Seeking Alpha
Deep value, long/short equity, contrarian, hedge fund manager
Profile| Send Message|
( followers)  

Copper has been on top of the world for much of the past half decade. If you started investing in copper or copper producers in the early years of the new millennium, you would have made spectacular returns in a time when the S&P 500 would’ve produced modest to flat returns.

Just how well did copper do? From September 2002 to February 2011, copper prices increased a whopping 450%! Not a bad little gain. If you had been fortunate enough to have held stock in Freeport-McMoran Copper and Gold (NYSE:FCX) during that same timeframe, you would’ve seen even greater returns; around 700% – 800%!

And here’s where it gets really interesting: Freeport’s returns look impressive until you take a look at the astronomical 1900% gains you could’ve realized by owning shares of Southern Copper (NYSE:SCCO)! Aside from owning stock in Apple (NASDAQ:AAPL) during that same timeframe, it would be very difficult to beat that.

This data looks even more dramatic in chart form, where the S&P 500 looks almost like a straight line compared to the massive twin mountains produced by FCX and SCCO; which is of course odd for those of who have watched the housing bubble, followed by the crash, and then the rebound of 2009. On this chart, however, all of those major market movements are overwhelmed by the otherworldly movements of copper producers.


(Click to enlarge)

In spite of this, both Freeport-McMoran and Southern Copper have been some of 2011’s worst performers. Freeport has tumbled 38% from its all-time high last December. Meanwhile, Southern Copper is down an almost-identical 39%. This rapid decline is, in no small part, a result of falling copper prices. Copper is down about 23% from its peak in February ’11.

The Investment Case for Copper Producers

Given this precipitous drop, one has to wonder if this is a great time to buy copper producers. Indeed, most analysts have been bullish on Freeport-McMoran. Barclays maintained and reiterated its bullish “overweight” opinion recently, while Standpoint Research upgraded the stock to “Buy” at the end of November.

It’s not difficult to find bullish opinions a-plenty in the blogosphere, as well, with market blogger Jim Van Marteen arguing that the stock is depressed and looks attractive. Similarly, Kevin McElroy, a commodities researcher at Wyatt Investment Research, states that the “stock is cheap” and has a good chance to produce significant gains in 2012. While Southern Copper isn’t quite the darling that Freeport is, that’s mostly because people prefer Freeport over it, rather than because of an overwhelming bearish sentiment on copper.

It’s certainly not difficult to understand the bullish case for Freeport. The stock has an astoundingly low trailing P/E of 6.5. Over the first three quarters of 2011, revenues have increased a whopping 25% year-over-year! The company has raised its dividends and is now paying out a 2.8% yield. Even if copper prices have fallen a bit, the stock looks cheap by earnings, cash flow, and revenue growth metrics. Given this, it’s easy to see why many investors peg the company as a strong buy at these price levels.

Yet, I would be very wary of Freeport and its counterpart, Southern Copper. Copper prices have been artificially inflated for years by China’s fixed asset bubble and while it might seem like a 25% drop in prices would be enough to compensate for weakening demand, it’s completely plausible that we can still see another 50%+ drop in copper prices from here! Once the price of copper starts plunging off a cliff, the massive profits and revenue growth of Freeport and Southern Copper also will take a huge dive.

Historical Copper Prices

To understand how copper prices might be at unsustainable levels, we only need to take a look at the historical price record for the past thirty years. The chart below graphs out the average monthly price per Metric ton of copper:


(Click to enlarge)

It’s difficult not to notice that the copper boom largely coincides with China’s real estate boom. It’s big run starts around 2004, then comes crashing down in 2008. Right about that time, the Chinese government took dramatic steps to re-stimulate its economy, which then re-fueled the housing market and demand for fixed asset construction. Finally, copper prices peak around February 2011, only a few months before we start seeing price declines in real estate in some of the major Chinese cities.

Of course, while the above chart looks quite dramatic, it also ignores real purchasing power and inflation. For that reason, I decided to create a CPI-scaled set of copper prices, as well. Since I view this as a more accurate representation of real copper prices, this is the data I will refer to for the remainder of this article:


(Click to enlarge)

The CPI adjusted prices only look slightly less dramatic than the nominal copper prices. In this chart, I also added the CPI-adjusted 30-year average monthly price of copper (in green), which was at $4,136 per Metric ton. I also went one step further and calculated the average CPI-adjusted price from 1981 – 2003, in order to try to gauge a pre-boom average price. This comes in significantly lower at $3,285 per Metric ton (see light blue line).

There are several interesting observations from this chart. The first is that, even during the dark days of late 2008, when commodity prices were plunging across the board, the average copper price only fell 19% below the long-term CPI-adjusted average price. Even more shockingly, prices never fell below the pre-boom CPI-adjusted average at all!

The second observation here is that prices would need to fall by another 45%, even after their recent 25% swoon, in order to once again hit their 30-year CPI-adjusted averages. Once again, that fall is even more dramatic if you look at pre-boom prices, which suggest that copper prices would have to fall another 57% to hit their long-run averages!

The Japanese Asset Bubble

Then, there’s a third observation I made from this chart. It’s one that might not be immediately evident, as our eyes naturally tend to drift towards that giant mountain that develops after 2004. But there is another “copper price mountain” in this chart and what’s interesting about this mountain is the date range of it: 1986 to 1990. This range happens to directly coincide with the Japanese Asset Bubble.

I’ve often argued that much of the economic instability that marred the 1970’s and ‘80s was a direct result of economic distortions emanating from Japan. Japan pegged the yen to the dollar for decades, and refused to move it after their initial export spurt came in the 1960’s and early ‘70s. As a result, the yen became extremely undervalued versus most other major currencies; particularly the dollar.

It’s plausible that this significant currency undervaluation in one of the world’s largest economies caused major worldwide distortions in trade, interest rates, and prices; which helped fuel the economic instability of the era. Indeed, it was only after the Plaza Accord *AND* the collapse of the Japanese Asset Bubble, that the U.S. was able to enjoy consistently low-inflation and high-growth during the ‘90s boom years.

The beginnings of the current U.S. struggles, not surprisingly, date back to the late 1990’s. And perhaps it shouldn’t be too surprising that in 1996, China pegged the yuan to the dollar and left the peg unchanged until 2005, creating another massive currency undervaluation. China allowed the yuan to float more freely for three years after that, before re-pegging in 2008 right in the midst of the worldwide economic crisis. Given this, there are very obvious parallels between Japan’s situation in the 1980’s and China’s situation over the past decade.

Back to the discussion on copper, the price peaked in December 1988 during that prior boom period. It then went into retreat until November 1993, falling from a high of a CPI-adjusted $6,565 per Metric ton, all the way down to $2,533 per Metric ton; a 61.5% overall drop. It then went back into a mini-boom period in the mid ‘90s, before bottoming out around $1,753 per Metric ton (CPI-adjusted) in October 2001.

The copper boom produced by the Japanese Asset Bubble looks like a tiny hill compared to the giant mountain that emerges from 2004 to the present date; which suggests just how astronomical in size the Chinese Asset Bubble may, in fact, be.

Margin Compression for Freeport-McMoran and Southern Copper

Now that we have the macroeconomic backdrop, it’s time to see how falling copper prices could affect Freeport-McMoran and Southern Copper’s bottom lines. My data for both firms goes back to 1994, so unfortunately, we don’t have a good proxy for how copper producers would have performed during the Japanese Asset Bubble. However, we can still see major changes in both firms’ profitability due to commodity price fluctuations.

Since both firms have fairly low interest charges and few other odd items, operating margins tend to be a relatively good measure of pre-tax profitability. Likewise, the only major difference between net income and cash flows from operations tends to be depreciation charges; which act as a reasonable proxy for necessary capital expenditures. At the same time, operating margins are sometimes affected by one-time items, exploration costs, and a few other miscellaneous costs; so gross margins tend to be a more stable measure of how copper prices affect the two firms.

Gross margins dating back from 1994 are shown in the chart below:


(Click to enlarge)

And here are the operating margins:


(Click to enlarge)

If you’d like to see the more detailed data underlying those charts, here it is:


(Click to enlarge)


(Click to enlarge)

From examining all of these charts, we can see that the boom-era margins are significantly higher than the pre-boom margins that prevailed in the 1990’s and early ‘00s. Gross margins for Freeport-McMoran hovered in the 30% – 40% range from 1996 – 2004; then pushed upwards to the 50% – 55% range during the boom; with a brief dive during 2008. Operating margins appeared to be in the 25% – 35% range from 1994 all the way to 2005. They pushed upwards into the 45% – 50% range for much of the boom.

The shifts are slightly more dramatic for Southern Copper, which is more dependent on copper in its overall portfolio than Freeport. SCCO’s gross margins fluctuated from 30% to 50% in most of the years before 2004. Since 2004, gross margins have come closer to 60%. Even during 2008, they only dipped to 55%. SCCO’s operating margins fell below 20% for much of the period from 1997 – 2002, but have drifted upwards of 50% since the start of the boom.

Both companies have grown significantly during the entire timeframe, growing revenues at a rapid rate and dominating a larger share of the market. Given that copper is a commodity, it stands to reason that 50%+ operating margins for a copper producer are simply unsustainable.

The trend throughout history is that there are large commodity boom periods that last from about 8 – 20 years. During these years, there is rapid price appreciation, but commodities tend to be big losers in other periods. This is for a few reasons:

(1) The end-users of commodities have a motivation to always lower costs,

(2) Technological advances tend to lower the cost of extraction,

(3) More substitutes become available over time

This is partly offset by the decreasing supply of commodities available on the Earth. However, before jumping up and declaring that the current prices are the result of a worldwide shortage that has radically driven up costs, the margins suggest just the opposite!

By examining these margins, we can see that Freeport and Southern Copper can make adequate returns even with dramatically lower prices. And as demand from China dwindles, that’s likely what they’ll have to do. Unfortunately, this affects the earnings picture in dramatic ways and it’s the main reason why these two stocks are not nearly as attractive as they might look on the face of it.

How Margin Compression Will Affect Profitability

As the prices of copper and other metals fall, FCX and SCCO’s top-line revenues will drop, as well. Obviously, part of this is that consumers will be less willing to pay high prices for copper; but it also means that both firms will be less willing to supply as much copper to the market, thereby lowering volume. Lower volume and smaller gross margins will flow down the income statement.

The chart below shows Freeport-McMoran’s earnings picture over the past four quarters (i.e. three quarters from FY ’11 and Q4 from FY ’10.) All the income statement data is in millions.

Working with this, I modeled out estimated Earnings per Share based on revenue shrinkage and margin contraction scenarios. For instance, the first cell turns up a result of $0.94 EPS, based on a 40% revenue decline and a 15% operating margin.


(Click to enlarge)

FCX earned $5.77 per share for common shareholders over the past four quarters. With a modest 20% revenue decline and a reasonable 30% operating margin, my estimated EPS for Freeport drops to $2.77; a whopping 52% decline! If we apply a reasonable P/E of about 15 to value FCX’s operating assets, that might imply a valuation around $30 – $35 per share; a little bit below where it’s trading now.

If the crisis creates a rapid drop in demand, it’s plausible that things could get significantly worse than that. With a 30% decline in revenues and a 20% operating margin, FCX’s EPS falls to $1.55 per share. My simple estimate of valuation in that instance would fall into the $15 – $20 range. Keep in mind, I’m not saying that this is the “real valuation” of the firm in that scenario, as cash flows would likely vary significantly over the long-term; but the market tends to look at short-term cash flows as an indication of long-term cash flows.

We can see a similar picture at Southern Copper. SCCO’s past four quarter earnings results are below (once again, income statement numbers are in millions):

Using the same methodology as we did for Freeport, the following table shows the results for SCCO:


(Click to enlarge)

With a 20% decline in revenues and a 30% operating margin, I came up with estimated EPS of $1.27 per share for SCCO. My back of the envelope valuation suggests the firm should be worth somewhere around $17 – $23 in that scenario; a significant drop from its current price near $30. If we use the same scenario as we did for FCX for a more rapid drop in demand, yearly EPS drops all the way to $0.74. In this case, my back of the envelope valuation is closer to $8 – $13 per share. That's around a 67% drop from the current price! And I do not view that scenario as all that implausible.

Factors that Could Improve the Outlook for Copper

While I do have a bearish bent on copper, there are two scenarios that could play out that would make my analysis flawed.

(1) China re-stimulates its economy,

(2) Other emerging markets and a recovering U.S. market pick up the slack

As we’ve already seen above, copper crashed in 2008 amidst the global financial crisis. As a result, China enacted several stimulus measures in late ’08. Perhaps, not coincidentally, copper bottomed one month later, before entering a clear uptrend by March ’09. In hindsight, it appears that China’s stimulus package refueled a bubble. The next question becomes, “will China try to re-stimulate the economy again if there’s a replay of 2008?”

The answer is not clear. First off, it’s unclear whether China could re-start the bubble, even if it wanted to. Now that housing prices have started falling off a cliff, there may be no turning back. More importantly, while China could try to re-stimulate the bubble, it’s clear that this would re-stimulate inflation as well, which has been a nagging problem for the country. Hence, China might be in a bit of a catch-22. Still, I would keep a close eye on how China responds, because it could have the potential to refuel the copper bubble.

The second scenario is that China’s economy slows down, but that demand from other emerging market economies, coupled with some sort of recovery in the United States, picks up a bit and allows the copper market to hit a bottom. This scenario seems semi-plausible, but I also view it as unlikely.

First off, there aren’t really too many economies that could conceivably pick up the slack from waning Chinese demand. India is having significant problems of its own right now, and the other two BRICs, Russia and Brazil, are heavily dependent on Chinese demand. Maybe Turkey, the Middle East, and Africa could see increased demand, but it’s highly unlikely to be anywhere near sizable enough to make a difference. Therefore, it seems like the only conceivable source to pick up the slack in demand would be the United States. But once again, past history suggests that the U.S. is unlikely to have a high level of demand at the current prices and we would need to see significant price depreciation before American demand picked up significantly.

All of this is to say, there are scenarios where market or non-market actions could stabilize or create more upward pressures in copper prices; but I view all the scenarios as unlikely to make much of a difference.

Conclusions

Copper’s historically high prices are not merely the result of “emerging market growth” but rather, are the result of market interventions by Chinese governments, which are ultimately unsustainable. Prices will likely have to retreat anywhere from 30% to 60% before we see stabilization, if historical data is a useful guide. If the experiences from the Japanese Asset Bubble are any indication, it’s likely that we will see a continued decline over the next several years before finally bottoming out.

Even after suffering major price declines in 2011, FCX and SCCO could still have a long way to fall. I view SCCO as having more downside than FCX due to its higher exposure to copper; while FCX should also suffer significantly, as its exposure to gold (likewise tied to China’s asset bubble) will also hurt it.

I have been short FCX since Nov ’10 and began buying 2013 put options on it in spring of this past year. I have recently initiated a small number of 2013 put options on SCCO, as well.

Disclosure: Author is short FCX. Author owns long-dated put options on both FCX and SCCO.

Source: Copper Producers Could Still Have Long Way To Fall