Alumina Ltd Is All About Assets, Not Earnings

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This story features RIO TINTO LIMITED, and other companies.
For more info SHARE ANALYSIS: RIO
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

Forget about US recession fears or Fed cuts – most economists in Australia believe the RBA will have to raise rates this month due to persistent inflation. While you and I can nod understandingly every time we fill up on a Friday or buy a lamb roast, one only need to look at fourth quarter mining results from the Australian resources sector to appreciate why the RBA will move.

While most miners have either met or fallen short of production targets, the theme this quarter has been one of costs, costs, costs. There’s always something each quarter to collectively shock resource analysts, be it unrelenting super-cycle prices or currency adjustments. But while costs have been a factor building throughout 2007, the final quarter has blown many an analyst away. As it has come at a time when base metal prices have been lagging due to those US recession fears, suddenly costs have become the great spectre of 2008.

No more has this been evident than in the full year result from alumina/aluminium producer Alumina Ltd ((AWC)). All you could hear around the CBD yesterday were the thumps when Alumina analysts fell off their chairs. The company had forecast an operating cost per tonne figure of US$4. The ultimate cost was US$32. What’s more, expectations are for an additional increase of US$24/t on top for 2008. With aluminium the laggard amongst the base metals in recent times, how is Alumina Ltd ever going to make money?

Production growth was flat in 2007, so the 29% fall in earnings year on year (which was already flagged ahead of the result) was only due to those cost increases and constantly squeezed margins from an uncooperative aluminium price (oh, and that wretched currency). Increased Chinese production has held the aluminium price down, and the London Metals Exchange is already holding a 1mt surplus while global capacity additions continue. The outlook for 2008 is not particularly rosy from here.

And so the analysts pulled out their hatchets, and hacked anything from 15% to 45% off their 2008 earnings estimates, with further trims for 2009. Target prices also took a beating, with the FNArena average falling from $6.94 to $6.25. Macquarie summed up the sentiment:

“Let’s make no bones about it, the short-term earnings outlook for Alumina Ltd is increasingly ugly”.

But wait – Macquarie still rates Alumina as Outperform. In fact, six out of ten brokers or advisors in the FNArena database are calling the stock a Buy, with only one (Credit Suisse) suggesting Sell. Has the stock been trashed? Well, yes it has. Its 52-week range is from $8.88 in July down to $4.50 in the January dump, and it is hovering now above $5.00. But with little prospect on the earnings horizon there’s no point in talking discount to cashflow.  What makes the difference with Alumina Ltd is actually something that once more comes back to cost.

While Credit Suisse has based its Underperform rating on a short-term earnings view, the analysts acknowledge Alumina’s “sunk capital in a rapidly growing industry” as well as its “long life, bottom-of-the-cost-curve assets”. Those brokers on Hold make the same acknowledgement, and have hence played off earnings and assets to reach their middle-ground ratings. The Buy raters, however, see asset value as the overriding factor.

Aluminium smelting is a very costly business needing, as it does, an awful lot of power and water. To actually build an aluminium smelter is another story again, and indeed current prices make such a project uneconomical. But if you already have a smelter, or better still, a portfolio of them, you are sitting in the box seat for what most agree will be an ultimate return to strength in aluminium prices. Alumina’s assets are, as Macquarie suggests, “world class”.  Citi calculates the replacement cost of these assets to be $8.50 per share. That is the simple reason why Citi maintains a Buy rating, and the analysts’ views are echoed across all the other positive broker recommendations.

Apart from latent value, the next obvious point to make about Alumina is that these assets could be very valuable to someone else – such as Alcoa. Alumina is, after all, the 40% junior partner in the Alcoa World Alumina & Chemicals (AWAC) venture, with Alcoa all of the other 60%. The market has been holding out for a full Alcoa takeover for some time, but Alcoa itself has been subject to takeover speculation ever since Rio Tinto ((RIO)) took Alcan. The prime contender is BHP Billiton ((BHP)), but then BHP is trying to take over Rio. Alumina is just another item down a shopping list somewhere.

But with its irreplaceable assets firmly grasped for now, the next big catalyst for the Alumina share price would be a move in the aluminium price. This doesn’t appear like it’s going to happen tomorrow, but for the fact that there have been production disruptions across the globe with China and South Africa in particular looking at systemic power delivery problems. But in the longer term the super-cycle is still considered by all and sundry to be in place, and medium-wise it is expected Chinese demand will grow without domestic production keeping pace.

In reality, ten out of ten brokers find Alumina a great bottom-draw proposition, and who knows? It may never be this cheap again.

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