REPEAT Significant Valuation Upside For Alumina?

This story features ALUMINA LIMITED, and other companies. For more info SHARE ANALYSIS: AWC

This story was originally published on 23 August, 2010. It has now been repeated to make it available to non-paying members at FNArena and readers elsewhere.

By Greg Peel

Alumina Ltd ((AWC)) has long been a stock market disappointment. The company holds considerable legacy value in its alumina production assets but the AWC share price has been perennially dampened by the underperformance of aluminium within the base metal spectrum. The problem is not so much one of weak global aluminium demand, but one of excess supply through smelting capacity, particularly in China.

Copper and aluminium are considered as the two “unsubstitutable” base metals. Nickel, zinc and tin can all be substituted in the production of (mostly steel) alloys if their spot prices run too high, meaning they always have a natural limit. But copper is the only metal of choice for electricity conductivity, and aluminium cannot be matched among metals in strength-for-weight ratio. This is particularly important today given vehicle carbon emissions are weight dependent.

There is now a move across the globe to substitute fibre-reinforced plastics for aluminium, but price is as yet prohibitive on a mass-production scale.

While the smelting of aluminium is an expensive business (requiring significant electricity and water input) the construction of an aluminium smelter is not prohibitive. China, in particular, saw hundreds of smelters built in the construction rush and “super-cycle” of the early twenty-first century. While many marginal smelters have now closed down, and other heavily polluting smelters have been forcibly shut by the government, the fact remains every time the price of aluminium rises, idle smelters are fired up again. This acts as a dampener on the aluminium price.

But while processed aluminium may become “abundant” in this sense, the input product – alumina – is not so abundant. The cost of producing alumina from bauxite is much higher than the cost of producing aluminium from alumina, such that the marginal cost of building an alumina production facility is much greater than that of an aluminium smelter. For that reason, the alumina production market is very concentrated across the globe.

One quarter of the world's alumina output is produced by the 60/40 joint venture between Alcoa of the US and Alumina Ltd of Australia, known as AWAC. One would thus expect AWC (Alumina Ltd) to have been a highly profitable company in recent times given demand for alumina. While the price of aluminium coming out the other end might be dampened by excess production, all those smelters still need to source their alumina from a limited supply.

In actual fact, the opposite has been closer to the truth. Alumina Ltd, and Alcoa for that matter, have been serial underperformers. The reason is that while alumina price fluctuations should reflect the unique demand/supply balance of alumina and not of aluminium, a longstanding market tradition has the alumina price indexed to the aluminium price. No matter how critical the supply of alumina becomes, too much aluminium production means a lower aluminium price, and thus a lower alumina price.

But that all might be about to change.

While aluminium is traded on a spot price basis, alumina never has been. What's the point? The alumina price is indexed to the aluminium price, so it makes sense simply to trade alumina on longer-term contracts. This has always put alumina in the same class as the likes of iron ore and uranium. But last week US-based Platts – the world's foremost provider of energy and metals market information for industry use – announced it has introduced a daily alumina spot price index to add to its suite of other spot price calculations.

The index will reflect the true demand/supply impact on the alumina price, rather than its indexation to the aluminium price. However, just because Platts decides to publish a spot price does not thus imply alumina producers can move from aluminium-indexed contract pricing to spot pricing. There is nothing “official” about the Platts initiative. Aluminium producers can simply choose to ignore it.

But can they?

There is an abundance of aluminium producers across the globe, and a paucity of alumina producers. There is a significant barrier to entry to alumina production simply as a matter of extensive start-up cost. But the likes of AWC and Alcoa boast legacy alumina production assets, long ago written down. In today's aluminium pricing regime, such assets are virtually irreplaceable. The boot is squarely on the foot of the alumina producers, not the aluminium producers.

It is for that reason analysts expect alumina producers to swiftly embrace the Platts spot price as the new alumina pricing mechanism, thus abandoning traditional aluminium price-indexed contracts. Were this to occur, the extensive value embedded in AWC's assets, long recognised by analysts but rendered dormant by the alumina pricing model, can potentially be released.

There have been a couple of recent precedents for the effect of the spot/long-term contract split.

While industry consultants have long published a uranium spot price, that price only reflected short-term demand/supply discrepancies. The bulk of uranium trades on long term contracts reflecting the long term nature of reactor construction and power production. But when nuclear power became a hot issue again last decade, hedge funds moved into spot uranium and speculation pushed the spot price up nearly ten-fold in only a couple of years. This set the share prices of uranium producers alight.

It was all smoke and mirrors nevertheless, given actual producers and customers (mostly utilities) stayed out of the frenzy. Existing supply contracts were anything from 5-20 years in duration, and the industry worked on a cooperative “cap and floor” contract pricing system in order to reduce potential price volatility to everyone's benefit. If supply was constrained in the short term, producers provided customers with price relief, knowing full well supply would soon swing back again. Similarly, customers would continue to pay reasonable prices in times of short term glut.

While the result was that the long term uranium price has moved up from US$15/lb to US$50/lb over the last decade, the process has been smooth and the peak spot price of US$136-138/lb reached in 2006 was never traded between players within the actual industry. And the spot price is now below US$50/lb.

So the uranium experience might lead some to suggest the simple publication of an alumina spot price will not impact that heavily on the bottom line of alumina producers, even if hedge funds and commodity funds suddenly rush in to speculate and in so doing push up the alumina spot price. Indeed, Citi analysts suggested last week that while the de-linking of the alumina price from the aluminium price is a positive for AWC, it is not a “game-changer”.

But there is another example.

The world's big iron ore producers had also spent most of the twenty-first century bemoaning the traditional annual contract price mechanism, which had changed little since Japan first started importing iron ore many decades previously. China entered the market as the big new player, but only under the existing system. In the meantime the iron ore spot market – again, only previously relevant in closing short term demand/supply gaps – became more and more active.

Earlier this year BHP Billiton ((BHP)) achieved a big win by exerting its leverage, and iron ore pricing has now moved from annual contracts to quarterly contracts. This is seen as the first step towards eventually moving to a pure spot price mechanism. BHP could only achieve such a move after years of trying because local rival Rio Tinto ((RIO)) stood shoulder to shoulder, and to much surprise Brazilian rival Vale also provided individual support.

Few analysts disagree that this move was indeed a “game-changer” for iron ore producers.

So while Citi is somewhat circumspect about a similar alumina pricing evolution, Credit Suisse is a lot more enthusiastic. Like the BHP-Rio-Vale triumvirate, the world's major alumina producers are few and powerful within their own industry. Credit Suisse reported on Friday that Alcoa already intends to negotiate future supply contracts on a spot-based pricing mechanism. The analysts expect BHP – another significant alumina producer – to follow suit. That's hardly a leap of logic.

The current Australian alumina spot price is US$317/t. Both Citi and CS see this moving to US$350/t in 2011 and both CS and AWC see a US$400/t price in 2012. Global alumina refineries are still coming back on line since shutting down post-GFC, so on the basis of excess capacity CS calculates the current supply cost floor to be about US$280/t. The analysts expect a return to full refinery capacity by 2012, and thereafter an alumina price in excess of US$400/t would be required to encourage new refinery construction. Given the likes of AWC, BHP and others dominate current refinery capacity, the value of that capacity must increase accordingly.

AWC shares are today trading at $1.80, while Credit Suisse has set a base-case valuation of $2.33. The analysts' 12-month target price is nevertheless only $2.05 given FY11 is expected to remain subdued in terms of earnings. But under a spot pricing model, CS can see AWC's valuation rising to as much as $4.65.

It won't happen overnight, however. Again, we can look to both uranium and iron ore to see why.

Because uranium trades on very long term contracts, Energy Resources of Australia ((ERA)) was still only receiving around US$35/lb net for its contracts old and new when the spot price was trading north of US$100. Paladin Energy's contracts, which were all new at the time, still only achieved prices of US$50-60/lb. Utility buyers recognised increased demand over limited supply, but ignored the spot price folly.

BHP, too, did not suddenly jump to an iron ore spot price mechanism overnight, nor even a fully floating quarterly price mechanism. Rather, BHP has been driving a gradual transition so that everyone can become accustomed to the idea, and so that the Chinese don't get too bent out of shape in the short term.

So combining existing longer term contracts that have to yet roll off, and a need to let aluminium producers down gently, the transition to alumina spot pricing will be a gradual process. Hence the valuation Credit Suisse suggests for AWC will not mean an immediate re-rating but a gradual one.

This plays into why Citi is less excited. While the AWC share price has long been a source of disappointment, the price still represents at least some valuation for the company's legacy production assets. This means the stock trades at a premium multiple within the resources sector.

So that premium first has to be justified, and thereafter consideration has to be given to the alumina/aluminium market being of higher risk than, for example, the iron ore market. Thus the Citi analysts suggest while the AWC story is a good one, there's still actually a greater discount to net present value to be found in BHP, Rio, Fortescue ((FMG)) or even Iluka ((ILU)).

But we can't discount the other longstanding market expectation. Given the value of its assets, the market has long pegged AWC as a takeover target, with the most obvious buyer being its joint venture partner Alcoa. The big diversified miners could not be ruled out either. It was Moses who first suggested such takeover potential, and the market has been waiting ever since.

For the first time in many quarters, Alcoa last month posted an earnings result that beat Wall Street expectations. Last week, AWC announced its profit had jumped year on year from $4m to $44m. Could a takeover actually be on the cards this time?

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