The investment case we outlined for Alumina back in Alumina: Lousy business, hot opportunity(Speculative Buy - $1.44) was as simple as Alumina is complex. The alumina market was changing from supplying integrated aluminium producers to supplying a growing third party market, mostly producers in China.

That distinction had forced a change in the price structure that would make alumina less dependent on aluminium prices and finally reflect its own costs of production. Prices, we argued, would eventually rise and industry profits would be restored.

Alumina, whose sole asset is a 40% stake in AWAC, the world’s largest alumina and bauxite producer, would benefit. Months after making that call, Alumina’s share price promptly halved and, in Alumina: for the bold and the patient (Speculative Buy - $0.65), we repeated our call: things would get better. Finally, they have.

The share price tells part of the story – it has tripled off its lows – but AWAC’s results are even more telling. Costs have fallen with AWAC claiming almost US$300m in productivity gains last year, and operating margins have risen. More capacity is being utilised and less capital spent on expansions.

The price is right

The pricing strategy is working, too: 75% of sales now use the new pricing regime and it offers higher, more stable prices than the old aluminium link. If used today, the old aluminium link implies prices of US$1800 a tonne while the new regime delivers over US$2100 a tonne, margin that is crucial to AWAC.

The industry’s transformation isn’t complete yet: output continues to be cut and third party sales continue to rise so we expect improvements to continue. Aluminium producers compete viciously for margin but the alumina market, like iron ore, is far more concentrated and reliant on several large, well connected basins for supply.

Alumina was once a renowned distributor of dividends and should reclaim that title as distributions from AWAC increase and capital expenditure declines. All these improvements mean that this is no longer the maligned business it was and we must now plan an exit.

The share price rise has been slow, it is up 72% since our last upgrade in Alumina: Results 2012(Speculative Buy - $1.00), but that increase reflects genuinely better operating metrics. The balance sheet has been cleaned up and, with just US$87m in net debt, is no longer a concern.

Our original sell price of $2.50 remains on target and would imply a market capitalisation of about $7bn for Alumina, almost 3 times the implied book value of its AWAC stake. Considering most of AWAC's assets are heavily depreciated and difficult to replace, that's not an outrageous price. Until then, the investment case is on track and we’re happy to HOLD.