Strong Alcoa Result Supports Recovery Hypothesis for Alumina Ltd.

Alcoa AA reports a 20% increase in first-quarter 2011 income from continuing operations to $309 million, the best quarter in almost two years. Record profits were recorded in midstream and downstream businesses. The company reaffirmed its 2011 global aluminum demand growth projection of 12%. The upbeat take comes in stark contrast to heavy losses reported in 2009, when margins in primary aluminum vanished. Alcoa World Alumina and Chemicals (AWAC) had faired better during that period when alumina margins held up preferably, though AWAC still reported a bottom line close to break-even. But AWAC has been on the mend since first-half 2009 lows and the implication from Alcoa's first-quarter result is positive again.

Alcoa's alumina division is a good proxy for the AWAC result, after adjusting for retirement benefit obligations (RBO) and embedded derivatives. It reported first-quarter 2011 operating income of $142 million, a rise of 118% on the fourth-quarter result. This suggests an underlying first quarter profit for AWAC of around $160 million, pushing pre-global financial crisis levels, and pleasingly close to our current forecast. As a result, we make no changes to our earnings forecast for Alumina Ltd. AWC or to our valuation. Of course, those earnings have been diluted by capital raisings in 2008 and 2009, meaning the recovery won't be fully reflected in the "per share" statistics, bonus elements not withstanding.

The rise in the Dow during the last quarter is positive for RBO, though the accompanying strong rise in aluminum prices, and implication for hedges, more than offsets the benefit. We estimate a net negative of $11 million for first-quarter 2011, though both are unrealized, noncash, and are excluded from our underlying AWAC earnings forecasts.

Alumina's shares recently hit a near two-year high from March 2009's lows. This has seen the stock flirting closer to our valuation. That valuation assumes a long-term aluminum price of $1.30 per pound, still $0.10 above the much-improved spot price. But we haven't specifically allowed for the favorable impact of the decoupling of alumina prices from aluminum prices in our model. For the moment, this is captured in the higher assumed long-run aluminum price.

We continue to watch aluminum price action with interest, as it appears encouragingly strong in the face of still sky-high LME stockpiles. This seeming enigma is supportive--though not yet proof--of the notion that alumina prices, for the first time reflective of genuine industry fundamentals, must necessarily be reflected in aluminum prices. As the saying goes, just as the only cure for high prices is high prices, the only cure for low prices is low prices. And we've had comparatively low aluminum prices for far too long.