Lundin Mining (OTCPK:LUNMF), a Canadian company, which produces copper, zinc, nickel, silver, gold, and lead, encountered a few headwinds last year. Its revenue plummeted from $2.08 billion in 2017 to $1.73 billion in 2018; the firm also turned FCF-negative, as the operating cash flow nearly halved while capex increased. 1Q19 and LTM figures have not significantly improved and remained bleak. It is not coincidental that the market capitalization mirrored the top-line dynamics and since June 2018 share has lost around 29.6% of its value (before dividends). The stock underperformed the S&P 500 (SPY) and iShares MSCI Global Metals & Mining Producers ETF (PICK).
The main culprits were lower copper and nickel sales volumes and slipped copper price, as the firm generates the bulk of revenue from selling this metal (around 64% in 1Q19). Sell-off has recently even accelerated as copper price went into a tailspin dragged by the fears that the Chinese economy would be hammered by the trade war and demand for industrial metals would inevitably weaken.
In the short term, share price might be extremely volatile due to copper price fluctuations caused by the tariff war. But if concerns settle, which is though hardly predictable and not entirely likely, shares of miners will recuperate.
However, despite the lackluster performance in 2018, I reckon the company is not on the cusp of the precipice and has moderate upside potential given anticipated EPS momentum backed by higher metal production secured by the South Sector of Candelaria and Zinc Expansion Project at the Neves-Corvo mine.
Source: Seeking Alpha Essential
Besides, I consider a recent acquisition of the Chapada gold-copper mine in Brazil from Yamana Gold (AUY) as a positive value-accretive step, which will shore up revenue growth. In previous years, Lundin Mining amassed a cyclopean cash pile ($734.7 million on March 31, nearly 21% of current market cap) and had to utilize it in the most lucrative way possible. An attempt to leverage the balance sheet power and acquire Nevsun Resources (NYSEMKT:NSU) ended to no avail, but the acquisition of the Chapada is progressing successfully with anticipated close in 3Q19. Ultimately, as an investment, LUNMF is attractively priced with a 0.7 PEG. Now let's proceed to details.
Pivotal matters worth considering
The principal beneficiary of Lundin Mining is Lundin Group focused on the exploration for and production of natural resources and renewable energy. The group encompasses Swedish Lundin Petroleum, which I have already covered a few times, Lundin Gold, Lundin Mining, and a few others. Lundin Mining operates in stable and predictable countries like Chile, the US, Portugal, Sweden, and Finland (having an indirect equity stake in Freeport Cobalt Oy). Chile is the company's bulwark, as its flagship Candelaria mine is located there. The country is the world's biggest producer and exporter of copper, and its wealth is hugely dependent on mining. According to the CIA World Factbook, copper exports provide 20% of government revenue. Here, it is worth mentioning that ore-rich Chile actively seeks to diversify away from mining and invests in tech. American geopolitical intelligence platform Stratfor touched upon that matter in an article published last year. I do not regard it as a substantial risk for Lundin and other firms, as the government's decision to diversify the economy does not imply that it will handicap mining companies or issue tougher regulations. On the contrary, base metals can provide cash flow essential for the transition to a South American tech hub, especially considering that the country needs sizeable funds to pour into the power grid update.
At the moment, the company's mines are as follows:
- Candelaria in Chile (copper, gold); 80% ownership
- Neves-Corvo in Portugal (copper, zinc, lead); 100% ownership
- Eagle in Upper Peninsula of Michigan (copper, nickel); 100% ownership
- Zinkgruvan in Sweden (zinc, copper); 100% ownership
The Chapada gold-copper mine will be added after the closure of transaction with Yamana Gold. Also, on May 23, the company announced that cobalt refinery in Kokkola, in which it had a 24% interest, would be sold to Umicore (OTCPK:UMICF) (OTCPK:UMICY); the transaction is expected to be closed by 2019 end.
In 2018, the company produced 199,630 tonnes of copper, 152,041 tonnes of zinc, and 17,573 tonnes of nickel. All that allowed it to show revenue of $1.73 billion, operating margin of 17%, and negative levered FCF, mainly caused by weaker net income and unfavorable working capital change.
A brief 1Q19 review
The company has not started the year on an up note. 1Q19 results were hammered by harsh weather conditions at the Eagle mine in the US and consequent lower nickel production. In the first quarter, the company produced 98,000 tonnes of base metals, primarily copper; zinc and nickel brought only 20% and 6% of revenue respectively. The company reported revenue of $416.38 million; this figure compares favorably to 4Q18 revenue of $407.74 million but, at the same time, looks faint compared to the 1Q18 top line of $470.48 million.
Quality of earnings and FCF
In the previous years, Lundin's operating cash flow has consistently exceeded net income, indicating the high quality of earnings. Its trailing twelve months net OCF equals $365.64 million, while accounting profit amounts to only $166.27 million. Importantly, since 2014, operating cash flow margin has increased by 10% compared to the profit margin. I regard this as a positive sign, as, in capital intensive industry, inflows from operations, in my view, are a far more critical matter than accounting profit.
Unfortunately, the firm has positive net income combined with negative free cash flow, as trailing twelve months capex of $783 million was not covered by net OCF of $365.64 million. Yet, Lundin's issue is not unique. In 2018, its peer First Quantum Minerals (OTCPK:FQVLF) had the same flaw. However, in the industry, there are players like Swedish copper and zinc-focused Boliden (OTCPK:BDNNF) (OTCPK:BDNNY) and Chile-focused Antofagasta (OTC:ANFGF) (OTCPK:ANFGY) (OTCPK:ANTFY) with both positive net profit and levered FCF.
However, in a few cases, substantial investing outflows are inevitable for future organic growth and, apparently, valuation. Without pouring funds into fixed assets, a company might face a stasis at some point when revenue will stagnate or decline raising investor concerns. Upon more in-depth inspection, Lundin turned FCF-negative because of capital investments in Zinc Expansion Project (ZEP) at the Neves Corvo mine in Portugal. The bulk of 2018 investments in this mine were classified as expansionary, indicating that the company is not merely replacing the asset base to sustain output but pour funds to propel future output. So, humongous capex was necessary, and 2020 top line will likely reflect the results of these investments.
- With Zinc Expansion Project finished, zinc production at Neves-Corvo, according to guidance (see p. 8), will surge to 120-130 thousand tonnes in 2020 and 155-160 thousand tonnes in 2021.
- The South Sector of Candelaria is expected to start up by the end of 3Q19. As a result, Candelaria's production is anticipated to jump to 165-175 thousand tonnes in 2020 and 175-185 thousand tonnes in 2021.
- In sum, annual copper production is expected to increase ~51% in 2021 from 2018 level and would equal around 302 thousand tonnes.
According to data provided by Seeking Alpha Essential, analysts anticipate the firm's revenue to grow steadily in the medium term up to $3.11 billion in 2023, which represent a 1.8x increase from FY18.
Assuming no changes in P/S ratio, in 2023, LUNMF might be valued ~$6.5 billion, representing a ~180% upside potential. In the case of the contraction of the ratio towards 1.5x, the company might be worth ~$4.66 billion (34% upside).
Copper has a gamut of applications, from electronic connectors and microchips to construction and transport. Demand for copper (and other base metals) is dependent on the global economic cycle and especially on the Chinese economic momentum, as the country consumes the bulk of metals. Reignited trade war concerns and a new round of the tariffs tightening might impact global economic expansion and industrial output. The International Monetary Fund has warned that tariffs would cause "a 0.5% hit to growth - or about $455 billion." Investors are fretted about it, and the copper price has already reflected their concerns. However, chairman for the London-listed Antofagasta told a Chilean newspaper that without the commercial war, copper price might increase up to $3.20-3.50 per pound. So, if the tariff war ultimately settles, red metal producers will reap benefits. The flipside is that in the case of harsh confrontation, their shares will be pummeled.
To figure out if Lundin Mining is imperfectly priced, I selected the following cohort of comparables, which have similar market caps and copper production: Antofagasta, Boliden, and First Quantum Minerals.
- All the companies are profit-making, and P/E ratio is relevant. Lundin has the P/E of 20.4x, Boliden trades at 8.7x, while First Quantum's investors pay 12.4x per dollar or profit. Here Lundin looks overpriced, mainly due to high revenue growth prospects.
- As far as Lundin and First Quantum Minerals are FCF-negative now, while Antofagasta and Boliden are FCF-positive, FCF yield will be irrelevant for comparison.
- In the peer group, Lundin has the highest debt-adjusted earnings yield (EBIT/EV), 14.4%, and appears to be undervalued on an operating income basis.
- On a P/B basis, Lundin and First Quantum Minerals are apparently undervalued, as they have Price/Book ratios of 0.9x and 0.6x respectively, while the peers trade at 1.5x (Boliden) and 1.4x (Antofagasta).
- Ultimately, Lundin has an attractive PEG of 0.7, which makes the stock worth considering for investors who stick to the tenets of the GARP strategy.
Lundin Mining has clear production growth prospects, which secure a considerable revenue increase in 2019-2021. At the same time, the stock is not dramatically overpriced and looks worth considering both for value and growth-focused investors. The company's main issue is the negative free cash flow, but I expect it to turn FCF-positive after copper and zinc production surge. Also, its dividend yield is not impressive, only 1.9%, and the stock does not look like a perfect holding for dividend-oriented investors. Besides, there is a high risk that shares of mining companies will continue to slip on the trade war news. In sum, Lundin Mining has merits as well as flaws, and investors should carefully weigh all pros and cons.
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.