Southern Copper's Profits Are Under Pressure

Southern Copper (NYSE: SCCO  ) is one of the world's premier copper miners, and it boasts a strong 28.8% profit margin. Recently Mexico announced new royalties, and this has investors in Southern Copper worried. The problem is that this new tax is not driven by simple resource nationalism, but deeper fiscal issues that will affect Mexico for years to come. 

Mexico's dilemma
Mexico nationalized its oil production in 1938. In 2007 petroleum-related taxes provided a full 33% of the government's funding. Now, the nation's oil production has fallen to 2,550 thousand barrels per day (mbpd) from 3,400 mbpd in 2004. The trend is only heading downward. President Enrique Peña has tried to relax Mexico's constitution to increase oil production, but it is up for debate when he will be able to allay the opposition's fears. 

There are good reasons to expect that this will not be the first mining tax increase. In the early 2000s Mexico's informal economy was estimated to be almost 30% of the nation's total economy. With such a large informal economy raising income taxes or VAT taxes could drive a significant portion of Mexico's economy further underground. Some estimate the current tax evasion rate of small business and professionals is already around 70%. The end result is that the government has one place to find more tax revenue: big business.

Big corporations that float stock in the U.S. have to abide by U.S. anti-bribery laws, making it difficult for companies like Southern Copper to use bribes to decrease their current and future tax burden. Mexico could become a net oil importer by 2020, and there is a good chance this latest tax increase will not be the last one.

Don't run for the hills quite yet
Even though more tax increases are on the horizon, it doesn't mean that Southern Copper is a bad investment. In the third quarter 43.8% of the firm's operating income came from its Peruvian segment. These operations help to shield the company from future Mexican tax increases. 

Southern Copper's tax bill will rise, but the company already sports very high margins. The large copper miner Freeport-McMoRan Copper & Gold (NYSE: FCX  ) has an overall profit margin of 17.5%, significantly below Southern Copper's profit margin of 28.8%. Southern Copper's cash costs net of byproducts were $1.00 per pound in the first half of 2013, while Freeport-McMoRan copper's operations had comparable cash costs net of byproducts of $1.46 per pound.

Also, Southern Copper's total debt-to-equity ratio of 0.78 is less than Freeport-McMoRan's total debt-to-equity ratio of 1.04. At the same time Freeport-McMoRan offers more diversification thanks to its recent oil and gas acquisitions. Oil and gas contributed 16% of the firm's Q3 2013 operating income. 

In summary Freeport-McMoRan and Southern Copper both have their own upsides and downsides. Freeport already has lower margins and can be seen as a play on global raw material demand with mining and oil and gas operations. To make up for Freeport's greater diversification it does have more debt than Southern Copper.

If you want to invest in industrial base metals Southern Copper offers strong margins and targeted exposure to copper.

Heading north can be risky
Rising taxes in developing nations would suggest that abandoning South America for Canadian miners like Taseko Mines  (NYSEMKT: TGB  )  would be a good idea. The problem is that Canada has relatively stable tax policy, but getting mines past environmental regulators can be a royal pain.

Taseko Mines has taken a beating recently after an environmental review slammed its proposed New Prosperity mine. The negative review has not cancelled the project, but it seriously decreases the chances that the project will be approved. The mine could be quite profitable as it is estimated to have 7.7 million recoverable ounces of gold and 3.6 billion pounds of copper. 

Taseko's news is not completely negative. In 2004 the company restarted Canada's Gibraltar copper-molybdenum mine. Thanks to this mine in Q3 2013 the company was able to post operating income before deductions and amortization of $13.71 million and net income from operations of $0.12 million. At the of the day Taseko is still a risky mid-tier miner as it needs to bring more mines online to grow the company, but environmental regulations are daunting.

Final thoughts
Southern Copper faces rising taxes over the next decade as the Mexican government raises taxes to supplement lost income from falling oil production. At first glance selling Southern Copper for Freeport-McMoRan sounds like a good idea due to Freeport's lack of exposure to Mexico, but Freeport already has lower margins than Southern Copper. Buying a Canadian firm like Taseko Mines is another option, but Southern Copper already has four large producing mines while Taseko only has one, and it faces high regulatory barriers.

In the end one of the most attractive strategies for Southern Copper investors is to sit tight and prepare yourself for higher taxes and compressed earnings growth. 

Putting your money where your mouth is
This incredible tech stock is growing twice as fast as Google and Facebook, and more than three times as fast as Amazon.com and Apple. Watch our jaw-dropping investor alert video today to find out why The Motley Fool's chief technology officer is putting $117,238 of his own money on the table, and why he's so confident this will be a huge winner in 2013 and beyond. Just click here to watch!

  


Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

DocumentId: 2721141, ~/Articles/ArticleHandler.aspx, 4/23/2014 8:45:55 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement