Value Investors Club / Amerigo Resources (ARG CN)

Description

Amerigo Resources (ARG CN on Bloomberg) is a copper and molybdenum producer whose enterprise value is trading below 5 times free cash flow on a trailing basis. The company has no debt and pays a 5.9% dividend at current prices. While a buyback program is in place, I’m not touting it because management doesn’t seem to want to pursue it with any vigor. Because a significant production ramp has just begun after the end of the third quarter, Amerigo’s next 12 months’ free cash flow multiple is under 3 times. Amerigo’s ore source includes the tailings from El Teniente, the world’s largest underground copper mine, as well as ore that had been deposited in two nearby tailings ponds over five decades. Therefore the depletion issues relative to production that challenges virtually every other copper producer today is not a problem here. Further, Amerigo’s highly experienced management team has demonstrated an impressive ability to consistently deploy the company’s enormous free cash flow into low risk, high ROI projects.

Issambres introduced Amerigo to the VIC almost 3 years ago. Since then, the company has constructed a large-scale molybdenum concentrating circuit, completed plant upgrades to increase annual copper production capacity from 35mm pounds to 65mm pounds, and printed $1.00 per share in earnings. With the price of copper up from $1.20 per pound to $3.00 per pound, and molybdenum prices virtually unchanged at about $34 per pound, it’s hard to believe that you can buy Amerigo today (in Canadian dollars, at least) for the same price that you could back at the beginning of 2005.

There are several reasons for the multiyear share price stagnation – none of which contradicts the original investment thesis that Issambres presented. While my discussion here will include a brief overview of Amerigo’s fresh tailings processing operation, I want to focus more on recent events, projections, and our valuation analysis for highlighting why the stock remains such a compelling investment. I strongly encourage readers to also review Issambres’ excellent writeup for more background.

Background

Amerigo’s primary business is processing the fresh tailings from Codelco’s El Teniente mining operation. As previously mentioned, El Teniente is the world’s largest underground copper mine. It started production in 1904, and has an estimated 60-year remaining mine life. Crushed ore flows from the mountaintop El Teniente site down a concrete chute for over 20 miles to Amerigo’s Minera Valle Central (MVC) facilities. The copper grade in these fresh tailings is approximately 0.11% (eleven basis points) and the moly grade is approximately .002% (two tenths of a basis point). Amerigo currently receives and processes approximately 130,000 tons per day (tpd) of fresh tailings flow from El Teniente. After copper and moly extraction, the tailings flow another 30 miles to their final resting place at the Caren dam.

Amerigo had also been extracting and processing tailings from the nearby Colihues pond since 2004. The Colihues pond is where El Teniente’s tailings were impounded during the period from 1977 to 1985 before the construction of MVC. There are approximately 1.3 billion pounds of contained copper within the 200mm tons of tailings deposited in Colihues. Amerigo had targeted extracting approximately 10,000 tpd of these tailings in 2005, and growing throughput from this source to 45,000 tpd by the end of 2006. Importantly, the copper and moly grade of these “old” tailings are three times as high as the fresh tailings received from El Teniente. Therefore the production from the 45,000 tpd Colihues throughput could be expected to be approximately equal to the production from the 130,000 tpd of fresh tailings from El Teniente.

Here is where Amerigo drifted a bit off course, and perhaps initiated the turnover in its investor base that continues today. Chairman Steven Dean had set a target to ramp annual copper production to 60mm pounds and moly production to 1mm pounds by the end of 2006. While plant capacity was constructed in time to accommodate these goals, equipment procurement issues prevented extraction from Colihues from ramping according to plan during 2005.

Then they were really blindsided: just as new hydraulic monitors were deployed to increase Colihues’ throughput, Codelco announced in April 2006 that it needed to reduce the flow from MVC to Caren in order to reinforce bridgework along that route. Not only was Amerigo forced to completely curtail the Colihues operation until further notice, the fresh tailings flow from El Teniente was reduced by 25%. Intermittent curtailments continued through the beginning of 2007, and full flow was not restored until March 2007. Colihues extraction remained prohibited through the third quarter of 2007. Instead of ramping toward 60mm pounds of production, Amerigo’s copper sales actually fell from just under 30mm pounds in 2005 to 24.6mm pounds in 2006.

Production Ramp

Amerigo announced during its Q3 07 conference call that it has restarted processing the old tailings available to it at the MVC site. While management did not specifically state that they had gotten the “all clear” from Codelco, it was obvious from the language during the call that Colihues is finally back online, and a more formal announcement was not made because of Codelco’s sensitivity to public communications about its operations.

Because the tailings currently being processed from Colihues are actually fresh tailings that had been deposited into the pond while the flow was disrupted during 2006, the ore from the extraction during Q4 07 and Q1 08 will be similar to the lower-grade fresh tailings from El Teniente rather than the higher-grade old tailings that had been deposited in the late 1970’s and early 1980’s. We therefore expect a slow production ramp from last quarter’s 8mm pound copper production rate to Amerigo’s target of 15mm pounds per quarter by Q4 08. Historical and our projected quarterly copper and moly production estimates look as follows:

Q2 07A Q3 07A Q4 07E Q1 08E Q2 08E Q3 08E Q4 08E FY 09E

Copper (mm lbs) 9.31 8.05 10.00 10.50 12.00 13.50 15.00 60.00

Moly (mm lbs) 0.20 0.13 0.19 0.20 0.22 0.23 0.25 1.00

Note that copper and moly production dipped in the Q3 07 because of a Codelco-wide strike that resulted in significantly reduced tailings flow for approximately two weeks during the month of July. Amerigo will undoubtedly continue to be impacted by temporary, one-time issues such as this, and we expect the actual production ramp to be lumpier than what is presented above, but nonetheless trending steadily upward to the 60mm pound copper/1mm pound moly production goal.

Copper Price Sensitivity

As Issambres pointed out in his writeup, Amerigo’s profits really aren’t sensitive to copper prices. This fact is clear when production costs and royalty fees are analyzed in the context of the realized copper price each quarter. Codelco is entitled to a 13.5% royalty on the copper revenue generated from fresh tailings. The fact that this is a revenue share rather than a bottom-line share has a dramatic effect on Amerigo’s operating margins at elevated copper price levels. As many analysts have now noted, much of the rise in the market price of copper is due to higher production costs faced by major producers. Thus the jump from $1.50 copper to $3.00 copper over the last few years did not translate into as big a windfall for producers as one might have thought, since much of that price increase was effectively a passthrough of higher energy and labor input costs.

Amerigo’s processing costs have increased from 36 cents per pound in Q1 2005 to $1.72 per pound in Q3 2007, primarily as a result of higher energy prices. Further, as copper prices rose from $1.50 per pound in Q1 2005 to $3.50 in Q3 2007, El Teniente’s royalty fee rose from 19 cents per pound to 58 cents per pound. In other words, as copper prices rose by $2.00 per pound over this period, production costs rose by $1.36 per pound and the royalty rose by $0.39 per pound, for a total expense increase of $1.75 on these two items alone! It is easy to see that only modest increases in smelter costs, taxes, and administration would gobble up most of the remaining 25 cents in margin advantage offered by the higher copper price. Our analysis suggests that if the correlation between energy prices and copper prices continue to hold, Amerigo’s earnings will be virtually unaffected by copper price movements between $2.00 and $4.50 per pound.

MVC Cashflow

As production ramps from Colihues, we expect copper margins to increase as the total cost per pound declines on modest economies of scale, lower unit costs from the richer grade in throughput, and the fact that the Codelco royalty only applies to half of the production from Colihues (in contrast with a full production royalty against the fresh tailings flow). Moly production will also become an increasingly significant contributor to profits. In fact, moly production may well surprise to the upside, as the technical assessment of Colihues estimated moly content at 0.01%, which is five times the grade of the fresh tailings.

Our 2008 and 2009 cash flow projections for MVC are as follows:

2008 2009

Copper Production (mm lbs) 51.00 60.00

Moly Production (mm lbs) 0.90 1.00

Copper Price ($/lb) 3.00 3.00

Moly Price 25.00 15.00

Processing cost ($/lb) 1.30 1.20

Royalty 0.45 0.43

Admin 0.03 0.03

Transport 0.03 0.03

Overhead 0.02 0.02

Moly byproduct credit -0.44 -0.25

Net Costs ($/lb) 1.39 1.46

Net Cash profit/lb 1.61 1.54

Operating Cashflow 82mm 92mm

Tax (17%) 14mm 16mm

Maintenance Capex 5mm 5mm

Free Cashflow 63mm 71mm

Growth/Optionality

Amerigo’s management team has demonstrated considerable aptitude at investing the cash harvested from MVC. Recent examples of their effectiveness at deploying capital include:

1. The molybdenum circuit completed in March 2005 took 3 months to construct with a capital cost of $4.4 million. The project returned its full capital cost in 3 months, and will deliver at least $15mm in cash value annually for the foreseeable future. This project will therefore deliver a virtually perpetual return on capital of over 240%.

2. During the second quarter of 2006, Amerigo acquired 31.8mm shares and 11.5mm warrants in Chariot Resources, a development stage copper operation, for $12.5mm. These securities were sold within 5 months for $21.3mm, generating a pre-tax profit of $8.8mm. Although the purchase was intended as a longer-term strategic investment when it was made, the 70% pre-tax absolute return and 250% annualized equivalent return on capital they realized when their overtures were rebuffed provides some evidence that these guys know what they’re doing when they choose projects in the space.

3. During the second quarter of 2007, Amerigo acquired 6.9mm share of Candente Resources, a development stage copper operation, for $8.6mm. At today’s price of $1.91 per share, this stake is worth $13.2mm, representing a gain of $4.6mm, or 53% over a 6 month holding period. While I acknowledge that this represents a possibly ephemeral mark to market gain, it is worth noting that this share appreciation equates to a 135% annualized return on capital.

4. In the third quarter of 2007 the company began the installation of two 10-megawatt generators to reduce reliance on rising grid electricity costs in Chile. At current grid prices, this $9mm capital investment is expected to achieve full payback within about a year of the project’s completion in mid-2008. Thus, in addition to the strategic value of achieving energy self-sufficiency and diversifying the company’s ultimate energy source from natural gas to bunker seed oil, the investment is likely to realize an ongoing 100% annualized return on capital.

Likely future large-scale investment opportunities include extending the strategic relationship with Candente to move their extensive Canariaco copper resource in Peru into production, as well as integrating Codelco’s Cauquenes tailings deposit into the MVC operation. The tailings in Cauquenes were deposited between 1935 and 1975, and have copper grades similar to the ore in Colihues. At a copper grade of 0.30%, there are an estimated 3.3 billion pounds of contained copper within the 500mm tons of tailings in Cauquenes.

Valuation

Amerigo’s balance sheet has no debt and $40mm in cash and securities. With 95mm fully diluted shares outstanding, Amerigo’s market cap at $2.21 per share is $210mm. Subtracting the cash leaves an enterprise value of $170mm. Using our projected $63mm in 2008 free cash flow, Amerigo’s enterprise value is approximately 2.7 times forward free cash flow. Using our projected $82mm in 2008 EBITDA, we get an EV/EBITDA multiple of 2.1 times. A comparison of Amerigo against its copper producing peer group is presented below:

2008 EBITDA 2008 EV/FCF 2008 EV/EBITDA

Amerigo 82mm 2.7x 2.1x

Antofagasta 3,106mm 7.1x 6.0x

Anvil 270mm 4.2x 3.4x

First Quantum 1,653mm 4.1x 3.0x

Frontera 135mm 3.0x 2.1x

Inmet 806mm 5.0x 4.2x

Quadra 278mm 3.2x 2.6x

Taseko 233mm 4.2x 3.6x

Average 4.2x 3.4x

Source: Raymond James, Company Filings (used to determine maintenance capex)

Arguably Amerigo’s EBITDA multiple should be higher than these comps given that it is debt-free, is far less sensitive to copper price fluctuations, has a virtually inexhaustible resource relative to current production, and has an advantageous tax rate. Further, while many of these comps have better growth profiles, much of this growth relies on large capital outlays and risky developments of new resources, whereas Amerigo’s growth involves lower-risk fine-tuning and expansion of existing operations. At 5 times 2008 free cash flow, Amerigo would trade at $3.75, which is almost 70% over the current price.

Catalyst

- Production and earnings ramp, beginning Q4 2007

- Steady profitability through fluctuating copper prices

- Rapid value accrual as large cashflow relative to marketcap continues to be deployed into high ROI projects

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			2007	2008
Price:	2.21	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	210	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT