Treasure Chest: Alumina Ltd’s Newfound Corporate Appeal

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

By Greg Peel

US aluminium giant Alcoa plans to demerge its upstream and downstream businesses next year. The upstream business includes bauxite, alumina and aluminium production and once demerged, that entity’s biggest asset will be the Alcoa World Alumina and Chemicals (AWAC) joint venture which is owned 60% by Alcoa and 40% by Alumina Ltd ((AWC)).

Brokers agree the demerger will be of considerable benefit to AWAC. As is the case in any demerger, the single upstream entity will benefit from having full management focus and funding. In recent times, Alcoa has concentrated heavily on its downstream manufacturing business, leaving upstream not only to compete for capital but to cede capital to downstream investment.

A demerger will thus help unlock the true value of the upstream business. Alcoa intends the downstream business to attract an investment grade rating and the upstream to attract a “strong” non-investment grade rating. On that basis, Macquarie, for one, does not see any risk of the dividends being paid to Alumina Ltd from the AWAC JV as being reduced in payout.

But it also means Upstream Co will not have enough balance sheet capacity to buy out Alumina’s 40% joint venture stake. However, this is where it gets interesting.

Macquarie expects a standalone Upstream Co would be a more attractive takeover target than is Alcoa in its current form. Buy Upstream Co, and you buy 60% of AWAC. Under the joint venture agreement, the sale of any AWAC stake in excess of 9% triggers a first option for Alumina Ltd to be the buyer on the same terms. And Alumina Ltd can block any sale in excess of 9%.

Alumina Ltd should be seen by the market as having improved corporate appeal, JP Morgan suggests, being a logical way to grow the upstream company. The acquirer would have to pay a stiff premium given the structure of the joint venture, Macquarie notes.

UBS takes the M&A potential discussion even further down the path.

BHP Billiton demerged its South32 business. Alcoa is now also demerging. What if Rio Tinto ((RIO)) also decided a demerger has its attraction? And if Rio were to demerge its aluminium smelting business, combining this business, AWAC and South32 would create a company with 33% global market share of bauxite, 18% of alumina and 10% of aluminium, UBS notes. Such a consolidated entity would have a much greater capacity to compete with China.

All of which plays into increased corporate appeal for Alumina Ltd.

At the very least, an unleashed AWAC will have the opportunity to grow third party bauxite exports, which JP Morgan, for one, believes would potentially add meaningfully to earnings.

Morgan Stanley nevertheless finds the specific benefits/efficiencies of a demerged Alcoa hard to quantify, while admitting the long lead-time means more will no doubt be revealed. The broker has downgraded Alumina Ltd to Equal-Weight from Overweight, but not because of the demerger announcement. Morgan Stanley, like all brokers, has just made major downward revisions to commodity price forecasts across the board.

This leaves four Buy ratings for Alumina Ltd in the FNArena database, two Holds, including Morgan Stanley, and one Sell (Citi). Citi has yet to report its thoughts on Alcoa’s plan. Morgan Stanley also cut its price target to $1.30 from $2.20 following commodity price downgrades, but this brings it in line with the rest of the database. The consensus target now sits at $1.56, suggesting over 40% upside.

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