I’m taking a dimmer view of market conditions than most, but nonetheless manage to find something sparkly to add to the portfolio.
Differing Perspectives
I’ve read through an awful lot of conference call transcripts over the last couple of weeks as I work my way through year end results.
This is the kind of commentary I would have liked to have seen…
“We enjoyed a strong finish to what was an exceptional year. The combination of government stimulus payments and shifting consumer behaviour caused by the pandemic resulted in record sales and profits. With limited supply and insatiable demand, consumers were willing to pay full price for our merchandise and this more than offset the inflationary pressures we faced. Both sales levels and profit margins were far above our pre-pandemic baseline. As we move beyond this unusual period of activity, we expect sales and profits to normalise. The challenges we were facing before covid are likely to return, while at the same time we will be faced with a new set of challenges in the form of rapidly rising raw material, labour and transportation costs. Consumer sentiment is falling, and leading indicators are showing worrisome signs of an impending economic slowdown. Inflation is likely to pinch consumer spending and the covid related business we enjoyed in 2020 and 2021 will subside. While we would like to take credit for our company’s recent strong performance, we realise these results were due in large part to a very unusual set of external circumstances. Our guidance is for a moderating of business conditions and a more difficult year ahead.”
Instead, what I saw far more often was closer to the following…
“We enjoyed a strong finish to what was an exceptional year. This was due to the hard work and dedication of our employees and the efforts management has made to streamline the business and improve operational efficiencies. We are emerging from this pandemic stronger than we have ever been. We believe that the process improvements we have made over the past two years have resulted in a step change up in profitability and this will continue moving forward. We expect to build on the strong momentum of the last 8 quarters and our guidance calls for double digit growth in both sales and profit margins in the coming year. While there have been many challenges over the last two years, management has been extremely nimble in facing these challenges and growing the business despite them. While cost pressures and supply chain issues continue, we expect these to resolve themselves in the first half of the year and we see growth accelerating as we move into the second half.”
Who’s right? Me or all of corporate America? Time will tell. But until I’ve got more conviction that this really is a brave new post-covid world that we’re in, I’m clutching the purse strings very tightly. I continue to pencil in a return to pre-covid profit margins and sales levels for the majority of the companies I look at. This rules out a great number of investments that would otherwise look compelling if you were willing to use 2021 results or management guidance as your guidepost.
Paydirt
With that curmudgeonly attitude keeping new investment ideas at a low ebb, I did manage to stumble across one interesting play in the jungles of South America that caught my eye. This company is in the resource sector, a sector I usually avoid as I don’t feel I have any particular edge when it comes to predicting commodity prices. But with inflation levels threatening to breach the double digit mark, perhaps it’s time for an old dog to learn some new tricks.
Ero Copper (ERO, trading under the same symbol on both the TSX and NYSE) is a copper mining company. They have a mine in Brazil that is currently producing about 45 000 tonnes of copper a year. This mine has been in production for 5 years now and in that time, they have grown production, grown their reserves and lengthened the mine life (from 8 years to 12). The mine enjoys exceptionally low production costs, among the lowest in the world and this has helped them churn out consistent profits even before the recent run-up in the price of copper.
They also have a gold mine in Brazil that is part of the mix and have plans to expand production there, but it is a relatively small part of the picture. Copper is their main bag.
Neither of these mines is particularly long-lasting, which is probably the main reason that the company appears to be cheap. Or cheaper than its peers at any rate. However, with these mining companies, you never really know how much gold or copper is there until you hit the bottom of the barrel. You can poke a bunch of holes in the ground to try to make a guesstimate as to how much is down there but poking holes in the ground is expensive, so you try to do as little of that as possible.
With the holes they’ve poked, they’re estimating that their current copper mine will last at least another 12 years, but they say it’s open at depth meaning there is the possibility they’ll find more copper as they dig deeper.
The real sweetener here is not their existing mines and the possibility of extending the lives of those, it is the new copper mine that they are building. Also in Brazil, this mine has very promising economics as well. A low cash cost and a very quick projected return on their investment of 1 1/2 years makes it a slam dunk to put into production. They recently raised $400 million in debt which they think is enough to get the mine built plus do some expansion at their existing mines. Even with this new debt raise, their balance sheet looks healthy, with debt sitting at around 2 times earnings.
The new copper mine is estimated to be finished by the second half of 2024 and once it kicks into high gear will double their annual production. Cash costs are estimated to be similar to their existing mine and so there is reasonable hope that the doubling in production that they are predicting for 2025 will translate into a doubling of profits as well. The new mine has an initial mine life of 12 years (same as their existing mine) but again, if they get lucky, it might last longer.
I’ve heard it said that the best predictor of future oil prices is current oil prices. I dare say the same thing applies to copper. Based on current copper prices, this investment looks pretty solid. The company reported EPS of $2.27 USD last year. Putting their figures under my microscope, I get essentially the same number. At the current $14 share price ($18 CDN), that gives a trailing p:e ratio of 6. That seems pretty cheap any number of ways that you might look at it.
At some point they will dig up their last tonne of copper or ounce of gold. You have to take this into account and value it less favourably than an operating company that might theoretically last forever (although in practice rarely does). But on the other hand, there is that new mine they are building which will double their level of production, quite possibly double their earnings and keep the party going for another 12+ years.
Put all that together and I think the current share price looks quite reasonable.
The next crucial part of the equation is the future price of copper. Here I am on much shakier ground.
Some very smart people are saying that we are running out of copper. There are not nearly enough new mining projects on the books to satiate the demand for a transition to electric vehicles which, of course, use a tonne of copper. And this is going to drive the price of copper way higher than it is today. But very smart people make a lot of predictions that don’t end up panning out. If I were to play my usual role of perennial skeptic, I would point to the possibility of a collapse in the Chinese property market sucking the wind out of worldwide copper demand in the years to come. A looming recession here at home wouldn’t do copper any favours either.
As well, I could look at the timing of the resurgence in copper prices and put this down to yet another covid induced distortion. (Try as I might I can not get away from this nagging concern that so much of what we are seeing in the marketplace today is due to a temporary covid-fueled bonanza.)
If I do a pro/con evaluation this is what I come up with: On the upside, the company has a great set of low-cost mining assets that have generated solid profits over the past 5 years in both low and high commodity price environments. The trailing p:e is low. If production doubles in the next 4 years as the new mine comes on stream, if the price of copper doubles into the bargain and if the p:e ratio also doubles or even triples as a response to all of this, then a 10 bagger is not out of the question.
On the downside, a drop in the price of copper back to 2019 levels would knock earnings back down a peg or two and make the whole enterprise worth a lot less. But cash costs at all their mines are low and if the new copper mine comes on stream as planned then this would help to offset the drag on profits caused by a lower commodity price. Add in the fairly low starting p:e ratio and I think you might reasonably get away with a 50% haircut if things go sideways.
On the whole, those look like good odds to me. I’m hoping that the hyper-optimistic scenario is the one that plays out and I sold off some dribs and drabs of my other stocks to make room for this new kid on the block. I ended up paying a little over $18 a share on the Canadian market for my stake.
There are a few stragglers still left to report this earnings season but assuming none of these pans out, this will likely be it for me until Q1 rolls around in early June. Until then…
Full Disclosure: I own shares in Ero Copper.