Supply and demand key to base metals success: Adam Low

Adam Low: Yes, although our view is not universal. We are most positive on copper and zinc, somewhat less enthusiastic about nickel. We’re fairly neutral on iron ore, although we do expect a bit of softening in iron ore prices.

TGR: Why do you like zinc?

AL: We are starting to see fundamental changes occurring in the market. This is a supply story. Zinc has been an unloved metal for decades. As a result, there has been very little investment, which means that six major mines in operation for decades have or will soon end production.

The first two, in Canada, closed in 2013. The next major shut down, scheduled for mid-2015, is MMG Inc.’s (1208:HK) Century mine in Australia, the world’s second-largest zinc mine.

TGR: How much global supply will be lost as a result?

AL: About 10%.

TGR: So prices will rise?

AL: Yes. Visible inventories on the London Metals Exchange, as well as on the Shanghai Futures Exchange, are down about 30% over the last year. And zinc demand is increasing steadily. There are some suggestions that we have a small zinc deficit already.

TGR: What are the supply and demand fundamentals in copper?

AL: I’d characterize the copper market as being infected with “short-termism.” Mine supply grew quite spectacularly in 2013: between 6% and 7%. How sustainable is that growth? In a couple of years, we could easily have the same problem we had a decade ago, when mine supply lagged behind demand.

TGR: Why would this happen?

AL: One-third of global copper supply comes from Chile. This country is increasingly constrained by power and water supplies; labor rates are rising as well. Chile’s state-owned copper enterprise, the Corporación Nacional del Cobre de Chile (CODELCO), produces about one-tenth of global copper, and it requires something on the order of $20–27 billion ($20–27B) in reinvestment over the next five or six years in order to maintain both current production and grow its production base. That will be quite difficult.

TGR: Why are you less enthusiastic about nickel?

AL: In the long term, we remain skeptical about that market. Indonesia, one of the world’s largest nickel miners, has implemented a ban on exports of raw ore, which curtailed a major source of global supply. Nevertheless, nickel has abundant visible inventories. It also has growing supply from long-beleaguered laterite projects now finally coming to fruition: Ambatovy, Koniambo and Onça Puma.

TGR: Why are iron ore prices softening?

AL: We expect supply growth from mines to outweigh demand growth, particularly as major mines start up in Australia and Brazil. At current prices, the industry is making phenomenal margins, more than 100%. At lower prices, companies at the high end of the cost curve will struggle, but the others should continue to do very well.

TGR: To what extent are higher base metal prices dependent on positive global economic news?

AL: Growth is a key factor. The U.S. economy appears to have improved, although I’m a little bit skeptical about just how robust or sustainable this growth is, especially now that the Federal Reserve has decided to reduce its bond buying.

TGR: How do you view the short-term economic prospects of China and Europe?

AL: In Europe, the latest purchasing manufacturers’ index is at its best since 2011. We are beginning to see some resurgence from some of the weakest economies, such as Greece. And Germany still looks good. Even so, I don’t think we can count on Europe being the key driver for world economic growth quite yet.

TGR: And China?

AL: China is still growing and from a larger base. So while its relative growth may be less impressive than it was, its absolute growth is still quite extraordinary. Any industrialized Western nation would be incredibly envious of “only” 6–7% GDP growth per year.

TGR: There is a growing concern that the equities markets are overheated, particularly with the Fed tapering quantitative easing. If there is a significant correction, will base metals equities follow suit, or could we see instead a flight to safety in metals?

AL: If there is a significant correction, we could see base metals equities follow suit, even though they didn’t enjoy the upside the rest of the market did. In the longer term, the widening gap between the growing demand and the dwindling supply of many base metals should spark a resurgence of investor interest in this sector.

TGR: Will base metals equities continue to lag prices in 2014?

AL: This trend should begin to correct. Base metals prices have been quite steady over the last year despite headlines that have generated fear and volatility. This steady price environment should provide investors with greater comfort about metals prices, which should, in turn, lead to greater confidence in investing in the equities.

TGR: What are Raymond James’ top base metals picks for 2014?

AL: In copper, our preferred stocks are Capstone Mining Corp. (CS:TSX), First Quantum Minerals Ltd. (FM:TSX; FQM:LSE), Nevsun Resources Ltd. (NSU:TSX; NSU:NYSE.MKT) and Rio Alto Mining Ltd. (RIO:TSX.V; RIO:BVL).

In zinc, Trevali Mining Corp. (TV:TSX; TREVF:OTCQX; TV:BVL), Nevsun and Lundin Mining Corp. (LUN:TSX).

In iron ore, Labrador Iron Ore Royalty Corporation (LIF.UN:TSX) and Alderon Iron Ore Corp. (ADV:TSX; AXX:NYSE.MKT).

TGR: First Quantum has announced production estimates for its Cobre Panama copper project significantly higher than those of previous owner Inmet Mining Corp. (IMN:TSX). Will this allay fears over its cost?

AL: The new Cobre Panama capital expenditure (capex) is $6.4B, only about 4% higher than Inmet’s former guidance. It has projected a design rate of 70 million tons (70 Mt)/year ore being processed versus Inmet’s 55 Mt/year. It is also projecting a higher throughput rate. So the capex is slightly higher, but the cash flows to be generated from the mine have been increased significantly.

Given the size of this project and the inflationary nature of this industry, the market has taken the view that Cobre Panama is actually very well managed.

TGR: When will Cobre Panama begin production?

AL: My colleague Alex Terentiew covers First Quantum, and he’s forecasting 2017–2018.

TGR: To what extent is the company’s future leveraged to Cobre Panama?

AL: First Quantum is now a fairly well-diversified company. It has done numerous acquisitions recently, and it has a base of operations that includes Australia, Africa, Europe and South America. Cobre Panama is certainly its largest growth project but not its only growth project; it has many other mines generating cash flow.

TGR: What distinguishes Cobre Panama from Barrick Gold Corp.’s (ABX:TSX; ABX:NYSE) Pascua Lama white elephant?

AL: First Quantum has a phenomenal record of executing major projects, including those that other companies have stumbled on. For instance, the Ravensthorpe nickel mine in Australia, which BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK), the world’s largest mining company, struggled with for many years. First Quantum bought it and got it operating at the rates it promised.

Unlike Barrick, First Quantum does much of its engineering and construction in-house. It uses teams it has used multiple times for projects around the world. It takes lessons from previous successes and replicates them elsewhere. It leverages a vast amount of experience and thus contains its costs.

TGR: What’s your rating for First Quantum?

AL: We have an Outperform rating and a $25 target price.

TGR: Nevsun has transitioned its Bisha mine in Eritrea from gold to copper. Has that been successful?

AL: Very much so. Bisha is a polymetallic volcanogenic massive sulfide deposit that had a gold oxide-rich cap. Nevsun was fortunate to produce that gold when prices were at their peak. It had a very successful commissioning period with the new copper plant in late 2013, with production coming in near the high end of its guidance and exceeding our estimates. It has already declared commercial production of copper.

TGR: And Nevsun pays a dividend of $0.07/share.

AL: Actually, it’s $0.07 twice annually, so you’re actually getting $0.14/year.

TGR: Why do you say that Nevsun trades at a significant discount?

AL: It trades at a significant discount relative to its peer group. Its valuation is cheaper based on key valuation metrics: price/cash flow, price/net asset value (NAV); enterprise value/earnings before interest, taxes, depreciation and amortization or price/earnings.

TGR: What explains this discount?

AL: Two key factors. First, country risk. Bisha is located in Eritrea, which suffers from a perception problem. I’ve been to Eritrea twice, and I’ve been impressed, both with Nevsun’s operation and its level of cooperation with the government, a 40% partner in Bisha.

Second, a mergers and acquisitions (M&A) overhang. This is probably a larger factor right now than geopolitical risk. Nevsun has about $300 million ($300M) in cash, no debt and it’s a one-asset company. This makes it a likely M&A suitor, and the company has been vocal about its intentions. M&A always involve risk, and we often see an acquirer’s share price trade down on an announcement, so investors are taking a cautious approach.

TGR: How does Nevsun overcome these obstacles?

AL: On Eritrea, we believe that the impressive cash flow accruing to the company over the next couple of years will force the market to re-evaluate its risk assessment.

With regard to M&A, Nevsun has been very prudent. It refrained from acquisitions when valuations were much higher than now. It doesn’t want to grow for growth’s sake. Its key criterion in evaluating potential acquisitions is return on investment. So a smart buy now could actually improve its valuation, as it would no longer be an all-eggs-in-one-basket company in a country that people don’t understand. If we look at recent examples, some base metals companies have had their share prices perform quite well after acquisitions, most notably Capstone and Lundin.

TGR: What’s your rating for Nevsun?

AL: We have an Outperform rating and a $5.50 target price.

TGR: Rio Alto’s La Arena mine in Peru is now a gold producer. When will it begin to mine copper, and what effect will that have on its future?

AL: Rio Alto has a relatively large copper-gold porphyry deposit at La Arena. Currently, it is a fairly significant gold producer, about 200,000 ounces per year. It has a gold oxide processing plant on site. That said, the future of La Arena really is more in copper. The transition will likely happen in 2016 or 2017. But if it were to find additional gold within its concessions, we could see the life of the gold mine extended.

We have a favorable view of La Arena’s copper project. We expect it to have a very low capital intensity, $11,000–14,000 per ton annual copper equivalent, about half the industry average. It can benefit from existing power and transportation infrastructure. As well, it can use the existing open-pit oxide deposit for the tailings during the startup of the copper. At current gold prices, it should be possible to fund the copper expansion using cash flow from the existing gold mine.

TGR: Will Rio Alto be aggressive in beginning new projects in Peru?

AL: La Arena is in a very prospective region of Peru. It is surrounded by many major gold mines, and its concession is relatively underexplored. Rio Alto most likely will look for potential gold oxide satellite deposits that could provide supplemental feed to its existing plant.

Longer term, future acquisitions wouldn’t surprise me, given its cash flow. But Rio Alto could be a potential acquisition target itself, given that we view it as an undervalued company with a good organic growth project.

TGR: What’s your rating for Rio Alto?

AL: Companies that transition to base metals from precious metals typically encounter trading volatility because these different sectors have different investor groups. However, companies with good projects should weather this volatility well. Nevsun managed a very similar transition quite well. We have an Outperform rating and a $3.50 target price.

TGR: Not long ago, Peru was seen as a country not friendly to mining. Has that changed?

AL: It’s hard to classify Peru as being friendly or unfriendly. Projects should be assessed on a case-by-case basis. Some areas have been opposed to mining, and we have seen violent protests. However, several mining companies have succeeded in Peru, despite its pitfalls of left-wing political parties and social community activism.

Rio Alto has flourished with a concentrated, hands-on, local approach, using a predominantly Peruvian management team. Even some members of its non-Peruvian management team have moved to the country.

TGR: Trevali is also in Peru, where its Santander zinc-lead-silver mine is about to begin commercial production.

AL: Trevali is the only pure-play producer listed on the Toronto Stock Exchange and one of a few in the world. By pure-play, I mean it will be generating the majority of its revenue from zinc. This is an enviable position. Because of the coming zinc scarcity I mentioned above, investors will be funneled into zinc equities to gain leverage to the zinc market. I’ve followed Trevali for about four years, and it is in a stronger position now than I’ve ever seen it. The Santander commissioning process has gone well, and its balance sheet is robust.

TGR: How do you rate its non-Peru operations?

AL: Trevali has quite a bit of organic growth potential through its other operations, particularly the Halfmile and Stratmat brownfield sites in New Brunswick, which it intends to restart in the next year or so. The bulk of our NAV for Trevali comes from New Brunswick. That’s where we’re going to see a lot of the value in this story start to accrue.

TGR: What’s your rating for Trevali?

AL: We have an Outperform rating and a $1.40 target price.

TGR: Capstone announced that it had met its overall 2013 copper production targets from its Pinto Valley, Cozamin and Minto mines in Arizona, Mexico and Yukon. Even so, shares fell 14% in January. Why?

AL: First, Capstone has been one of the best-performing stocks in the sector, so it faced some profit taking. Second, there has been some waning of momentum. Yes, it came in very close to its 2013 production guidance, but its 2014 production guidance was weaker, particularly for Minto, than we expected. Third, some lackluster economic data from China has caused a selloff in many base metals equities in the early part of this year.

TGR: What’s your rating for Capstone?

AL: We have a Strong Buy rating and a $4.25 target price.

TGR: What’s your outlook for Lundin?

AL: Lundin has a solid management team and a very steady portfolio of mining assets. It also has pretty good cash flow growth coming in soon from its stake in the Tenke Fungurume copper-cobalt mine in the Democratic Republic of the Congo, as well as from the startup of its Eagle copper-nickel mine in Michigan, recently acquired from Rio Tinto Plc (RIO:NYSE; RIO:ASX; RIO:LSE; RTPPF:OTCPK).

Like Nevsun and Trevali, Lundin should benefit from the coming zinc scarcity. It could leverage this by increasing production at its Neves-Corvo zinc-copper mine in Portugal.

TGR: What’s your rating for Lundin?

AL: We recently upgraded it from Market Perform to Outperform. Our target price is $6.25.

TGR: The various iron ore projects in the Labrador Trough have been bedeviled by transportation costs. How serious is this problem?

AL: I think it’s been overemphasized. There are already two existing railways in the region that supply existing ports, and both have upside capacity potential. Unfortunately, these railways are controlled by two companies that restrict access. The Cartier Railway is controlled by ArcelorMittal S.A. (MT:NYSE), and because it doesn’t cross any provincial boundaries, ArcelorMittal is under no obligation to provide third-party access.

The other route, Quebec North Shore and Labrador Railway, is owned by the privately held Iron Ore Company of Canada (IOC), Canada’s largest producer of iron ore pellets. That railway does cross provincial boundaries and is bound thereby to provide third-party access. But that access doesn’t come cheap. The challenge is to build a new railway to break the monopoly. Access to existing infrastructure is the reason why our preferred iron ore companies are Alderon and Labrador Iron Ore Royalty Corporation.

TGR: What do you like about Alderon?

AL: Alderon has a very good project, Kami, which, as noted, is close to an existing rail line. It has a top-notch management team poached from IOC and strong backing from China’s largest steel company, Hebei Iron & Steel Co. Ltd. (000709:CH). We think 2014 is going to be a monumental year for Alderon, as it will complete many milestones: receiving key permits, bringing on additional offtake and/or joint venture partners and securing financing for mine construction.

TGR: What’s your rating for Alderon?

AL: We have an Outperform rating and a target price of $2.60.

TGR: Why do you like Labrador Iron Ore Royalty?

AL: It owns 15.1% of IOC and gets a 7% revenue royalty on IOC’s production. So here you have a company that owns a stake in a mine that not only operates throughout the commodity cycle—IOC has been operating its current mine for five decades—but it also owns its own transportation infrastructure.

We see this company as one of the safer ways to play iron ore, and it’s also a dividend growth story due to an expansion that is underway at IOC. Its royalty payments should increase because IOC’s capital expenditures will decline, as that expansion is nearly completed.

TGR: What’s your rating for Labrador Iron Ore Royalty Corp.?

AL: We have an Outperform rating and a $37.25 target price.

TGR: Any other iron ore companies?

AL: Champion Iron Mines Limited (CHM:TSX) is still at the discovery stage. It has a very large tonnage but low-grade specular hematite and magnetite deposits at its Consolidated Fire Lake North project, which is close to the Cartier Railway. Its challenge is that its transition to production is hampered by a lack of interest from the capital markets in Canadian iron ore projects and ready access to infrastructure.

Mamba Minerals Ltd. (MAB:ASX) of Australia intends to buy Champion. Mamba’s chairman, Michael O’Keeffe, sold Riversdale Mining and its Mozambique coking coal project to Rio Tinto for $4B in 2011. Mamba will bring credibility and know-how to Champion in its transition from developer to producer.

TGR: What’s your rating for Champion?

AL: We have a Market Perform rating and a target price of $0.45.

TGR: What are the characteristics common to your top picks in base metals?

AL: Almost all are companies with current production. Cash flow is key to positive investor sentiment. We like companies with strong and stable balance sheets, such as you find with Nevsun, Capstone, First Quantum and Lundin.

TGR: Adam, thank you for your time and your insights.

Adam Low joined Raymond James Ltd. in April 2005 and is part of the equity research team covering mining and metals producers and developers. Prior to joining the firm, he was employed as a financial analyst with IBM. Low has a Bachelor of Commerce degree from the University of Manitoba and holds the Chartered Financial Analyst designation.

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