Ero Copper: I Prefer The 8.85% Bonds Over The Equity

Jun. 08, 2022 10:00 AM ETEro Copper Corp. (ERO), ERO:CA65 Comments

Summary

  • Ero Copper produces copper and gold in Brazil.
  • The company just raised $400M to help fund a new copper mine which should be operational in 2024.
  • The $400M in senior notes are now trading way below par, making them an interesting income investment.
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Coiling shiny copper cable onto reels to package at plant

Nordroden/iStock via Getty Images

Introduction

It’s been more than two years since I last discussed Ero Copper (NYSE:ERO), a copper and gold producer in Brazil. While the share price initially moved up alongside the increasing copper price, the ERO share price is now back to where it started as it is up just 6% while the copper price is still trading about 100% higher. This may be a good opportunity to have another closer look at Ero Copper.

ERO price chart
Data by YCharts

As the company reports its financial results in USD, I’ll refer to the US listing as the average daily volume of approximately 80,000 shares is pretty good. Investors can also head to the TSX where the average daily volume is almost 400,000 shares.

A decent start of the year but the overhead expenses are quite high

In the first quarter of this year, the company produced 21.5 million pounds and sold just over 22 million pounds of copper while it produced almost 9,000 ounces of gold (at an AISC of just under $1,100 per ounce). This resulted in a total revenue of almost $109M and after deducting the COGS, the gross profit came in at just shy of $61M.

Income Statement

Ero Copper Investor Relations

As you can see in the image above, Ero Copper was very profitable as the bottom line shows a net income of $52.5M but this includes a $18.7M non-cash FX gain. Excluding this non-recurring item, the pre-tax income would have been just $42M while the net income would have been just around $30M.

I was very surprised by the high G&A expenses so I decided to pull up the management information circular, the documentation the company has to send out ahead of its annual general meeting. And it looks like the management is taking very well care of themselves despite being a relatively small producer.

The executive chairman took home about US$1.35M in cash (and an additional $935,000 in share-based compensation and almost US$184,000 in option-based compensation). The CEO received the same compensation package and even the CFO received a very attractive total compensation of almost US$1.1M (including about US$400,000 in stock and option based compensation).

Management Compensation

Ero Copper Investor Relations

While I’m definitely in favor of making sure key staff remains on board and while I understand offering an attractive compensation package is key to retaining said staff, we have to make sure the company can carry it. In the current environment of high copper prices it clearly isn’t an issue but it is quite interesting to see in excess of 10% of the revenue (!) was spent on overhead expenses. Fortunately this will change soon as the company is working towards opening a second copper mine which will provide an excellent contribution to the revenue and cash flows. I’ll keep an eye on the evolution of the total management compensation as it explains the relatively high overhead expenses.

Ero Copper reported an operating cash flow of $44M in the first quarter but this includes an investment of almost $10M in the working capital elements and excludes the just over $2M in lease and interest expenses. On an adjusted basis, the operating cash flow was US$52M.

Cash Flow Statement

Ero Copper Investor Relations

That’s nice, but keep in mind Ero Copper is in growth mode and we shouldn’t expect to see any free cash flow (on a reported basis) this year. The total capex bill was about $55M in the first quarter which means Ero Copper was technically free cash flow negative, but there is a good explanation for that.

The construction of the new copper mine has now started

In February, the company’s board of directors approved the construction of the Boa Esperanca copper project. Construction activities are currently in full swing and the mine should be in production in Q3 2024. Delays are quite frequent in the mining sector so perhaps we should build in a margin of safety but it is clear the company’s ambition is to increase its production rate towards 80,000 tonnes of copper (180 million pounds) per year by the end of 2024.

The Boa project is quite interesting and a 2021 feasibility study outlined an open pit mining scenario with a throughput of 4 million tonnes per year which should add about 27,000 tonnes of copper per year to the production profile. The first few years will be the most important at Boa as the average production rate in those first few years is estimated at 35,000 tonnes per year at a C1 cash cost of US$1.12 per pound. More (exploration) work will be needed to improve the production profile from Y7 on but the company obviously has plenty of time to further optimize the mine plan for 2030 and beyond.

Boa Mine Plan

Ero Copper Investor Relations

I commend Ero Copper for raising more money than it actually needs. The 2021 feasibility study estimated the initial capex as US$294M but earlier this year, Ero closed a $400M debt financing. That’s a good move as the increasing inflation rate will for sure result in the total cost of the initial capex exceeding the $294M estimate (let’s put it this way: I would be very surprised and impressed if the total capex would come in below $300M). By raising $400M in senior notes with a maturity date of 2030 (well beyond the anticipated start-up date of the new mine) Ero has bought itself a lot of financial flexibility.

Let’s also not forget the other assets will continue to bring cash in the treasury but the total amount will be minimal in 2022 as Ero Copper will also be investing in growth on its main MCSA Mining Complex.

Capex Guidance

Ero Copper Investor Relations

As you can see above, the anticipated total capex at MCSA and NX will be north of US$250M including $130M in growth capex. So based on these projections I think it’s fair to say the existing mines are in a good position to self-fund their own growth investments but I don’t expect there will be a lot left on the table to help fund the Boa construction.

Keep in mind 2022 will be the ‘worst’ year when it comes to capex. The total capital expenditures will decrease from next year and in 2024 the total capex bill (still including growth) will be about 40% below the 2022 results. And the capex will drop further in 2025 while from that year on the new Boa mine still start contributing to the operating cash flow as well. And there’s no better time to ramp up the capital expenditures than in a year with strong copper prices as it minimizes the impact for the shareholders and the balance sheet.

Long-Term Capex Guidance

Ero Copper Investor Relations

Investment thesis

Will I become a shareholder in Ero Copper? No, likely not as I think (and I obviously could be wrong here) there may be better opportunities before the Boa mine is completed. I will definitely keep an eye on the share price but at this point I’m getting very interested in the company’s bonds.

Issued earlier this year and maturing in Q1 2022, the 6.5% senior notes are currently trading at just over 86 cents on the dollar for a yield to maturity of 8.85%. The company does have the option to repurchase the notes from 2025 on at a small premium (and that could happen if the copper price remains strong) in which case the yield to call is approximately 13% should the bonds indeed be called in 2025.

So rather than being a shareholder, I like Ero Copper’s debt to have some exposure to the copper price. I realize this is a very conservative stance and believers in a higher copper price should definitely buy the stock. But for me personally, the debt is more attractive.

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This article was written by

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We zoom in on capital gains and dividend income in European small-caps
As I'm a long-term investor, I'll highlight some stockpicks which will have a 5-7 year investment horizon. As I strongly believe a portfolio should consist of a mixture of dividend-paying stocks and growth stocks, my articles will reflect my thoughts on this mixture.

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