Alcoa and Alumina strike a clever win-win deal

The Alcoa logo displayed in the lobby of Alcoa's headquarters in Pittsburgh. (Gene Puskar/AP)

Alumina’s opportunistic bid for freedom via its threat to derail Alcoa Inc’s demerger plans has ended with what appears to be a value-adding outcome for both parties. It’s definitely improved Alumina’s position.

The litigation that threatened to complicate and delay Alcoa’s splitting of its upstream and downstream businesses was terminated overnight amid a major reworking — some might say modernisation — of the longstanding Alcoa World Alumina and Chemicals (AWAC) joint venture between the companies.

The redefined relationship is clever. It will add value and flexibility to Alumina in the near term while not only clearing the way for Alcoa to press ahead with its demerger but potentially creating a value-adding outcome for it, too, in the longer term.

For just over two decades, the Australian component of AWAC, a 40 per cent interest that originally resided within Western Mining before its own demerger created Alumina in 2002, has been essentially a financing vehicle, with some limited ability to influence but none to control.

The nature of the arrangements — which evolved out of a relationship between WMC and Alcoa that actually dates back more than half a century — meant that the only potential acquirer of Alumina was Alcoa, stripping Alumina of any control premium.

The overwhelming control Alcoa had, and has held until today, was underscored by a letter written by its then CEO, Alain Belda, to WMC’s Hugh Morgan in 2001, when the Alumina demerger was in train after WMC dismissed an Alcoa takeover approach.

Belda made it clear that WMC’s AWAC interest was “only a minority interest which is subject to Alcoa’s virtually complete control, is subject to an absolute prohibition on transfers to a certain class of buyers and is further subject to Alcoa’s right of first refusal in the event of a proposed transfer to a buyer.”

That was effectively the position Alcoa maintained when Alumina, confronted by the prospect of a new, less-diversified and robust partner with a collection of loss-making aluminium smelters, decided to use Alcoa’s own demerger as leverage.

Alumina threatened to at least delay Alcoa’s demerger plans by claiming the transfer of AWAC into a new legal entity — central to the spin-off — triggered first-right-of-refusal rights to acquire Alcoa’s interest in the joint venture, pre-emptive rights over individual assets within AWAC and/or rights to market its share of the joint venture’s production.

That threat, which Alcoa dismissed, nevertheless created negotiating leverage and ultimately brought both partners to the negotiating table.

An underlying reality of the AWAC relationship, particularly once the “new” Alcoa is distanced from the larger and more profitable vehicle (to be named Arconic) which will hold Alcoa’s downstream businesses, is that both parties need to be able to work together and trust each other in the long term.

The revised joint venture agreement creates a more equal partnership, will inject a takeover premium into Alumina’s share price, should give it a bigger flow of cash from AWAC and could give it the ability and capacity to become something more than a conduit for AWAC dividends.

It also, however, provides the new Alcoa with a more defined long-term relationship with Alumina and a framework that could attract and create a new value-adding partner in future. The agreement is one of those sensible “win-win” deals that produces something better than the status quo for both parties.

From Alumina’s perspective the immediate win is that it gets a bigger say, or at least an enhanced ability to veto significant acquisitions, divestitures, expansions or production curtailments and related-party transactions within AWAC, with the range of issues requiring a super-majority vote — a voting threshold of 80 per cent — expanded.

It will also potentially get bigger cash flows from the joint venture, with the minimum quarterly distribution of 30 per cent of the previous quarter’s earnings raised to a minimum of 50 per cent. Surplus cash within some of AWAC’s companies will also be distributed quarterly. AWAC will also be given an enhanced ability, with some limitations, to use debt to fund its investments.

Those are obvious and near term gains for Alumina. The potential longer term benefits, which should be reflected in some element of a takeover premium in its share price, are the elements of the agreement that related to a change in its control. Those are also potentially of considerable value to Alcoa.

If there were a change of control of Alumina in the future, the acquirer would be entitled to buy alumina, at market prices, from the joint venture (within a cap reflecting Alumina’s 40 per cent interest in AWAC).

The volume it would be entitled to would be its own net short position in alumina and up to one million tonnes a year, which it would be free to market itself. It would also be entitled to buy bauxite to cover its own net short position, with the same 40 per cent ownership cap.

That’s a very clever change to the current relationship. It opens Alumina to an acquisition by a trade player — but only someone who needs to acquire alumina and/or bauxite — and therefore creates prospect of a takeover premium in its share price.

Within the detail of the agreement there is also protection for Alumina in the event that the new Alcoa, without access to the big and more stable cashflows that flow from the downstream businesses today, were to find itself in Chapter 11.

One of Alumina’s key concerns about the demerger was that it would have a weaker and more financially vulnerable partner. It is a provision of the agreement that AWAC subsidiaries couldn’t also be placed in Chapter 11 if the new Alcoa filed for bankruptcy.

From Alcoa’s perspective, the new agreement creates the potential for Alumina to be transformed from a financing vehicle into a partnership with an active participant in the industry — and a big new customer.

The million tonnes of offtake envisaged by the arrangement is equivalent to about 7.5 per cent of AWAC”s current output and is essentially the volume that AWAC sells into the spot market today.

The other aspects of the new arrangements that cut in after a change of control would also help attract a trade buyer for Alumina. At present, AWAC is the exclusive vehicle for either company’s interest in bauxite or alumina.

In future, after a change of control, either would be free to develop or expand an asset within or without AWAC, funding it themselves and gaining access to all the offtake, provided they gave the other an opportunity to explore participation.

The changes effectively remove a poison pill. Currently, anyone who acquired Alumina would not only be trapped in the current governance structure, with its limitations, but have to vend in any existing alumina and bauxite assets they own — and the right to market them.

(It was that poison pill that caused WMC to demerge Alumina, because it deterred anyone with alumina or bauxite assets of their own — other than Alcoa — from bidding for WMC and therefore suppressed its own control premium).

When Alumina initially claimed that Alcoa’s demerger plans would trigger a range of rights over AWAC assets and output, Alcoa was scornful and dismissive and headed straight for the Delaware courts to seek their confirmation of its views.

With a really tight timeline to execute its demerger before the end of the year, however, a continuing stand-off with Alumina threatened delay and, potentially, an implosion of the joint venture that would have been very destructive.

Alumina might have been threatening that implosion, but almost certainly didn’t want it regardless of its claims and their validity. It has no operational capabilities today and would have had to scramble to acquire the people and systems and financial capacity if its ambit position had actually been successful.

The outcome reflects both a sensible and mature approach from both parties built around recognition that they are and will remain long-term partners in AWAC and that Alcoa’s demerger provided a catalyst for an overhaul and modernisation of their relationship to create something fairer and hopefully value-adding for both.