Description

Zinifex is a return-of-capital story with strong potential investor momentum and sentiment. Should zinc prices go higher (or stay at current levels for longer) than the market expects, there is significant potential upside (50-300%) to the current share price due to the low current valuation on earnings and EBITDA.

**Share px and Mkt Cap in Australian Dollars.

Why Is Zinifex Interesting?
1) Zinc Market Offers Significantly Favorable Conditions:

History
• The strength of today’s zinc market stems from actions taken (or not taken) in the 1990s.
• As the zinc price underperformed that of other metals, development spending was shifted away from zinc and into those areas of stronger price performance (notably copper and gold).
• During that period, Chinese mine production and smelter output grew at a pace of 10% per year, compared to 2.5% growth for the rest of the world.
• Chinese refined zinc supply exceeded demand by a wide margin, and the country exported an average of 360 kt per year of product. This put constant pressure on the global zinc price.
• This underinvestment in mine capacity led to lower available zinc concentrate, and consequently lower treatment charges (TCs).
• The urbanization and industrialization of China has required massive increases in China’s fixed asset investment, which has been used to fund the construction of roads, railways, power generation and transmission facilities, as well as housing and industrial plants. This has been the driver of increased Chinese zinc consumption.
• Chinese zinc consumption growth has accelerated from 10% during the 1990s to 16% since 2000. In 2005 China accounted for approximately 27% of global zinc consumption.
• China has now swung to a net importer as a result of these low TCs, power restrictions and reduced VAT export rebates.

Current Market Statistics:
As a result, zinc inventories have experienced a steady fall while zinc prices have risen (I have charts, but will try to explain):
• In the past 5 years, zinc inventories peaked at ~780k tonnes and sits at in Apr/May 2004 and has experienced a steady drawdown to ~240k tonnes today...while prices have increased almost 300% to current prices of ~$1.70/lb
• In Jun 2005, zinc inventories 'spiked' from 520k to 640k tonnes before continuing it descent to today's levels

Supply/Demand Dynamics:
• Zinc’s stocks-to-consumption ratio has fallen to about 6 weeks from 9 weeks at the 2002-2003 market bottom. This compares to 5 weeks for aluminum, 5 weeks for nickel, and 3 weeks for copper...this level of tightness should provide fundamental support for high(er) prices
• Global demand is expected to exceed global supply at least through 2007
• Not only is the market expected to be in deficit during this period, but the annual supply/demand gap does not appear likely to narrow in the next two years
• New mine supply is factored into supply projections, but the small magnitude of near-term new mine production illustrates the chronic underinvestment in zinc:
a) Industry consultant Brook Hunt estimates new mine supply providing an incremental 750K tons by 2008
b) Other expansion projects that are not yet committed, financed or under construction could add another 100K tons in 2006, 400K tons in 2007 and 800K tons in 2008
c) Note that supply projections already account for much of the new production; any delays would only exacerbate the already tight market situation
d) For example, the San Cristobal project’s Bolivian location will always be cause for concern in the marketplace

Important role of fund investors:
• A wave of new investors has entered commodity markets in recent years because commodities can provide significant diversification benefits within an investment portfolio, comparable expected returns with equity markets and a broad hedge against inflation
• Much of the new investment has been relatively passive exposure via long-only commodity indexes
• Investors can now utilize more sophisticated instruments, such as structured notes that provide exposure to a tailor-made basket of commodities
• Investments in commodity index funds are expected to total $120B in 2006, up from $90B in 2005, $50B in 2004 and $30B in 2003
• The impact of fund investors on the commodity price is large, but the magnitude is debatable and difficult to quantify. Brook Hunt estimates the true fundamental price of zinc dictated by supply/demand fundamentals to be $0.75/lb in 2006 and $1.00/lb in 2007. This compares to current prices of $1.70/lb


2) Potential for significant return of capital to shareholders:
Zinifex’s stated policy is to return all surplus cash to shareholders in the absence of any other internal requirements
• The amount of cash deemed to be “surplus”, not to mention the inherent volatility in commodity prices which will determine ultimate generation of cash flow, make estimating the total return of capital difficult
• A sensitivity analysis of reasonable scenarios illustrates that between 25-40% of total capital is likely to be returned to shareholders over the next 2 years
Example:
-At a 60% payout ratio with zinc @ $1.50/lb, ZFN can return 28.4% of total capital to shareholders;
-At a 70% payout ratio with zine @ $2.00/lb, ZFN can return 47.9% of total capital to shareholders

% of Current Stock Px Returned: 2007 & 2008
Avg Zinc Px $1.25/lb $1.50/lb $1.75/lb $2.00/lb
Payout ratio
50% 17.7% 23.7% 29.6% 35.5%
60% 21.3% 28.4% 35.5% 42.6%
70% 24.8% 33.1% 41.4% 49.7%

Zinifex would of course have to weigh the return of capital against potential capacity expansions
• According to management, operating costs have risen by over 20% in the past 2 years
• Project development and capital expenditure costs are also up 20-25% over the past 3 years
• Similar to what we have seen in the energy markets, the floor has likely been raised on zinc prices to achieve adequate returns on capital. Industry consultants have recently stated that the old floor of 50-55 cents/lb now stands at 60-65 cents/lb or more



3) Implications of “produce out” model:
• I have modeled the existing assets of Zinifex out through the duration of their existing lives to determine the underlying net asset value
• Assuming a long-term sustainable zinc price of $0.65/lb implies a value for ZFX of approximately $12 per share. This is actually slightly below the current share price, implying that the stock is fully-valued
• The typical sell-side methodology is to project reasonable prices for the foreseeable future (in this case, through 2008) and then assume a long-term price deck for the commodity. There is obviously great sensitivity to this long-term price assumption as the useful life of mining assets could be 10-20 years or more
• A sensitivity analysis of ZFX’s net asset value relative to long-term zinc prices is as follows:

L-T Zinc price ZFX NAV Premium to current price
$0.60/lb $10.92 24.8%
$0.65/lb $11.82 35.1%
$0.70/lb $12.72 45.4%
$0.75/lb $13.62 55.7%
$0.80/lb $14.52 65.9%

** Note that the long-term price accounts for annual inflation of 2.5% over time (meaning that the $0.60/lb in 2009 translates to $1.11/lb in 2030).


4) Potential takeover candidate:
Several factors make Zinifex an interesting takeover candidate:
• Relatively small market capitalization
• Scarcity of pure-play and of-scale zinc producers
• Strength of balance sheet
• Strong free cash flow, balance sheets and stock prices of potential acquirers
• Potential buyers would include Teck Cominco, BHP Billiton and Rio Tinto, among others


5) Valuation:
ZFX trades at P/E multiples of 4.3x for 2006 and 2.2x for 2007, and at EV/EBITDA multiples of 5.0x for 2006 and 2.7x for 2007.
• Comparables companies trade at least double these multiples, yet do not have as favorable capacity conditions or a management team willing to return a significant portion of the company to shareholders.
• Even with significant decline in zinc prices, I believe ZFN will outperform from current levels...50-300% total return over the next 2 years.

Catalyst

-Higher Zinc Prices
-Announcement of Return of Cash
-Takeover bid
-Upsize Share Buyback