Quick Pitch: Alumina (AWC:AX)

Merger Arbitrage – 10% Upside

This idea was hinted by George.

 

This arbitrage opportunity involves a merger of two joint venture partners and seems pretty close to a “done deal”.

AWAC is a privately held joint venture involved in bauxite mining (aluminum ore extraction), alumina refining, and aluminum smelting. The JV is 60% owned by NYSE-listed Alcoa and 40% by Australian-listed Alumina. The interest in AWAC is Alumina’s only asset. Alcoa does have a few other small mining-related assets, but AWAC JV is the core holding.

At the end of February, the companies announced that they are on the verge of signing a definitive merger agreement. Alumina shareholders are set to receive 0.02854 shares of Alcoa per each Alumina share. Alumina’s board has already agreed to recommend the deal to shareholders and its largest shareholder Allan Gray, with a 19.9% stake, has also agreed to support the transaction. The announcement follows a round of private negotiations and Alcoa has now secured a 20-day exclusivity period to conclude the final touches of the deal. I expect a binding agreement to be signed in the coming weeks.

The spread has been hovering at 10%-11% and there is plenty of cheap borrow available for this arb. Alcoa will pay 1 or 2 quarterly dividends before the buyout closes, which will reduce the total upside by 1%. The transaction might be getting a “non-binding stage” discount, although it’s extremely unlikely the deal could get withdrawn at this stage. However, most of the spread probably exists because this is an international merger with no overlap between the trading hours of both stocks. There’s some exposure to FX volatility as well.

Prices of both stocks are up about 10% from their pre-announcement levels. In case the deal breaks, the potential downside on a hedged trade should be minimal.

Any competing bids are unlikely. Notably, the support agreement with Allan Gray also includes a provision allowing Alcoa to acquire all of Allan Gray’s stake in Alumina. This would grant Alcoa immediate access to a blocking stake (although it wouldn’t be able to vote those shares for its own offer then).

Among Alumina’s other major shareholders are the Chinese investment giant CITIC Group, holding 18.9%, and the Australian fund manager Schroder Investment Manager, which owns 7.5%. CITIC Group’s stance on this merger is not clear yet, although AFR reported that it already had discussions with Alcoa/Alumina about it. I guess the fact that Alcoa and Alumina went public with the merger suggests that the talks with other shareholders were positive.

Overall, I expect no issues with shareholder approval. This is a pretty straightforward merger of two JV partners and the consideration comes in stock with plentiful and cheap borrow for hedging.

The buyout will require approval from Australia’s foreign investment watchdog, however, there should be no issues here given that Alcoa already owns 60% of the JV and has full operational control of the asset.

 

Why the merger makes sense

Elimination of this messy JV structure would not only reduce costs (Alumina’s annual overheads stand at US$12m), but also streamline the decision-making process at AWAC JV and resolve the potential liquidity concerns at Alumina.

Although Alcoa already has full operational control of the JV, the actual decision-making body of the JV is its Strategic Council, which consists of 5 members (3 of Alcoa and 2 of Alumina), and needs consent from 4/5 members for any matter to proceed. Streamlining this process will give Alcoa greater control of the JV to navigate the currently turbulent market conditions.

The whole alumina sector is currently in a down-cycle, with AWAC JV experiencing a particularly strong impact due to other operational issues, including lower production volumes, delays of mining permits, and low-grade feedstock. Last year’s performance was quite bad with the JV’s EBITDA dropping to US$165m vs US$817m in 2022 and US$1146m in 2021. The JV burned almost US$300m of cash in 2023 and Alumina was even called to inject an additional US$159m of capital into AWAC compared to net receipts of US$166m from the JV in 2022. This year, AWAC’s capex is projected to grow by 30% YoY due to very expensive refinery curtailment (estimated total cost of US$130m), so further cash injections from the JV partners will likely be required again.

Meanwhile, Alumina’s net debt was already at US$300m as of year-end versus the US$500m limit of its credit facility and Alumina’s CEO noted that the company might face a dilutive equity raise in case Alcoa’s buyout doesn’t go through. Overall, the elimination of the JV structure will result in greater financial flexibility and access to capital.

 

A few other things

• The trading hours of Alcoa’s and Alumina’s shares do not overlap, so the arb will have to get locked-in with a slight time lag. The most efficient option seems to be shorting Alcoa at the end of the US market hours and then buying Alumina two hours later when the Australian market opens.
• According to AFR, the combined company will be the world’s second-largest bauxite miner, 3rd largest alumina refiner outside China, and 5th largest aluminum producer outside China.
• Interestingly, CITIC is also a minority partner in a separate JV with AWAC called Portland Aluminum (aluminum smelter). AWAC owns a controlling 55% interest, CITIC hods 22.5%. The remaining stake in Portland Aluminum JV is held by Japanese trading conglomerate Marubeni.
• There’s been some chatter from the retail crowd on Hotcopper forum, claiming the offer comes at an opportunistic timing, when Alumina’s stock price is at all-time lows and USD/AUD exchange rate is unfavorable. I believe it’s unlikely that retail shareholders could impede this merger. Firstly, these claims lack substantial grounds, given that the industry-related and operational challenges of the AWAC are impacting both JV partners. Share prices of both JV partners have actually seen a similar decline over the recent years. The consideration is in stock, which provides a continuous upside exposure. The historical correlation of these stocks has been very high (see the chart below) except for the turbulence during COVID outbreak and the start of Russian/Ukraine war in 2022 when Aluminum prices skyrocketed. Lastly, retail shareholder ownership at Alumina is quite limited. The support from the 3 largest shareholders (46.5% combined stake) would secure the shareholder approval condition.