Is It Time To Take A Position In Turquoise Hill?

| About: Turquoise Hill (TRQ)

Summary

Turquoise Hill's Oyu Tolgoi expansion back on track.

Approval still needed for underground feasibility study and project financing, along with obtaining necessary permits.

Why I believe Rio may acquire TRQ once development ramps up.

It's been a long time coming for Turquoise Hill (NYSE:TRQ) and Rio Tinto (NYSE:RIO) concerning their stake in the massive Oyu Tolgoi, as they have finally come to an agreement with the Mongolian government to move ahead with its development of the next phase of the mine, which is to expand the major underground portion of the resource, which at this time, is estimated to account for approximately 80 percent of the mineral value of the mine.

Major sticking points which led to the differences have been resolved, including cost overruns and taxes.

With that behind them, the next areas to approve and make transparent will be an underground feasibility study and project financing. There is little to suggest there will be a problem in those areas, so it appears Turquoise Hill should fairly quickly be able to move operations forward.

Now investors can start to focus on typical mining operations of the project and the potential of the resource, rather than when the next phase of the project would proceed.

source: StockCharts.com

Terms of the agreement

Here's a look at the terms of the agreement that will have an effect on how investors analyze the company. According to a press release:

In 2003, Turquoise Hill acquired a 2% net smelter royalty from BHP Billiton. The enforceability of the royalty has been challenged by the Assistant General Prosecutor of Mongolia under Mongolian law. The Company has conceded that it has no entitlement to receive payment.

In June 2014, Oyu Tolgoi LLC received a Tax Act (Tax Assessment) from the Mongolian Tax Authority as a result of a general tax audit for the period 2010 through 2012. Oyu Tolgoi appealed the assessment and in September 2014 received a response reducing the amount of tax, interest and penalties claimed to be payable, from approximately $127 million to approximately $30 million. In a separate agreement with the Government of Mongolia, Oyu Tolgoi has agreed, without accepting liability and without creating a precedent to pay the amount of the determination by way of settlement to resolve the tax matter.

The parties have agreed that Oyu Tolgoi's 5% sales royalty paid to the Government of Mongolia will be calculated on gross revenues by not allowing deductions for the costs of processing, freight differentials, penalties or payables. Oyu Tolgoi will recalculate royalties payable accordingly since the commencement of sales and submit any additional amount payable to the Government within 30 days.

Notwithstanding the terms of the ARSHA, the parties have agreed that in calculating the Management Services Payment (NYSE:MSP), the rate applied to capital costs of the underground development will be 3% instead of 6%, as provided by the ARSHA. The MSP rate on operating cost and capital related to current operations remains at 6%.

Taken together, the agreements will have an impact of under 2 percent "of the value of the reserve case of $7.4 billion." While that's not a great outcome, it's worth it in my view in order to get the next, and most important phase of the project going.

In the end, Turquoise and Rio Tinto had to bend, but they didn't break, and that's the key factor I was looking for at the end of the negotiations. Along with the loss of the smelter royalty, the company will also not be able to include former deductions, which will cut some into earnings.

Over the short term this could put a little pressure on the company, but the expansion and resultant production is where the future is for Turquoise Hill, and that's where investors need to primarily focus.

Production expectations and development costs

For some time I've been saying investors had to wait until this agreement was made in order to start to analyze the company in the usual way it needs to be. With that now behind us, we should look at some of the numbers going forward; specifically expected revenue for all of 2015 and costs associated with expansion.

The estimated costs to complete the underground expansion is about $5.4 billion. That will be added on to the $6.6 billion already spent to get the mine going in the first phase. Investors will have to assume some of these costs are likely to rise, although after the strain between the government and Turquoise Hill and Rio Tinto, I'm sure they provided more room for unexpected expenses than before.

As for production, in 2015 the company said it will produce as high as 195,000 metric tons of copper and as much as 700,000 ounces of gold. The lower estimate is 175,000 metric tons of copper and 600,000 ounces of gold.

Copper has been stronger recently, surpassing the $6,300/t mark in April; the first time it has done so in 2015.

One of the major reasons I'm bullish on copper for the rest of 2015 is China, with its economic slowdown, has been looking at spending more on infrastructure projects, which should remain a positive catalyst going forward. The challenge there will be for copper producers to meet expectations, which they at times have struggled to do on a consistent basis.

In April China imported 430kt in unwrought copper, which was the most it has acquired in a year. This should help Turquoise Hill for the rest of 2015.

On the gold side, the drop in the price of gold has resulted in companies lowering production and cutting back on exploration. That and the drop in the amount of reserves at major projects points to gold prices going up over time.

source: Casey Research

source: Casey Research

If the global economy starts to improve in a sustainable and meaningful manner, that would change the above scenario, but there's nothing at this time that points to that happening. Consequently, Turquoise Hill and Rio Tinto will benefit from this emerging trend.

Generally, the price of copper and gold should hold up well, and that will be an added catalyst for the miner. Silver, which is another part of the narrative, will certainly move in unison with gold, as it has done historically. By itself that wouldn't be a major event, but combined with stronger copper and gold prices, it would be a major boost to the performance of the company.

Will Rio acquire TRQ?

For some time I've believed there's a strong possibility Rio Tinto may eventually acquire Turquoise Hill. The reason for that is once it begins significant production on the second phase, I don't see why the giant miner would be satisfied to hold a little over a 50 percent stake in Turquoise Hill. Why not have all of it at that time?

What's tricky in this regard is the timing of that acquisition, which if it waits too long, would cost a lot more than it will cost if it was done before revenue and earnings start to jump.

While copper, gold and silver will continue to go through cyclical demand and major price fluctuations, I believe the overall trend will continue to be strong for these three metals, and that means once the bulk of the development costs have been incurred, there will be a lot of room for solid revenue and earnings growth for many years. I don't think Rio will just let that level of potential slip through its fingers.

If this is to happen, the best time in my view is when construction on the underground portion of the mind surpasses the halfway point. If it waits much longer than that, revenue and earnings will climb, and investors will start pricing that into the share price, which will make TRQ a lot more expensive to buy.

The extraordinary size longevity of the reserves of Oyu Tolgoi means it could move the share price of Rio Tinto, even with a current market cap of a little under $83 billion.

What this means for Turquoise Hill shareholders is an even bigger pay day if that is how it plays out. There are no guarantees of course, but it is something that should be included in any analyses concerning the long-term prospects of TRQ and the associated risk/reward factor.

Conclusion

I've been bullish on Turquoise Hill for a long time, and I remain so. Now that the major hindrance to development has been resolved, the company will work to get the second phase of development going - which is the underground portion of the project, accounting for about 80 percent of the value of the mine.

There will still be a period of time to wait to get a serious boost in production, as underground development will be steady but slow, and production won't have an impact on the company's top and bottom line until that is ready.

That is of course obvious, but the point is it is likely to have a similar impact on the company as we've seen over the last couple of years, albeit for different reasons.

To me that means continuing volatility in the share price, as investors wait for news on costs, revenue and earnings, along with ongoing reports on the progress of the underground development, with the inevitable setbacks that always accompany that part of the mining business.

I don't see it becoming real stable and consistent in performance until the bulk of underground development is completed. That means a lot of opportunities should present themselves to find good entry points for the long-term investor over the next couple of years.

Barring some unforeseen event, I see the share price range moving up by about $1 per share during the underground development process; somewhere in the $4.20 to $5.50 per share range.

That is based primarily upon the removal of the uncertainty surrounding the mine itself in relationship to the Mongolian government. A lot of that has already been priced into the stock, but there will be an additional boost over time from expectations of increased production in the underground segment of the mine.

To me this is a good time to get into Turquoise Hill. As less significant hurdles are removed and underground development launched, it's unlikely we'll see the price range as low as I mentioned above for many years.

Add to that the inevitable increase in demand and prices for copper, gold and silver, and that adds even more positive elements to consider when looking at the future share price of TRQ.

I've been waiting for official confirmation of an agreement between all parties associated with Oyu Tolgoi, and now that that has happened, I see no reason to wait any longer to take a position in Turquoise Hill.

Disclosure: The author is long TRQ.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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