Antofagasta: Expensive Valuation, Expansive Operationally

About: Antofagasta plc (ANFGF)
by: Hans Centena

Higher capital expenditures would deliver muted free cash flow for the next few years.

Meaningful global copper supply growth from 2020 to 2022 could keep copper prices range-bound.

Centinela expansion is going for bigger and more expensive project feasibility option.

Image credit: Company presentation.

The doubtful track record of value creation in the metals mining industry stems from the fact that the sector often lacks a clear sense of direction. This vague direction has a few causes including long production response times, a production cycle which induces major risk-on/off periods and mismatched time horizons between companies and investors.

However, near-term fundamentals for the copper market could improve with an increase in demand from China. Higher copper prices in the near term could be positive for the share price.

I consider Antofagasta (OTC:ANFGF) as one of the most expensive pure-play copper stocks. I do not see any meaningful share price catalysts that could drive outperformance, apart from the positive macroeconomic data.

Analysts had noted adverse share price catalysts ahead driven by decreasing ore grades and climbing operating and capital expenditures which will restrict free cash flow (FCF) generation close to zero using spot prices over the next five years.

Following the rally in copper prices towards the end of 2016, ANFGF has outperformed its peers and is now trading near record-high valuation multiples, relative to the sector average (see chart above).

Stabilizing Copper Prices

According to a Barclays (LON:BARC) research note, copper prices continue to show a reasonable supply-demand dynamic despite the broad industrial slowdown. We are in the 7th year of copper prices sitting below incentive price levels. Copper prices now hover at the 87th percentile of the cost curve which is slightly below normal support levels as the cost curve flattens. The lower the price goes, the more copper producers begin to experience losses and the higher the chance of reductions in supply.

Source: Barclays Research

Consider the 90th percentile as a typical support level (as shown by the chart above) shows the copper price bouncing off the 90th percentile for most of the last seven years. It did break through it from 2015 to 2016. Further downside is possible this time around too.

Economists had noted the factors below that caused the broad industrial slowdown which led to this price dynamic in copper:

  • Oil prices crashed from a high of $106/bbl in 2014 to a low of $28/bbl in 2016, while the US trade-weighted dollar rallied 25% from mid-2014 into late 2015.
  • Copper supply growth was also strong as new capacity continued to come online from delivery of late-cycle projects.
  • The US was entering a rate hike cycle with 100bps of hikes ahead.
  • The market was arguably even more pessimistic about China’s prospects than it appears to be today.

The most crucial market is China, which comprised 48% of global copper consumption in 2018. This is significantly more than Europe and North America combined, which used up 16% and 10%, respectively. Global growth in total consumption from 2017 to 2040 is estimated to be 1.8% annually. This will reach 43.8 metric tons underpinned by manufacturing, electrification in transportation and buildings.

The volume growth in ANFGF that we could expect this year is the result of temporarily higher grades and softer ore which will reverse in 2020. The year 2018 saw record production with ANFGF producing 725,300 tons of copper. Net cash cost was $1.29/lb up 3.2% year-on-year in 2018, as average grades fell while rising input prices contribute to more cost pressures.

Source: Company data.

Cost performance significantly improved in 2018. This was due to its successful Cost and Competitiveness Programme which yielded 10c/lb of cost savings. That is equivalent to $184 million over the whole of 2018 and targeted to be $100 million in 2019.

Centinela Expansion: Monetize Water Assets

The company decided to proceed with conducting the feasibility study for the second concentrator in Centinela. The decision to monetize the existing water infrastructure assets at Centinela should enhance overall shareholder returns. They figured out that this option is more feasible despite having a higher capital intensity as compared to the other project option, and that is to expand its existing Esperanza concentrator. The size of the more capital-efficient concentrator expansion is limited by the existing footprint of Esperanza.

Centinela was formed in 2014 from the merger of El Tesoro and the Esperanza mining companies. Production for 2019 is forecast at 260,000 to 280,000 tons of payable copper, 190,000 to 200,000 ounces of gold and 2,000 tons of molybdenum. Production is expected to diminish in the second half of this year as grades decline. Cash costs are forecast to be approximately $1.85/lb while net cash costs at $1.35/lb in 2019.

Total capital expenditures were valued at $2.7 billion based on the company's 2015 pre-feasibility study. It includes approximately $600 million to $700 million allocations for the expansion of the water infrastructure (inclusive of the capacity expansion of the second phase of Centinela).

The timing of the construction would possibly be around 2021. They chose that timeline to limit the overlap of capex spending with the Los Pelambres expansion. The expansion of Phase 1 of the Los Pelambres project was approved last November 2018 for $1.3 billion capex which also includes the $500 million for a desalination plant.

ANFGF’s desalination plant will supply water for the Los Pelambres expansion project. The $500 million capex also includes the construction of Phase 2 as well as to act as a buffer for existing mining operations in case of extremely dry conditions.

Higher Capital Intensity For Sustainable Copper Supply

Given the copper industry’s long asset development lead times and a mean-reverting copper price, economists believe that a steady capital deployment model generates superior returns on capital throughout the commodity cycle.

The company would need to invest larger amounts of capital to maintain production and then grow it. Subsequently, plans for future expansions will be at higher capital intensity/lower returns than its existing production base, which will weigh down on returns.

The capital expenditure estimate from the 2015 pre-feasibility study is forecasted to increase from $2.7 billion to $3.2 billion on the assumption that the inflation rate remains flat at 2.6%. A Barclays analyst assumes that ANFGF will sell the Los Pelambres desalination plant at its replacement cost of $500 million once it is ramped up in 2022.

The water infrastructure assets at Centinela may be sold at $550 million in 2021. Then the company will utilize third-party funding for the expansion of the water infrastructure assets for $650 million.

I believe this should keep ANFGF’s FCF yields to be among the weakest in the sector over the succeeding years and limit the possibility of declaring further large special dividends. Spot FCF yield is 3.7% this year and 0.5% in 2020. This makes ANFGF’s shares appear less appealing compared to its industry peers taking into account the limited production growth beyond 2019.

Balance Sheet: Sufficient Debt Cover

Balance sheet remains sound with Net Debt to EBITDA not expected to exceed 1X in the near term. The level of debt is appropriate for its asset size being a large-cap. The company booked a short-term debt of $1.3 billion where the current ratio is pegged at 2.63:1. ANFGF has $1.9 billion liquidity sufficiently remaining in cash and short-term investments, readily available for working capital use.

Over the past year, ANFGF slashed its total debt from $2.7 billion to $2.5 billion. The company’s operating cash amply covers its debt as operating cash flow generated $1.3 billion during the same period. This yields satisfactory operating cash to total debt ratio of 53%. ANFGF is a safe large-cap play with interest cover ratio of 15.97X, thus it can pump out huge earnings multiple times its interest payments for its debt.

Source: CNN Business.

IRR Analysis: High Capital Intensity/Low Returns

The company’s internal rate of return (IRR) could improve from 10% to 15% assuming that capital intensity for the disposal of the water infrastructure and third-party funding of the expansion will meet together at the midpoint.

I expect that future expansion plans of ANFGF would adopt the strategy of higher capital intensity/lower returns. The funding of Los Pelambres comprising of 100% debt is indicative that gross cash should continue to build at the parent level (while subordinated debt rises at the mine level).

At this rate, the company will continue to pay out higher dividends with the investor expectation that its net debt would increase this year until next year.

I believe that this creates a negative impression to investors that ANFGF is funding dividends through borrowings although that is not the real case.

Comparative Spot Price to Net Present Value

Stock Valuation

I recommend a sell. I consider ANFGF stock as one of the most expensive pure-play copper stocks (if EV/EBITDA is used as a gauge). The current share price is trading on spot EV/EBITDA of 5.8X in 2019 and FCF Yield of 3.5%.

I anticipate negative share price catalysts ahead due to elevated operating and capital expenditures that limits FCF generation which is nearing the zero level at spot copper prices, thus lower shareholder returns. Although I must say, the declining cash flows were mildly offset by the $265 million VAT refund received at the onset of 2019.

Source: CNN Business.

My Takeaway

To recap, ANFGF spends a significant amount of capital expenditures in the Centinela mine development on top of its sustaining capex guidance. Production and unit costs have been very volatile every quarter over the past year. Costs continue to increase despite grades being higher over the past couple of years. Inflationary cost pressures are mitigated through cost-cutting programs and productivity gains.

The demand for copper is a critical element in renewable energy and electromobility. These two represent the optimal new sources of demand which will help offset the worst excesses of continued global trade disputes.

I noted that copper prices performed well in the first half of 2018 while the second half saw global trade tensions which led to a fall in prices. Hence, the market suffered from persistent volatility. However, fundamentals remain positive with a supply deficit in 2018 which continued to grow in 2019. The copper prices have strengthened, as the year 2019 started with progress in the trade negotiations and limited opportunities for supply growth.

In the near term, ANFGF offers low-risk exposure to copper price upside, while operational/financial performance should also improve. The company has a robust balance sheet and sound debt profile.

However, ANFGF stock is unattractive compared to either pure-plays or the diversified miners given its more expensive valuation. Needless to say, I prefer those "other" pure copper plays that have already absorbed its capital expenditures or on the verge of stronger growth with already visible share price catalysts.

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.

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