Investors in mining companies usually have the choice between two strategies. One could invest in a low-cost producer which should be able to survive downturns thanks to a relatively high buffer between production costs and the sales revenue per produced unit. But one could also invest in companies with a higher average production cost which should theoretically result in higher returns when a commodity price increases.
Capstone Mining (OTCPK:CSFFF) belongs to the second category and in an article that was published in September last year, I said Capstone appeared to be an excellent call option on the copper price as the company’s all-in sustaining cost per produced pound of copper is estimated to be around $2.50.
Capstone is a Canadian company and its listing on the TSX is much more liquid with approximately half a million shares being traded on a daily basis. The ticker symbol in Canada is CS, and the market capitalization is almost C$250M. However, as the company sells its production in US Dollars and also reports its financial results in USD, I will use the US Dollar as base currency throughout the article. The current market capitalization in USD is almost exactly US$180M.
The reported results were negatively impacted by the Minto mine
Capstone’s Q1 results were absolutely fantastic as the company was able to combine a relatively high copper production (41.4 million pounds) with a low C1 cash cost per produced pound ($1.56). That’s a 15% production increase at a 20% lower C1 cash cost compared to the first quarter of last year, so Capstone can be very happy with its performance.
Source: press release
The combination of more copper at a lower production cost obviously also had a positive impact on Capstone’s financial performance. The total revenue increased to almost $109M, and the earnings from mining operations increased by almost 40% to $23.2M. The net income from continuing operations was a very robust US$12M (which is approximately US$0.03/share) for the first quarter, which isn’t too bad for a company trading at a market capitalization of just $180M. Unfortunately Capstone is still trying to sell the Minto mine and the expenses related to the discontinued operations at Minto caused the total reported net income to fall to US$8.3M.
And this has important consequences, as the US$8.3M also provides the starting point of the cash flow statement. On a reported basis, Capstone’s operating cash flow was approximately $28.7M, but this includes paying $3.4M more in taxes than what was due over Q1 2019, while it also includes a $2M change in the company’s working capital and excluded the $4.23M in interest payments. Taking these elements into consideration, the adjusted operating cash flow was approximately $29.8M.
Source: financial report Q1 2019
This does include the expenses related to the discontinued assets (the Minto mine in the Yukon) and the additional cash expenses related to the care and maintenance requirements of the facility and the restructuring expenses have cost the company an additional $4.2M, so should the Minto mine be sold soon (there was an agreement but the purchaser couldn’t raise the money), the adjusted operating cash flow in Q1 would be approximately US$34M.
And with a total capex of $22M, Capstone’s adjusted free cash flow result of $12M is almost exactly the net income of continued operations. Of the $22M, approximately $2.3M was spent on non-sustaining capex (mainly some activities at the Santo Domingo project in Chile), so the sustaining capex would be closer to US$15M.
The performance will deteriorate in the rest of this year
Long story short, Capstone’s performance in the first quarter was absolutely excellent, but unfortunately it will also be the best quarter of the year.
Capstone’s full year guidance remains unchanged at a production of 145-160 million pounds of copper at an average C1 cash cost of $1.8-2 per pound. That’s indeed substantially higher than the reported $1.56 C1 cost in Q1. If we would use the mid-point of the guidance ($1.90/lbs) as base case scenario, the average C1 cost in the remaining nine months of the year would be just over $2/pound.
Source: company presentation
The main culprit will be the Pinto Valley operations. Whereas it processed rock at an average grade of 0.35% copper (10% above the full-year mine plan grade), the grade will drop by 20% to just 0.28% in the current quarter before edging back up to just over 0.3%.
If we would look at the full-year production rate, C1 cash cost and capex guidance, the ‘pure’ capex on the existing mines will be approximately $79M, or $0.52 per produced pound of copper, which would push the all-in sustaining cost to $2.42/pound. If you’d also include the $12M in exploration expenditures, the full-year AISC will be around $2.50 per pound.
With the copper price trading at around $2.85/pound right now, Capstone should still be able to generate approximately $30-35M in free cash flow. A respectable amount compared to its market capitalization of $180M, but let’s not forget the balance sheet also contains approximately $151M in net debt (including the short term investments which I deem to be ‘as good as cash’ considering the majority consists of money market funds). With a cost of debt of LIBOR +2.75% and the current LIBOR rate to be around 2.6%, the $217M in gross debt will cost the company approximately $12M per year.
Nothing has changed since my previous article, and Capstone Mining still is a call option on the copper price due to the relatively high all-in production expenses. You should expect the Q2 results to be very weak due to a disappointing average grade at the Pinto Valley mine in the USA, and perhaps that could create a new opportunity for punters wanting to bet on a higher copper price.
For every $0.10 change in the copper price, Capstone’s annual operating cash flow will increase by almost $0.04 per share.
Consider joining European Small-Cap Ideas to gain exclusive access to actionable research on appealing Europe-focused investment opportunities, and to the real-time chat function to discuss ideas with similar-minded investors!
NEW at ESCI: A dedicated EUROPEAN REIT PORTFOLIO!
Take advantage of the TWO WEEK FREE TRIAL PERIOD and kick the tires!
Disclosure: I/we 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.