Alumina Ltd Next To Raise Capital?

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This story features ALUMINA LIMITED.
For more info SHARE ANALYSIS: AWC

By Greg Peel

“Once again,” note irate resources analysts at Macquarie, “we’re left questioning Alumina Ltd’s ability to directly influence its own destiny and Alcoa’s underlying motivation given its joint venture partner’s willingness to act as a funding vehicle”.

The outburst follows the news that Alcoa World Aluminium & Chemicals (AWAC), of which US aluminium giant Alcoa is a 60% joint venture partner and Australia’s Alumina Ltd ((AWC)) a 40% partner, has announced a US$1.2bn blow-out in the cost of AWAC’s Brazilian expansion. That’s a 48% increase over forecast capital expenditure. Macquarie describes the blow-out as “outrageous!”.

The Macquarie analysts were quick to question the JV relationship, and the Citi analysts chimed in with a questioning of AWAC’s project management skills. The costs are associated with the Alumar and Juruti projects in Brazil, and have been put down to appreciation of the Brazilian real, the weather, and “low contractor productivity”.

Whatever the cause, whatever AWAC’s incompetence, and whether or not Alcoa is merely taking advantage of Alumina’s willingness to provide funding, the very real risk now is that Alumina Ltd may have to go to the market for more capital to fund expansion. There is a certain unfortunate irony here, because Macquarie’s Outperform rating is based almost entirely on the fact that Alumina boasts legacy alumina/aluminium production assets that simply could not be replaced at today’s prices. Citi puts the replacement cost at $8/share, yet Alumina shares are trading at only $4.40 – a “widening chasm” as the analysts call it.

With aluminium prices strong and getting stronger, all analysts were of the belief that Alumina might avoid the necessity of a capital raising, despite that possibility always being a risk. But this 48% cost blow-out has likely sealed the deal. It is not just a case of cost blow-out either. Alumar was originally due to be completed in mid-2008, and that has now become mid-2009. The first bauxite from Juruti was due in the first half of 2008, and now it looks like the third quarter of 2009.

Both Citi (Buy) and GSJB Were (Buy) are holding on to their ratings because of their bullish stances on the aluminium price. The Citi analysts even describe themselves as “card carrying aluminium bulls”. The Weres analysts are slightly less overt, noting that their prediction that China will move from being a net exporter of aluminium to a net importer will need to happen sooner rather than later.

Credit Suisse (Hold) had been calling Alumina Ltd expensive already, and this hardly helps. The company may try to take on another $500m in debt, the analysts suggest, unless it’s not viable in the current debt environment. If not, its off to market.

The Merrill Lynch analysts, on the other hand, are smug. Having downgraded to Underperform in June, they suggest “neither the extent of the capex overruns nor the timing of the delays is a surprise”. Merrills concedes that Alumina is trading at a 20% discount to net present value, but notes it is still expensive compared to peers on a price/earnings basis. With gearing set to reach 48%, the balance sheet looks stretched even with an extension of the dividend reinvestment plan into 2009, the analysts believe.

On the positive side – perhaps – Alumina Ltd has suggested the first half earnings result due at the end of the month will still be within guidance, at least once adjusted for changes in the aluminium price, the exchange rate, increased production costs and the Varanus gas explosion. (Citi is expecting similar cost blow-outs at Wagerup). There is also the matter of Alumina being one of the recipients of the biggest hand-outs in the new emissions trading scheme, and the perennial possibility that someone will take over the company for its aforementioned legacy assets, the most likely contender being Alcoa itself.

But in the meantime, the chip-spitting Macquarie analysts note that these cost blow-outs will force investors to focus on the sub-optimal returns that are being achieved across the industry today and the implications for longer term pricing, margins, earnings and valuation. “Unless we plan to drive wooden cars over the next twenty years,” they seethe, “something has to change”.

The B/H/S ratio for Alumina has remained at 6/1/2 while the average target has fallen from $6.07 to $5.77.

As the resources sector posts another more positive day today in general, Alumina offers  good point of reflection on earnings expectations in that sector. There is a propensity among investors to plough in to certain stocks on the basis of upward movements in the price of the commodities produced. While increasing commodity prices are indeed a fillip, investors must not lose sight of the fact commodity prices increase for everyone. This means cost blow-outs, particularly in the case of energy consumed in the process of commodity production (even for oil producers), and in the case of the “commodity currencies” such as the Aussie and the real, headwind appreciation. All of this adds up to the potential for downside earnings surprise in the upcoming result season.

Indeed already earnings forecasts are being slashed across the board, with property hit this morning through the Mirvac warning and Citi taking a big razor to bank sector earnings as well. We are about to hit the middle of the US quarterly earnings season, which has been mixed so far, and this week sees the first trickle of local interim/final earnings reports before the flood in August.

Hang on to your hats.

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