demand for alumina is a balanced market or there's a balanced-type market, or it's a slight deficit.  Whichever way you cut it, there's not an oversupply, and we do not see an oversupply in the market going forward certainly outside of China in the near future.  There is some new capacity coming on stream, particular in the Middle East, but that's needed capacity which will be matched by additional smelting capacity.  Demand-supply dynamics going forward look very positive for those who are low-cost producers like ourselves and already in industry. 

Within China, will they move to overproduce?  The problem they have now, which they didn't have previously a number of years ago, is that they're becoming more and more dependent on imported bauxite and what that is doing is increasing their cost of production.  They're essentially becoming the marginal cost producer, which on average at the moment is about US$330 a tonne, compared to us, which is around US$220 a tonne.  We're extraordinarily well placed both as a low-cost producer, and also the structure of the market presently in going forward, I think supports a more stable dividend environment.  For example, dividend really shot up last year and you'd say, "Well, that's volatility for you," but was really a reflection of the fact that the market is so finely tuned on the demand-supply aspects that there was a major shutdown in Brazil and that caused a significant spike in the price. 

At the start of last year, I had expected a good year and less volatility, but we did get an upward volatility and we’re always thinking about it and looking into it and assessing it, I struggle to see that there could be a significant downturn volatility.  That would have to be arising from a number of smelters closing or significant new capacity or combination of significant new capacity in alumina production coming on stream.  And the latter, outside of China, is very expensive to build and you need to be close to the bauxite source, which places limitations on new capacity. 

I would never say never because I've been around in too many cycles as I'm sure you have, but certainly in the medium term in going forward I think the outlook is positive.  It won't be the same performance as last year, but we still expect to have a good return to shareholders.

It's also the case isn't it that alumina has been separated in terms of its pricing from directly the aluminium price, is that correct?  And if so, what impact is that having on the volatility of alumina market?

That's right, Alan.  Since 2010 when the separation occurred, an index similar to the iron-ore index was introduced, there was a disconnect with the aluminium price.  Now our price is determined on a one-month lag based on the index pricing, so it's real time and reflective of the fundamentals of alumina supply and demand, which is quite different to aluminium.  Previously, the pricing of our product was linked as a percentage of LME.  For example, it could have been 18 to 21 per cent, something like that or something less than that.  Now, it doesn't trade linked to the metal price itself.  It's trades on its own fundamentals.  Last year, for example, the price of alumina went as high as up to 30 per cent of LME, which is not sustainable.  At the end of the day our customers are smelters and they need to make a living.  But it's currently trading probably at around 20 per cent of LME.  But we do not link it to the LME price anymore. 

The other advantage that our company has compared to competitors is that 92 per cent of our product last year was sold on an index basis, and the rest was legacy contracts.  Whereas our competitors globally, an average of 70 per cent last year was sold on an index basis and the balance was on legacy contracts which probably had some LME metals linkage.

Is the experience over the last eight or night years then, since that change happened, that the trading in alumina has been less volatile than before?  Is that what's happening?

It was certainly pretty volatile and poor up until the time that ourselves and others made decisions to shut down expensive or high-cost operating capacity.  But the industry has rationalised more or less globally, and particularly where we are as one of the lowest-cost producers on the curve, probably since 2016, we have been in a very good place and the industry for alumina production is in a much better place.

Just looking at the dividend before that change up to 2010, the half yearly dividends were 10, 10, 10, 10, 10, 10, 10, 12 ,12, 12, 12...  It was all...

That's right.

It was pretty steady.  I mean, that was great, and then it's got a bit rocky since then, I’ve got to say. 

Rocky, better.  But you're quite right.  I think, how would I describe it going forward, are we a dividend stock?  We're regarded by the market as that.  But I would say we are, well, some of our professional investors, institutional investors, said we’ve probably going forward, got less volatility than bond yields, which is quite a surprising thing, and positive.

Yeah, that's right.  Well, that’s good and it's fully franked, so it's all terrific.  I mean, the dividend in the last 12 months was 30 cents, which just a bit under 14 per cent of your current share price.  I think looking at what the analysts are saying, they're expecting the dividend to come down in the next 12 months.  Is that a reasonable…

That is correct because our average selling price of alumina last year was $445 a tonne, after our legacy contracts.  This year the price has ranged from about just over $420 a tonne.  At the moment it's about $350 a tonne, off the back of built-up stock levels.  The first quarter is always like that and also the fact that a large producer is likely to come back on stream.  But we would expect that to stabilise over the next little while, and we'll see what happens to alumina price.  But even at $350, our cost of production is around US$220 a tonne, we will still make a very good margin.  The joint venture is forecasting to produce about 12.6 million tonnes this year.  Our economic benefit of that will be about 5 million tonnes, so it's not hard to work out the numbers.

Another thing is, I note that you've held back a bit of cash this year.  You've got $657 million roughly from AWAC as your dividend share.  But the dividends you paid out was $515 million in cash and the increase in your own cash store was $145 million, which was much larger than last year.  I just wonder, are you trying to build a cash buffer?

No, that was just actually a timing difference because what we do is we pay out to shareholders all distributions that we've received up to the payout date.  So not only the distributions received from the joint venture in the calendar, as we're in a calendar year accounting period, but also if we receive distributions from the joint venture before March, which is usually our dividend payment date for first part of the year, then that cash is included.  It's a long explanation, but essentially, it's just a timing difference.  We don't really retain cash.

Right, okay, and do you benchmark your percentage costs in terms of the cash and look at getting those down?  In terms of paying for the establishment of Alumina and the headquarters and so on, how has that changed over time?

Our costs have been relatively stable but also very low.  For example, if we were an index fund manager, we'd be much higher cost that the actual management that we have here and the way we manage the investment because we're pretty active.  We're very heavily involved with Alcoa in various touch points, various meetings, various updates we provide ideas on strategy, on growth opportunities that we see in the market.  We're constantly collecting information and feedback about the market and being a very active manager of our investment.  What it means, the actually total cost last year was probably about $20 million, similar to prior years, which includes financing costs.  If you exclude financing costs, it's probably around $13 million.  We have a team of 12 people.  We have a small office, which hasn't been refitted in about 20 years, so we do manage costs quite tightly.

$20 million.  So that's a good way to think of it as an ETF.  That's very interesting.  If you're an ETF, your costs would be...  I'm just working it out...  0.3 per cent.  That's about an ETF price.  That's about an ETF fee. 

Have you done that on our market cap?

Yeah, on your market cap.  Is that the wrong way to do it?

No, no, that's probably the right way to do it.  I thought an ETF fee might be a bit higher – I’m not that close to them these days.  But you're probably right.  So, that includes...

In fact, a lot of ETFs are 0.2.

Yeah, the ETFs don't include some expenses on top of that, would they?  Or would they absorb the expenses within the 0.2?

You've got me there...

Not sure.

I mean, I think it's 0.2, that's it.

Yeah, okay.  Whichever way you cut it, I think we're very conscious of the expense, but we're very conscious of adding value and not just being a post box.  Because of the additional rights we have, because Alcoa is fully integrated and buys 30 per cent of the product  and so at times their interest would naturally conflict with ours, because of our knowledge of the market and the fact that we do want to grow in a sustainable, discipled way and we have quite a bit of input into that.  Because the Alcoa market cap is similar to ours these days, we do ensure that we have as much say in the joint venture as we can possibly have, in an educated and knowledgeable way.

You mentioned before that Brazilian operation that was closed down, was that Alu...?

Yeah, that was Alunorte.  What happened with them is that in February last year they had to curtail 50 per cent of their capacity.  They were the largest alumina producer outside of China, producing about just over 6 million tonnes of alumina per annum, quite a significant...  I can't recall...  it's probably about 6 or 7 per cent of total outside of China production.  They were curtailed by 50 per cent because they had an environmental breach and it's taken quite a long time for them and the regulators to work through that.  They're almost at the final point now.  They have support from government stakeholders to reopen and they're just waiting the outcome of a court decision, which is expected any day now and we expect it to be positive.  That will allow them back to full production from 50 per cent over the next few months.

Will that weigh on the price?

We think a lot of it, if not all of it, has already been built into the price because the market is expecting it to come back.

Do you have a forecast you can share with us for the current financial year in terms of your own cashflow and dividends?

No, we don't have a forecast on cashflow and dividends.  We do though give the market a quarterly update.  Every quarter, when our Alcoa issues its quarterly announcement, we issue an announcement off the back of that showing the distributions we've received up to that date.  It's pretty up to date and it's pretty easy to work out what our dividends would be from the joint venture distributions.

I don't mean to get personal here Mike, but I just wonder what you and the team do all day.  Most mining companies, they're running around trying to get mines going and doing things and doing deals and so on.  But what do you have to do? 

I spend quite a bit of time, actually I'm quite busy, but that's a good question.  So, in the last month I've been to China.  I've met with a number of producers to understand what they're doing, how they're responding to the market there, to confirm a number of things that we know about the growing demand for imported bauxite, to understand the impact that will have on their cost structures, and whether they're producing to self-sufficiency and the impact of higher environmental standards. 

I then went to London to meet with investors, talk about the sort of conversation we're having now and update them on the full-year results.  I came back.  Since then we've been preparing – we've got a strategic council, which is our governing joint-venture body meeting in early June.  And we prepare a number of papers and proposals around the issues that we need to focus on around growth, sustainability, climate change, risk management.  We want to discuss and reach agreement with Alcoa.

In between that we have various calls and have meetings in Perth with the joint-venture operators who run the West Australian operation, which represent 9 million tonnes of our total production, 12.6 million tonnes.  We sit down with them and go through how the operations are running; whether maintenance is within plan or not planned; what the health and safety record is looking like to date; where there are deficiencies what's being done about that; other issues that have been in the pipeline, have they been addressed, how they changed, how things been improved.  Then separately we've been attending some international producer and industry conferences to get a perspective of what is happening in other parts of the world outside of China, so we can help educate our investors.

There's been a reasonable amount of activity.  There's a lot of other day-to-day stuff that needs to be taken into account around our funding and so forth, but they’re some of the highlights.

Yeah, right.  Okay, well it's good to know.  Appreciate you time Mike, thanks. 

You're welcome.  Thank you, thank you very much, Alan.

That was Mike Ferraro, the CEO of Alumina Limited.