It might be the resolution of the image. I'm looking at the tga file in photoshop and the blocks appear all over the image. So its the resolution quality of the image rather than the alpha channel that is causing the blocks. I don't think you can smooth out the edges because the engine takes the image and copies it over and over on top of itself...so there isn't really an edge you can refine or smooth out.
The original image is blocky if you zoom in and look at it.....it is also 72 dpi. The tga file used in game is standard of 256 dpi. He just needs a higher resolution image to work from instead of crappy blocky low resolution pic from net.
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