Alumina's earnings are under extreme stress. The outlook is

for continuing low aluminum demand. Despite considerable

global production cuts, London Metal Exchange stockpiles

remain stubbornly high. Our investment thesis is that

Alumina is predominantly placed in the higher-margin

alumina segment with less exposure to the more pressured

aluminum segment. Further, AWAC refineries are worldclass

with low sovereign risk. They took decades to build,

are low-mid cost, and replacement value is many multiples

of the current market capitalization. We look to global 

production cuts to eventually support prices and in the

longer term for population growth and urbanization,

particularly in China, to return the market to growth. The

capital raising goes some considerable way to ensuring

Alumina survives in the meantime. Risk is very much

lowered. It is not without cost, acutely so for shareholders

who don't take up their entitlements and for ADR holders.

Alumina has a 40% interest in Alcoa World Alumina and

Chemicals, the world's largest alumina producer. Alcoa AA

owns the other 60%. AWAC is predominantly exposed to the

first two stages in the aluminum production chain: bauxite

mining and alumina refining. Five of its eight refineries are

in the lowest-cost quartile, and overall, the company is

firmly in the bottom half of the cost curve. Australian

refineries have gas contracts with the North West Shelf

Venture until 2020. Alumina production near bauxite mines

and cheap power should have a considerable cost

advantage. Prolific growth in Chinese alumina capacity,

predominantly in the highest-cost quartile, enhances

AWAC's relative cost position. Alcoa's aluminum smelters

are the natural market for AWAC's product.

Is Alumina a hostage or beneficiary? AWAC is the exclusive

vehicle for Alcoa's and Alumina's bauxite and alumina

businesses, enshrined in joint-venture agreements. The

ownership structure means that Alumina can be called on

for its 40% share of as much as $500 million in capital costs

in any year--that is, as much as $200 million. For capital

calls greater than $500 million but less than $1 billion,

Alumina has 30 days to decide to participate or suffer

dilution of its AWAC interest. For capital calls greater than

$1 billion, there is a requirement for unanimous agreement.

For its part, AWAC must distribute at least 30% of prioryear

earnings as dividends and must not let the net

debt/net debt plus equity ratio rise above 30%.

Any new bauxite or alumina venture from Alcoa or Alumina

must first be offered to AWAC. Any successful bidder for

Alcoa or Alumina would necessarily inherit the AWAC jointventure

agreements and would be required to offer its

independently owned bauxite and alumina assets to the

structure. This may be positive, given the right assets, but it

could also force Alumina to stretch financially to maintain its

participating interest. A successful bidder for Alcoa would

probably bid for Alumina as well, to avoid compromising its

own bauxite/alumina businesses. The AWAC-Alumina

arrangement is somewhat of a poison pill in this regard.

AWAC's 25% global market share is double those of nearest

rivals, Chalco ACH and Alcan AL, and more than 3 times

BHP Billiton's BHP; this size affords efficiencies and

flexibility. AWAC flags potential for an additional 40%, or 6

million metric tons annually, of equity alumina capacity.

AWAC is unleveraged, and Alumina is moderately leveraged

at about 50% net debt/equity. AWAC is expanding at the

expense of near-term dividend growth to Alumina.

Near-term production cutbacks

and commodity price weakness are a feature. That said, we

think a number of factors are working against long-term

Chinese production growth: limits to low-cost energy, a lack

of quality domestic bauxite/alumina feedstock, and carbon

emission considerations. China is a high-cost producer.

Although AWAC has numerous competitive advantages, we

don't believe these are sufficient to assign any economic

moat rating. Alumina production costs have been rising

because of higher energy, caustic soda, and bauxite costs.

We forecast operating margins to stabilize because of an

easing in cost pressures, generally in addition to pricelinked

costs.