Description

INCO

Overview:

INCO (N-NYSE), previously International Nickel and a one-time Dow Industrials component, is a basic materials company at a low point in its stock-price cycle. N is undervalued at present prices, as investors have priced in a dramatic economic slowdown. The company is currently priced low enough that anything short of a serious recession in the near future ought to allow for developments to unfold “better than expected”.

Background:

 N is a multinational firm headquartered in Toronto. Its largest operations are also located in Canada, while it also has significant operations and investments in Indonesia and New Caledonia.
 N is the second largest nickel producer (producing 25% of the world’s nickel and behind only Russia’s Norilsk) in the world and is the largest publicly traded one.
 Nickel’s largest use is in the making of stainless steel.
 Nickel mining also produces trace amounts of higher cost metals, including copper, cobalt, silver, gold, and PGMs (platinum group metals, which include platinum and palladium). Higher cost metals provided 18.6% of revenue in Q2.

Fundamental Situation:

 N has become the lowest cost nickel producer in the world and the most profitable.
 N is a commodity-based company that has experienced the type of performance that these companies have produced in recent years: reasonably large price swings and overall poor performance.
 N has three large projects in various stages of development. The Indonesian project (PT Inco) is ramping toward full production this year after a major expansion. The New Caledonian project (Goro) is at the pilot plant stage. A major reserve area at Voisey’s Bay in Labrador is stalled due to a dispute with the provincial government.
 N has below-average management. The CEO is 61, has been in his position since 1991, and is not talking retirement. Although they have brought in a couple of execs from other cos. recently, the current regime seems entrenched. Worst case is that they are allowed to continue to manage the co. as they have.
 N has a history of acrimonious labor relations. This may have changed this year with the introduction of company-performance based incentives in the most recent labor contract. Such incentives are similar to adopted by the automobile industry a decade or so ago.
 N faces a number of environmental regulations that are common to large mining and/or refining companies. There have been no recent developments to suggest that there are any ST or LT negatives yet to be publicized.
 Recent nickel spot prices are slightly above the mid-point of the price range for the last 3 years, while current LME nickel inventories are at 8 year lows.
Valuation:

 At 15, N is trading at less than 60% of book value. When comparing relative market-to-book multiples of the company and the market, N has not traded lower. Book value for a nickel company is likely to be far less ephemeral than for, say a retailer.
 At 15, N is trading at less than 7.5X consensus estimates for ’00 and ’01.

Recent Developments:

 Inco’s 1997 cost reduction program was completed in 7/99: 18 months ahead of schedule and 50% above the original goal.
 N has reduced its breakeven (on an earnings basis) point to $2.35 per pound (LME cash/spot). Cash cost of nickel production has been reduced to $1.25. FYI: Nickel prices have ranged from $2.00/lb. to $4.50/lb. over the last decade, averaging $3.22.
 Company reported Q2 ahead of expectations, primarily driven by high PGM prices. N generated $353 million in cash from ops in the Q, while mkt. cap is $2.8 bil.
 New Australian production has started to come on-line. These sources could produce 20% of projected world demand by 2003, but their costs and profitability are a ?.
 Russia has become an uncertain supplier and another nickel producer, Falconbridge, had its workers go out on strike at midnight on July 31.

Likely developments:

 The economy slows materially, cutting nickel demand. Inventories rise and prices moderate. However, N remains profitable at expected futures prices.
 Voisey’s Bay remains undeveloped without an agreement with the Provincial government for at least 6 months.

Possible Developments:

 N is so cheap that it may be acquired, even though it is a Canadian company.
 An agreement to develop Voisey’s Bay is made on terms favorable to N. Since its ore is projected to be fairly rich and since it has been an idle and not inexpensive asset; this would be positive news.
 Battery operated cars become more prevalent and/or are mandated by more governments ala California. Due to the high nickel content of ni-cad batteries, N is a major benefactor from trends away from traditional internal combustion engines.

Recommendation:

 N is a trade with a 6-12 month time horizon, not a long-term hold.
 Stock is dirt cheap. Any reversion to traditional means will be fairly large. Stock price moves have tended to be quick: either you’re on board for the trade, or not.
 A floor for this stock exists at about 10, upside into low 30’s is possible.
 Favorable risk/reward suggests 2% position with a 16 limit. Target: 25-30.

Catalyst