Description

Capstone Mining (TSX: CS) is a base-metal producer in Mexico, with copper (Cu) ~88% of rev at current futures prices, trading at ~2x (2008end EV)/(2009 free cash flow) using current futures prices.

As I hope to show, the market does not appreciate CS is expanding production 36% by Sept 2008. Other minor potential reasons: it is only covered by one not well-known Canadian bank and Cu hedges mask current profit.

Assuming that Cu producers with market caps=<$1BN trade at 5x (2008end EV)/(2009 FCF), CS is worth ~$6.50/fd share +/- 5%, rising ~60% within 9-11 months, implying an IRR of ~75%.

Within 9 months CS should report Q4 2008, the 1^st Q at fully expanded rate. By late April 2009, CS should report Q1 2009, the second quarter at fully expanded rate.

One potential objection is that metal prices may fall sharply, hence no one can accurately estimate the value of any metal producer.

One alternative is shorting Cu metal at least several years into the future. Such shorting will lower IRR because of increase in invested capital.

If short $1.30 of Cu metal per long $1 of CS EV (to account for current gross margin leverage), one “locks-in” long-term metal prices (one would still be exposed to short term volatility from disagreement between equities and metals markets), that prevent loss due to sharp fall in metal price. To “lock-in” the upside to $6.50/share, one needs to short $1.30 of Cu metal against the higher EV such price implies.

CS as of Apr 30, 2008, had >$1.20/share in cash and marketable securities (assuming capital gains on securities are taxed at 23%, using a $1.20/share cost basis, and assuming 85% of value of cash in case it is dividended). Subtracting $1.20/share from current CS stock price yields an EV/share of $2.80, which has the volatility of $3.64 in Cu metal. Therefore, to hedge this Cu exposure, (roughly assuming 100% of rev is Cu), one should short ~$3.64 of Cu metal.

To “lock-in” $6.50/fd share target, one should short ~$7.00 of Cu metal per share long CS. (At $6.50/share mcap the EV/share is $5.30; multiplying it by $1.30 yields ~$7.00 of Cu metal exposure.)

The naked CS IRR of ~75% adjusted to long $2.80 of CS EV and short $7.00 Cu is ~24%. The IRR is ~22% if also short the $0.90 per CS share in Silverstone value.

With such shorting, one exchanges commodity risk for execution risk, betting CS can complete its expansion on time. Given CS’s  >1.5 year production history, mgt’s track record of already having expanded production 100% on time and budget, my recent discussions re status and difficulty of expansion, and my own technical due diligence, I believe this 22% IRR is low-risk.

Another comfort re CS is their head of business development, John Wright, co-founder and former CEO of Pan-American Silver, a huge success. His frankness and understanding of CS operations has earned my trust.

By the end of 2008, I calculate CS will have >=$160MM in cash and securities, including proceeds from options/warrants exercises, as I use fd share count.

Here’s how I derive at least $160MM in value for estimated 12/31/08 cash and securities:

As of April 30, 2008 (per CS presentation on its website), CS had:

1. Cash and receivables of $60MM ($53MM as of March 31, 2008); total current liabilities were $10MM at Q1 2008 end, leaving net current assets of $50MM. I believe npv of non-current liabilities is immaterial.
2. 26.7MM shares of Silverstone at $2.68 worth $71.5MM pre-tax, $62.5MM after-tax assuming cost-basis of $1.20 per Silverstone share purchased.
3. CS would receive ~C$12.5MM from exercises of options and warrants
4. Between 5/1/2008 and 12/31/2008, at current metal curves, CS should generate $50MM +/- 5% in FCF. At a 15% discount this becomes $43MM.
1. CS, in slide 3 of presentation on website, states they care capable of “generating +$60MM in free cash flow in 2008 and +$70MM in 2009 at current metal prices” (presentation dated May 2008)
2. CS, in slide 12 of same presentation, states 2008 net operating cost of $0.95/ Cu payable lb. They also forecast 2008 payable Cu production of 30MM lbs, implying net operating cost (which is gross operating cost minus by-product credits of Zn, Pb, and Ag) of ~$30MM. 30MM times Cu price over May (since they tell us cash and a/r on 4/30/2008) and next 7 months per futures curve yields after-tax cash flow of $50MM +/- 5%.
3. CS generated $2MM in FCF in Q1 2008, implying $58MM in FCF from Q2-Q4 2008 if they are to meet their guidance.
4. Slide 12 also provides another way to estimate total costs. Mining, Milling, and G&A costs of $33.34/ton. CS states they will run 850,000 tons in 2008, so $33.34/ton multiplied by ~850,000 yields site costs of ~$30MM. Add to that a ~$2-3MM annual royalty and $0.40 per payable Cu lb for smelting, refining, and transportation ($16MM), and total costs should be ~$48MM. Total revenue (including all by-products and using ytd prices and futures curve for rest of year) would be $138MM.

4. Therefore, the value of cash and securities at end of 2008, which assumes taxes paid on Silverstone and on cash as if it were dividended and the current price of Silverstone, should be $50MM+$62.5MM+$12.5MM+$43MM = $168MM, ~$2 per fd share.

At $4.02/share and today’s curves, on 12/31208 one would pay ~$2.00/share EV for CS.

CS 2009 guidance provided on their website, combined with reasoning in 4d above, implies $83MM in FCF, higher than the “+$70MM” CS explicitly guides.

Assuming 5x FCF, the implied market value is $415MM, or $4.66/fd share. Adding “value of cash and securities” (above) of $2 per fd share yields US$6.66/fd share.

In 9 months, my NPV, discounted at 10%, will be ~C$6.50/fd share +/- 5%.

In sum, CS should rise to $6.50/fd share +/-5% within 11 months.  

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