Friday, 29 September 2017

Copper Mountain Mining Corp (TSE:CMMC) - Looking for a play on the red metal

Copper is used in many industrial applications and has historically been a leading indicator of industrial expansions. The technicals for Copper have recently shown some signs of life and the broader macro environment of a weaker dollar seem supportive for the price. It has broken a long run downtrend and prices are now close to 2015 levels. 

Copper Price vs Trend 

Copper also suffers from declining grades globally which puts pressure on supply with much of the new incremental production being located in localities of dubious safety for investors. 

Cyclical Equities

I feel the cyclical value stocks are often rather unappreciated by the market especially commodities. There exists a paradox in equities where if Copper is in a bear market you don't really want to own any Copper stocks yet the one's with strong balance sheets are likely to weather the storm. On the other hand in a bull market you want to own the smallest and most leveraged players because the upside to the value of the equity is huge from only small incremental increases in revenue. 

My favourite kind of investment is those that act a bit like options - unlikely to go completely bust but with excellent reward upside from a shift in commodity prices or another factor - case in point Diamond Offshore Drilling which is now seems to be bottoming out.

Copper Stocks

As with most investments in commodities the key competitive advantage is to be the low cost operator. A low cost operator with a strong balance sheet can survive a major downturn as smaller and less profitable players shut up shop. The issue with copper and many industrial metals is that the large mining conglomerates tend to dilute the pure play aspect - by which I mean stocks like BHP and Rio Tinto are driven by Iron Ore prices, Coal prices and other industrial metals and commodities. 

Therefore whilst BHP's massive Chilean Escondida mine may offer good low cost copper exposure ultimately the exposure is muddied by Iron Ore prices (a much more abundant mineral) and other noise. Chile is the world's copper capital but most of the mines there are operated by Codelco a private state company. 

Other huge mines include Southern Copper's assets in Peru and Mexico - but SCCO has terrible corporate governance, social and a environmental records leaving it liable to fines and problems. Finally there is Grasberg which was recently 'appropriated' by the Indonesian government from Freeport who now hold a minority stake.

So I wanted to look for small pure play copper producers in safe parts of the world where property rights are generally protected (US, Australia, Canada, Europe etc) - which took me to Canada.


This stock is a small cap, highly leveraged copper and gold producer based in British Columbia. The company has one relatively low grade open pit copper project which is fairly close to the Pacific Ocean for shipping with long term sales contracts to Japan.

A few interesting points;

It has a lot of debt

CMMC Annual Report 2016

Confusingly CMMC reports accounts in $CAD despite being a $USD commodity producer. The underlying debt of the company is happily denominated in $USD which matches the currency profile of revenues but is reported in $CAD. The total debt of $CAD362m is big given the market capitalisation of CMMC to date is $CAD 164m - > 2x levered on a market cap basis is a lot of debt.

What seems to have happened in the project was built and developed during the past commodity price boom and the subsequent bust in copper that started in 2011 could not have come at a worse time for the mine. A lot of debt was taken on to finish development at that time with both credit facilities maxed out and this is now being paid down incrementally.

CMMC Annual Report 2016
The good news is that during 2016, despite copper prices averaging $2.19/lb the company managed to generate sufficient operating cash flow to make substantial payments on it's debt. The stock has more than doubled since last years bottom due to the rise in copper prices which will drive up surplus cash flow and thus the value of equity in CMMC. It's very levered - great on the way up, not so great on the way down. 
CMMC Annual Report 2016
The company generated CAD$47m in operating cash with only CAD$6m in capex leaving net cash flow of CAD$41m - with that the company was able to meet CAD$17m in interest payments and another CAD$17m in capital repayments on loans alongside CAD$6m in lease payments - or ~CAD$40m. Thus staying afloat. 

Now with copper prices this year touching $3/lb and the average so far around $2.60/lb surplus cash flow generation should be greater this year allowing for more rapid reduction of leverage meaning the company can meet its CAD$37m in debt repayments, plus interest and the CAD$7.5m in lease payments with room to spare.

Now the schedule of repayments accelerates toward 2021 but if the company meets that it will have only CAD$100m in debt in 4 years time - and interest payments will have more than halved (assuming steady rates). The reduction in leverage if achieved will also give ample room to refinance at more attractive terms - although the current rates are mostly swapped for 3.565% or linked to LIBOR plus a spread. Rising US rates therefore have some negative impact - but to my mind survival looks possible and more assured as copper prices rise. 

By my estimates CMMC could generate as much as CAD$80m this year in FCFF so net of debt repayments they could start to build a reasonable cash surplus and potentially accelerate debt repayment on the term loans or alternatively reduce its reliance on finance leases for new equipment.

Net debt/EBITDA in 2016 was around 4.5x which is high but not nearly as bad as 10x in 2015! I estimate it could fall to around 2.2-2.5x this year with interest coverage improving from 2x to 5x putting the business on a more even footing. Not hard to see why the share price has more than doubled in 12 months.

Cash costs are reasonable

CMMC Annual Report 2016
The company has competitive cash costs especially given the relatively low grade of the mine (~0.3 / 0.34%) when compared to some of the best mines globally. Escondida for instance is 0.6% and the global average is around this level and has been declining for many years. The cash margin declined slightly in 2016 due to weaker copper prices despite a fall in costs because byproduct credits were positively impacted by gold and silver prices. In general higher gold prices rising in tandem with copper help margins.

2015 Cash cost curve - SNL Metals & Mining
As can be seen here $1.74 in 2015 for CMMC (comparable with this curve) is not bad but is not as low as bigger mines like Escondida. It seems on par with Grasberg. Southern Copper has very low cash costs at under $1/lb after byproduct credits or roughly 2/3 of CMMC's cost in 2016. But of course operating mostly in Peru and Mexico means labour costs etc are cheaper and their mines tend have higher grades too.

Currency Impact

The company is generally short CAD, long USD in its cost structure since local wages and transport costs are payable in Canada but revenues and debt are linked to the USD. However a weak dollar generally improves commodity demand globally and accordingly pricing so excepting unprecedented strength in the CAD by itself in general the company should fare better in a weak USD environment. 

Reserves and Resources

The mine life is currently estimated at around 15 years in terms of reserves. So I limit my DCF valuation to 2030 with that time period. They are currently stockpiling less rich ores for future use.

CMMC Annual Report 2016

This is not a massive resource base but at copper prices in the region of  $2.65/lb rising to $3.07/lb in 2022 (quite modest assumptions at $2.97 today) I gain a DCF valuation of $4.13 using a 8.7% WACC (ke 11.2%, kd 5.5% pre tax @ 35% debt). 

I think total FCF generation can be CAD$80-90m in the each of the next 3 years with those prices (assuming gold and silver prices hold and drive a virtuous cycle on the cost side). Given the debt repayment schedule that should leave CAD$35-45m per year for equity holders or at current rates a FCFE yield of 24-30% by current estimates! This is hardly a given because of the volatile nature of commodity prices but it goes to show the potential of this stock. Even a FCFE generation of CAD$6m as per last year is a not wholly inadequate 4%. 

What's my price? Well with bullish Copper assumptions around the $3/lb mark and including gold prices rising from $1,250 to $1,450 by 2022 I foresee a DCF value of $4.13 against a current share price of $1.25. If this sounds extreme that's because it's highly at risk - this stock could easily go back to zero if copper prices take a prolonged dive under $2.50/lb. 

Still an interesting risk/reward exists for me and I have taken a starter position in the portfolio. If it goes to zero I lose $1.25 a share. If copper prices stay where they are today I reckon the stock is worth 3x current value. That seems a fair deal.

Disclosure: I have established a modest long position in CMMC. These are opinions only, not investment advice. If in doubt read my disclaimer.