Alumina Ltd: The Next Yield Stock?

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

– Alcoa result an improvement
– Alumina prices looking better
– AWC's dividend set to increase
– Shareholders should benefit

By Greg Peel

Let’s get a couple of things straight first up.

Alumina Ltd ((AWC)) is an Australian listed company which produces alumina, which is a commodity. Bauxite ore is refined to produce alumina, which is then smelted to produce aluminium. AWC is the lesser partner in a 60:40 joint venture with US alumina/aluminium giant Alcoa, called AWAC, for which AWC is paid a quarterly dividend by Alcoa as its means of income. That dividend has an agreed floor of US$100m per year.

Alumina, the commodity, has for decades traded on a long-term contract basis with aluminium smelters across the globe. But in recent years the push has been on to switch to more of a spot trading market, as has been the case over the last decade with other bulks such as iron ore. Spot trading markets are seen to benefit producers on average given bulk long-term contracts tend to settle on a discount-for-volume basis. In 2013, AWAC’s spot alumina exposure grew to 53%.

Analysts had expected the switch to spot would lift average alumina prices and thus the fortunes of alumina producers, but alas aluminium has been produced globally to a level of oversupply while demand growth has eased. Thus any gain on the swings for alumina producers was lost on the roundabout. However, in recent months, spot alumina prices have begun to find a little bit of strength.

Alumina, the company, is a stock that tends to split analyst opinions. On the one hand, AWC’s legacy assets are seen as largely irreplaceable, certainly not on a viable cost basis in today’s market. Hence AWC boasts a strong underlying value. But on the other hand, if global aluminium supply is more than enough to match demand growth then it’s hard to derive exciting earnings growth from alumina production.

Prior to this morning, FNArena database broker ratings for AWC were split as two Buy to four Sell (or equivalent) with one Hold. The split largely reflects broker views on the direction of aluminium prices, given there is little argument over the underlying value of AWC’s assets. Compounding the disagreement are some recent supply-side developments.

In its process of rationalising non-core assets, Rio Tinto last year closed its Gove alumina refinery, thus removing a not insignificant annual tonnage from the market. Late last year the London Metals Exchange tightened up its inventory rules which, to cut a long story short, should by rights prevent price manipulation through aluminium hoarding and subsequently knock down aluminium prices. The price effect is yet to be seen, and no one is quite sure why. In the meantime, the Indonesian economy has taken over India’s mantle as “the next China” and the government is pushing to speed up the “emergence” process. One measure is to quarantine the country’s raw materials for domestic value-add and hence on the weekend exports of bauxite were banned. This indirectly removes another slab of alumina supply from the market.

The problem with the latter is that Indonesia’s biggest customer, and the world’s biggest producer of aluminium, China, has built up stockpiles of bauxite and alumina equating to around half a year’s consumption. China is the master of the restock-destock cycle, and at this stage there seems little need for the Chinese smelters to switch to buying more alumina from other sources.

All of the above offers up further reason for uncertainty in the alumina market and cause for analyst division. Analysts do agree, nevertheless, that Alcoa’s December quarter alumina division performance was an improvement on the September quarter. Margins increased as productivity gains led to cost reductions and alumina prices were a little better than they had been. But performance can only be measured against analyst forecasts, and here the FNArena database brokers were split on their forecasts and hence their responses to the result.

Throw in views on the direction of aluminium prices, and the Buy-raters and Sell-raters both maintained their positions. But this morning Credit Suisse broke from the pack, and on closer review decided to switch its Sell straight to a Buy (equivalent). The change of heart is not about a price view on aluminium but a view on AWC’s dividends received, and thus potentially paid.

AWAC’s spot alumina exposure was 53% in 2013 but by 2015 Credit Suisse sees that as rising to 80%. As long as spot prices stay off the lows they have recently rebounded from, CS forecasts an increase from 2013’s US$107mpa dividend to US$200mpa in 2015. Throw in expectations of a quietly falling Aussie dollar (CS forecasts US86c in 2015), and the payment to AWC will be even more enticing.

Then consider that AWC has been using its dividends to reduce debt, and by 2015 should have little left. The company has wound down its capital expenditure and is not flagging any great leaps ahead. This means the dividend paid by Alcoa to AWC could be largely passed through to shareholders of AWC.

On that basis, Credit Suisse sees the potential for AWC to provide a 7.3% fully-franked yield in 2015, after a less exciting 2014 (1.0%). This has led the broker to increase its target price to $1.30 from 90c and thus upgrade its recommendation to Outperform from Underperform.

That now leaves a half-half split of three Buys, three Sells and one Hold for AWC.

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