Description

Mercator Minerals is an undiscovered, emerging North American copper/moly producer. Its shares are temporarily depressed due to a recent legal dispute over purchased equipment, which should be resolved by early 2007. Based on expanding to target production levels during 2008, shares could rise above its published NAV of C$5.57 (implied gain of 148%) which is based on $1.5 copper (currently at $3.13/ lb) and $10 moly (currently at $25.5/ lb). If copper/ moly prices persist at “high” levels for a few years (which seems likely), then the potential upside is greater than published NAV. Moreover, the published NAV calculation excludes the company’s current profitable copper cathode production as well as the company’s net cash balance.

In addition to trading at a significant discount to NAV, the company should benefit from several advantages versus many other junior and mid-tier copper and moly producers:

-          Feasibility study complete (Note: the company refers to it as a “pre-feasibility study”, even though the report is sufficient for non-bank debt)

-          Reserves defined (43-101 compliant; part of feasibility study)

-          Permitting complete, including environmental work

-          Mine based in Arizona (no country or political risk)

-          Management team with significant production experience (unlike a large number of junior copper producers, which were formed by former exploration executives who have little or no production experience)

-          Perhaps most importantly, mine already in production, profitable and on plan (which provides downside protection to current share price)

-          Net cash balance

-          No equity dilution expected for expansion of mine to targeted levels (to be funded from cash from operations and debt)

Furthermore, the 100% owned Mineral Park mine has several advantages versus many other junior and mid-tier copper and moly producers:

-          Mine located near Kingman, Arizona (year round mining; local, available workforce that is non-union)

-          Mine with prior operating history (operated for over 15 years by Duval: 1964-1981)

-          Mine with significant drilling history (over 1,100 drill holes)

-          Expansion plan offers excellent economics (starting 1Q08):

o        Significant proven and probable reserves: 1.4 B lbs Cu, 343 m lbs Moly, 35,000 ounces Ag

o        Long mine life (over 30 years)

o        Low one-time capital costs of $129 m, including $17 m contingency

o        Low operating costs: cash operating cost of $0.72 per lb of copper equivalent for first ten years of mine (based on an extremely low stripping ratio of 0.18:1 and an average Cu equivalent grade of 0.37%)

o        Most equipment for expansion plan already purchased

-          Local infrastructure in place, including smelters and transportation

Valuation

Dr123 introduced ML on 9-27-05. At that time, copper prices were much lower and Mercator’s mine economics were not clear. The feasibility study (published 9-1-06) details the potential economics of its expansion plan.

With a 10% discount rate, published after-tax NPV is $345 m, which equates to C$5.57 per share with 70 m FDS and 1.13 CAD/USD. This “base case” includes the following assumptions: 37,000 tons per day (tpd), 0.371% Cu equivalent grade, average annual production (33.2 m lbs Cu, 7.8 m lbs Moly, 415k ounces Ag), average metal prices ($1.5/ lb Cu, $10/ lb Moly, $7.5/ oz Ag), life-of-mine capital cost of $168 m, and operating cost of $4.72 per ton milled.

As a check, the base case implies average operating cash flow after taxes of $62 m per year for the first ten years, which is about C$1 per share (44% cash flow yield).

If copper/ moly prices persist at “high” levels for a few years (which appears likely; see industry comments below), then the potential upside is considerably greater than the published NAV, with operating cash flow per share potentially equaling the current stock price. 

Importantly, the base case is for the production of copper and moly concentrate; in other words, it EXCLUDES the company’s current profitable copper cathode production and the company’s current net cash balance. Mercator is currently producing copper cathode (SXEW) at an annualized rate of 11 lbs a year with a cash cost of around $1.03/ lb. Mercator generated $5.9 m in cash flow in 3Q06, about C$0.10 per share. Hence, on an annualized basis, Mercator is trading at 5.6x cash flow based on current production. Copper cathode production is set to increase from 9.7 m lbs in 2006 to about 14 m lbs in 2007 and 11 m lbs in 2008. Proven reserves of leachable ore are about 115 m lbs, or ten years at current production rates. Further, Mercator has a growing cash balance (cash of $15.6 m and debt including equipment loans of $8.1 m, as of 9/30/06). The current production and net cash balance provide downside protection for the stock, as we wait for the expansion plan to be realized.

Recent Legal Dispute

Mercator purchased the 20,000 tpd Mission South Mill from Asarco LLC for $6 m in July 2005, which was Asarco’s asking price. Asarco closed the mill in 2001 and started soliciting offers in 2004. Asarco filed for bankruptcy in August 2005. The 20,000 tpd mill represents about half of the equipment necessary for the proposed expansion to 37,000 tpd.

On 10/24/06, Asarco (in bankruptcy proceedings) asked the Corpus Christie, Texas court for a preliminary injunction to prevent Mercator from dismantling and relocating the mill until the complaint is resolved. The complaint from Asarco (which has a new management team) is that Mercator failed to pay “reasonable equivalent value” for the mill and, as a result, the sale should be cancelled as it occurred within one year prior to the bankruptcy filing. The economic value of the mill is estimated to be around $50 m today (due to dramatically higher copper prices).

While Mercator appears to be well-represented by Paul Yetter of Yetter & Warden LLP, on 11/6/06, the Corpus Christie, Texas court granted a preliminary injunction until a trial can be held. With the near-term uncertainty regarding the status of Mercator’s expansion plan, shares fell from an intra-day high of C$2.9.

It is our sense that Mercator will resolve the situation by early 2007 (which should benefit the stock in any outcome):

1. Mercator will likely publish an amended feasibility study by year-end or early 2007. This “Plan B” would involve buying new and used equipment to bypass the equipment from Asarco. Importantly, without the equipment from Asarco, Mercator could expand to 25,000 tpd initially (1Q08) and then to 50,000 tpd (late 2008), which would actually IMPROVE the mine economics and published NAV (which is based on only 37,000 tpd), despite the higher upfront cost and slower ramp. Debt financing would likely occur in early 2007, with no expected dilution of the equity.
2. Meanwhile, Mercator will pursue an appeal in the Texas district court (expected January 2007) and the trial (scheduled for February 2007). If Mercator wins either the appeal or trial, it will continue with the relocation of the mill, as per the current base case. If Mercator loses both, it would proceed with Plan B.

In either case, the situation should be resolved and the uncertainty cleared by early 2007, which would benefit the stock.

Will copper and moly prices remain “high”?

Copper Fundamentals

It is our sense that copper prices will remain “high” (that is, above $1.5/ lb) for the foreseeable future (through 2010). A scenario in which copper prices remain above $1.5/ lb would result in a higher NAV than published (C$5.57 per share).

Some data points to support our view:

* Copper futures currently indicate $3.2/ lb in December 2007, $2.9/ lb in December 2008, $2.6/ lb in December 2009, and $2.4/ lb in December 2010.

* Phelps Dodge (largest copper producer in North America) sees copper price of “$2.5 or higher in 2007” (10-25-06). Phelps Dodge’s “preliminary outlook” for 2007 is “balanced to modest surplus”, with a caveat that further deficit remains a risk if supply shortfalls persist at 2005/2006 levels. As background, production shortfalls in 2006 have been about 1.4 B lbs (about 3.5% of world supply), which is similar to 2005.

Phelps Dodge cited three drivers for copper prices to remain “high”: 1) 2006 supply disruptions have been driven by labor discontent (e.g. year-end negotiations remain at Codelco’s Norte division); 2) Exchange inventories are unlikely to be rebuilt before 2009; 3) Limited substitution away from copper: about 900 m lbs in 2006 (about 2% of copper supply), up from 500 m lbs in 2005.

* As background, copper supply/demand has been running at a deficit for the fourth straight year (2003-2006). The 30 largest copper mines in the world will likely see significant declines in ore grades over the next 5-10 years, as well as higher stripping ratios, which will arguably keep current production levels flat, even with high copper prices. That means no supply increases from current mines.

To estimate new supply we aggregated announced new and expanded copper mines for 2006-2010 (over 40 projects). This new supply represents an annual increase of 4.4% (2006-2010) in world supply, assuming no delays in these projects and no supply disruptions (both very aggressive assumptions). By comparison, demand for copper is growing roughly in-line with global economic growth (3.5-4% a year). China economy is growing 9% a year and represents around 30% of world demand, which implies nearly three percentage points toward global demand growth. We feel that the close parity between potential new supply increases and historic demand increases implies copper will likely remain “high” for the foreseeable future.

Moly Fundamentals

It is our sense that moly prices will also remain “high” (that is, above $10/ lb). Moly currently trades at $26/ lb. Like “high” copper prices, any scenario in which moly prices remain above $10/ lb would result in a higher NAV than published.

As background, about 80% of world moly supply comes as by-product of copper production (e.g. Phelps Dodge, Codelco) and about 20% comes from primary moly mines. About 80% of moly demand is from the steel industry (to improve strength and ductility of certain steel alloys). Moly has a very high melting point (fifth highest), which few substitutes.

Some data points to support our view:

* Phelps Dodge (largest moly producer in North America) sees moly price over $24 for the balance of 2006 and a “modest surplus” in 2007, but it depends on whether mines in Huludao region (represents about 25% of China capacity) re-start production. China represents about 30% of world moly supply. Overall, China, with its growing economy, has been limiting moly exports (as it has for several other commodities), which should persist and continue to support moly prices.

* Chile moly production (about 30% of world supply) has been down about 9% year-to-date through September 2006. Chile moly production is flat since 2004, despite higher prices.

* No major new moly mines are expected in 2007. Rio Tinto confirmed that their moly production (about 10% of world supply) will be in decline in 2007. Phelps Dodge’s Cerro Verde could add 8 m lbs (about 1.7% of world supply of 450 m lbs). Overall, we project a supply increase of about 5.5% in 2007, which is in-line with historic demand increases.

Potential new moly mines in 2008 include: Mercator (up to 8 m lbs), Adanac Moly (up to 14 m lbs), and Moly Mines (up to 20 m lbs). Potential new moly mines in 2009 include: Idaho General (up to 35 m lbs). Potential new moly mines in 2010 include: International Molybdenum (up to 22 m lbs) and Phelps Dodge’ Climax (up to 25 m lbs). These potential new mines, if developed, could add about 10% a year in supply growth (2008-2010), which would offset supply declines from producing mines (e.g. Rio Tinto, Codelco) and may more than offset demand increases. Moly demand has grown about 5-6% a year on average for the last 20 years.

Catalyst