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Teck Resources (NYSE:TCK), often known as Teck by investors, reported excellent earnings a few weeks ago despite the challenging operating environment. The company, which has operations in copper, zinc, steel-making coal and energy, is an excellent investment for conservative investors looking for a well-managed miner in their portfolio. The stock has retreated $4 or approximately 13% since its 3rd quarter earnings report on October 24 due to weak sentiment in the global mining sector. The spillover of negative sentiment due to worries of a global economic slowdown has negatively impacted the entire sector. In my opinion, the correction in commodity prices experienced in 2013 presents an excellent opportunity to add to high quality mining firms. I will present a compelling long-term outlook for each of Teck's divisions and explain my investment thesis in detail.

Graph 1: Earnings and Cash flow for the Past 8 Quarters

(click to enlarge)

Source: Teck Q3 Report.

Outlook for Teck's Main Divisions:

The long-term driver for Teck is the solid long-term demand for its commodity products: steel-making coal, copper, zinc and oil (production starting 2017). Worries about a global economic slowdown (China, Europe etc.) led to a sizable correction in prices of copper, zinc and steel-making coal this year. (See table 1 below). Nevertheless, there will be either supply cuts or structural deficits for these commodities looking beyond 2017.

Table 1: Consensus Estimate for Commodity Prices 2013-2017

(click to enlarge)

Source: 2012 Actual came from Teck's 2012 Annual Report. 2013-2017 estimates are Bloomberg consensus estimates as of November 15.

Steel-Making Coal (Coking Coal):

As shown in table 2, the average price of $152/t in 2013 is down significantly from the average price of $193/t realized in 2012 and the high of $300/t in 2011. The 21% decrease in price is attributable to increasing worries of a hard landing in China especially after its GDP growth slowed to 7.5% from 8%. Even with a liquidity crunch in June, China managed to ease the damage to the real economy and recent data, such as the Chinese PMI, have shown considerable improvements.

Investors should not confuse steel-making coal with thermal coal. As the name implies, steel-making coal is used in the production of steel while thermal coal is primarily used for energy. Steel-making coal is also priced much higher due to its special use in steel production. The demand for steel-making coal should increase as hot metal production increases as shown in graph 2. Countries such as China and India will experience large growth in hot metal production. Mass transit and urbanization will drive the need for additional steel which will drive the demand for steel-making coal.

Graph 2: Hot Metal Production 2002-2022

Source: Teck Investor Day Presentation

Table 2: A Look at Coking Coal Demand through Seaborne Imports

in millions tonnes ((Mt))20082013(NYSE:E)2017(E)
China36973
Asia ex-China122142170
North America777
South America171918
Europe554955

Source: Teck Investor Day Presentation

Looking at table 2, seaborne steel-making coal imports will roughly hit 286Mt in 2013 and 323Mt in 2017. On the supply side, seaborne exports was 240 Mt in 2012 and estimated to increase slightly in 2013 due to higher production in Canada and Australia but offset by a small reduction in U.S. production. However, looking out 10 years, there is a lack of deposits for hard coking coal which is only located in Canada, U.S., Mongolia, Mozambique, China, and Australia. With labour costs going up in China and lack of infrastructure in Mongolia, Teck and other Australia producers can capture more of Asian demand for hard coking coal. Teck is forecasted to produce 25Mt in 2013 and has the option to expand capacity to 27Mt in the near future. The current cash margin is about 40% (realized price of $145/t last quarter and cash costs of $88) despite the record low price of near $145/t. If prices do rebound as anticipated in table 1 to near $170/t, then the profitability of Teck's coal division will improve significantly. Teck's management has indicated in its Q3 call that supply cuts are coming to the market, which should lift prices in the future. (See graph below)

Graph 3: Steel-making Coal Margin Cost Curve

Source: Teck Investor Day Presentation

Graph 4: Historical Quarterly Steel-Making Coal Sales

(click to enlarge) Source: Teck Q3 Report

Copper:

The copper market is sensitive to supply fundamentals and prices are extremely cyclical. As shown in table 1, copper prices have fallen from $3.60/lb to the current $3.15/lb. Prices should stabilize near the $3/lb level as excessive inventories are drawn down and demand starts to pick up as the global economy stabilizes. For long-term investors, it should be interesting to note that the copper market may face a structural deficit once the excess inventories draws down and production growth is unable to match demand growth. Graph 5 shows that copper production is only forecasted to grow by 1.5Mt in the next 10 years. However, demand is expected to grow at a CAGR of 2.5%, implying mine production is unable to match supply beyond 2017. The average increase of 150,000 tonnes in production per year is much smaller than the forecasted average increase in demand of 600,000 tonnes. If the highly probably copper projects are included in the long-term projection, the copper market will face a deficit beyond 2018. Production growth in the next 10 years will be unable to match demand due to lower grades and existing mines coming near the end of their life. New projects are difficult to finance and construct in a tough operating environment miners face today. Of the 42 highly probably projects considered in 2008, only 50% made it to production decision stage.

Demand for copper will increase as urbanization increases in countries like China. With new reforms announced last Friday, people can move to urban areas easier due changes to the hukou system and better treatment of rural people in urban areas. China's urbanization rate is only 50% compared to 70-80% for developed countries like U.S. or Canada. Therefore, there is still room for growth. Urbanization has led huge spending on infrastructure. China is forecasted to spend $11.1 trillion RMB to develop its domestic power sector, which accounts for 45% of China's total copper consumption. Copper demand in U.S. and Japan has picked up as well in addition to the robust demand from China. The strong fundamentals imply copper prices should stabilize near the current $3.15/lb and move higher as inventories draw down.

Graph 5: Forecasted Copper Production:

(click to enlarge)

Source: Teck Investor Day Presentation

Graph 6: Forecasted Copper Production vs. Demand (+2.5% CAGR)

Source: Teck Investor Day Presentation

Zinc:

The zinc business is benefiting from strong demand from steel producers and tight supply. As graph 7 shows below, zinc production is expected to reduce by 1.5Mt in the next 10 years mainly due mine closures. However, demand is expected to grow at a CAGR of 2.6%, which means 350,000 tonnes of supply needs to be added to meet the increasing demand in the upcoming decade. In fact, the zinc market faces a structural deficit beyond 2015 because of limited supply. Adding the highly probable projects, the zinc market still faces a deficit beyond 2017. The outlook for zinc is the best among Teck's three major products because of tight supplies. LME zinc inventories are down 16% YTD while Shanghai warehouse inventories are down 22% YTD. On the demand side, zinc demand is forecasted to grow as steel producers galvanize more of their crude steel production. If China galvanize at half the rate of the U.S., zinc demand would increase by 2.7Mt (21% of current global consumption). The increase in urbanization and need of public transit will fuel demand for galvanized steel, which will increase demand for zinc. Another positive for the zinc division is that it produces lead as a by-product. Looking at table 1, lead prices are forecasted to increase dramatically because of robust demand for batteries (i.e. for electric cars). Overall, despite zinc is the smallest division, it has the best growth potential given the outlook for zinc and lead.

Graph 7: Forecasted Zinc Production:

Source: Teck Investor Day Presentation

Graph: 8 Forecasted Zinc Production vs. Demand (+2.6% CAGR)

Source: Teck Investor Day Presentation

Energy:

Teck's energy unit leverages Teck's mining expertise in the oil sands mining business. Teck's choice of diversifying into the energy space will provide a profitable source of cash flow. Its energy portfolio consists of a 20% interest in the Fort Hills Mining Project, 100% interest in the Frontier Project, and 100% interest in Lease 421. The company clearly announced that it is not interested in expanding into the conventional oil and gas space. The reason it decided to expand in oil sands mining is because it is essentially a truck and shovel operation like Teck's other mining operations. This oil sands mining business is profitable. Given a netback of $60/bbl and cash costs of $25/bbl, this implies a 58% cash margin. The 58% cash margin is similar to a low cost (lowest quartile) copper mine's margin of 62% ($3.25/lb LME copper and $1.25/lb of C1 cash cost)

This unit is not generating any cash flow or earnings at the moment. However, one of its major Joint Venture project, the Fort Hills Mining Project, has been sanctioned. Suncor (NYSE:SU), the projector's operator, officially announced the Fort Hills sanction in its third quarter earnings report (see my prior article on Suncor). With Teck's 20% share of Fort Hills's production, Teck's share of 36,000 bbls/d will be similar to the production level of a mid-size oil producer. Fort Hills is also unique because it has a mine life of over 50 years, compared to a reserve life of approximately 15 years for major oil and gas producers.

Graph 9: Fort Hills Mine Life vs. Major Oil and Gas Reserve Life

(click to enlarge)

Source: Teck Investor Day Presentation

The other two energy projects in Teck's portfolio are Frontier and Lease 421. Both are still in planning stages right now, although Frontier has completed a preliminary resource estimate. Frontier's contingent bitumen resources are approximately 2.82 billion barrels and design capacity of 277,000 bbls/d of production. The company is expected to continue the regulatory approval process for Frontier and expect to seek a partner in 2015/2016 to further develop the project. Lease 421 still requires a resource review and expected to develop after Frontier. All in all, Teck has 3.5 billion barrels of bitumen resource (includes 20% Fort Hills share and 100% Frontier) to extract and all projects have good economics to create long-term shareholder value. Because all projects are not delivering cash flow or earnings at the moment, investors are underestimating Teck's energy division, which is almost hidden from some investors if they do not look carefully.

Investment Thesis:

I believe Teck is an excellent name to own in a portfolio because of its (1) solid outlook for its main products as described above (2) strong financial position and (3) attractive valuation.

Given I predict EPS of $2.11 in 2014 (consensus is at $2.02 according to Reuters), the shares are currently trading 12.8X my 2014 EPS estimate, which is cheap in my opinion. At a forward multiple of 12.8X, investors can gain exposure to a miner with solid operations in steel-making coal, zinc, copper and a real option on energy prices. Although pure-plays are valued higher in the market, the difficult operating environment should favor a diversified miner like Teck.

The company has a strong financial position. It has $2.25 billion in cash at the end of Q3/13 and a $2 billion credit line if needed. Trailing 12M cash flow of $3 billion is more than enough to cover the anticipated capital expenditure of $1.8 billion in 2013. The net debt of $5 billion is roughly 1.66 times trailing 12M cash flow. In addition, Teck's debt has a weighted average maturity of 15.7 years and the next major bond payment is at end of 2016. Management has done a superb job at managing the firm's balance sheet by re-financing old debt by extending maturities beyond 2040 and saved over $250 million in interest expense. There is no doubt that management will continue to exercise its financial savvy in the future.

Table 3: Brief Valuation Summary of Teck Using 2 Methods

DCF/NAV at 10%EV/EBITDA Multiple at 7X 2014E EBITDA of $3400 MM
Enterprise Value ($MM)25,14423,800
Add: Equity Investments10431043
Less: Net Debt ($MM)(5001)(5001)
Less: Minority Interest ($MM)(200)(200)
Equity Value ($MM)20,98619,642
Shares O/S (in Millions)576.24576.24
Value per Share$36.50$34.10

*Note: The DCF/NAV value is based on my own model. The commodity/FX assumption used is based on data in table 1 except my copper price assumption was slightly higher than table 1.

Averaging the two approaches, my intrinsic value estimate of Teck is about $35.25, which is 30% higher than current price of $27. Given mining shares are volatile, investors may want to wait until it is near $25 or lower to buy Teck.

Conclusion:

Given Teck's solid fundamentals, the share price currently undervalued because of negative sentiment towards the overall mining sector. The company's value, like most mining companies, is heavily dependent on commodity prices assumptions.

For investors interested in looking at Teck, I highly recommend Teck's Investor Day videos on YouTube where the CEO, CFO, and senior division heads present their strategy and outlook. The candidness of the management team and excellent long-term outlook for Teck's key products should allow Teck to deliver strong long-term returns to its shareholders. My analysis shows Teck's share price can reach to $35.25 in the next 12-24 months.

Source: Teck Resources: A Diversified Miner With Great Long-Term Potential Despite Near-Term Weakness

Additional disclosure: This article is for informational purposes only and does not constitute an offer to buy or sell any securities discussed in the article. The stock mentioned in this article does not represent financial advice. The target price presented in this article is based on current information and are subject to change without further notice. Investors are recommended to conduct further due diligence before committing capital to any investment.