Over 2021, the alumina price has soared due to interruptions to supply and higher industry costs. In turn, this has supported a re-rating in Alumina (ASX:AWC) shares to a high of $2.30 last month. However, the shares have recently weakened, as the market has taken the view that the strong alumina price is unsustainable. While the alumina price is the main catalyst for AWC shares, we assess the extent to which there may be other factors that could support a recovery in the shares.
AWC’s sole asset is a 40% interest in the Alcoa Worldwide Alumina and Chemicals (AWAC) joint venture (JV). This has interests in bauxite mining, alumina refining, alumina chemicals, and aluminium smelters. The other 60% interest in the JV is held by Alcoa. The Company has a 31 December balance date and recently reported results for the September 2021 quarter (3Q21).
Key Fundamental Drivers
Can the High Alumina Price Be Sustained?
Alumina prices recently reached a peak of US$480/t. While this factor provides earnings upside risk for 4Q21, peak prices appear unsustainable.
Firstly, while alumina prices have historically been highly sensitive to interruptions in supply, the above-mentioned supply disruptions are expected to be temporary. Secondly, alumina prices have only traded above spot for a period in 2018 when Hydro’s Alunorte asset in Brazil had a power outage. Alumina prices have average US$345/t since the start of 2015.
Although, alumina prices have already corrected after the recent rally, most recently trading around the US$435/t mark. Further, the Platts alumina FOB Australia future price is at US$395/t. Aluminium prices have followed the same trend, dropping sharply over the last few weeks.
Cost Pressure Mitigating Margin Expansion
Cash costs for 3Q21 averaged US$239/t, which was 3% above the prior quarter (2Q21) and continues the successive upward trend in cash costs from the most recent low of US$188/t in 2Q20. Higher energy costs, caustic soda prices and unplanned outages at Alumar were key impacts on cash costs in 3Q21. In July 2021, the Alumar operation experienced some disruptions due to a bauxite ship unloader damage. Alcoa noted in its earnings release in mid-October that Alumar’s alumina production was restored to ~95% of its capacity in early October.
Alcoa is expecting further cost pressure in 4Q21. The San Ciprián refining operations are expected to face significantly higher energy and raw materials costs, as well as the loss of value-add premiums while strike conditions persist. Beyond San Ciprián impacts, Alcoa also anticipates continuing inflationary pressure on raw materials and energy. In addition, additional costs will be incurred in 4Q21 related to the recommencement of the Portland Aluminium smelter.
While the Company continues to face cost pressure, margins for the time being, are holding up. AWAC reported a US$55/t alumina margin for 3Q21, which was a slight improvement on 2Q21, but remains well below recent levels as the costs continue to increase. Accordingly, an improvement in margin is expected in 4Q21 on the back of higher realised alumina prices, which are expected to offset the additional cash costs. AWC noted that should the alumina price remain at ~US$430/t, the cash margin is expected to be around US$190/t in 4Q21.
Predicting Distributions Becoming More Challenging
The distribution policies of Alumina Ltd and the AWAC JV require free cash flows to be paid to their respective shareholders. The AWAC JV pays a minimum quarterly distribution of 50% of the prior quarter’s net profit of each company comprising the AWAC JV. In addition, any surplus cash within certain of the AWAC companies will be distributed on a quarterly basis.
A disappointing aspect of the recent 3Q21 update was that the net cash distributions received from the AWAC JV of US$32m was lower than US$75m reported in 2Q21. This result was well below market expectations for higher distributions, which were expected given the stronger alumina price. However, this difference (i.e. between what was delivered versus what was expected) was likely a timing issue, with the higher average realised alumina price in 3Q21 to be reflected in the distribution for 4Q21. Also, AWC noted that the expected higher margin for 4Q21 is expected to flow through to increased distributions in 1Q22.
We highlight two factors that make predicting distributions in FY22/33 more challenging:
i. Limited Production Growth. While an improvement in production is expected in 4Q21 from the resumption of full production at the Alumar refinery in Brazil, limited production growth is assumed over the near to medium term, with JV partner Alcoa continuing to defer around 0.8Mtpa of high returning creep projects at the WA alumina refineries. However, first production from the recommencement of the Portland Aluminium smelter is expected in 3Q22, with the higher aluminium production from FY22 onwards expected to improve AWC’s earnings profile over the medium and longer term.
ii. Potential free cashflow headwinds in FY22 from higher CAPEX, higher one-off & restructuring costs, and a potential tax liability from the Australian Tax Office (ATO). The potential tax liability from the ATO remains an overhang on the stock from the viewpoint that it impacts cash generation and future distributions and that an equity raising may be needed to partially/fully fund any penalties imposed by the ATO. In terms of CAPEX, FY21 guidance of US$265m is well above the 5-year average of ~US$190m. The Company also noted at the interim results release in August 2021 that CAPEX will remain elevated over the coming years.
The higher alumina price in the current quarter is expected to benefit margins and distribution in 4Q21/1Q22. However, expectation of a retreating alumina price as supply returns is the main factor precluding a more favourable view on AWC at present, especially as the cost base remains elevated.
AWC had an upside break at the end of August. After pushing higher for several weeks, AWC then fell back quite swiftly towards the breakout area. It continues to fall and trade poorly. It is likely that we see AWC shares continue to pull back from here in the short term. The next line of support is expected to come in near $1.70.
Michael Gable is managing director of Fairmont Equities.
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