Description

(All $ are US$, except where otherwise indicated. C$=Canadian$)

Mercator Minerals Ltd. (ML.TO) is a junior copper (Cu) producer that is in production and producing positive cash flow. ML owns 100% of the Mineral Park Copper Mine near Kingman, Arizona, 90 miles from Las Vegas.

I believe that if Mercator traded in line with its closest comp, Amerigo Resources (ARG.TO), its stock would trade to over C$5.00/share. ARG was written up on VIC within the last 12 months.

If Cu and moly prices do not fall more than 30% from current levels for the next few years, ML is worth C$20-$40/share.

As production is just beginning to ramp, few have noticed ML. In 2006, however, ML will increase its Cu production to 15MM lbs from 8MM in 2005. In 2007, ML will likely add molybdenum (moly) and silver production and, in mid to late 2007, ML will ramp to an annual run-rate production of 60-80MM lbs of copper and 8.5-11.5MM lbs of moly.

Cu currently trades at $1.70/lb and moly at $34/lb. At these prices, and assuming midpoint run-rate production in late 2007 of 70MM lbs of Cu and 10MM lbs of moly, ML would generate annual revenue of $460MM. There will also be about 300k oz. of silver produced each year, adding about $2MM in revenue, but I exclude this benefit to keep numbers round. Cash opex will be $65-85MM. Using the midpoint of $75MM for cash opex, pre tax income would be $385MM or roughly $270MM net income (30% tax rate). ML shares trade in C$, so one needs to convert $270MM in net income to C$323MM, or C$5.05 in EPS using a C$1.20/US$ exchange rate.

This analysis uses cash cost and thus excludes depreciation, not to mention accelerated depreciation, or ML’s NOLs. There is also the possibility of ML converting to a trust, perhaps a grantor trust, in which case it would not pay taxes but its distributions would be taxed at 15%.

Annual capex after an initial $60MM outlay will be minimal, at most $1-3MM, so free cash flow (FCF) would approach $5.00/share at a 30% tax rate.

ML currently has 64MM FD shares out and expects to finance the cost of the production ramp via debt, so share count will not increase. $324MM in net income and 64MM FD shares implies C$5.00 in FCF per share. Cu equities trade at 6-8x FCF, putting ML’s stock price between C$30-$40/share.

If Cu falls to $1.00/lb and moly to $5/lb by late 2007, ML’s revenue would drop to $70MM from Cu and $50MM from moly, for total revenue of $120MM. If Cu fell to these levels, costs would probably drop a bit as well because input costs like diesel fuel, acid, plastic tubing and steel parts would also fall in a falling commodity price environment. But let’s use $75MM to be conservative. Using $120MM in rev and $75MM in opex, that is $45MM in pre-tax income. Assuming a 30% tax rate, ML earns $31MM in net income, which is C$38MM. Using 64MM FD shares, FCF/share would be C$0.60. A 7x FCF multiple yields a C$4.20 stock price.

Most analysts, including Cu industry experts, believe Cu will stay above $1.20 for at least the next two years. The current 2006 Cu futures price is over $1.50.

One of the main drivers of either scenario’s huge upside is ML’s recent acquisition of a used 20,000 ton per day process mill for only US$6MM. Given ML’s stock price trajectory, I believe this transaction went nearly unnoticed.

This mill, however, has tremendous economics, enabling ML to exploit its moly and silver reserves and become more than a Cu-only producer. Furthermore it will allow ML to ramp production of Cu in 2007 to annual run-rates of 9-10x its 2005 production of 8mln lbs. This last ramp to about 70MM lbs will cost about $60MM, including relocating the mill from its current home of Tucson, AZ to the ML property in Kingman, AZ, and adding equipment. The CEO has supervised the construction of 4 other such mills. A bankable feasibility study detailing the economics/free cash flows of this mill, including taxes, will be finished by Q1 of 2006.

The news release announcing the purchase of the mill, dated July 2005, states that “the mill was operated at a capacity of 20,000 tons per day of Cu ore processed. Mercator’s personnel have determined that, with minor modifications, the mill is capable of throughputs of 30,000 to 40,000 tons per day at Mineral Park, because the ore at Mineral Park is softer than the ore previously processed through the mill. Some additional modifications would be required to produce a molybdenum concentrate, which will be required because molybdenum has the potential to be a very significant co-product at Mineral Park.”

ML’s reserves and their relation to estimating mill production rates:
ML has disclosed that the grade of its proven and probable reserves of 84.6MM ore tons, 77.25MM of which is proven, is 0.24%. At 35,000 tons processed/day, the reserve life is 6.5 years.

The run-rate production of a mill in lbs equals the number of tons of Cu ore run through the mill per day multiplied by the number of days per year the mill runs multiplied by 2000 lbs per (short) ton multiplied by the grade of the ore in the rock multiplied by the recovery rate. The recovery rate estimates how much of the ore grade can be recovered through the milling process.

Using 0.24% grade, 88% recovery, and 35,000 tons/day one gets 54MM lbs of Cu. (The math works as follows: 35,000 times 365 times 0.24% times 2000 times 88%.) The SX-EW (solvent-extraction electrowinning) plant outside the mill will still produce 3.6MM lbs of Cu, getting the total to 57.5MM lbs. As for the 88% recovery, other Cu operations in Arizona, such as the large Phelps Dodge (ticker PD) mines of Sierrata and Bagdad get comparable recoveries with similar ore types.

The 0.24% grade is the projected average grade over the life of the mine. In 2004, 2.5MM tons were mined and average grade was 0.28%, or about 20% higher than life of mine average grade of 0.24%. I believe the grade over the first few years of the mine will be significantly higher than 0.24% because ML will go after the highest grade ore first to maximize NPV of the mill and because the highest grade is over 30%. So how should one quantify grade over the next few years?

My discussions with ML suggest grade in 2007-2009 of 0.30% is appropriate. I believe this grade estimate because the March 2005 Mineral Park Technical Report (in the public filings accessible via website) shows that ML has 25MM tons of ore at 0.33% grade and 71MM tons of ore at 0.25% grade. The first 12 months of production, at 35,000 tons/day, would mean 12.8MM tons of ore processed in one year. So if ML were to go after the highest Cu grade they would have about 2 years of 0.33% copper grade and then about 5 years of 0.25% copper grade.

At 0.30% grade, the annual copper production beginning in late 2007 will be 67MM lbs. Another 3.6MM lbs from SX-EW operation would bring production to over 70MM lbs. If grade is 0.33% rather than 0.30%, then production will be a bit over 77MM lbs at 35,000 tons/day. At 40,000 tons/day and 0.33% grade, and using same 88% recovery, 84.8MM lbs of Cu would be produced. Another 3.6MM from SX-EW would bring annual total production to over 88MM lbs of Cu.

The molybdenum resource, measured and indicated, is 174MM lbs at 0.045%. As for moly grade, although the life of mine projected average grade is 0.045%, there are 95MM lbs with projected grade of 0.05% or higher. At 0.05% grade, 35,000 tons/day, and 75% recovery, the annual moly production would be 9.5MM lbs, so 10 years of production can occur at that grade. At 40,000 tons/day, the production increases to 11MM lbs/year with just under 9 years at 0.05% grade.

Copper supply/demand outlook:

I believe Cu supply and demand fundamentals indicate a secular bull market. 2005 world Cu mine output was 15.1B tons, consumption was 17.3B tons. World Cu demand is currently growing in excess of 3%/year or more than 1B lbs/year.

Supply
1B lbs/year and growing could prove a difficult amount to satisfy as both new mine openings and existing mine expansions are constrained. The largest new Cu mine coming into production in 2006 is BHP Billiton’s Spence Mine near Sierra Gorda, Peru. Spence is projected to produce 200MM lbs/year, only 20% of just one year’s demand growth. There is no new Cu mine coming into production in the next 5 years that will produce much more than 200MM lbs/year. 21 of the world’s top 28 Cu mines cannot meaningfully expand production due to reserve lives and/or problems with water, waste disposal, ore grades, etc. At least 4 of the largest are in decline.

Demand
Western world demand growth is approximately 3%/year. Asian growth cannot be estimated as confidently. Consumption estimates are as follows: North America, 19 lbs/person/year; China, 6 lbs/person/year; India, 0.7 lbs/person/year. There are 400-500 lbs of Cu in an American house and about 50 lbs in a car. As Asian countries accumulate wealth and grow their middle classes, their demand for plumbing and automobiles should continue growing at rates multiples higher than western GDP. For example, Chinese Cu demand is projected to grow 9% this year.


Molybdenum supply and demand:

To learn about moly supply and demand, visit: http://www.teckcominco.com/investors/presentations.htm

At the website above there is a presentation on moly by Mike Schwartz, Teck Cominco Market Research Analyst. The presentation notes that moly’s surge in price has been driven by the oil sector and infrastructure demand by China, implying oil and moly prices are positively correlated.

What if world economy slows and copper and moly prices collapse? Where does ML breakeven?

So at what Cu price would ML break-even? If moly collapses to $4/lb, then ML breaks even at a Cu price of $0.50, assuming production of 70MM lbs of Cu and 10MM lbs of moly. Such low cost Cu production makes it one of the lowest cost Cu producers in the world. I believe $4/lb is conservative as a price floor for moly because moly has rarely traded below that price and demand/supply dynamics are more bullish now thanks to oil prices.

The cost of producing 70MM lbs of copper and 10MM lbs of moly:
So assuming one can get comfortable with the production, how can one get comfortable with the operating expense (opex) range of $65MM to $85MM? There are two ways. One, Duval Corp operated a similar 12,000 tons per day mill on the ML property for 17 years. ML has all the operating data of that mill and thus knows the input quantities (kilowatts, grinding balls, etc.) required to run it. This data allows them to adjust the old cost of running the Duval mill to the cost of running the newly acquired mill using today’s input prices and adjusting for differences between the mills. The old mine ran at a cost of $3.75/ton and I estimate the new mine will run at between $4.50-6.00/ton, with a more likely range of $5.00-5.50/ton.

At 35,000 tons/day, the mill would process 12.8m tons/year. At a cost of $5.25/ton, the annual cash opex would be $67MM. The $75MM opex, which was assumed in calculating FCF above, implies a $6/ton operating cost. Cost of $6/ton is probably too high because other similar yet higher-cost mills, such as Phelps Dodge’s Sierrata, which has published cost reports, are running at $5.50/ton. Sierrata is a higher cost mill because of its 1:1 strip ratio, whereas Mineral Park has a 0.3:1 strip ratio. The strip ratio indicates how many tons of waste need to be stripped away to get one ton of ore. In other words, Sierrata needs to move 3 times as much tons of waste per ton of ore. Hence Sierrata’s mine cost/ton of ore is $1.75, while ML’s will be near $0.65 at 70MM lbs production. Therefore, one would expect that ML’s mill would average a mine cost $1.10 lower than Sierrata’s mill, implying $4.40/ton mining cost. So though I estimate cost of $5.00-5.50/ton, the comparable mine analysis suggests this estimate is $0.60-$1.10/ton too high.

Why is ML’s strip ratio so low versus Sierrata? The answer is that the old 12,000 tons/day mill that produced Cu, moly, and silver in concentrate from 1963 to 1980, stripped the original leach cap off the deposit, thus reducing the future strip ratio and increasing profitability of mining the property. A lower strip ratio means less waste needs to be removed per ton of ore.


Using Comparable analysis to value ML:

How does one use Amerigo (ARG.TO) as a close comp to value ML at over $5 per share? Amerigo’s current market cap, using FD shares of 87MM, is about C$150. This year ARG will produce 33MM lbs of Cu and 0.6MM lbs of moly ramping to 63MM lbs and 2MM lbs of Cu and moly, respectively, in 2007.

Ignore for now that ARG’s cash cost, including the moly credit (using a $6 moly price) and royalty costs, will be at least $0.86 for the mine life, which is much higher than ML’s comparable cash cost of $0.21. (This ML cash cost is derived as follows: the total cost to run the mill at 35,000 tons/day would be $75MM, $60MM of which would be offset by moly revs, 10MM lbs at $6/lb moly. The remaining cash cost of $15MM would need to be derived from 70MM lbs of Cu, implying ML’s cash breakeven from Cu would be $0.21/lb.)

Also ignore for now that ML will produce 9-11MM lbs of moly versus ARG’s 1.5-2.0 lbs in 2007. Also ignore that the sell-side analysts covering ARG have it’s NAV at about C$2.50/share while its share price is $1.70.

Imposing today’s ARG market cap on ML suggests that ML’s market cap should be at least C$150MM, or C$2.34/share.

An ML share value of C$2.34, however, does not factor in ML’s 10MM lbs of moly production versus ARG’s 2MM nor ML’s much lower production cash costs, which we've ignored thus far. 8MM lbs of moly production above ARG’s moly production is valuable given moly’s current price of $34/lb. If I use $6/lb long-term moly price, which most moly experts would consider conservative, then this incremental production translates into about $60MM in incremental revenue per year. What is the value of this revenue stream?

I estimate the value of ML’s incremental moly production is worth another $2.25/ML share. Our reasoning is as follows: ARG, using $1.10/lb long-term Cu price and $6/lb long-term moly price, will generate $76MM in revenue given current production guidance ramp. So its market cap, at C$150MM, is about 2x the long-term revenue of $76MM. Using the 2x market cap to sales multiple to value ML’s moly production, one gets $120MMM or C$144MM, which is $2.25/ML share in value incremental to the $2.34/ML share derived earlier, making total value of ML equal to over C$4.50.

ML’s value is actually greater than C$4.50/share, however, because its costs are much lower than ARG’s. ARG’s average (over life of mine) cash cost/lb of Cu produced is $0.87/lb, which includes the moly credit (at $6/lb) and the cost of royalty they pay. ML’s comparable cash cost by late 2007 will be $0.21/lb. Lower cash cost producers trade at a significant premium to higher cash cost producers because of the former’s ability to better withstand severe Cu price declines. On this basis the C$4.50 value should be multiplied by a premium.

Moreover, our C$4.50 estimate for ML/share value assumes ARG's market cap at $1.70/share (ARG’s average stock price in Sept 2005) as the fair value of ARG. My discussions with ARG mgt and the sell-side confirm that ARG’s NAV is between $2.50-$3.00, using $1.10/lb long-term Cu and $6/lb moly price.

Roughly speaking, the low-cost producer premium and ARG’s NAV of $2.50 suggest ML’s per share enterprise value today, on a comparable basis to ARG, is over $8.50. This value is derived by using $2.50 ARG NAV/share instead of $1.70 ARG share price and assuming that ML should trade at a 30% premium to that $2.50 NAV/share because of its lower cost production profile. The 30% premium is based on my analysis of the following Canadian Cu equities and where they trade on a P/NAV versus their 2005-2007 estimated cash costs: QUA, EZM, TKO, AUR, IM, and FM.

QUA, EZM, and TKO have estimated cash costs of $0.80-$0.90 net of by-product credits and have P/NAV of 0.5, 0.8, and 0.4, respectively. ARG’s P/NAV is about 0.6.

AUR, IM, and FM have estimated 2005-2007 cash costs of $0.50-$0.60/lb and trade at 1.1, 0.7, and 1.2 P/NAV.

The latter group’s average P/NAV is 1.0 while the former’s (ex ARG) is 0.56, indicating a 76% premium for the lower cash cost group. Our 30% premium seems conservative per this analysis.

The $8.50/share enterprise value, however, needs to be reduced by the $60MM in debt (C$72MM) that ML will need to raise and pay off; ARG has no debt. Such a reduction would bring the $8.50 down to $7.50 per ML share.


Other considerations:
I AM A SHAREHOLDER OF MERCATOR.

Mgt owns 2m shares and 4m options.

ML as a play on oil and the weaker dollar:
ML is a play on oil in two ways, via moly and via the Canadian currency. I believe the C$ will appreciate against the US$ dollar if high oil prices continue because so much of the Canadian economy is based on oil. One will make money on ML through this appreciation because ML trades in $C. Moreover, demand for moly should strengthen as oil prices strengthen because the creation of new projects to add to oil reserves will inevitably use steel and moly will be used to strengthen that steel.

Cu price should rise as the US$ weakens but ML’s costs ex commodity-based input costs, which are 10-20% of their total costs, should stay same, unlike non-US producers whose currency may appreciate against the US$.

Catalyst

Ramping of production
Bankable feasibility study being released in Q1 2006