Mercator Minerals Ltd ML.TO W
August 29, 2007 - 7:19pm EST by
dr123
2007 2008
Price: 6.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 485 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

ML has been written up twice before; the more recent write-up summarizes background.

ML probably doubles within 2 years if current copper (Cu) and molybdenum (moly) prices hold for foreseeable future. If ML converted to a Master Limited Partnership (MLP), valuations of similar MLPs or trusts suggest a C$40/share ML price.
 
If assume current Cu futures prices and half current moly price, ML’s value is C$10/share +/- 10% within same period. ($=US$, C$=Canadian$)
 
ML is fully-funded to expand production 10x to ~130MM Cu equivalent lbs, 60% of revs from moly and 40% from Cu assuming spot prices. ML will finish phase I expansion to 25,000 tons per day within 1 year and phase II to 50,000 tons per day within 2 years. Refer to Dec 29, 2006 news release on ML’s website for details re this expansion. The section detailing economics begins on p.180 of the report. P.184 shows annual payable production. The first 5 years at full capacity average 60MM lbs Cu, 11MM lbs moly, and 700koz silver annually. Assuming all warrants/options exercised, ML’s net debt post start-up capex will be $60MM +/- 10%.
 
Reasons behind ML’s upside:
1. As ML transitions from development to production, it should trade in-line with comps
2. ML can convert to a tax efficient, yield vehicle such as an MLP or LLC
3. ML’s moly grades may be up to 25% higher than in feasibility  
4. ML will probably run at 10% higher throughput than in feasibility
 
Cu is $3.30/lb, moly $32/lb, and silver $12/oz. At these prices, in 2009, ML would generate revs of $558MM. In this scenario, total costs should average $130MM (over first 5 years), suggesting EBITDA of $428MM. Per the “Cash Flow Financial Analysis” on p.192, cash taxes as % of EBITDA approximate 33%, suggesting free cash flow (FCF) of $288MM, (C$300MM) or C$3.50/share assuming 85MM shares fully diluted. Comps trade at 3-4x (2009 EV)/(2009 unlevered FCF), implying C$10-$14/share price.  
 
At half of today’s spot prices, in 2009, ML would generate revs of $280MM. In this scenario, total costs should average $115MM (over first 5 years), suggesting EBITDA of $164MM. Assuming 33% of EBITDA goes to taxes, free cash flow to equity should be $110MM, (C$115MM), or C$1.35/fully diluted share. ML trades at 4.5x such FCF.
 
Using the “half of today’s prices” scenario to value ML is excessively conservative, however, because Cu on the London Metal Exchange can be “locked-in” via shorting at $2.90/lb for 2009, $2.67/lb for 2010, $2.44/lb for 2011, and $2.21/lb for 2012. ML’s NPV discounted at 10% using such curve and $2.00/lb LT, $12/oz silver price, and $32/lb moly in 2008, $24/lb in 2009, and $16/lb in 2010 and LT, is C$10/share +/-10% assuming NO upside from reasons 2-4 above.
 
Moreover, moly prices could be tight for the foreseeable future. See report entitled “Structural changes in molybdenum demand” by Denis Battrum available at http://www.thompsoncreekmetals.com/s/Home.asp and his August 2007 monthly molybdenum commentary available at http://sprottmoly.com/home.html. Sprott Molybdenum Participation Corporation, a new public company intent on capitalizing on moly’s future, comments on recent moly developments in MD&A of its June quarterly:
            “The most significant development in the molybdenum industry in the period ended June 30, 2007 was the imposition of export quotas in China. In late May 2007, the Chinese government established a list of qualified exporters of molybdenum consisting of 32 companies. In late June 2007, foreign trade bureaus informed traders that export quotas would come into effect on July 1, 2007. The total quota for the second half of 2007…represents a 50% reduction to last year’s levels. Such a reduction in Chinese exports is expected to have a significant impact on the world supply, and, therefore, molybdenum prices.
In addition, the Chinese government has announced it will eliminate or reduce VAT tax rebates on certain molybdenum products effect July 1, 2007…This change highlights the robust demand growth in China and the country’s desire to reduce exports in energy intensive industries.
China is not the only country demonstrating concern about the supply of strategic resources. Resource-poor Japan is aiming to increase its molybdenum inventory to 60 days of consumption [from] 21 days’ worth.”
 
REASONS BEHIND ML’s UPSIDE:
 
Reason #1:  As ML transitions from development to production, it should trade in-line with comparable producers’ free cash flow multiples, which range from 3x-4x (2009 EV)/(2009 unlevered FCF)
 
Comparable copper producers include: Quadra Mining (TSX: QUA), Frontera Copper (TSX: FCC), Taseko Mining (TSX: TKO), and Sherwood Copper (TSX: SWC).
Comparable moly producers: Thompson Creek Metals (TSX: TCM)
 
TCM, a pure moly producer, seems like ML’s closest comp because 60% of ML’s revenue stems from moly (assuming spot). ML is about half the size of TCM on a moly-equivalent basis, i.e. converting Cu to moly using ratio of prices, with similar costs. With Cu at $3.30 and moly at $32, about 10 Cu lbs equal 1 moly lb. 
 
In a rosy scenario for TCM re production/costs and assuming $32/lb moly holds through 2009, TCM, at $17/share, trades at 3x (2009 EV)/(2009 unlevered FCF). Such ratio implies an $11 ML share price.
 
Reason #2: ML could convert to an MLP or LLC
 
Master Limited Partnership (MLP) is a limited partnership that combines the tax benefits of a limited partnership with the liquidity of a publicly traded security. MLPs trade at yields of 6-12%, implying FCF multiples of 8-16x.
 
An MLP has a partnership structure but issues investment units that trade on an exchange like common stock. The modern form of MLPs was defined by the Tax Reform Act of 1986 and the Revenue Act of 1987, which outline how companies can structure their operations to realize certain tax benefits and define which companies are eligible. In order to qualify, a firm must earn 90% of its income through activities or interest and dividend payments relating to natural resources, commodities or real estate.
 
Tax implications for MLPs differ significantly from corporations for both the company and its investors. Like other limited partnerships, there is no tax at the company level. This effectively lowers an MLP's cost of capital, as it does not suffer the problem of double taxation on dividends. Companies that are eligible to become MLPs have a strong incentive to do so because it means a cost advantage over their incorporated peers.

In an MLP, instead of paying a corporate income tax, the tax liability of the entity is passed on to its unitholders. Once a year, each investor receives a K-1 statement (similar to a 1099-DIV form) detailing his or her share of the partnership's net income, which is then taxed at the investor's individual tax rate.

One important distinction must be made here: While the MLP's income is passed through to its investors for tax purposes, the actual cash distributions made to unitholders have little to do with the firm's income. Instead, cash distributions are based on the MLP's distributable cash flow (DCF), similar to FCF. Unlike dividends, these distributions are not taxed when they are received; instead, they are considered reductions in the investment's cost basis and defer tax liability until the MLP is sold.

Fortunately for investors, MLPs generally have much higher distributable cash flow than they have taxable income. This is a result of significant depreciation and other tax deductions. Investors then receive higher cash payments than the amount upon which they are taxed, creating an efficient means of tax deferral. According to a report by Wachovia Securities, titled "Master Limited Partnerships: A Primer" (2003), the taxable income passed on to investors often is only 10-20% of the cash distribution, while the other 80-90% is deemed a return of capital and subtracted from the original cost basis of the initial investment.

If ML, once debt-free, converts to an MLP (or LLC) its EBITDA would become FCF.
 
If prices hold, ML operates at 50kptd (using feasibility moly grades), and ML as an MLP trades at 8x FCF multiple, it would have a $3BN market cap, implying C$40/share price.
 
Coal mining MLPs exist, but there aren’t any copper producing MLPs. The valuations of Fording Canadian Coal Trust (NYSE: FDG) and Southern Peru Copper (NYSE: PCU), however, suggest that a 10% yield is appropriate for ML as an MLP.
 
Fording is a Canadian royalty trust producing metallurgical coal and trades at 7.5% yield. Metallurgical coal’s market is opaque like moly’s. PCU is a Mexican/Peruvian producer of copper, moly, zinc and silver, with 90% of revs coming from copper and moly for foreseeable future. Its dividend yield is 10% and it dividends most of earnings.
 
 
Reason #3: ML could run at 10% higher throughput than in feasibility
 
A 10% increase in throughput would likely increase costs by 10%, equal to $11-13MM, for additional power, consumables, etc but would add 6MM lbs of Cu and 1.5MM lbs of moly annually (on avg) within first 5 years. 
 
Reason #4: ML’s real moly grades could be 0.05%, 34% higher than in feasibility
 
Management says that actual moly grades mined by previous operator, Duval Corp, over 17 years were between 0.04% and 0.05% rather than 0.038%, which feasibility assumes.
 
Such higher grades imply proportionally higher payable metal output, i.e. 11.6-15MM lbs at 50ktpd, adding 0.6-4MM lbs of production annually versus feasibility.

Catalyst

Mercator begins 25ktpd production in mid 2008
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