Investment Activity Review - July 2015

July was highlighted by some violent turns in global stock markets, led by China. It fed into a continued drop in commodity prices, which included copper. The combination of a surging US dollar along with continued evidence that the China economy was slowing down more dramatically than thought, took down the whole commodity complex. At first blush I was looking at jumping back in and opening a position in Freeport MacMoran (FCX) which is one of the largest copper producers, but I decided to go in another direction. As usual I asked the 8 questions. Some of the answers as you can see are quite similar to my responses when I was looking at Freeport, which is quite normal when you are analyzing companies in similar industries.

OPENED Position in Southern Copper Company (SCCO)

1) What Do They Sell?

Southern Copper is one of the largest integrated copper producers in the world. The firm produces copper, molybdenum, zinc and silver in Peru and Mexico. It has one of the largest copper reserves in the world. Southern Copper was founded in the 1950s and is based in Arizona.

2) Who do they compete with?

The main players in the copper and mining sectors are BHP Billiton, Vale, Freeport MacMoran and Rio Tinto who also have extensive mining assets globally.

3) Who buy their products and services?

Presently, copper is used in building construction, power generation and transmission, electronic product manufacturing, and the production of industrial machinery and transportation vehicles. Copper wiring and plumbing are integral to the appliances, heating and cooling systems, and telecommunications links used every day in homes and businesses. Copper is an essential component in the motors, wiring, radiators, connectors, brakes, and bearings used in cars and trucks. The average car contains 1.5 kilometers (0.9 mile) of copper wire, and the total amount of copper ranges from 20 kilograms (44 pounds) in small cars to 45 kilograms (99 pounds) in luxury and hybrid vehicles.  In a nutshell, copper permeates through our society. As emerging economies have growth, the demand for copper has been insatiable, especially from countries like China.  It is often said that as goes copper, so goes the economy.

4) Will people buy their product over and over again?

As long as industrialization and urbanisation continues to grow, there will be a need for copper. China has been the big purchaser of copper as they have literally built cities and infrastructure overnight. The problem is those cities are pretty much empty and there is a threat that the economy will slow down materially which could constrain future demand for copper.

As per the CRU Group, copper supply will see a deficit from 2018 onwards. As a result, due to favorable demand-supply dynamics, the price of the metal will increase in the future. Moreover, companies with a strong production profile will be in a stronger position to take advantage of the supply deficit in the copper market.

5) Do they make money?

Source: Valuentum Securities

Source: Valuentum Securities

SCCO’s Return on Invested Capital has been falling the past few years from 33 percent to 17 percent, but is still much higher than it’s cost of capital which is running around 9.8 percent. Southern Copper's 3-year historical return on invested capital (without goodwill) is 24.5%, which is above the estimate of its cost of capital of 9.8%. So the company is still managing to create tangible wealth and Economic Profit in a slowing market.

A big reason why they have been able to do it is that it has the lowest cash operating costs as compared to its peers, according to Morningstar. Its consolidated cash costs average just $0.71 per pound as compared to the global copper price of about $2.34 per pound. In comparison, Freeport-McMoRan (NYSE:FCX) and Codelco, which are major global copper producers, have consolidated cash costs of approximately $1.26 and $1.43 per pound, respectively.

Thus, it is not surprising to see why Southern Copper carries strong margins. Its operating margin stands at 38.6%, while the profit margin is also impressive at 22.6%. Looking ahead, as copper prices improve or at the very least stabilize,  Southern Copper should see further improvements in its margin profile.

6) What do they own and who do they owe money to?

As with most miners, the firm's balance sheet houses a lot of debt. Southern Copper, however, is in much better financial shape than Cliffs or Freeport, for example. As of March 2015, it held ~$285 million of cash and short-term investments and ~$4 billion of long-term debt. It’s current ratio is trending near 2 times it’s current liabilities so the company will be able to operate comfortably during the slowdown. It’s debt/equity ratio is tracking at 0.66 which is high but much lower than it’s competitors which are well well above 1.0. The company has hardly any goodwill or intangible assets. Overall the company has a relatively strong balance sheet.

7) How risky is their business?

The company's performance is largely impacted by changes in the price of copper. The per pound LME copper price has ranged from $0.65 to $4.60 during the past 15 years. During the last 5, 10 and 15 year periods, it has averaged $3.31, $2.66 and $2.02, respectively. More recently, copper prices have plummeted to the $2.40. Copper prices have been driven primarily by demand from China which is the world’s largest consumer of copper. If China’s economy continues to slow down, then falling demand will continue to put pressure on copper prices. What’s interesting with SCCO is that their sales distribution is more evenly balanced and are not as dependent on the China market compare to other copper producers. On the other hand there appear to be continued headwinds in commodity prices as a result of the strong US dollar. When the dollar rises, commodity prices tend to fall. Given that the Federal Reserve is signaling that they will increase interest rates sometime this year, that will put more juice on the Greenback and potentially could drive copper prices even lower.

Source: Harsh Singh Chauhan, Investor Presentation

Source: Harsh Singh Chauhan, Investor Presentation

8) Is the stock cheap?

Source; Valuentum Securities

Source; Valuentum Securities

The stock was trading at the $26.80 level when I started looking at it. The stock appears to be value at between $29-36 on a Discounted Cashflow basis. On a relative valuation basis the stock is more expensive than it’s peers at about 20 times earnings. For a company in an industry that is experiencing some hard core pricing pressures, the stock could come under further downward pressure.

My premise for buying SCCO is the same as when I bought Freeport. It really comes down to how long copper prices remain depressed. If prices should normalize a bit then there is great opportunity for the stock to pop a bit. SCCO is considered best of breed in the copper mining sector and more of a pure play in copper than Freeport.  SCCO fits one of the classic stock profiles I look for which is to buy well run, best of breed companies that are out of favour and selling at a discount. I have no idea when copper prices will come back up, so I have to be prepared to hold the stock for a long period and also be prepared to stomach some violent shifts in stock prices. At the same time, there’s nothing holding copper back from falling even further and this is where I have my stop-loss set at 20%, so I can control the losses. SCCO has demonstrated they can still make money in a depressed market. Their balance sheet is solid enough. I like the fact that their client portfolio is more diversified than FCX and their cost structure is very low and management appears to have instilled a discipline to keep their production low and competitive. I decided to open a small position and will over time add to it if prices fall.