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Southern Copper (SCCO) is among the leading basic material producers around the world. Established in 1952, the company with headquarters in Phoenix, Arizona, has grown into a diversified mining giant. Southern Copper has interests in several mines spread around the world. As of 2011, the company reported copper reserves of about 146 billion pounds. While the company's production facilities are mainly concentrated in Peru, its sales are well diversified. 30% of the production is marketed in the U.S., followed by Europe, and Mexico. The demand for processed copper in Latin America is also on the rise. While the demand for copper is strong, the oversupply concerns in the copper market have negatively affected the investor sentiment. Southern Copper was able to boost its earnings by 50% in this year, but the stock lost about 10% in the last 12 months.

As of the time of writing, Southern Copper stock was trading at $28.99 with a 52-week range of $22.34 - $36.88. It has a market cap of $23.7 billion. Trailing twelve month P/E ratio is 10.00, and forward P/E ratio is 10.1. P/B, P/S, and P/CF ratios stand at 5.3, 3.4, and 10.5, respectively. Operating margin is 54.6% and net profit margin is 35.3%. The company has some debt issues. Debt/equity ratio of 0.6 is slightly above the market average. Southern Copper was one of the top dividend payers in the last year. Trailing yield is 8.15%. The forward yield will probably be lower, as the company cut the quarterly dividends to 19 cents this year.

Southern Copper has a 2-star rating from Morningstar. Out of two analysts covering the company, 1 has hold, and 1 has underperform rating. Wall Street has diverse opinion about the company's future. Average five-year annualized growth forecast estimate is 8.7%. Given the company's past growth rate of 3.67%, this is a pretty bullish target.

What is the fair value of Southern Copper given the forecast estimates? We can estimate Southern Copper's fair value using discounted earnings plus equity model as follows.

Discounted Earnings Plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.

E0 = EPS = ($2.91 + $2.67) / 2 = $2.79

Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 8.7%. Book value per share is $5.26. The rest is as follows:

Fair Value Estimator

V (t=0)

E0

$2.79

V (t=1)

E0 (1+g)/(1+r)

$2.73

V (t=2)

E0((1+g)/(1+r))2

$2.68

V (t=3)

E0((1+g)/(1+r))3

$2.62

V (t=4)

E0((1+g)/(1+r))4

$2.57

V (t=5)

E0((1+g)/(1+r))5

$2.51

Disposal Value

E0(1+g)5/[r(1+r)5]

$22.84

Book Value

BV

$5.26

Fair Value Range

Lower Boundary

$39

Upper Boundary

$44

Minimum Potential

34%

Maximum Potential

50%

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Southern Copper is between $39 and $44 per share. At a price of $29, Southern Copper is trading at a significant discount. The stock has up to 50% upside potential to reach its fair value.

Peer Performance

While there are several companies in the copper business, Freeport McMoran (FCX) is probably the closest competitor of Southern Copper. Both stocks did not perform well in the recent months. However, Freeport McMoRan's annual return is deep in the red territory compared with Southern Copper. The stock disappointed its shareholders with a return -30%.

Freeport McMoRan has a cheaper valuation, as its stock is trading at single digit P/E ratios. It also has a relatively lower debt/equity ratio. However, its yield is much lower. Current yield of McMoRan is 3.83%. With a trailing yield of 6.98%, Southern Copper offers a much better dividend income. That is probably the reason why Southern Copper is priced with a relatively lower discount. Based on an EPS growth estimate of 5%, Freeport McMoRan has a fair value range of $56 - $73. Thus, it is also a cheap one based on my fair value estimates.

Technicals

(click to enlarge)(Source:Finviz)

From a technical perspective, Southern Copper has recently broken a narrow-triangle formation. At the current valuation, it is trading near the middle of its 52-week range. The stock started the new year with strong bullish momentum, but it could not stay above $36, and retreated. The relative strength index of 31 suggests that the stock is trading near the oversold territory. Those, who trade on technical indicators, should look for the stock's behavior around $30, as this price level supports a strong local support point.

Summary

Based on the historical valuation metrics, Southern Copper is trading at a discount. The trailing P/E ratio of 10.0 and P/B ratio of 5.5 are significantly lower than the 5-year average P/E ratio of 18.4, and P/B ratio of 7.3. Compared with the market's forward P/E ratio of 13.4, SCCO is significantly undervalued. The stock looks like a deep bargain as it is trading with low valuation multiples.

Based on my FED+ valuation, SCCO is substantially undervalued. The stock has at least 50% upside potential to reach its fair valuation range. Analysts also agree with me. While not as bullish as the model suggests, their target price of $36.45 suggest almost 25% upside potential. Note that, similar to other commodity producers, Southern Copper's future growth is determined by its primary commodity output. If copper prices collapse, then its stock might also suffer.

Source: Southern Copper Corporation: 50% Upside Potential