Breakwater Resources and Boliden AB are both zinc producers, yet the former trades at 3.5x (2007start EV)/ (2007 free cash flow) and is growing production ~30-50% per annum for next several years, while the latter is at 8.5x and growing less quickly over same period. (These EV/FCF multiples are midpoints of two versions of free cash flow, one using only maintenance capex, the other using full projected capex.)

Buying BWR and shorting BOLI in a 1:1 ratio should return ~30% on total capital over 6-9 months. Such return assumes BWR multiple expands to 5x (2007end EV)/(2008 free cash flow), as BWR clarifies economics of its growth over next 4 years, while BOLI multiple falls to ~6x as people see effect of falling smelter charges. More on explanation re multiple expansion at BWR and contraction at BOLI below. (I give BOLI 20% premium for greater trading liquidity)

Valuation:

Metal price assumptions:

Zn: $1.50/lb

Cu: $2.50/lb

Pb: $.70/lb

Gold: $600/oz

Silver: $12/oz

 

BWR:

Fd shares: 460MM

Cash from warrants, options if all exercised: C$48MM

Unrestricted cash/investments net of debt as of Dec 31, 2006: C$100MM

Total cash if use fully diluted share count: C$150MM

BWR stock price: C$1.85

BWR market cap using fully diluted shares: C$851MM

BWR EV: $700MM

My estimate of BWR 2007 free cash flow:

Using only maint capex: C$250MM (maint capex of $50MM)

Using 2007 forecasted capex and exploration: C$180MM (full capex & exploration of $120MM)

2007start EV/(2007 free cash flow) ~3x if use maint capex, 4x if use full capex and exploration

 

BOLI:

Fd shares: 289.4MM (fully diluted shares equals basic shares)

Cash flow warrants, options if all exercised: 0

Net debt: (SEK$0.2)

BOLI stock price: SEK$150

BOLI market cap: SEK$43.4BN

BOLI EV: SEK$43.2BN

My BOLI 2007 free cash flow:

Using only maint capex: SEK$6.7BN (maint capex of SEK$1BN)

Using total capex: SEK$4.2BN

2007startEV/(2007 free cash flow) ~ 6.4x if use maint capex, 10.3x if use full capex/expl

 

 

Two obvious differences between BOLI and BWR: BOLI is a Zn and Cu miner and a smelter (a refiner in base metals, converting Zn and Cu concentrate produced by mining into Cu and Zn metal), while BWR is primarily a Zn miner, though also producing a bit of Cu. (BOLI has hedged 89% of Cu in 2007 at $1.80/lb, 70% of 2008 at $2.90 and 70% of 2009 at $2.70.) Secondly, BWR is a turn-around story, transitioning from high to low-cost producer, while BOLI is not. This cost structure change will drive the multiple expansion; investors will award BWR a low-cost producer multiple. Size in production or diversification is not a significant difference because BWR is diversified among 4 mines, each having large production expansion potential probably realized over next 3-4 years.

 

Both differences in 2007 (and probably in 2008) will benefit BWR rather than BOLI because Zn and Cu prices are so high. A miner that has no smelting capacity, pays a smelter between 20-40% of the price of Zn and/or Cu, to convert concentrate into metal.

This percentage, negotiated every year between the miners and smelters, reflects the supply/demand in the concentrate market, i.e. where miner sells concentrate to the smelter. The London Metal Exchange, in contrast to concentrate market, is one of refined Cu and Zn, i.e. the output of the smelter.

 

This year, the Zn and Cu concentrate markets are very tight, perhaps the tightest ever. Such tightness benefits the miners because they can negotiate (some already have) lower smelting cost, which has two components: the fixed processing cost (fixed for year but re-negotiated annually) and the price participation. The price participation begins at a base or benchmark price and has both an escalator and de-escalator, i.e. the smelter reduces smelting cost to miner as Zn price falls below base or benchmark price.

 

In 2006, the standard terms between a Zn miner and smelter were fixed treatment charge of US$128/tonne, with an escalator of $14/tonne at a base of $1400/tonne. A recent deal between Teck Cominco, the world’s largest Zn miner, and German smelter MG Rohstoffhandel, suggest dramatically better terms for miner in 2007, namely a fixed treatment charge of US$300/tonne, a base price of US$3500/tonne, a 10% escalator and -6% de-escalator. Such terms suggest a reduction in Zn smelting cost of ~30% +/- 5% assuming a Zn price of $4000/tonne for 2007. Keep in mind, however, that miners typically keep 30-60% of their smelting contracts open for renegotiation per year, so the full benefit will not be seen until 2008. (For more detail on this topic and BOLI, read research by SEB ENSKILDA.)

 

Note BWR, in announcing its Q4 2006 results, for the first time broke out its sensitivity to change in Zn smelter treatment charges. A 5% reduction in Zn smelter charge yields C$3.8MM increase in annual cash flow. Hence, a 30% reduction would yield a C$23MM increase in after-tax cash flow. Keep in mind that this number is probably fully taxed because BWR has a valuation allowance against most of its tax assets and may also assume that only a portion of smelting contracts can be reset in 2007. I’m guessing the portion is 50% (midpoint between 1/3 and 2/3) because typically miners have 1/3 of contracts long term, 1/3 1-2 years long, and 1/3 spot.  

 

Looking at benefit pre-tax, cash costs in 2006 were US$134MM, or US$0.65/lb, and treatment charges were US$128MM, or US$0.55-$0.60/lb, depending on whether one looks at cash cost per lb sold or per lb produced (there is a 2-3 month lag between production and sale). Given BWR is nearly a pure Zn play, if the concentrate market remains tight through 2008, cash costs should fall by 30% or  ~US$0.20/lb, which yields about C$60MM in incremental pre-tax cash flow, C$35MM assuming 40% tax. The mid-point between the two methods yields about C$30MM in incremental after-tax cash flow, about C$0.06 per fully diluted share, if full drop realized. Only 50% of this benefit should be realized in 2007.

 

In contrast to BWR’s benefit from falling treatment charges, Boliden’s smelting business, which sources only 20% of its copper and 75% of its Zn concentrate smelter feed from its own mines, will be hurt by dropping treatment and refining charges in both Cu and Zn. Simply, Boliden will not be able to charge other miners as much for refining those concentrates (Cu treatment and refining charges have fallen between 30-40% from 2006). Based on sensitivity published in BOLI’s Q4 2006 report (p.5), a 30% and 35% drop in Zn and Cu treatment charges respectively, will cause ~5% decline to BOLI’s 2007 EBIT.

 

Assuming no growth in production from 2006 to 2007 at BWR and BOLI and assuming half realization of lower treatment charges, BWR’s operating profit should climb by 18% in 2007 vs 2006 while BOLI’s should fall by 5%, yielding ~ 25% increase in 2007 operating profit in BWR vs BOLI.

 

The assumption of no growth, however, is not a good one. BOLI has two mine expansions, Aitik and Garpenberg, and and one smelter expansion, Odda, that combined will increase EBITDA by 35% +/- 10% beginning in 2010/2011 using $2.00 Cu and $0.80 Zn. Through 2009, however, production growth will be negligible.

 

Production at BWR is growing by 30-50% per annum over the next 4 years. BWR recently issued 2007 Zn production guidance of 270MM lbs of payable Zn (miners are only paid about 85% of the contained Zn they produce, payable denotes this discount has been applied), which is about 30% more than the payable Zn produced in 2006. I believe mgt is conservative with this forecast because BWR missed their original 2006 payable production guidance due to mishaps at Myra Falls. They will really produce 300MM lbs of payable Zn, hence hitting the 50% end of my growth target. Moreover, the growth at existing operations will continue in 2008-2010 such that BWR should grow Zn production to more than 700MM payable Zn lbs by 2010, more than 3.5x that of 2006. Such assertion is based on my due diligence that BWR’s four operations could run at the following ore throughput rates by 2010: Myra Falls at 1.35MM tonnes, Langlois at 1.4MM tonnes, Toqui at 1.4MM tonnes, and Mochito at 0.9MM tonnes. Contrast these throughputs with 2007 guidance: Myra 0.86MM tonnes, Langlois 0.4MM tonnes, Toqui 0.54MM tonnes, and Mochito 0.6MM tonnes. Because BWR is growing production at existing facilities, as opposed to green field, and has mills at Bougrine and Bouchard-Hebert not being used, the capex per operation should be ~US$30-$50MM, funded out of existing cash or cash flow.

 

In addition to throughput expansion, there will be improvements in Zn, Cu, and Pb recoveries due to installation of lead circuit at Myra Falls. Lastly, 2007 production assumes a weighted avg Zn grade of 6.6% while the weighted avg of proven and probable and measured and indicated reserves is 7.9%, a 20% increase. In other words, 2007 is a below average grade year. When all these factors are counted, BWR should push payable Zn production to 700MMlbs by 2010.

 

Why hasn’t BWR grown sooner? They lacked the money because Zn price only started to materially rise over US$0.50/lb in 2H2005. The last 24 months have provided BWR the money to delineate its true reserves, the first step in justifying expanded production noted above. Once such delineation is complete, mgt should present a three year plan that clarifies the growth potential to ~700MM Zn lbs and the resulting economics. If they don’t, shareholders should request such a plan as exploration results justify expansion,  as it would probably incline investors to award BWR a growth multiple.