The Long Case for Southern Copper Corp.

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 |  About: Southern Copper Corporation (SCCO)
by: David Tsao

When you turn on the TV these days or open up the papers, there is much talk about investors parking their money into gold. It’s “safe” and “recession proof” as some people say. If you had picked up gold a few years ago, it definitely would have been a wise investment choice.

Copper, on the other hand isn’t a commodity that is covered as much. It is less lustrous after all and not good enough for anyone’s engagement ring. It is however used to build stuff, and a lot of it. The recent market weakness has punished some mining companies to some good value ranges. Southern Copper Corporation (PCU) slipped into my screen thanks to the falling stock price. This is my next company of focus.

What does Southern Copper do?

Southern Copper Corporation has been in the business exploring, digging up dirt, extracting, and refining copper, molybdenum, zinc and silver for the open market since 1960. The company has done well to vertically integrate their operations. This essentially means they manage the whole production process from mining to transport and logistics using their own employees and equipment [1]. The company sells the material to various companies which in turn use it to manufacture products. Copper in particular is the main source of revenues for the company and is used in a wide variety of products from the tubing in your house to electronics in your computer. They currently have mining and refining operations in Peru and Mexico, and currently have exploration projects in Chile [1].

Why I am investing in Southern Copper

Investing in Southern Copper comes down to a few simple things:

  1. They had slipped down into my stock screen that I used in testing Joel Greenblatt’s magic formula system (low P/E, high Return on Assets). Keep in mind that this is just one of the many basic screens in searching for value. The company has also been rewarding their shareholders with some very nice dividend yields.
  2. The company continues to focus on increasing operational efficiencies with several investments in mining and refining equipment. The company can not control copper prices, and are at the mercy of global demand. This is a good thing right now as copper prices continue to rise.
  3. Copper demand continues to grow world wide, but inventories remain low [2].

Let’s focus on each of these points in more detail.

Value: The company has shown very excellent values of late. Just to give a quick overview I decided to compare Southern Copper to its bigger brother, the juggernaut mining company Freeport-McMoRan Copper and Gold Inc. (NYSE:FCX) in relation to some basic measures:

Both companies are finely tuned, but sometimes I have a tendency to pick the 2nd fiddler that doesn’t have as much focus, but manages to generate extreme margins and returns. You could say it gets back to the time in my life when I first saw Rocky Balboa beat Ivan Drago. But this isn’t about Southern Copper being a better investment than Freeport, this is about Southern Copper just being a good investment period. The company has also treated their shareholders very well with healthy dividend yields. Just for carrying their stock, they have rewarded their shareholders $6.50/share over the past 4 quarters which equates to roughly a 6% yield [1].

They have been able to do this because copper prices have continued their upward climb. I mentioned earlier that Southern Copper can not control copper prices which can be construed as a major risk to the company’s forward revenues, profits, and dividend distributions. However, part of my decision to add this to the Ten Grand portfolio has more to do with global demand for copper. More about this in a bit.

Investing in capacity and mining technology: I am not a geologist, mining specialist, or an industrial engineer, but what I do know is Southern Copper has made choices to invest capital back into digging up more copper. Based on global demand for copper this is obviously a good move. The company just recently finished up studies on the “Tia Maria” project which will require a $65 million investment. When this project is completed it will output approximately 120,000 tons of copper per year.

Global Demand for Copper: Global demand for copper has increased 7.2% in the first 10 months of 2007 from the same period in 2006 [4]. This growth in demand for copper has caused copper prices to grow skyward. Southern Copper’s future results ride on how high copper prices will go. Prices rise, revenues rise, and then profits rise. Well, that doesn’t really offer up any intelligent insight.

However, I wanted to get an idea of copper prices’ affinity to Southern Copper’s revenues and profits over the past 5 years. I also wanted to examine what investor sentiment was like for the company’s shares during this time in relation to copper prices. Combining all of these relationships would give me a high level overview of how efficient Southern Copper was at squeezing out all those nice profits as copper prices rose, and an indication of market sentiment regarding the company’s value. Sometimes companies can really screw up profit margins as revenues rise (ie. Very bad management, bloated operations, etc.).

I was curious to see how PCU shares traded in relation to copper prices, and there was no surprise here as the market has latched on to the trend and has been pushing the share price higher the past few years. One can argue that market expectations may have gotten a little ahead of itself lately, with the increasing spread between copper prices and PCU’s share price. However, my cash flow analysis shows the company’s share price is currently trading within a good valuation range:

The next thing I wanted to analyze was Southern Copper’s revenue growth in relation to copper prices. Mining operations have only so much capacity. What I wanted to see was Southern Copper’s ability to grow revenues in line with rising copper prices. Accomplishing this would mean the company leveraged existing mines through more efficiency, or demonstrated the speed at which new mines were launched and utilized, or a combination of both. This would give me the confidence in Southern Copper’s ability to increase mining capacity quickly to satisfy rising demand.

Last but not least, if Southern Copper runs a finely tuned operation, their bottom line earnings should trend in line with rising copper prices:

So now that we know the relative relationship of the company’s earnings to copper prices, we have to predict where copper prices are going in the future. This is the hardest part of the analysis and I don’t think anyone out there can accurately predict where copper prices are heading. If there were, some of them got into copper 5 years ago and are living large at the moment. Prices are dictated by world supply and demand. In this playing field, China has a big appetite for copper.

Let’s dig a little deeper to find out what Southern Copper is doing to feed this appetite. Southern Copper’s sales breakdown by segment from 2006 shows the majority of the sales (30%) going to the United States, whose economy is currently softening. This would explain some of the recent weakness in the company’s stock and its fourth quarter drop in net income compared to the same period a year ago. Asia represents a smaller 6% of Southern Copper’s total sales. In order to keep revenues afloat, the company is shifting a sizeable chunk of its North American sales (12%) to Asia [5].

We now need to make an estimate on whether the China’s economic growth will continue to grow, and in turn keep copper prices moving higher or at least stable. China currently consumes 22.7% of the world’s copper production [2], while the country’s GDP growth will continue at an estimate rate of 10.6% in 2008 [3]. Although the estimate is toned down somewhat from the current 11.1% in 2007, this still represents massive economic growth. The International Copper Study Group recently released world supply and demand for copper last month which illustrates lower operating supplies since 2006:

  • In the report, the first 10 months of 2007 show the copper market operating at a deficit of about 220,000 metric tons. Compared to the same period in 2006, the global copper market operated with a surplus of 78,000 tons [4].
  • World usage of refined copper was primarily driven by China’s massive consumption as it grew by 37% in the same period. Net Imports by China of refined copper increased by 170% [4].
  • World demand is exceeding at a faster rate than production [4].

Southern Copper obviously has more access to detailed data, and its action to move its capacity to serve Asia’s need will help the company realize this opportunity. COMEX futures (forward prices of copper that 2 parties agree to buy/sell copper at) show prices still hovering at record highs in the $3.50’s/lb range for the first half of 2008 [6]. This helps gauge the company’s growth, its worth, and thus a value for its shares.

What is Southern Copper’s business worth?

The next step is to determine the best and worst case scenario for the company’s outlook to determine where the company’s shares should be valued at. The following assumptions were used to determine the company’s future cash flows for the business:

  • Based on the company’s 2007 year performance, we estimate the company’s cost of capital to be 6.28%. This is basically how much it costs Southern Copper to finance its initiatives with a mixture of public investment (equity) and debt financing.
  • The company has been in operation since 1960, and will see continued operations for the next 10 years. In our worst case scenario, I am assuming the US falls into a recession and copper demand within the US falling off dramatically, with China absorbing some of this brunt. From 2008 to 2012, revenue growth was fixed at 5% per year.
  • From 2013 to 2017, I dropped the growth estimates to 1% growth. From Year 2018 onwards I also fixed annual growth at 1%. This is a commodity based business after all, and at some point global production will catch up with global demand.
  • Costs and SG&A (selling, general, and administrative expenses) were averaged out over the past 5 years of operation to forecast these amounts as a percentage of the overall company’s revenue going forward.

The worst case scenario results in the following value for all future cash available to the firm, resulting in a value of $83.20/share:

Now let’s look at the best case scenario. The company has experienced annualized revenue growth of 31% over the past 5 years. Assuming copper continues to be in demand, and prices trend slightly higher, I toned the growth down to 10% annualized growth for the next 5 years. I then moved revenue growth down to 1% for each year thereafter. This results in a valuation of $105.16/share. Based on this range [83.20 - 105.16], I’ll be looking to add to my existing position if the company’s shares fall further. I know I am already deviating away my initial test of Joel Greenbelt’s magic formula system, but I feel the argument for Southern Copper remains relatively strong.

What are the impending risks to the business?

There are some impeding risks to the business to keep in mind:

A global recession: The US drags down everyone, and with it copper prices. There is much heated debated about whether the emerging markets are tied to the US economy or not. There obviously is a relationship, but current growth rates in China, India, and other emerging markets aren’t showing any signs of weakness.

Labor Problems: One reader brought to my attention, the company’s recent labor problems with their work force. The work stoppage last year didn’t help matters and severely affected the company’s revenue streams. The company has taken steps to resolve their labor disputes. Considering the company holds selling, general, and administrative expenses [SG&A] relative to revenues at a low 1.62%, paying the workers more will not put a big dent the company’s bottom line. Southern Copper needs to respect the front line to keep things humming.

Beijing Olympics: (warning, my funky economic theory) Market valuations in China have soared to blistering levels. The Chinese market indexes could possibly be propped up at these high levels to ensure the Olympic Games runs smoothly. Chinese culture considers “face” extremely important. Once the Games have come and gone, any type of violent market adjustment downward may have rummaging effects on the country’s growth, thus reducing the need for copper. If this happens at the same time during US economic weakness, there will be more things to worry about besides Southern Copper (like my job). If this were to materialize it would be out of Southern Copper’s control.

Given the risks, I still consider my position a good one. Copper makes a lot of sense at the moment, and I hope it will wring out some good returns for the Ten Grand portfolio. I welcome any feedback out there, especially from any commodity experts.

Disclosure: I own a long position in PCU.