|Shares Out. (in M):||0||P/E|
|Market Cap (in M):||210||P/FCF|
|Net Debt (in M):||0||EBIT||0||0|
Amerigo Resources (ARG CN on Bloomberg) is a copper and molybdenum producer whose enterprise value is trading below 5 times free cash flow on a trailing basis. The company has no debt and pays a 5.9% dividend at current prices. While a buyback program is in place, I’m not touting it because management doesn’t seem to want to pursue it with any vigor. Because a significant production ramp has just begun after the end of the third quarter, Amerigo’s next 12 months’ free cash flow multiple is under 3 times. Amerigo’s ore source includes the tailings from El Teniente, the world’s largest underground copper mine, as well as ore that had been deposited in two nearby tailings ponds over five decades. Therefore the depletion issues relative to production that challenges virtually every other copper producer today is not a problem here. Further, Amerigo’s highly experienced management team has demonstrated an impressive ability to consistently deploy the company’s enormous free cash flow into low risk, high ROI projects.
Issambres introduced Amerigo to the VIC almost 3 years ago. Since then, the company has constructed a large-scale molybdenum concentrating circuit, completed plant upgrades to increase annual copper production capacity from 35mm pounds to 65mm pounds, and printed $1.00 per share in earnings. With the price of copper up from $1.20 per pound to $3.00 per pound, and molybdenum prices virtually unchanged at about $34 per pound, it’s hard to believe that you can buy Amerigo today (in Canadian dollars, at least) for the same price that you could back at the beginning of 2005.
There are several reasons for the multiyear share price stagnation – none of which contradicts the original investment thesis that Issambres presented. While my discussion here will include a brief overview of Amerigo’s fresh tailings processing operation, I want to focus more on recent events, projections, and our valuation analysis for highlighting why the stock remains such a compelling investment. I strongly encourage readers to also review Issambres’ excellent writeup for more background.
Amerigo had also been extracting and processing tailings from the nearby Colihues pond since 2004. The Colihues pond is where El Teniente’s tailings were impounded during the period from 1977 to 1985 before the construction of MVC. There are approximately 1.3 billion pounds of contained copper within the 200mm tons of tailings deposited in Colihues. Amerigo had targeted extracting approximately 10,000 tpd of these tailings in 2005, and growing throughput from this source to 45,000 tpd by the end of 2006. Importantly, the copper and moly grade of these “old” tailings are three times as high as the fresh tailings received from El Teniente. Therefore the production from the 45,000 tpd Colihues throughput could be expected to be approximately equal to the production from the 130,000 tpd of fresh tailings from El Teniente.
Here is where Amerigo drifted a bit off course, and perhaps initiated the turnover in its investor base that continues today. Chairman Steven Dean had set a target to ramp annual copper production to 60mm pounds and moly production to 1mm pounds by the end of 2006. While plant capacity was constructed in time to accommodate these goals, equipment procurement issues prevented extraction from Colihues from ramping according to plan during 2005.
Then they were really blindsided: just as new hydraulic monitors were deployed to increase Colihues’ throughput, Codelco announced in April 2006 that it needed to reduce the flow from MVC to Caren in order to reinforce bridgework along that route. Not only was Amerigo forced to completely curtail the Colihues operation until further notice, the fresh tailings flow from El Teniente was reduced by 25%. Intermittent curtailments continued through the beginning of 2007, and full flow was not restored until March 2007. Colihues extraction remained prohibited through the third quarter of 2007. Instead of ramping toward 60mm pounds of production, Amerigo’s copper sales actually fell from just under 30mm pounds in 2005 to 24.6mm pounds in 2006.
Because the tailings currently being processed from Colihues are actually fresh tailings that had been deposited into the pond while the flow was disrupted during 2006, the ore from the extraction during Q4 07 and Q1 08 will be similar to the lower-grade fresh tailings from El Teniente rather than the higher-grade old tailings that had been deposited in the late 1970’s and early 1980’s. We therefore expect a slow production ramp from last quarter’s 8mm pound copper production rate to Amerigo’s target of 15mm pounds per quarter by Q4 08. Historical and our projected quarterly copper and moly production estimates look as follows:
Q2 07A Q3 07A Q4 07E Q1 08E Q2 08E Q3 08E Q4 08E FY 09E
Copper (mm lbs) 9.31 8.05 10.00 10.50 12.00 13.50 15.00 60.00
Moly (mm lbs) 0.20 0.13 0.19 0.20 0.22 0.23 0.25 1.00
Note that copper and moly production dipped in the Q3 07 because of a Codelco-wide strike that resulted in significantly reduced tailings flow for approximately two weeks during the month of July. Amerigo will undoubtedly continue to be impacted by temporary, one-time issues such as this, and we expect the actual production ramp to be lumpier than what is presented above, but nonetheless trending steadily upward to the 60mm pound copper/1mm pound moly production goal.
Copper Price Sensitivity
Amerigo’s processing costs have increased from 36 cents per pound in Q1 2005 to $1.72 per pound in Q3 2007, primarily as a result of higher energy prices. Further, as copper prices rose from $1.50 per pound in Q1 2005 to $3.50 in Q3 2007, El Teniente’s royalty fee rose from 19 cents per pound to 58 cents per pound. In other words, as copper prices rose by $2.00 per pound over this period, production costs rose by $1.36 per pound and the royalty rose by $0.39 per pound, for a total expense increase of $1.75 on these two items alone! It is easy to see that only modest increases in smelter costs, taxes, and administration would gobble up most of the remaining 25 cents in margin advantage offered by the higher copper price. Our analysis suggests that if the correlation between energy prices and copper prices continue to hold, Amerigo’s earnings will be virtually unaffected by copper price movements between $2.00 and $4.50 per pound.
Our 2008 and 2009 cash flow projections for MVC are as follows:
Copper Production (mm lbs) 51.00 60.00
Moly Production (mm lbs) 0.90 1.00
Copper Price ($/lb) 3.00 3.00
Moly Price 25.00 15.00
Processing cost ($/lb) 1.30 1.20
Royalty 0.45 0.43
Admin 0.03 0.03
Transport 0.03 0.03
Overhead 0.02 0.02
Moly byproduct credit -0.44 -0.25
Net Costs ($/lb) 1.39 1.46
Net Cash profit/lb 1.61 1.54
Operating Cashflow 82mm 92mm
Tax (17%) 14mm 16mm
Maintenance Capex 5mm 5mm
Free Cashflow 63mm 71mm
1. The molybdenum circuit completed in March 2005 took 3 months to construct with a capital cost of $4.4 million. The project returned its full capital cost in 3 months, and will deliver at least $15mm in cash value annually for the foreseeable future. This project will therefore deliver a virtually perpetual return on capital of over 240%.
2. During the second quarter of 2006, Amerigo acquired 31.8mm shares and 11.5mm warrants in Chariot Resources, a development stage copper operation, for $12.5mm. These securities were sold within 5 months for $21.3mm, generating a pre-tax profit of $8.8mm. Although the purchase was intended as a longer-term strategic investment when it was made, the 70% pre-tax absolute return and 250% annualized equivalent return on capital they realized when their overtures were rebuffed provides some evidence that these guys know what they’re doing when they choose projects in the space.
3. During the second quarter of 2007, Amerigo acquired 6.9mm share of Candente Resources, a development stage copper operation, for $8.6mm. At today’s price of $1.91 per share, this stake is worth $13.2mm, representing a gain of $4.6mm, or 53% over a 6 month holding period. While I acknowledge that this represents a possibly ephemeral mark to market gain, it is worth noting that this share appreciation equates to a 135% annualized return on capital.
4. In the third quarter of 2007 the company began the installation of two 10-megawatt generators to reduce reliance on rising grid electricity costs in Chile. At current grid prices, this $9mm capital investment is expected to achieve full payback within about a year of the project’s completion in mid-2008. Thus, in addition to the strategic value of achieving energy self-sufficiency and diversifying the company’s ultimate energy source from natural gas to bunker seed oil, the investment is likely to realize an ongoing 100% annualized return on capital.
Likely future large-scale investment opportunities include extending the strategic relationship with Candente to move their extensive Canariaco copper resource in Peru into production, as well as integrating Codelco’s Cauquenes tailings deposit into the MVC operation. The tailings in Cauquenes were deposited between 1935 and 1975, and have copper grades similar to the ore in Colihues. At a copper grade of 0.30%, there are an estimated 3.3 billion pounds of contained copper within the 500mm tons of tailings in Cauquenes.
2008 EBITDA 2008 EV/FCF 2008 EV/EBITDA
Amerigo 82mm 2.7x 2.1x
Antofagasta 3,106mm 7.1x 6.0x
Anvil 270mm 4.2x 3.4x
First Quantum 1,653mm 4.1x 3.0x
Frontera 135mm 3.0x 2.1x
Inmet 806mm 5.0x 4.2x
Quadra 278mm 3.2x 2.6x
Taseko 233mm 4.2x 3.6x
Average 4.2x 3.4x
|Entry||12/06/2007 04:33 PM|
|You mention that you believe that the cost component of their copper production is highly correlated with the spot price of copper, and that any move between $2 and $4.50 copper would be basically a net zero to their cash margin per lbs. How did you come to this conclusion? Company management mentioned that while Chilean energy costs do affect the overall supply in the longer term (people are hesitant to invest in new mining operations), there are a number of exogenous factors, particularly a reduction in natural gas importation from Argentina, that have been keeping Chilean energy prices high.|
That being said, great work, very interesting idea.
|Entry||12/06/2007 07:53 PM|
|Thanks for this follow-up of my write-up so long ago.|
1)Why do you think management doesn't own more shares of this? Or why aren't they buying? They actually large sellers earlier this year.
2)Have you met with management, talked with them? What is your opinion?
3)What do you think management does with the excess cash? I'm not sure I like them speculating on copper juniors. And this question actually relates to question #1. If they owned a lot of shares, dividends would be their highest priority.
|Entry||12/07/2007 10:55 AM|
|Hi Britt - |
Thanks for the very good questions.
A regression of the company's production costs per pound produced against the average selling price in each quarter yields a correlation of almost 70%. That is, 70% of the variance in production cost per pound could be explained by the price of copper itself. A good portion of the remainder of the variance in this cash margin is eaten up by the royalty, which at a given production level increases and decreases with 100% correlation to the copper price. Using this model and playing with different copper price assumptions showed a net cash income swing of about $800k at the 8mm pound quarterly production level, which seems neglible relative to the impact of throughput and grade levels (particularly with regard to moly grades) on cash profits.
You correctly point out that the high cost of natural gas in Chile is largely country-specific. However, since Chile represents over 35% of the world's copper production , the need for Codelco to pass through these higher costs undoubtedly influences the global price.
I think the cost factor influences short term prices as well as long term, particularly when the industry is operating at the high capacity utilization levels we have seen in the last few years. In essence, the balance of the negotiating power has moved to the side of the producers, who can now insist that they recover all of their costs plus a decent profit margin without fear that new supply can easily come on as prices rises.
While admittedly overly simplified and probably has a variety of explanations, it is instructive that regressing the monthly copper price against oil prices over the last 2 years shows a 20% R-squared, whereas it was under 2% over the last 20 years, which includes the long period of high capacity relative to demand.
|Entry||12/07/2007 04:41 PM|
|Issambres - |
Thank you for your questions.
1. I see bloomberg showing Klaus having sold 200k of his 3.2mm shares in April, when the stock traded to its all-time high and broke $3 for the first time. I have a call in to Klaus and will ask him his reasoning. I would guess that he's just taking some chips off after watching this thing trade up to $2.50 in early 2004 and meander for 3 years. Klaus and Steven do have an additional equity interest in the form of their Class A shares, which gives them 1c per pound of copper sold and a small take of moly revs, which arguably only partially aligns their interests with shareholders. They are not young, and they don't pay themselves much beyond what they garner from the Class A Shares. They have also operated through a long, depressed commodity cycle, which undoubtedly influences their mindset.
2. Steven and Klaus have been to our offices several times. I find them as credible as their impressive resumes would make you expect. They seem serious and almost the opposite of promotional, which I like but probably wins him few friends within their longtime shareholder base.
Mr. Dean tends to get very sensitive and cantankerous when investors make suggestions for enhancing shareholder value, and this may explain some of the discount on Amerigo shares. I find Klaus Zeitler much easier to speak with, and he seems have much more detailed information on the operation in any case.
These guys clearly want to do bigger things, and I think they have the capacity to accomplish their goals. I also strongly feel that they will bide their time, find the right opportunity, and move only when they feel they have a sure thing. They are clearly on the conservative side of mine operators.
3. Related to the last paragraph, I think they want to manage a bigger, more diversified producer. Obviously the tailings pond opportunities are large resources that they could pursue, but after their experience in 2006, I think they want to have a non-Codelco project in their portfolio. They tried this with Chariot, and now Candente. Joanne Freeze and Fredy Huanqui apparently have a very strong reputation in the industry for finding large resources. Candente's starter pit alone has 1.4 billion pounds of contained copper. Production is expected sooner (late 2009) than any of the other development companies we've seen. With potential capacity starting at 80mm pds per year and growing to 250mm, you're looking at $100mm in initial runrate cashflow growing to four times that on a company with no debt and a $180mm market cap (but also a $200mm - $300mm construction capex spend, which could be mostly bankable).
In almost every case, I like dividends and when a company is really undervalued I like a real buyback even more. However, if they can find projects with even higher IRRs than the free cashflow yield on their stock, and they're conservative, I'm fine with them deploying my capital. We think the junior mining space is full of opportunities with multibagger upside, but also full of dogs, and we feel we're too generalist to vet most of these properly. Here we have two conservative experts that seem to understand risk and capital allocation very well to do it for us.
|Entry||12/18/2007 03:36 PM|
|I just spoke with Klaus Zeitler to ask him about his share sales in April. He said he hasn't sold any of his original shares since the inception of the company and the only shares he has sold were from option exercises. The exercise early in the year was to generate some cash for personal reasons (daughter buying a house, etc.) and unrelated to his view of Amerigo's valuation or prospects, for which he expresses a very bullish view.|
He confirmed that Colihues is online and they are drawing a modest 10-15k tons per day, which they expect to increase steadily throughout 2008. Recall that the current draw is from the lower grade tailings that were deposited at the end of 2006 as the Caren bridge was being reinforced, so it will take a few months to get through this before they will see the benefit of the higher grade ore that was originally deposited in Colihues 25 years ago. The operation is running well and electricity prices have receded somewhat from the seasonal spike that impacted last quarter's results.