Here's a question for all you metalheads out there: Which company boasts the largest copper reserves (for a publicly traded corporation) in the world, trades at a discount to its peers while sporting the richest dividend, and has the greatest potential for upside earnings surprises?
Could it be the world's largest mining group BHP Billiton
How about Freeport-McMoRan
The company I'm talking about is Southern Copper
I know, I know ... the valuation discrepancy could be attributed to the labor strikes I mentioned above, but if we are to follow that logic, then why haven't BHP Billiton or Rio Tinto seen their shares prices take a commensurate hit following the recent strike at the Escondida mine in Chile? After all, according to Macquarie Bank, the world's biggest copper mine contributes about 20% of earnings for both companies.
As my Foolish colleague Anders Bylund wisely pointed out in his recent article "3 Stocks That Missed the Mark," it's not like Southern Copper's results were really disappointing. For the second fiscal quarter ended June 30, 2006, the company reported that revenue grew some 34% to $1.28 billion, despite a 13% decrease in copper production and a 35% decline in molybdenum output. Earnings came in at $439 million, or $2.98 per share, up 41% from last year's quarter, as tight expense control -- coupled with higher copper, silver, and zinc prices -- more than offset the temporary decline in production.
Hmmm ... so the valuation discount isn't caused by a lack of performance. Is it because -- unlike BHP Billiton, Rio Tinto, or even Freeport-McMoRan -- Southern Copper is a pure copper play and lacks the diversified assets that could cushion a cyclical downturn in copper prices? Sounds reasonable -- and it is an issue that prospective investors do have to consider in the longer term -- but given the continued strength in copper demand worldwide, that argument seems to carry little weight with regards to Southern Copper's current valuation.
Maybe I'm just being a Fool, but I don't see how this valuation discount won't narrow. But just to make sure, let's take a look at the outlook for the copper market in general and the prospects of Southern Copper in particular.
The copper market
As we are all aware, commodity markets have been on fire over the past few years, driven by the strength of the global economy and voracious demand from developing nations such as China and India. This demand shows little signs of slowing, as evidenced by the fact that China's economy continues to expand at a double-digit clip, India's GDP growth is around 8%, and, according to the World Bank, emerging markets overall should see collective growth that remains above 5.5% in both 2006 and 2007.
Copper prices, like those of all metals, have soared. Since 2003 -- the first year that copper consumption outpaced demand in the current cycle -- copper prices have jumped some 422%, from $0.67 per pound to their current levels of around $3.50/pound.
Obviously, we can't expect this type of appreciation going forward, but there's enough evidence to conclude that elevated copper prices are here to stay -- at least for the next couple of years.
Three quick items that support that theory are:
1. 2006 looks like it will be the fourth year in a row where consumption will exceed production. According to Arthur Miele, senior vice president of sales and marketing at Phelps Dodge, copper production was likely in a deficit of roughly 100,000 tons in the first half of the year. This deficit occured because industry inventory numbers (which showed a build of 7,000 tons) were skewed by the fact that China's State Bureau of Resources had released 100,000 tons of refined copper into the market over the past six months -- a one-time attempt to lower domestic prices.
2. Phelps Dodge has just increased its expectation of copper consumption growth to 5%, up from its prior estimate of 4% growth, citing strong demand coming from Asia, Europe, and even non-residential construction in the U.S.
3. According to Ken Heebner of CGM Funds "When you look around the world today, the earliest we see incremental new production coming online is 2009, 2010."
Simply put, continued strength in demand coupled with limited production capacity growth should continue to support copper prices. The above-mentioned estimates don't even take into account the recent strike at Escondida, a mine that produces between 6%-8% of the world's total copper production.
Pretty good looking outlook, isn't it? Now, here's a quick snapshot of Southern Copper.
The company, majority owned by Grupo Mexico, holds the largest copper reserves of any publicly traded company, with 44.9 million tons. The company has all its current mines in Mexico and Peru, one of the more stable Latin American countries. In fiscal 2005 (before the strikes), it produced around 1.5 billion pounds of copper, 317 million pounds of zinc, 33 million pounds of molybdenum, and 18 million ounces of silver.
With the strike issues recently resolved, the company plans to have both the Caridad and Cananea mines back in full operation by the end of September. The resumption of these operations (and the ramp-up to full production at its San Luis zinc refinery by the end of August) should boost earnings substantially, not least of all because, as the company notes, a $0.01 increase in the price of copper per pound equates to a net gain in annual earnings of $8.7 million.
Given the fact that copper prices are already around $3.50/pound this quarter, up from an average $3.32 in the second quarter, the potential upside is obvious and similar gains are to be expected from zinc, molybdenum, and silver production.
In my Foolish opinion, the upside potential of these resumed operations alone, coupled with the benign outlook for the copper market as a whole, make shares of Southern Cooper attractive at around $90 per share, or 6.3 times fiscal 2006 estimates. If that sounds pricey, don't forget the fact that the shares carry a yield of 8.8% and trade at a 23% discount to the average multiple of competitors Rio Tinto, Freeport-McMoRan, Falconbridge, and Phelps Dodge.
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Fool contributor Will Frankenhoff enjoys writing for The Fool more than reading The Financial Times, rooting for the N.Y. Giants, or pondering the vagaries of life (pretty unsuccessfully up to this point). He welcomes yourfeedback. He does not own shares in any of the companies mentioned above. The Fool has adisclosure policy.