Is New Alumina Pricing Paradigm Closer Than Thought?

Compared with its June quarter, Alcoa AA reported a 55% decline in headline September-quarter earnings, to $61 million. The alumina segment--a proxy for Alcoa World Alumina and Chemicals' and Alumina's AWC performance--suffered a 26% fall to $70 million, though this figure includes a discrete favorable $30 million tax item attributable to noncontrolling interests, which will not be recognized in Alumina's accounts. This all sounds surprisingly grim for AWAC, given the improved aluminum price and stronger demand. However, these numbers include $38 million in ongoing commissioning costs associated with the Sao Luis refinery in Brazil, in addition to what we estimate is around $74 million in unrealized derivative losses partially offset by $33 million in unrealized gains on employee retirement benefit obligations. The last two items are purely a function of marking to market.

Alcoa's numbers suggest AWAC's underlying third-quarter earnings are probably around $70 million, though with a pretty wide margin for error. This compares favorably with our more conservative forecast of $64 million. We are happy to remain on the cautious side, given the usual uncertainties. However, we have modestly upgraded our aluminum price forecast and it results in a considerable percentage increase to our forecasts for Alumina, as earnings are coming off a very low historical base. A 1% change in aluminum price results in a $0.75 per share or 5% change to our fiscal 2011 earnings forecast for Alumina.

Alumina shares have seen a healthy boost since Alcoa's third-quarter release. A number of positives were highlighted in Alcoa chairman and CEO Klaus Kleinfeld's presentation. Alumina's larger American cousin has given added weight to its assertion that alumina prices will favorably decouple from aluminum. Kleinfeld said exciting things were going on in the alumina markets. This quarter, Platts launched a smelter-grade alumina pricing system. The average price since the index began is $327 per tonne and was last at $348. This is a premium of around 20% to third-quarter contract pricing. Of note, Kleinfeld said AWAC is concluding index-based contracts already. About 20% of AWAC's volume will be up for contract renewal every year. AWAC is successfully concluding volume for 2011 using a monthly average of a basket of different published alumina prices.

Significantly for Alumina, Alcoa's smelters buy on the same terms as external customers--AWAC is run as a separate at-arm's-length business. We can't help but think that Alumina becomes increasingly attractive to Alcoa under the new alumina pricing regime. The ideal time to launch a bid for Alumina has probably passed. Regardless, it's still relatively early days in the change. Pricing for now remains based largely on a two-month lag to London Metal Exchange aluminum.