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.

CMMC

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

Valuation

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.

Portfolio Strategy: General Update

I wanted to give a brief update on some new positions in the portfolio - not had time lately to do any full notes with models but I have generally been making limited purchases and holding cash/metals due to the high valuation in the market and now a likely period of seasonal weakness going into the second half - years ending in seven are notoriously rocky!

Composition:

High level I am still heavily invested in Gold with a modicom of Silver for higher beta metals exposure - with negative real interest rates in the UK some Gold is something of a hedge. In addition the yellow metal tends to outperform in uncertain markets - and it has broken out of a long run technical bear market that started in 2012. So present allocation is a reasonable 20%;

Amiable Minotaur Portfolio

In more detail I have mostly GBP cash and Gold with a little Silver and USD.

Amiable Minotaur Portfolio

Equities

Additions:

The equity side of the portfolio has seen a couple of new additions and changes since my last update at the end of June. I have added AstraZeneca, The Global X Uranium ETF and CF Industries. I have sold out of the IBZL Brazil ETF.

AstraZeneca - I bought this opportunistically the day of the recent announcement of the failed trials for their new lung cancer drug. Its not a sector I have great experience in but a quick look at the debt metrics, overall valuation and the scale of the sell off meant I took a small position. It is up a touch to date.

Uranium - This I view like a long term option with limited downside. Uranium has a history of long bear markets and stratospheric peaks in pricing. This is due to the supply and demand dynamics. At present all major producers are scarcely breaking even and no new production is incentivised. At some point this could shift with explosive price consequences. So this is a small but speculative position in a very undervalued sector.

CF Industries - Much like my views on CMP - CF Industries gives nice agricultural exposure and benefits from very low US natural gas prices. The stock has done little to date but the valuation case stacks up and you get a 4% yield while you wait for the agricultural cycle to turn. I got the idea from a report by Jesse Felder and I consider all his reasoning to be very sound on the name.

IBZL - I sold this for a tiny profit - which is a shame as it has since had a major bounce - but with such a high beta market and my bearish outlook for the near term I could see little value in holding it at this point and want a better entry point for the long term growth story that is Brazil. 

Amiable Minotaur Portfolio

Weight Changes:

I have added to Next, BLADEX and SQQQ and generally reduced Tullow Oil and Diamond Offshore as I trade these a little trying to pick a low in the oil bear market.

Next Plc - has broken a multi year downtrend and recent results showed signs of improvement. This is really such an obvious value diamond in the rough and that is why I keep banging the table on it. I've taken it up to 10% of the fund now. Downside could prevail in the near term if we see a wider market sell off and a consumer panic - but in general with such low expectations it should outperform the wider market in my opinion.

BLADEX - had a weak set of Q2 results and dropped - so I bought some more. Good dividend, good banking model, growing but out of favour markets and the local central banks on your side. 

SQQQ - I have been dripping into this very risky 3x levered short position - not for the faint hearted. I think we are seeing peak 'Big Tech' and I am looking for a 10% drop in the NASDAQ to give a 30% return on this ETF. We shall see - my time horizon is 3 months on this one. 

(The only reason I have the 3x levered is it saves FX costs to buy 1/3 the amount of dollars to gain the same exposure)

Diamond and Tullow I have been trading a bit with Oil prices - it feels like a bottom is near but I fear one more major blowout like early 2016 could be on the cards to clear out the weak shale producers and rebalance global oil markets. Time will tell. The energy sector has been such a dog for such a long time it's hard to not expect some reversion and I expect commodities will outperform tech over the next 3 years for this reason.

Sectors:

I still have a large slice in Gold Miners and a large slice in Retailers - with the additions of Materials stocks and Pharma things are getting a bit more diversified. Note this is also muddled by the 3x short position which is shown at ETF share value not notional exposure. Current long equity exposure is 61% and short is 13% with a net exposure of 48%.

Performance:

Overall things have improve since June end - I am down only around 1% now in GBP (lagging the FTSE all world return of 6% since inception). 

Star performers have been generally small positions with Guaranty Trust Bank of Nigeria and Kirkland Lake Gold having very good returns but limited attribution. IG Group posted good results with a solid rebuttal of all regulatory issues seeing a major tick up in the name. Endesa Generacion Chile had a great bounce due to some reorganization - if it settles down I may buy more...if I want utilities it is a no-brainer compared to the UK selection of indebted pension schemes utilities. 

Gold and especially Silver have also started to outperform. 

Unfortunately Bed Bath and Beyond has continued to be a dog after the Q2 selloff with no signs of a bounce and that stock alongside bealeagured gold miner Acacia Mining are the main drags on performance. SQQQ has been highly variable but is down a bit, same for Diamond Offshore.

Outlook

Going into the end of the year my instincts are pricked by opportunities in Copper once the futures settle back down again - I think we could be seeing the start of a shift into inflationary plays as the USD declines. So base metals will be a place that I am looking to pick up stocks. 

With high levels of cash, metals and short NASDAQ I am well placed for a modest markets decline - it is hard to expect a crash with so much Central Bank intervention at the moment - dont forget the Bank of Japan for instance owns 2/3 of the domestic ETF market!!


Disclaimer: I have an interest in all the securities mentioned in this article at present but i may change these in the future. These are opinions only, not investment advice. Construct your own portfolios with due care and attention.  If in doubt read my disclaimer.

Results are what counts - Once Again; Next Plc (NXT)

Next is my largest equity holding at the moment at 8% of my fund and the stock saw a significant pop this week following the publication of the August trading statement. I remain bullish on Next shares and think they offer the best value proposition in the FTSE 100 at this point. The stock rose around 8% off the back of the announcement due to better than expected sales following warm weather in the UK in Q2:

Next Trading Statement

Notice that Next directory saw 7.4% YTD sales growth and the stores a 7.7% decline. So 'bricks and mortar' is not doing so well but this long standing secular trend is something Next is extremely well positioned in having taken the Directory online years ago. Not only that but Next managed to make a huge profit and excellent cash flow running that business - unlike ASOS plc - (although yes overall top line growth is less exciting).

Next narrowed their lower bound sales guidance by 50bps and maintained their profit forecast guidance. The stock rallied because things arent getting any worse. This is a significant bottoming reaction to news - this and the May trading statements have seen a reversal of expectations after January's awful statement - which initially caused me to first start acquiring the stock.

Is the 18 month bear market in Next shares ending? Well I am a fundamentals guy but technicals give you an idea about whether you are stuck in a value trap - now I understand its a bullish move when you break the 200 day moving average and the 50 day in a nice gap up. Could this be the end of the wider downtrend?

Stockcharts.com

Regardless the healthy dividends continue and cash flow generation is just fantastic;

Next Trading Statement

More dividends, excellent free cash flow levels - just short on the growth front (hence the high divs and low valuation). Time will tell. I continue to maintain my personal bullish view on Next shares. 

I notice also, although it is early days, that Next has performed very well especially against the value trap that is Debenhams since my initial inquiries into the sector in March:

As the graph shows Next +13%, ASOS +2%, FTSE +2% and Debenhams down 22%. I maintain my view that within 2-5 years Debenhams will no longer exist - which will come about from first a dividend cut smashing the share pire and then a squeeze from lenders - the pension scheme will end up another minor scandal.

Disclosure: I have established a modest long position in NXT. I have no positions in ASC or DEB. These are opinions only, not investment advice. If in doubt read my disclaimer.

Sturm Ruger (NYSE:RGR): Is there Value in Guns?

Sturm Ruger is an American manufacturers of firearms namely pistols, shotguns and rifles. The company was founded in 1949 and is one of the largest producers of firearms in the states alongside their main listed competitor AOBC formerly Smith & Wesson.

Background Check

I have been having a look at RGR due to the apparent defensive nature of their business. Gun sales tend to rise due to economic fears, terrorist incidents, civil unrest, legislative threats of further gun control and the election of Democrats. 

97% of sales are domestic US so this means the stock is a pure play on American fear;

Gun Sales Rise after Shootings

Gun sales also rise ahead of restrictions - and peak before Christmas

This may also explain why the present moment does not offer the best entry point into RGR. The Republicans are in, there is little talk of new gun control measures and for now the economy is lumbering along. Both RGR and AOBC shares fell significantly on  June 30th after AOBC announced a weak outlook for the rest of the year. 

So I tactically I feel I need a better valuation point or catalyst to really want to own RGR now.

What I like about RGR

It has no debt. RGR runs net cash on the balance sheet meaning it is extremely under leveraged compared to most US corporates. This kind of balance sheet is highly unusual in this day and age and makes RGR significantly more robust than AOBC which is a rather more volatile share. 

Therefore somewhat unusually RGR finance their buybacks from cash:

RGR Annual Report

ROIC is extremely high. The company averages a 10 year median net rate of return of 19.7%. Similarly the 10 year average ROA is over 20%! This company has excellent returns and capital allocation and throws off a lot of cash.

The FCF yield is around 6-7% with no debt and the company pays out a dividend of around 40% of earnings yielding 3%. That dividend has been in place and growing since 2009. In terms of Earnings the PE is 14x last years earnings - which is a good discount to the wider market. 

There is also no ongoing pension liability as the company settled the scheme in 2014;

RGR Annual Report

So this is definitely the kind of stable business that I would consider highly investable for the long term. However the wider sell off in the sector and weak immediate term outlook means the stock may do nothing or trend down for some time.

Valuation

A quick valuation in my model with conservative growth assumptions (3% revenue growth, stable margins) gives a DCF value around $90 a share which is a good premium to the current value of $60. However it only scores a $45 price target on the DDM model due to the low dividend payout because of buybacks as an alternative capital distribution. 

I think with a turn up in underlying sales this stock could head up towards my $90 estimate but currently there seems little in the way of an immediate catalyst to turn the sales momentum back towards stronger growth. Certainly one to keep on eye on going foward.

Disclaimer: I have no investment in NYSE:RGR at present but may do in future. These are opinions only, not investment advice. If in doubt read my disclaimer.

Portfolio Strategy: July update

So a quick portfolio update as I have made a few changes in the past month increasing some positions.

Amiable Minotaur Portfolio

Performance

I will call this my First Quarter review as the portfolio began on the 19th of April so just less than one quarter of performance. How has performance been? Including all fees and costs I have returned -4.01% in GBP since inception and relative to FTSE AW which gained 2.82% in GBP I have under performed by 6.83% in the period! The big drag has been my Energy and Retail stocks under performing.

Not a great start - but in my experience a well chosen portfolio with fundamental characteristics can under perform for significant periods of time. One swallow does not make a spring.

I would also mention that I face various up front fees including an exorbitant 1.5% spread on FX transactions which has cost around 50bps of performance as I have bought dollars for various investments. Fortunately I can hold and settle in USD once I have some so going forward FX moves should be less of a drag at least until I buy things in Euros.

Cash drag is another issue as being under invested hurts relative performance in an upward market but it is hard to invest a portfolio all at once. I am at the end of the quarter holding 24% in cash and 19.3% in gold with only a 56.7% investment level in equities.

I expect to continue to under perform for as long as the wider market and especially the S&P grinds higher. The stronger GBP also has a negative impact on performance in absolute but not relative terms due to around 40% of the portfolio being in FX (mostly USD) and another 19.3% in Gold which acts as a proxy currency.

Stocks: The Worst and Best

My worst positions have been in US Energy and  Retail. 

These sectors have been laggards due to poor oil prices and weakening consumer spending. Value investing means looking for value often ahead of market turning points - immediate pain for long term gain.

I continue to think both Diamond Offshore and Bed, Bath and Beyond are undervalued fundamentally and the sectors as a whole are in a depression. This will likely continue for the medium term so I do not plan to add to these positions - but when energy demand increases and consumer spending rises I expect very strong performance from these bombed out sectors. 

The value of my holding Diamond Offshore is down around 16% over the period. The value of my holdings in Bed, Bath and Beyond is down 23%. 

Similarly my UK investments in these sectors; Next Plc and Tullow Oil have also been struggling but I have recently added to these on weakness.

The best positions have been in Gold Miners and IG Group. 

The Gold Miners have started to pick up a bit with Kirkland Lake having very strong performance up 19% due to exploration and insider buying alongside the removal of the GDXJ hangover. Acacia Mining has been up and down but is flat at 30 June awaiting news. Klondex has been outperforming too with only Goldcorp lagging a bit.

IG Group has been grinding higher since the big sell off on regulatory fears in December 2016. The stock is up 8% in the period in part due to benign regulatory actions in Europe. However a new Eurozone wide probe is delaying the UK regulatory enquiry until next year! This means the stock is 'dead money' for now to my mind but with a healthy dividend  I am happy to hold for now awaiting regulatory settlements.

Unfortunately these outperforming positions are some of my smaller ones. 

Developments

TLT

I sold my TLT bond ETF on the 14th of June following the Fed speech from Yellen. I made 3.5% overall. It seems to me that despite falling inflation the Fed seem intent on raising interest rates. The US credit growth is slowing and looks recessionary so if they were managing the economy this would be a bad idea. I believe this is because they in fact are trying to manage the level of the stock market - which has gotten rather too high. Rising rates and falling inflation is a bad environment for owning long duration bonds as the real interest rate picture will improve. 

Short term TIPS yields have all risen this month indicating rising expectations of higher real interest rates. Whilst I think the long term outlook for TLT is strong we need to see dovish moves from the Fed amidst the next recession before this really comes to the fore. So this is a tactical sale.

I bought SQQQ.

SQQQ is a 3x levered ETF which synthetically replicates the returns of the NASDAQ 100. As you will know I consider US stocks to be overvalued principally driven by overvaluation in the NASDAQ tech stocks. This is obviously a risky investment as if the index rises 30% I lose 90% of my position. However given that the Fed seems intent on attempting to 'manage down' the stock market a bit these stocks are highly vulnerable to a significant correction. 

Stocks like Apple, Amazon, Google and Facebook are all great businesses but the price of these companies is frankly outrageous. Similarly Netflix or Tesla are not even good businesses and their prices are even more outrageous. I am looking for a correction of at least 10% in the underlying index and probably more like 30% due to the fact that these stocks are likely being driven higher by passive ETF flows and algos which only know how to buy a bull market...what happens when that goes into reverse?

So this position (I wont call it an investment - it is tactical) - is a 3% of the portfolio. Now it is 3x levered so the real exposure is 9% of the portfolio and it is short so I now have the following levels invested:

Long Equity - 53.7%
Short Equity - 9.1%
Net Exposure - 44.6%

I consider SQQQ downside insurance against a broader drop in the stock market as this seems one of the most vulnerable areas.

Amiable Minotaur Portfolio

Gold Stocks

I continue to like Gold Mining stocks and have added to my position in Klondex Mines which has started to move upward as we move away from the GDXJ rebalancing debacle. 

I also continue to hold Acacia Mining as we await developments in Tanzania - now the big guns at Barrick Gold have weighed in I foresee some kind of revised royalty terms and a resumption of exports hopefully within the next month.

Kirkland Lake announced new exploration results which were very positive and the stock also has been gaining some momentum. If the gold prices moves up I expect these stocks to do very well.

I continue to hold some Goldcorp to give big-cap diversified exposure to gold.

Weights are:
ACA        2.7%
KLDX    4.7%
KL          1.8%
GG          2.4%

On the topic of Gold

I have been selectively adding to my Gold ETF position in GBSS and this now sits at 19.3% of the portfolio. I am reluctant to take any holding over 20% of the portfolio but have been keen to move cash away from GBP with recent strength in GBP and weakness in the Gold price. GBP cash stands at 22.8% with 1.2% of the portfolio cash in USD (most USD exposure is invested.)

Aside from ones view on Gold overall the negative real interest rates in the UK make holdings some Gold over GBP cash a 'no brainer' as far as I can see. Gold also acts as a cash proxy and with only brokerage to pay on ETF transactions it works out a lot cheaper to buy than FX. The only reason to own GBP over gold would be a significant change in the rate picture for the BOE - but with UK inflation running at around 3% and rates on the floor the BOE have a long way to go to create positive real interest rates. Recent hawkish comments have had some impact on GBP and I have taken this as an opportunity to add to gold. 

The BOE are behind the curve on rate rises vis-a-vis the Fed in my opinion as they have nowhere to go as the next recession hits except more negative. 

This is one reason I stay bullish on Gold - it is not really wealth creation only the protection of purchasing power.

Total Gold exposure is 31% of the portfolio (Miners + Physical ETF).

Position Sizes

My biggest positions in terms of sectors are Gold Miners, Retail and Energy. 

Amiable Minotaur Portfolio

My biggest single stock position is Next plc at 7% which I added to on recent weakness. I continue to love this depressed stock - it has brilliant capital management, a flexible business model, excellent high street and internet presence and a strong mid market proposition. I think it is seriously undervalued. The market disagrees.

I also have upped my Tullow Oil exposure  to 5.5% as a trade on higher oil prices. The recent sell off to new lows in oil last week lead to excessive bearishness on the oil price. I expect some OPEC 'news' imminently to prop up prices - they may have low well head prices but they have big social budget constraints and the Saudis in particular have a major cash flow problem for their handout based social model.

Remember I sold down TLW from an older portfolio around the rights period after it ralled ex rights to £2.40 a share! I have been buying again under £1.60 as TLW has improving cash flow generation and low cost offshore oil production.

Interestingly my smallest stock exposure is Guaranty Trust Bank at 1.4% which has proved a great performer up 15% since April 24th. This is highly illiquid though so big trades can move the price significantly.

An Observation

I tend to prefer Mid cap stocks and small caps to large caps at this point. This is really a bottom up observation as I haven't been looking for any particular cap size. My only large cap holdings are Goldcorp and then SQQQ and IBZL ETFs which are principally large cap.

Amiable Minotaur Portfolio

Conclusion

I remain bearish overall as regards the wider market. Volatility is very low, equity prices are very high, central bank liquidity is very high, interest rates are very low. Not exactly fertile conditions for findings assets at attractive prices. I remain long term bullish commodities and associated stocks and gold due to under valuation vs financial assets. 

Clearly my investments in Energy and Retail have been a touch too early but I still believe both sectors are signalling recession and will be the first places to pick up on the other side of a downturn.


Disclaimer: I have an interest in all the securities mentioned in this article at present but i may change these in the future. These are opinions only, not investment advice. Construct your own portfolios with due care and attention.  If in doubt read my disclaimer.

Tesla (NASDAQ:TSLA) - Read Between The Lines

Tesla has become every short sellers nightmare. Mine included. It is the stock that just won't die despite its hideous 'cash burn rate' evocative of the Dot Com bubble. Much has been written by minds much smarter than mine (See Mark Spiegel's analysis) on the subject of Tesla's financials, the upcoming competition in the market, the build quality issues and the dangers of the autopilot.

I wanted to look at something a little different and that is the motivations and truth revealed by actions as opposed to words. As investors we always look for insider buying and selling as a yardstick for what management do with their own cash - this tells us much more than words. 

A guy like Elon Musk of course knows this - so he borrows some more against his stock to buy into his equity raises - giving the idea of firm commitment. Insider buying is a great yardstick unless the business in question is a 'confidence' business which means either a bank or another business that requires constant funding....like Tesla.

But I digress....

"As I grow older, I pay less attention to what men say. I just watch what they do."

           -Andrew Carnegie 

"And so when Cora Tull would tell me I was not a true mother, I would think how words go straight up in a thin, line, quick and harmless, and how terribly doing goes along the earth, clinging to it, so that after a while the two lines are too far apart for the same person to straddle from one to the other and that sin and love and fear are-just sounds that people who never sinned nor loved nor feared have for what they never had and cannot have until they forget the words. Like Cora, who could never even cook."

          -William Faulkner As I Lay Dying

So in that spirit let us make a few simple observations in relation to Elon Musk and Tesla. I have my own theory that 'everyobody tells you everything you need to know' if you read between the lines - it is like a form of dupers delight. Here is an example:

I read these Tweets as admissions of failure. He is saying that starting Tesla has nothing to do with making money. Think about this for a minute. The guy has a company with a $60bn market cap with which he never intended to make money.

Now the second tweet. I think he knows Tesla is failing - why would you be mulling over the origins of your business on Twitter, the great gamble of it all...if it weren't for the fact that you think it is failing? Maybe he is preparing the runway...

Or just chilling to get away from the stress....

This excellent article from the Buffalo News tells you a lot - they report that the $750m former Solarcity (now Tesla) factory still remains effectively mothballed with a skeleton staff. Here are the things they are saying in this article:

Tesla has promised to hire 500 people to work in the factory within two years of its completion and create a total of 1,460 jobs in Buffalo within five years. But the clock does not start ticking on those deadlines until all of the manufacturing equipment has been acquired and delivered to the factory – a condition that has not yet been met.

Action undertaken: Funnily enough they have not been racing to complete the factory. The state government still think its on:

"It has all of the ingredients for great success," Zemsky said. "When that cake comes out of the oven – whether it's in the second quarter or the fourth quarter or mid-2018, I don't know – all of the ingredients are there for tremendous success. That's what I believe."

Hope is not an investment strategy. And the State government is hardly going admit its financing a huge white elephant...a white elephant with very little realisable value:

"By shifting more of the state funding toward the building, the contract amendments have reduced the amount of state money being used to purchase equipment and increased Tesla's obligation to purchase machinery. Tesla – not the state – will own any of the equipment purchased with the electric vehicle maker's funds."

If you never plan to actually open the factory, and your having to ramp it up is conditional on having all the equipment delivered why not just deliver some equipment (that you retain the rights of ownership on) and then sit on it. Do not install it - do not given tours of the factory.... 

Think about what a bad deal the state is giving themselves. Tesla can sell the equipment and leave the state with a huge white elephant of a an empty factory. 

What is the realisable value of an empty purpose built factory in Buffalo? 

Oh and if I were Tesla I would probably look to find a buyer pretty sharpish for that equipment...

Tesla now says the panels produced at the Buffalo plant will be a hybrid product that combines elements of the high-efficiency technology from both Silevo and Panasonic. As part of that deal, Panasonic is investing $256 million in the Buffalo factory, further easing Tesla's financing demands as it gears up for production to begin.

Hybrid product means the Silevo technology is technically rubbish and Panasonic have a better one. The Panasonic deal means another sucker (following the state government) is invested in this project and getting it built. Panasonic has workable technology evidently. What Tesla is doing here is setting up a deal where Panasonic has to buy them out because they will waste enough of Panasonic's money that the sunk costs become unbearable.

Oh and then you can be super clever and paint the deal as a factor slowing the progress on the project.

Smith said he believes SolarCity’s purchase by Tesla and the Panasonic manufacturing arrangement has contributed to delays in opening the factory.

The bottom line is Tesla are not remotely rushing to finish the factory. Otherwise they would be finishing it! 

The reason is making solar panels and selling them is no longer profitable. Tesla know that opening the factory will increase their cash flow drain more than keeping it closed. In the meantime they are hoping to suck Panasonic in to take it off their hands....

You could say this is all conjecture. You would be right. But it is obvious.

Read between the lines. You cannot trust any investment with Tesla written on it. 

Disclaimer: I have a modest short position in(NASDAQ:TLSA) Tesla. These are opinions only, not investment advice. If in doubt read my disclaimer. 

Grains & Canes; Adecoagro (NYSE:AGRO): Investment Case: Part II

After my qualitative discussion in Part I it is time to explore some risks and the valuation of Adecoagro:

Risks

Currency 

Although the Brazilian Real and the Argentine peso have suffered huge devaluations in recent years the local inflation rates play a part. This means that in real terms with 40% inflation in Argentina for instance costs have been rising in USD as the currency depreciates below that rate.

Adecoagro earns most of its revenues in dollars through commodity exports or in items linked to commodities and dollar prices such as Ethanol. This means the company does better when local currencies depreciate against the USD as it reduces their local costs.

The worst case macro scenario for the company would be a strong dollar driving down commodity prices in combination with also stronger BRL and AR$ rates driving up costs. This is an unlikely scenario and would require particular macro conditions in Brazil or Argentina to prevail that made their currencies appreciate with the dollar.

The debt of the company is split around 3/4 USD and 1/4 BRL:

Company Presentation

Lending in AR$ is essentially only short term due to very negative real interest rates. The debt seems fairly well matched in terms of currency given the domestic exposure to Brazil and predominantly USD derived revenue. Note also Net debt has been declining as the company pay down debt following a major expansion in sugar capacity (some of which is still ongoing.) 

Generally the debt levels are unconcerning to my mind at sub 2x EBITDA. Given that the appraised market value of the companies land holdings alone is $870m and they carry net debt of $600m it is effectively collateralized (but note the debt is mostly for the Brazil plants rather than Argentina farmland). It would be imprudent for a commodity company to carry high financial leverage due to the existing operating leverage and instability of the business. Still they do pay interest in excess of 6% on these debts (in part due to high rates in BRL) although interest coverage was around 3.5x last year which is reasonable especially given that net debt has expanded recently in part to finance the expansion of capacity which is now coming on stream.

Foreign Ownership Rules

Country and ownership rules mean it can be difficult to acquire land or hold onto it. Both Brazil and Argentina have foreign ownership rules and restrictions on land. 

Argentina has foreign ownership rules which restricts individual foreign owners from owning more than 1,000 hectares of land in the core area of the country. These were implemented in 2011. Presently Adecoagro have more than 200,000 hectares of land in Argentina but the restrictions are not retroactive however they do limit the ability of the company to acquire additional land in Argentina. This is however also a significant barrier to entry for competitors (or at least foreign ones) to build scale in the country.

Brazil has similar restrictions for similar reasons although the operations of the company are different there as they lease most of the sugarcane land and are instead more focused on industrial production of sugar and ethanol than actual land acquisition.

Obviously environmental disasters/problems can cause significant problems for production. Floods, droughts etc can mean entire crops are lost. One advantage is the diversity of crops that Adecoagro produce but still their geographical concentration is high. Environmental problems elsewhere can however be a boost due to raised global price conditions for a given commodity.

Is it cheap? How can we value it?

This has been a major headache. The reason being the predictability of earnings is hard as the company is something of a black box - by which I mean beyond say 1 - 2 years who can say what they will be planting - Soy or Corn? and what they will be producing? Ethanol or Sugar? As these decisions are all market condition dependent. This makes it very difficult to make a relevant and accurate DCF model.

This is further complicated by the accounting. Farmland is recorded at book value, crops to be harvested are carried as biological assets and there is a complex cash flow hedge accounting arrangement between the debt and expected revenues. Therefore the earnings look awful at +200x trailing PE! But the best thing is to focus on cash flow in my opinion.

What I can say is I think the stock is cheap for the following reasons:

Free cash flow:

Company Presentation

The company made positive free cash flow last year of $133m ($85m inc expansion capex) following several years of heavy investment and this gives gross and net FCF yields of 10.6% and 6.8% respectively. Note also 6 years of continued strong growth in operating cash flow, with the heavy investment of 2011-2015 in sugar capacity growth which is now operating. 

Remember this positive cash flow growth is during a generally depressed period in agricultural commodity pricing.

Capacity:

As I mentioned in Part I production capacity has expanded greatly in the past 5 years even while commodity prices have tumbled and the stock price has been broadly flat that whole time. So cyclically there should be great latent earnings capacity during a cyclical upturn.

Book value adjustment:

The company has a lot of land recorded at book value especially in Argentina which was acquired cheaply following the 2001 crisis. The book value is $122m -If we take the company's independent land value appraisal of $870m this means the accounts understate the value of the business by ~$750m. Currently the stock has a market cap of $1.2bn and book value of $671m meaning Price/Book is 1.8x but adjusting for this market value would increase book value to $1.42bn making the Price/Book 0.85x. 

Cheap.

Now yes stocks can trade below book value and not be cheap - it depends on the return on assets and the value of the assets underlying the business. But most of the other assets other than the revalued farmland are also tangible ~$500m+ of plant, machinery and buildings (recently built) from the sugar operation and ~$600m current in cash, inventories, unharvested crops and receivables offset by debt and current liabilities. No significant intangibles ($17m), deferred tax balances ($38m assets and $15m liabilities) or other difficult to realise assets.

Now those sugar / ethanol assets are very productive. In the segmental analysis the company notes the following assets in that business; 

2016 Annual Financial Statements

The Sugar/Ethanol segment generated EBIT of $142m last year on assets of $831m ~ 17% EBIT / Asset return. Even subtracting a proportional $40m in interest and taxing that at 34% gives net $67m and would give an ROA of 8%. Now lever that with the $298m of equity in this segment and you get an ROE of 22.5%. 

Note also the ROA +20% in farming but this is really much lower if we adjust the farmland to market value - because farming has low productivity of assets. If we take the farming EBIT of $49m less $10m in interest and taxing at 34% this gives $25m. Divide this by the assets of $245m + $750m MV = $995m and we have an ROA of just 2.5%. Now lever that with the $893m of equity in this segment and you get an ROE of just 2.7%. 

What does this tell us? Well farming has a poor ROE compared to the sugar and Ethanol business. But there are a few important reasons for this:

• The farming assets are owned outright with very low leverage (adj for market value) hence the low ROE. This is a good defensive strategy for selling commodities as your operating leverage is already high.
• The Brazilian lands for sugar cane are mostly leased so are off balance sheet driving up the ROA - also industrial assets should be inherently more productive due to greater capital efficiency
• The Brazilian assets have higher leverage and hence a better ROE (but they are now paying down debt)
• Remember the farming assets were acquired at very low prices meaning their ROA and ROE base level is extremely high. If we back out the market value adjustment ROA and ROE are 10.2% and 17.5%. This is an unrepeatable feat and is a 'mini moat' shall we say...

Now also remember that sugar pricing has been better in the past few years while grains have remained depressed - so there is cyclical upside in the farming business.

The Bottom Line:

So what is it worth? I will be conservative and say 1x adjusted book value or ~$12 a share (+20% from current levels). This is however not factoring in cyclical improvements in commodity prices and other improvements in efficiency and scale. 

Why 1x Book? Well that seems a fair and conservative price to put on the business assuming one wanted to start from scratch to make a similar business. Given the tangible nature of the assets a low multiple seems warranted but it does also provide some bearing on the realisable value of the assets of the company. 

As a quick excercise combining the two segments of the business we get our pro forma earnings post tax of $67m + $25m = $69m. Now subtract $20m in overhead at 34% tax means ~$56m in earnings. The equity value of the business is $440m + $750 MV adj =  $1.19bn which is a 4.7% ROE. 

I would not pay a lot more than 1x book for a business with a 4.7% ROE - but I feel this could be improved in future by better profitability from improved pricing. Also remember this is the adjusted ROE - if the business actually could revalue the land and release some of that adjusted equity the equity base would be lower meaning a more capitally efficient business.

I can't help but wonder how much the founders have made from this business before the IPO in 2011 - buying up farmland which with improvement is now worth 8x more! However I still see value here for a patient investor such as myself betting on a longer run improvement in commodity prices and happy to take a cash cow option on that for the future which trades below its book value.

Disclaimer: I am long NYSE:AGRO at present. These are opinions only, not investment advice. If in doubt read my disclaimer.