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Edited By Marianna Avilkina

Southern Copper (SCCO) is one of the largest copper producers in the world. Operating in southern Peru and northern Mexico, this mining company extracts, transforms and commercializes a wide range of basic materials. The core products are copper, molybdenum, zinc, lead, gold and silver. Currently, 80% of SCCO's outstanding shares are owned by a Mexican conglomerate, 'Grupo Mexico.', Southern Copper was ranked the world's largest copper miner in 2011. The stock performed well in the last 12 months, returning almost 40%.

As of September 22, 2012, SCCO stock was trading at around $34, with a 52-week range of $22.34 - $36.92. It has a market cap of about $28 billion. The trailing twelve-month P/E ratio is 12.1, whereas the forward P/E ratio is 14. P/B, P/S, and P/CF ratios stand at 6.2, 4.1, and 11.5, respectively. The operating margin is 54% while the net profit margin is 34.7%. The company has some debt issues, with a debt/equity ratio of 0.6 that is above the market average.

Southern Copper pays solid dividends - the trailing yield of 4.86% is substantially higher than the projected one. Upcoming dividends are expected to amount to $.24 per share, which is only half as much as the dividends paid in Q2 2012. The five-year dividend history suggests that SCCO is a relatively consistent, yet sometimes volatile, dividend payer.

SCCO has a 2-star rating from Morningstar. Out of two analysts covering the company, one has a "hold" rating, and the other - an "underperform" rating. This is good reason to suppose that Wall Street holds fairly neutral opinions about the company's future. The average five-year annualized growth forecast estimate is 8.7%. What is the fair value of Southern Copper given the forecast estimates? We can determine SCCO's fair value using the 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 intimidating 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 = ($2.80 + $2.50) / 2 = $2.65

Wall Street holds diverse 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 12.5%. Book value per share is $5.36. The rest is as follows:

 

 

Fair Value Estimator

V (t=0)

E0

$2.65

V (t=1)

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

$2.60

V (t=2)

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

$2.54

V (t=3)

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

$2.49

V (t=4)

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

$2.44

V (t=5)

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

$2.39

Disposal Value

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

$21.70

Book Value

BV

$5.36

Fair Value Range

Lower Boundary

$37

Upper Boundary

$42

Minimum Potential

8%

Maximum Potential

24%

(You can download FED+ Fair Value Estimator, here.)

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 SCCO is between $37 and $42 per share. At a price of about $35, Southern Copper is trading at a discount. The stock has at least 8% upside potential to reach its fair value.

Peer Performance

While there are several companies in the basic materials sector, Freeport-McMoRan Copper & Gold (FCX) probably remains the closest competitor of Southern Copper. In contrast to SCCO, Freeport-McMoRan has a relatively conservative debt policy. Over the last three years, Southern Copper has increased its dividend amount per share to $2.43. Freeport-McMoRan also boosted its dividends from 62 cents to $1.

Moreover, the interests of Freeport-McMoRan's shareholders are better protected in the case of a business decline because the company keeps rather reasonable debt philosophy.

 

Southern Copper

Freeport-McMoRan Copper and Gold

Trailing P/E

12.13

12.24

Forward P/E

13.59

8.42

Yield

4.86

2.77

Debt/Equity

0.6

0.2

Return on Equity

55.8

20.4

As a reference, FCX reported a revenue drop of 23% in Q2 2012 resulting in a 45% reduction in profits. By contrast, in the same period SCCO's revenues and profits dropped by 8% and 8.5%, respectively.

Current Business Climate

In Q2 2012, Southern Copper managed to decrease costs by 2% while still maintaining sales of $1.8 billion. The industry trend continues to follow low prices and high mining costs. However, an increase in China's demand means that SCCO stands to benefit more than its competitors. This is because Southern Copper has managed to keep the costs lower while continuing to maintain respectable sales. Its three-year EPS is far above the industry average.

Recently a $2 billion ruling for the company was upheld by a court in Delaware; however, this has had little effect on the SCCO due to the fact that the case dragged on for three years. At the time of the decision's announcement, SCCO's stock fell by 0.6%. More importantly, the company faces protests from miners, and one person was killed during clashes between police and citizens of Pierina in Peru. The protests continue to grow as the Peruvian Andean community protests against the mining industry of Peru for exploiting the work force. The workers are allegedly provided contaminated water and unsafe environment to work in. These events have caused the mines to be shut down, and production losses are expected

Summary

The copper industry continues to be unattractive because of low commodity prices and demand. However, the mining costs have also elevated for the industry, and SCCO holds an advantage on that front as the company has managed to reduce costs by 2% in the latest quarter, as opposed to seeing them increase.

Based on my FED+ valuation, SCCO is obviously undervalued. The stock has at least 8% upside potential to reach its fair valuation range. However, clashes with labor unions have added an element of uncertainty for the production capacity. Unless copper prices increase, I expect the company to face growing difficulties in cost restriction as well as in revenue and margin increase.

Source: Southern Copper: A Good Buy In Copper Recovery