Alumina Wants How Much?

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

By Greg Peel

Back in late July resource analysts were beginning to come to the conclusion that Australia’s only pure aluminium producer of note – Alumina Ltd ((AWC)) – may need to raise capital through either debt, equity, or both. The company had already announced an underwritten DRP with its interim result (a dividend reinvestment plan encourages shareholders to buy new stock with their dividends instead of taking cash – hence it is a capital rasing by any other name) but the continuing increase in the cost of aluminium production globally meant Alumina’s balance sheet would be severely stretched as the company attempted to fund ambitious production expansion projects.

The only saving grace would be a continuation of strong aluminium prices. Most brokers are long term bullish, but even with spot price increases, the general conclusion was that Alumina would need to raise at least some capital. That conclusion was confirmed emphatically when suddenly, Alumina’s joint venture partner – US aluminium giant Alcoa – announced a near 50% cost blow-out in the duo’s Brazilian projects.

The Brazilian project would lay Alumina bare.

At the time, long term Alumina fancier Macquarie was absolutely livid, suggesting Alcoa was simply using Alumina as a passive, pushover funding vehicle, while an also unhappy Citi questioned the competence of the JV managers (Alcoa has 60%, Alumina 40%). And in the meantime, the aluminium spot price has retraced rather heavily.

The problem with aluminium is that of all the base metals, aluminium’s production is the most expensive on a relative basis, largely because it requires vast amounts of power as well as water – another dwindling resource. With the surge in the oil price came a surge in the cost of aluminium production, while the costs of other inputs such as caustic soda have also blown out. The aluminium price has now fallen in the commodity slump, rendering many a global aluminium project – existing, ramping or at planning stage – borderline uncommercial. The oil price has also fallen, but at this point even the large global resource companies are keeping a wary eye on their aluminium project viability.

Most affected by cost blow-outs is China, which produces significant amounts of aluminium. China’s biggest problem is a combination of power supply unreliability and marginal producers being allowed to spring up like mushrooms in the first place. Thus China is now coming down heavily on its aluminium industry, forcing rationalisation.

An investor might be put off investing in an aluminium producer such as Alumina, if rising costs are going to put earnings under jeopardy, but the simple fact is that if marginal suppliers are forced out of the market, those suppliers who survive should thus enjoy higher spot prices. The reason why analysts are mostly bullish aluminium in the long term is that unlike nickel and zinc, for example, aluminium cannot be easily substituted. Like copper, aluminium is a vital element in the great emerging market economic boom.

That is also the reasoning behind Macquarie’s long term favouring of Alumina as an investment, particularly given the company boasts the sort of legacy reserve and production assets that are simply irreplaceable at today’s prices. If ever there was going to be a producer that remained standing in any cost crunch, it would be Alumina. However, the company still has to be able to fund its operations and that other crunch – the credit one – has put a strain on levels of gearing. It has also meant borrowing more money to cover increased costs is not necessarily the best option, even if, down the track, such investment pays off in spades.

On that basis, analysts had concluded that Alumina would look to raise about $500m in fresh capital. So when the company announced yesterday it would seek $910m through a rights issue, analysts around town promptly fell off their chairs. How much?

Granted, the broker kicking up the biggest fuss is Merrill Lynch, who has long been a wet blanket on the Alumina story – correctly, as far as the near term is concerned. Merrills has carried an Underperform rating on the stock for some time. The analysts have described the rights issue as “mammoth”, and quickly adjusted its numbers for equally mammoth dilution.

The 5:19 share entitlement issue has been offered at about a 30% discount to the last traded price, and Alumina shares are now in a one-week trading halt. This is some turnaround for a company that has long been voted a likely takeover candidate – probably by Alcoa – in which case one contemplates 30% premiums, not discounts. But it’s been done, and the company has provided a breakdown of where the money would be used.

For starters, about $140m will be used to replace the previously announced underwritten DRP, which is no longer necessary in tandem. Macquarie has questioned why Alumina insists on maintaining a dividend at all when it’s trying to raise capital- this is a growth story, not a yield story. But the analysts do concede that the company has a lot of franking credits to offer. Secondly, about $200m will be used to pay down a lot of that debt, which is the company’s working capital fund. The first allocation is just replacing apples with apples, but the second is more positive in the current debt environment.

The remaining $500m-odd is the original amount analysts suggested Alumina would need to chip in for its share of ongoing costs at the Alumar refinery expansion and Juruti bauxite mine ramp-up in Brazil.

Clearly this large capital raising effects a large dilution of earnings per share ahead and reduces analyst target prices on the stock, although not all analysts have yet adjusted their numbers. If you are an existing shareholder, your investment has thus been seriously diluted unless you cough up for the new capital at the 30% discount. This should be a great deal on share price terms, provided the Alumina share price doesn’t fall more than 30% after it comes off the trading halt. You will, however, need to find the money.

Is Alumina where you would want to put it? That comes down to your belief in the long term aluminium story, and that fact that Alumina shares already trade at what analysts agree is a big discount to the replacement value of the company’s assets. Notwithstanding, the fact is that if you don’t buy at the discount, you are losing 30% on your shares.

The current FNArena database B/H./S ratio of 3/2/2 (2 restricted) still stands, although Merrills has hinted a big sell-off post-halt might spark an upgrade.

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