Alcoa World Alumina (ASX: AWC) and Chemicals' joint venture partner Alcoa (NYSE: AA) has launched a scrip takeover offer for Alumina. Consideration is 0.02854 Alcoa shares for each Alumina share, representing a 13.1% premium to Alumina’s immediately preceding share price of $1.02, or a 19.5% premium based on the average 12-month exchange ratio.

Morningstar doesn’t cover Alcoa, but the implied $1.15 based on Alcoa’s Feb. 23, 2024 close is marginally below our stand-alone $1.18 Alumina fair value estimate. Choosing whether to accept or not may prove a moot point given major Alumina shareholder Allan Gray Australia has promised Alcoa 19.9% at the bid terms, and Alumina's independent nonexecutive directors and the managing director and CEO all intend to recommend in the absence of a superior proposal.

This, in conjunction with the fact that Alumina is likely to report a particularly poor 2023 result, makes the chance of bid success relatively high. Consequently, we reduce our fair value for Alumina to $1.16, implicitly assuming a 75% chance the bid will succeed.

The market response in the immediate aftermath appears relatively muted, with Alumina shares up 8% to $1.10, just within the 3-star band. The implication is that there is a limited chance for a competing bid, not to mention potential disappointment in directors seemingly rolling over.

At this stage, the bid is nonbinding, indicative, and conditional. There is no action yet for shareholders to take and no certainty that a binding offer will eventuate. Ultimately, for the bid to proceed, it will require an independent expert report on fairness and both Alumina's and Alcoa's shareholder approval.

Business strategy and outlook

Alumina's sole asset is a 40% stake in Alcoa World Alumina and Chemicals, the world's largest alumina producer. Alcoa owns 60% and is the manager of the joint venture. AWAC primarily operates across the first two stages in the aluminium production chain: bauxite mining and alumina refining. AWAC's refineries are, on average, just inside the lowest quartile of the cost curve. Australian refineries constitute slightly more than 50% of the company’s alumina capacity and have gas contracts with the North-West Shelf. An agreement in 2015 secured gas for the majority of Australian production until 2032.
Alumina’s cost-efficient refining operations stem from proximity to bauxite mines and access to cheap power. However, prolific growth in Chinese alumina refining capacity means that future returns on invested capital are likely to remain below historical averages. But Alumina's returns should regardless exceed its cost of capital in a midcycle environment.
Producing aluminium is a three-stage, energy-intensive process. Bauxite is the key raw material, a reddish, aluminium-oxide-rich ore mined in large, earth-moving operations. In the second stage, bauxite is treated with caustic soda and heated under pressure to form a white powder (alumina). In alumina refining, caustic soda typically constitutes about 15% of the costs, while bauxite constitutes around 25% and energy 20%, with labor and other items representing the balance. In the third and final stage, aluminium smelting requires vast amounts of electricity run through alumina mixed with cryolite, a sodium aluminium fluoride mineral. One metric ton of aluminium requires 2 metric tons of alumina, which requires 4 or more metric tons of bauxite.
Aluminium is essentially solidified electricity. Energy—either directly via oil, gas, and coal, or indirectly via electricity—represents more than 40% of total production cost, ahead of labor and raw materials. The dynamics see refineries benefit from being located close to cheap energy and, if possible, bauxite mining. Smelters are also ideally located next to cheap power and near-end markets.