Southern Copper: Great Economic Fundamentals, Yet I Have Some Concerns

Dec.26.13 | About: Southern Copper (SCCO)

Investors in Southern Copper (NYSE:SCCO) have completely missed out on the strong momentum in equity markets in 2013. For this reason, and the guidance for flat production costs next year, analysts at Citigroup remain upbeat about the prospects for the copper producer.

While I applaud the company's attractive operations, the concerns about the ownership and operations in not too stable political regions remain a concern which make me hesitant to invest at this point.

Citi Remains Bullish

Last week, analysts at Citigroup (NYSE:C) reiterated their "Buy" rating on Southern Copper which was accompanied with a $41 price target. The price target is quite aggressive, implying nearly 49% upside potential from Tuesday's closing levels.

Analysts noted that the company provided guidance of 640kt of copper production for 2013, up 1% on the year before. The net cash costs of $0.71/lb, which was flat on the year before, was slightly better than expected as well.

This should bode well for earnings, notably the flat cost guidance after competitor Antofagasta guided for a 36% increase in costs next year.

Valuation

Back in October, Southern Copper released its third quarter results for the year. Total cash, equivalents and short-term investments stand at $2.16 billion. Total debt stands at $4.21 billion, for a net debt position of $2.05 billion.

Sales for the first nine months of the year came in at $4.42 billion, down 12.0% on the year before. Reported earnings came in at $1.21 billion, down 13.6% on the year before. At this pace, annual revenues could come in around $5.8 billion as annual earnings could come in around $1.6 billion.

Trading around $27.50 per share, the market values Southern Copper at $23 billion. This values equity in the firm at 4.0 times annual revenues and 14-15 times annual earnings.

The company pays a quarterly dividend of $0.12 per share, for an annual dividend yield of 2.5%. Note that Southern Copper's dividend is notoriously volatile.

Some Historical Perspective

Long-term holders in Southern Copper have seen poor returns. Shares rose from $30 in 2004 to peaks approaching $140 in 2007. In 2008, shares fell of a cliff, falling to lows of just around $10 later that year.

Shares did manage to recover to levels of $50 at the end of 2010. Following year to date losses of over a quarter, shares are currently trading around $27.50 per share.

Between 2009 and 2013, Southern Copper is expected to increase its annual revenues by a cumulative 57% to $5.8 billion. Earnings growth is seen even higher, with earnings seen as high as $1.6 billion this year. Note that both revenues and earnings are set to decline compared to last year.

Investment Thesis

Southern Copper continues to offer growth potential to its shareholders. While the company produces silver, molybdenum, zinc, among others, the main operations are copper production. Sales of copper make up nearly 80% of total revenues so far this year.

What is interesting about the company are the huge reserves, growing operations and very high margins. With current production of 630kt per annum, the company is the fifth largest producer of the world, according to the company's own presentation.

Yet the company has the biggest reserves with some 67.1 megaton of potential production, representing over 100 years of reserves at current production levels. This gives the company a huge advantage versus the likes of other established names like Freeport-McMoRan (NYSE:FCX), BHP Billiton (NYSE:BHP) and Anglo American (OTCPK:AAUKF), among others.

What is good to see is the relatively modest leverage being employed, especially in relation to the fat earnings which the company is reporting. The good thing is that debt is mostly very long term with only a cumulative $600 million due to be repaid till 2020. This is important given the huge capital requirements, estimated at $2.3 billion in 2014, and $1.4 billion in 2015.

Following these investments, copper production could increase significantly from 630 megatons in 2013 to an estimated 1,145 megatons in 2017, representing growth of about 80%. With estimated copper revenues of $4.5 billion in 2013, in constant prices revenues from copper could increase towards $8.1 billion in 2017. One could conservatively add another billion in sales anticipated from the sale of other metals. Given similar production costs and product prices, earnings could increase north of $2.5 billion. Growth will have to come from the mighty Buenavista project, among others.

Yet shareholders are not left alone in the dark despite these investment requirements. The solid financial position and strong margins allow for shareholder payouts as well. Therefore investors receive a current yield of 2.5%, while the board recently doubled the share repurchase program being authorized to $2 billion, roughly 9% of the current market capitalization.

The sell-off in copper prices so far this year, driven by concerns about a Chinese slowdown, have pushed down shares of the company so far this year. While I really like the company's cost advantage and growing profitable operations, there are some reasons for concerns.

This includes the corporate governance issue, being that Grupo Mexico controls the company with a stake of 80% in the company, which could hurt the interest of small retail investors. Other risks include the risk of expatriation in Peru and potential for labor issues in Mexico and Peru, places where the company has its production facilities.

These concerns are serious in my opinion, offsetting the great economic fundamentals of the business, even as the company just like any other raw material producer is a price-taker. Therefore I remain cautious, although the company does really offer long term profitable growth prospects.

I remain on the sidelines, but keep a close eye on the prospects for the shares.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.