Thompson Creek: Fundamentals Look Strong, But...

| About: Thompson Creek (TCPTF)
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They just can't get out of their own way. Shares of Thompson Creek Metals (TC) struggled for two years, falling some 80 percent as the company simply could not manage to control costs at its Mt. Milligan mine. The mine, acquired through Thompson Creek's acquisition of Terrane Metals in 2010, had an original capital expenditure budget of C$915 million; that estimate has now ballooned to C$1.5 billion. That increase -- $568 million USD at current exchange rates -- was a substantial hit to a company whose market capitalization sits at $554 million as of this writing.

Now, the Mt. Milligan project -- which will diversify the company from its legacy molybdenum mining operations into gold and copper -- has finally begun to stabilize. Thompson Creek has, at the least, managed to keep the mine's opening on schedule; commercial production is set for the fourth quarter of this year. With winter nearing an end, equipment purchased, and construction of an on-site camp for workers commencing, the likelihood of a major obstacle to a Q4 opening is diminishing. Meanwhile, after potential funding difficulties popped up repeatedly during the mine's construction, the company noted in its investor presentation that it has a $217 million cushion with which to complete required capex.

But with gold and copper production at Mt. Milligan finally within reach, the company's molybdenum mines are now faltering. After investing in an expansion project at its Endako mine, which was completed only in March, TC ran into a series of problems at the property. Recovery rates came in well below average, and when winter came, the mine's sole available tailing pond froze, limiting the supply of water to the mill, and, thus, the amount of ore that could be processed. In its third quarter earnings release, the company guided for its share (75%) of moly production from Endako to be 2-3 million pounds; actual TC-owned production came in under 1.8 million pounds. The company also cut its guidance for Endako production in 2013 by about eighteen percent, leading to a $530 million write-down on the carrying value of the Endako asset. Adding insult to injury, the difficulties drove up the cash cost of moly mined at Endako, which came in a $15.42 per pound for the year, relative to a realized price of $13.48, according to the fourth quarter conference call. Endako's cash costs are guided to be $10.75-$12.25 per pound for 2013; but as CEO Kevin Loughrey noted on the call, the price of molybdenum had already dropped below $11.50, the midpoint of that guidance range.

The numbers were much better at the company's larger -- and wholly-owned -- Thompson Creek mine, but those figures are somewhat inflated by the company's decision to stop stripping at the mine. That lowers cash costs and defers capital expenditures, but if the company does not re-start the process of stripping (removing non-ore waste to access ore deposits), production at the mine will eventually have to stop. On the call, Loughrey said the company would have to re-start that process by June or July to avoid a pause in production. If moly prices stay at their current levels near $11 per pound, the cost of re-starting stripping and the associated higher cash costs may cause TC to let that mine go dormant. On the call, CEO Loughrey noted that "I think we need some improvement in the moly price to be optimistic" about re-starting stripping in 2013. But since the call, molybdenum prices have fallen even further.

Improvement is hardly guaranteed. Moly prices remain somewhat volatile in part because much of the molybdenum mined is simply a by-product of copper mining operations, making its supply less tied to demand than that of other minerals. With the world economy still somewhat depressed, the demand for moly's primary function of strengthening steel in alloys has not rebounded to earlier levels. And, as an analyst noted on the conference call, Polish miner KGHM Polska Miedz (OTC:KGHPF) is set to bring new supply to the market through a new copper-moly mine in Chile.

The company's bearishness toward future prices is shown by the steep writedown of the Endako asset, and that revaluation shows just how precarious the moly operations are. At the end of 2011, the two mines, plus the smelting operations in Pennsylvania, were carried by the company at a total value of $987.5 million. At the end of 2012, TC valued those same assets, using a discounted cash flow analysis, at just $475 million, a greater than 50% decline.

With those operations struggling, Thompson Creek, more than ever, will see its success -- or failure -- revolve around Mt. Milligan. The company still carries the mine at a book value over $2 billion, more than four times that of the molybdenum properties. Net book value for Thompson Creek, even after the writedown, remains elevated, at $1.4 billion. That figure represents $8.32 per share, and consists solely of tangible assets (the company wrote down the last of its goodwill in 2012).

Thompson Creek's projections for the mine do seem to justify the high carrying value of the property. In its Q4 presentation, the company noted that potential revenues from the company's copper stream and its 47.75 percent share of the gold stream would create $575 million in annual revenue over the first six years of the mine at current pricing. (Thompson Creek has sold the remainder of the gold stream to Royal Gold (NASDAQ:RGLD) at various points to finance the Mt. Milligan development.) Cash costs, in contrast, stand to be just $280 million per year, meaning that Mt. Milligan's EBITDA (earnings before interest, taxes, depreciation, and amortization) could, on its own, exceed $200 million a year. An EBITDA multiple of 8-10 would seem to justify TC's current $2 billion valuation on the mine. Similarly, I estimated the net present value of the mine's ore at about $2.3 billion in April; with both gold and copper prices having pulled back slightly, again, the $2 billion carrying value does not seem all that inflated.

There is one catch, though. While TC has not given detailed guidance for Mt. Milligan -- on the conference call, Loughrey said the company would do so "as quickly as we can" -- there has been one notable change in its projections for the mine. Cash costs in the future have echoed the movement of capital expenditure costs in the past: they have ballooned. In an investor presentation in March [pdf], the company estimated annual cash costs at Mt. Milligan at just $200 million. Less than a year later, the estimate of those costs has risen 40 percent, while revenue projections have narrowed. All told, guidance for annual gross profit at the mine went from $430 million in March 2012 to $295 million in February 2013. Given the company's recent history, investors have every reason to be nervous that the profit margin will continue to compress.

The company's financial structure only adds to those worries. Debt issued to finance construction of Mt. Milligan, according to the 10-K, carries a number of restrictive covenants that essentially handcuff Thompson Creek management. The covenants "impose significant operating and financial restrictions" on the company, limiting its ability to sell assets, issue additional debt, buy additional properties, and even merge with another company. It would appear that, given the nature of its now-substantial indebtedness and the diminishing ability of the molybdenum operations to provide substantial cash flow, Thompson Creek's fortunes are now solely dependent upon the Mt. Milligan mine.

With real fears about the value of the legacy moly mines, the question now becomes: is Mt. Milligan valuable enough? The company's enterprise value remains well below the carrying value of the mine, which is reflected in the stock's sharp discount to tangible book value:

TC Enterprise Value
Asset/Liability Value ($M)
Market Cap 554
RGLD Proceeds Due (112)
Cash On Hand (527)
Debt 938
2013 Milligan CapEx 460
Enterprise Value 1,313

If Thompson Creek's price tag for Mt. Milligan is correct, then that asset alone, even assuming a complete shutdown of both moly mines, is worth nearly $5.50 per share, a substantial premium to Tuesday's close of $3.28. That does not include the optionality of a potential rebound at the moly mines, or the possibility of an increase in gold and/or copper prices.

But those numbers are not entirely accurate. Last May the company issued 8.8 million hybrid securities, known as "tMEDs." These securities are convertible into equity in 2015; if TC trades below $4.64 per share -- a 41% premium to its current price -- the securities will be redeemed for 47.4 million shares of stock. The new equity would create substantial dilution; tMED owners would assume roughly 22% ownership of the company at current prices. As such, the adjusted enterprise value of the company should be not $1.3 billion, but $1.68 billion, assuming that current shareholders only have a claim to 78% of current equity. (tMED shares are removed from current calculations of shares outstanding because the company posted a net loss for 2012, making those shares "anti-dilutive," according to the company's 10-K.) Put another way, the company's book value dives from $8.32 per share to $5.40 per share when accounting for the tMED dilution (and the addition of $177 million in "paid-in capital" from the offering), and the value of Mt. Milligan alone dives from $5.50 to $4.27.

If the company's value for Mt. Milligan is correct, TC is a steal at $3.28, even if the worst-case scenario visits its molybdenum operations. Of course, the problem with Thompson Creek is that "if" has become a four-letter word. Anyone who has followed the stock -- or quickly reviews my previous coverage -- knows that the fundamental case looked solid at 8, and 6, and 4. Because of the importance of Mt. Milligan to Thompson Creek's valuation, and the company's high debt load, a lower valuation on the mine would drastically change the equity valuation. If cash costs come in higher than the company is currently projecting -- and, again, those estimates have risen forty percent in eleven months -- potential EBITDA will decrease and so will the valuation. Another 15% gain in cash costs and a 10% decrease in metal prices pushes EBITDA down toward $125-$150 million annually, and Mt. Milligan's valuation easily drops below the company's enterprise value. At that point, TC investors are left hoping that the moly operations can go back to creating cash flow, or facing further losses in the stock.

There is also the issue of the compressed valuation in the junior miner space, which is facing "desperate times." An admittedly somewhat random sample of fellow small- and mid-cap miners shows that TC may deserve a smaller EBITDA multiple than it appears to be giving itself:

SVM EV / EBITDA TTM Chart

SVM EV / EBITDA TTM data by YCharts

Even if projections hold, but the EBITDA multiple comes down to 6 or 7 -- let alone to 4-plus seen by AZK and SA -- Mt. Milligan's valuation comes down toward the company's enterprise value, and TC's share price seems far less enticing.

In short, the problem with investing in Thompson Creek is that investors must trust a management team that has burned them repeatedly over the past two years. To be fair, the cost inflation at Thompson Creek is an industry-wide problem, with higher input costs and a labor shortage being seen around the world. But investors can hardly be faulted for having a wait-and-see approach toward Mt. Milligan.

By the same token, however, it's very easy to make the bull case for Thompson Creek. Even reasonable execution would appear to offer upside, towards $4.50-$5 per share; a trifecta of execution at Mt. Milligan, a rebound in the moly price, and a boost in copper and gold prices could easily cause the stock to triple over the next 12-18 months. That's not a guaranteed scenario; but it's hardly impossible, either.

At current levels, TC still appears to be a speculative buy, for investors who can handle the likely volatility (the stock has a beta of 2.71) and can stomach the potential obstacles in the company's development going forward. The stock does have reasonably liquid options available as well, which can be used to hedge downside risk and/or establish a more desirable entry point.

What appears to be the best way to play the stock, however, is through the company's "tMEDs," a hybrid debt-equity offering issued in May 2012. As noted, the tMEDs are convertible into equity in May 2015, but also offer interest payments. 9 quarterly payments of $0.40625 per unit remain, for total payment of $3.65625. The units then convert to equity based on the company's volume-weighted average share price for 20 days prior to the settlement date of May 15, 2015:

  • If TC is less than or equal to $4.64, the tMED holder receives 5.3879 shares.
  • If TC is between $4.64 and $5.45, the tMED holder receives an amount of shares equal to $25 divided by the weighted average price (i.e., at $5, 5 shares are distributed)
  • If TC trades above $5.45, the tMED holder receives 4.5855 shares. (As a side note, contracts can be settled early for 4.5855 shares; if TC were to double, a tMED investor could take profits by settling and selling TC common shares.)

The tMEDs, publicly traded under the symbol TC-T, traded Tuesday at $17.35 each. As such, the interest payments on the units -- totaling $3.65 -- provide 21% return over the twenty-six months until settlement, a roughly 10% annual yield. And TC shares are actually discounted through the tMED; the current value of the 5.3879 shares claimed by a tMED unit is $17.67, versus the $17.35 trading price. The interest payments and the slight discount to the common price provide a downside hedge; meanwhile, Thompson Creek common stock would have to nearly rise by about two-thirds before the common outperformed the hybrid units:

Common Return Vs. tMED Return
TC Price 5/15/05 Common Return tMED Return
$2.00 (39.0%) (15.8%)
$2.50 (23.7%) (1.3%)
$3.00 (9.3%) 15.7%
$3.50 6.7% 29.8%
$4.00 22.0% 45.3%
$4.50 37.2% 60.8%
$5.00 52.4% 65.2%
$5.50 67.7% 66.4%
$6.00 82.9% 79.6%
$6.50 98.2% 92.8%

In exchange for knocking the breakeven down to about $2.54 per share, tMEDs investors give up only a modest amount of upside should the stock double, or come close to it. There are some risks: the tMEDs are far less liquid than the common stock, and their debt components seem doubtful to have any claim on TC assets should the company have to restructure or file bankruptcy if Mt. Milligan turns out to be a flop. And, of course, the above rates of return assume that the investor holds the tMEDs until settlement, over two years away; an earlier sale would negate much, if not of all the downside protection. But the tMEDs provide a reasonable hedge at an exceedingly reasonable cost, and they are publicly traded (albeit illiquid), lowering transaction costs.

The lack of liquidity in the tMEDs could even be spun as a positive, because the bid-ask spread will make it harder to sell. And it seems likely that any investor in Thompson Creek will think -- probably more than once -- about selling over the next two-plus years. The company's fate is literally hanging in the balance, dependent on a mine in a remote part of Canada. Commodity prices, labor shortages, and even the weather -- all impossible to predict -- will have the ability to cause huge moves in the stock price. TC stock looks likely to be a bit of a roller-coaster; but for those investors aware of that fact, and willing to accept it, it might be worth the ride.

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.