Description

Antofagasta Short

Thesis:

• Slowing global growth and slowing Chinese demand for copper

• Copper is currently in oversupply and supply is increasing in the near term

• The company has a recent track record of overpromising on guidance and not meeting expectation

• The company has been mining above its reserve grade for an extended period of time – future production and operating costs will disappoint as this is not sustainable long term

• Antofagasta’s growth projects require much higher copper prices to generate a positive return on investment

• The company will need to spend significant capex over the coming years just to keep production flat

• Management (albeit recently changed) has been poor allocators of capital, specifically paying ~$1.0bn in cash for 50% of Zaldivar in 2015 appears extremely rich

• YTD Chilean peso appreciation combined with continued weak copper prices will squeeze Antofagasta’s margins

• Antofagasta is overvalued at copper prices of $2.20 - $250/lb and very significantly overvalued at copper prices of $2.00/lb or lower

Antofagasta is an FTSE 100 larger-scale copper miner with key assets in Chile. The company currently operates four copper projects in Chile, including the flagship Los Pelambres (60% owned), Centinela sulphide and oxide operations (70% owned), newly commissioned Antucoya operation (70% owned), and the recently acquired Zaldivar SX/EW operation (50% interest).  The company also operates a rail network in Northern Chile. The Chilean Luksic family holds a 65% interest in the company.

The Los Pelambres and Centinela assets account for roughly 80% of the company’s value.  These assets provide relatively low cost production with cash costs (after credits for other produced metals) of US$1.22/lb and US$1.57/lb respectively.  The company produced 630 kt of copper in 2015, which was a decline of ~11% yoy.  

Despite having these low cost assets, the company generated only US$393m of operating cash flow in 2015, and spent $$1,127m in capex, generating significant negative free cash flow.  The company is expected to spend between $700 - $900m in capex for the next three years, continuing this trend of negative free cash flow generation.  

The company has gone from having a net cash balance in 2012 of ~$2.4bn to a net debt balance in 2015 of $1.0bn.   Copper production during this time has gone from 710kt to 630kt.  

Copper Market

Copper prices have declined since 2011 from ~$4.50/lb at its peak, to ~$2.05/lb today.  While this is already a significant decline further downside is likely due to the following reasons:

• Chinese demand is slowing – China FAI spending is trending lower

• Chinese grid spending is increasingly moving toward aluminum consumption in longer range grid networks

• The premium for physical copper in China is near 5 year lows, indicating little real demand

• Significant copper inventories are being held off-warrant (i.e. not in LME, Shangai or Comex), understating true inventory levels

• Supply remains strong – 80 - 90% of copper producers are producing at a positive cash cost margin, which provides little incentive to shutter production

• Global copper production is roughtly flat yoy despite significant copper price decline

• Global copper supply is set to grow by 8% over the next 6-12 months as a number of projects begin producing

• Mine supply growth is expected to come primarily from the following mines: Las Bambas (Peru), Cerro Verde (Peru), Grasberg (Indonesia), Escondida (Chile), Sentinel (Zambia), and by 1Q17 the Mopani and Katanga restarts (Zambia and the DRC respectively)

• Seasonal restocking period (March-June) is coming to an end

Mining Above Head Grade

Antofagasta has been mining above its reserve head grade at its key assets for many years already.  This is not sustainable long term, however, this is possible for a significant amount of time depending on the mine plan.  Mining above the head grade currently will result in the need to mine below head grade in the future.  As such, this will decrease production volumes and importantly, increase per unit production costs.

UBS has summarized the actual mining grade vs the reserve head grade as follows:

In 2015, the company did not achieve its production guidance and has lagged its global peers in terms of operating cost reduction.  I believe this is, in part, due to historically mining above the reserve grade and it becoming more and more difficult to continue this practice.

Weak Growth Pipeline

Antofagasta’s growth projects need significantly higher copper price to return positive return on investment.  Flat to declining production over the next 2-5 years, will require that the company continue to invest in order to maintain production, likely even if it is value dilutive.  

USB estimates the IRR to the company’s growth projects as follows, assuming a US$3.00/lb copper price.  Remember, copper prices are currently $2.05/lb.

Over the coming 4 years, the company will likely spend $1.6bn on the Los Palambres expansion, more or less to maintain current production levels.  At $2.00/lb copper prices, this is very value dilutive.   

Capital Allocation

Management has a poor track record of meeting guidance and making value accretive capital decisions.  The company paid $1.0bn for the 50% acquisition of the Zaldivar asset from Barrick Gold.  While copper prices were higher at the time of the acquisition, it is estimated that the acquisition needs $3.00/lb. copper prices to break even on an IRR basis relative to the $1.0bn purchase price.  Further, there a little to no operational or managerial synergies reported to date from the acquisition.  

The company is currently planning on going ahead with the Los Palambres expansion, despite the clear need for higher copper prices in order to add value to the company.  

The CEO recently stated in a news article that he is interested and exploring further M&A, although the market appears relatively expensive.  Given the company’s current asset base and lack of value accretive growth projects, I believe there is a risk that the company pursues further M&A potentially at the risk of downgrading its blance sheet.

Near Term Results & Chilean Peso

The company has continued to disappoint over the last 5 quarters.  This was primarily due to lower grades and lower throughput at its two key assets.  Further, a slower anticipated ramp up of its Antucoya asset has also challenged the company.  

Given weak Q1 2016 results already realized, the company will struggle to meet its 2016 production guidance of 710 – 740kt.  

Operating costs have remained effectively flat over the past year and management believes this that they will be able to reduce costs going forward.  For perspective, net cash costs have gone from ~US$1.00/lb to ~US$1.45/lb from 2012 to 2015, substantially lagging its global copper mining peers in operating cost savings as copper prices have declined.

Since January of this year, the Chilean peso has appreciated from 730 CLP/USD to 660 CLP/USD, selling off to 690 CLP/USD and then beginning to appreciate again.  In CLP, copper prices are breaking new lows (as below), and given relatively fixed operating costs based in CLP, Antofagasta’s operating margins are likely to be reduced further in the coming quarters.

Antofagasta (yellow) vs copper (white) in Chilean peso:

Valuation

On a relative basis, Antofagasta trades in-line with its peers and has a better balance sheet.  However, the longer term prospects and growth pipeline are materially worse than a First Quantum or Hudbay for example.  The capital structure of Antofagasta is, at present, better than its peers, but this also provides for a less volatile and more predictable trading direction for the shares.  Purely for leverage to changing copper prices, FM may provide better exposure, but you need to be prepare for more volatility.

Relative to its historic multiples, Antofagasta trades at 5 year highs:

On a DCF basis, broker generally see the company as fully value, however, this assumes a range of copper prices from ~US$2.50/lb. to US$3.40/lb.  

Running some of our own DCF analysis, we see the company being worth GBP2.00 or less, assuming copper prices do not decrease further and no operating cost appreciation.  With any material move lower in copper prices, the equity value is quickly eroded.

Conclusion

We believe that Antofagasta easily has 50% downside from today’s price and is a great way to play the theme of slowing global growth, slowing Chinese growth, and copper price downturn.  

Appendix: Financial Statements

Debt Profile:

Catalyst

• Copper price continues to decline
• Weak economic data from China (FAI, infrastructure and grid spending)
• Q2 and Q3 results not meeting guidance / downgrade full year guidance
• Value distructive M&A