Australia | Jul 10 2013
-Better returns ahead for Alumina
-Big beneficiary of weaker $A
-Improving position re bauxite supply
By Eva Brocklehurst
Improved margins reported by leading US aluminium/alumina producer Alcoa in the second quarter have given brokers a reason to expect a better performance from Alumina Ltd ((AWC)) this year. Alcoa reported a surprise quarterly increase in the alumina division's earnings margin to US$47/t from US$44/t. Costs have fallen faster than realised prices. The better cash flow means Alumina's 40% stake in the AWAC joint venture with Alcoa should deliver more than the guaranteed US$100 million in dividends in 2013. AWAC, the world's largest aluminium producer, achieved US$32m in absolute cost savings in the second quarter from weaker key currencies and productivity gains.
Significantly, the Alba dispute could be coming to a conclusion. The US Justice inquiry into alleged corrupt payments for alumina supply to Alba will require a 37.5% contribution from AWC. Alcoa has recorded a charge for an offer of US$103m in cash but if this is not accepted then up to a further US$200m may be required. All up, this implies US$15-45 million from AWC, depending on the actual settlement. Overall it doesn't appear material to JP Morgan's way of thinking. For Macquarie, it is still a wide enough range that creates some uncertainty and detracts from the incremental operational improvements that have contributed to a more positive second quarter.
The healthy aspect of the second quarter financials was a lift in alumina margin of 7% quarter on quarter despite the flat price. Operational improvements were also a highlight. AWC received a US$25m dividend from AWAC, as forecast, for the second quarter and distributions of US$4m. Macquarie expects continued productivity improvements and further savings in the caustic price in the second half should offset forecasts of lower alumina prices.
Supporting of AWC's case is that the company is one of the biggest beneficiaries of a weak Australian dollar as the majority of income is earned offshore. Each 1c move adds around US$9m to net profit. This forms the basis on which JP Morganhas upgraded the stock to Neutral form Underweight. At the time of downgrading to Underweight just two months ago the Australian dollar was US$1.02. It is now US91c and this provides significant cost relief.
Moreover, JP Morgan finds the company is not experiencing financial pressure based on revised cash flow forecasts. Aluminium and alumina prices are now well into the cost curve and are likely to have troughed. Buyers of the stock need to believe the global aluminium/alumina market will improve. In this case, the broker forecasts long-term earnings of US$90/t for AWAC, which is double where it is today, and does not think investors would be willing to short this stock in a falling Australian dollar environment.
Deutsche Bank supports a Buy rating with an investment thesis that highlights AWC's industry structure and improving position from rising Chinese refining costs as well as a lack of western refinery expansions, and more recently the Indonesian bauxite ban which has removed a significant amount of China's bauxite supply. Goldman Sachs also observes the most significant issue facing aluminium is over capacity in smelting and the import of bauxite and conversion to alumina in China. This has resulted in limited price increases. On a positive note for pricing there are signs the export bans on bauxite from Indonesia are changing the alumina supply situation.
Citi has a more cautious view. Alcoa's results imply that, with aluminium at US80c/lb, the falling Australian dollar will not be enough to turn profitability around in the second half, unless prices rally. Alcoa is forecasting a small surplus in the alumina market but a deficit in the aluminum market. Morgan Stanley notes operational metrics have improved and distributions are on track, but market conditions are poor and margins are still low. The broker believes weak earnings are likely in 2013/14 and retains a Neutral rating on that basis. The Alba settlement obligation compounds the uncertainty.
Goldman Sachs has a Sell rating, driven by a soft outlook for the alumina price and an oversupplied aluminium market, somewhat offset by the declining Australian dollar. Positives to come from the Alcoa result was the better than expected distribution from Alcoa and the lift in earnings margin. Offsetting this was a larger-than-expected loss from non-controlling interests of US$29m, driven by the Alba provision and a US$10m smelter loss in Victoria. This contributes to a downgrade to Alumina's expected earnings in FY13. Goldman expects a loss in FY13 and a move to profits in FY14 and FY15, which will be driven almost exclusively by a drop in the Australian dollar forecasts.
Goldman does not expected AWC to pass through dividends to shareholders, with a forecast second consecutive loss in FY13. Having said this, after recent capital raising initiatives the broker does not expect the company to have significant debt due over the next 2-3 years and is therefore more likely to pay a dividend than it was six months ago. Nonetheless, while shoring up the balance sheet this capital does not help profitability. That is reliant on commodity and currency rates.
UBS has an upbeat outlook and notes the better underlying earnings for AWC implied by Alcoa's minority interests. The broker calculates that underlying earnings attributable from AWAC to AWC is around $26m for the second quarter. The broker has lowered the cost base to also reflect favourable movements in the Brazilian real, which is down 10% against the US dollar since late May. The drop in costs appear to be driven by both foreign exchange movements and productivity gains and the full benefit of both the lower Australian dollar and Brazilian real is yet to be realised in the broker's view.
On the FNArena database recommendations on Alumina Ltd run the gamut. There are two Buy, four Hold and two Sell ratings. The price targets range from 80c to $1.36. The consensus target price is $1.13, suggesting 7.5% upside to the last share price.
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