Breakwater Resources Ltd. is a producer of zinc and various other base / precious metals, with a clean balance sheet and a future increase in production that is not widely appreciated by the market. Levered anywhere from 1.5x to 2.5x to the price of zinc on the upside (and arguably less on the downside), it has the potential to be a highly-convex investment with significant upside if zinc prices head north.
Breakwater is in the zinc business, as about 50% of its revenue comes from the value of the zinc contained in the concentrate it produces and sells. They own four mines: three are currently producing, two can be described as world-class by virtue of their low cost, and one is on care and maintenance with plans for its restart to commence in 2012.
Zinc cash cost of production = $0.03/lb (net of by-product credits)
Life of mine ~5y.
Zinc cash cost of production = ($0.02)/lb (net of by-product credits)
Life of mine ~6y
Myra Falls (Canada)
Zinc cash cost of production = $0.31/lb (net of by-product credits)
Life of mine ~10y
Currently on care and maintenance, due to be restarted in the beginning of 2012. Cash costs were $0.79/lb during Q3 2008.
Life of mine ~10y
By restarting their Langlois mine and by having completed some equipment upgrades at Toqui (new paste plant and ball mill), Breakwater will be producing approximately 60% more payable zinc in 2012 versus 2010. 2011 will see them producing about 95,000 tonnes of zinc (up from 88,000 in 2010) and by 2012 they'll be at 141,000 tonnes.
ZINC MARKET DYNAMICS
Zinc has been rangebound for the past 20 months, trading between $0.80 and $1.15 per pound since July 2009. Long-term fundamentals in the zinc industry are good for producers, as current plans for mine closures and ramp-downs exceed those for new mines / expansions, suggesting that in the next 9 years global zinc supply is set to decline by ~20%.
MANAGEMENT, SHAREHOLDER BASE
We met with CEO David Petroff back in October and found him to be refreshingly risk-averse. More of a cautious mathematician than an ambitious empire-builder, he is likely to be a good and conservative steward of the assets he's been commissioned to manage.
BWR has less than $10mm of gross debt, and has a balance sheet that is conservative nearly to a fault. Pro-forma for a bought deal they did in Q4, they had about $118mm worth of cash at the end of Q3.
We value BWR with the following assumptions:
- Burden EBITDA with exploration expenses that are budgeted to run at $0.05 per pound of zinc produced in any given year.
- Assume that BWR will never replace their reserves, but instead produce them to total depletion.
- Assume that the spot prices of all produced commodities persist in perpetuity at their current levels.
- Burden annual FCF by an average of 30mm worth of maintenance capex that will need to be spent from now through the useful life of the assets
- Burden TEV by $54mm of growth capex (including the remainder of the cost to restart Langlois).
- Pay a 17% tax rate on Toqui (Chile) and use up tax losses at Myra Falls such that BWR will likely never be a material payer of taxes on this asset. 30% tax rate at Mochito (Honduras) and a 30% rate at Langlois.
Based on these assumptions, modified TEV is $54mm higher than the above $478mm, or about $535mm. Using a 10% discount rate, the PV of all future reserve production (again, with zero reserve replacement but full exploration burden) is 91% of this amount, or $486mm.
- First key area of upside concerns reserve replacemet. If they can on average replace just 50% of the reserves they mine through their exploration spend, their PV10 value is not 91% of TEV but rather 61%. The Mochito asset alone has featured an average a 5 year mine life since 1948, and has a great track record of reserve replacement.
- Second, leverage to zinc. Pro-forma for the restart of the Langlois mine, BWR operates two mining assets that are not on the low end of the industry's marginal cost curve. These assets give BWR significant operating leverage to changes in the price of zinc. This is seen during their 2009/2010 operating history. In Q1 2009 they were at about breakeven margins (when zinc prices were below $0.60/lb) and for FY 2010E, they will enjoy a 39% FY EBITDA margin (with zinc prices averaging about $1/lb). According to my internal calculations, the PV10 value of their mines goes up by 15% for each 10% increase in the price of zinc (all else being equal). If the rest of the commodity complex rallies with zinc, that relationship goes from 1.5x to 2.5x levered. If Zinc were to reclaim its highs of $2.00/lb, BWR's intrinsic PV10 value will be about 120% higher. If the rest of commodities move in sympathy, intrinsic PV10 value would appreciate by 210%.
- Zinc prices collapse as they did in 2008.
- Production input costs (fuel oil, copper both significant inputs) tend to increase with the rest of the commodity complex. This could put pressure on their cash costs per pound of zinc.
- BWR overpays if/when they deliver on their stated goal to add another polymetallic mine asset
- Operational mistakes or unplanned incidents result in cost escalation at their mines
- One asset is in Honduras (Mochito) which is not as mining friendly a jurisdiction as Canada or Chile.