ARG - On The Cu-sp Of Growth

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By Nick Toor :

(Editors' Note: This article covers amicro -cap stock. Please be aware of the risks associated with these stocks.)

Amerigo Resources May 2013

Note: Write-up in Canadian Dollars.

Summary

Amerigo Resources ("ARG") [TSX: (( ARG )), OTC: (ARREF.PK)], a Toronto Stock Exchange listed company quoted OTC in the US, produces copper and molybdenum by reprocessing tailings. ARG is trading at a deep discount to fair value as a result of a perfect storm of issues including a recent dividend suspension, temporarily difficult extraction conditions, contract labor negotiations and high power costs, all of which have weighed on earnings over the last twelve months. These issues have been largely resolved and two major developments are expected to transform the company's profitability profile from 2013 onwards: 1) our estimated reduction in power costs from 2012 to 2013 of $27 million due to a new fixed price electricity contract and 2) imminent new contract to process tailings from the Cauquenes deposit, which will increase Amerigo's annual production by up to 80%.

At a $3.25 copper price and with current operations only, our price target is $.90/shr, or 88% above current prices and $1.83/shr, or 280% upside, with the Cauquenes contract. Downside is limited by the replacement value of the company's assets, estimated to be twice the current market cap, and a debt-free balance sheet able to withstand short-term pricing declines. The company's tailing sources have long remaining lives and ARG takes no exploration risk since it reprocesses an existing supply of tailings.

ARG is on the higher end of the cost curve; if you believe copper prices are headed below $3 on a long-term basis, this idea isn't for you. As long as you see $3 as a long-term floor for copper, ARG provides an excellent risk / reward profile.

Business Overview

Minera Valle Central ("MVC") was founded in 1992 and sold to Amerigo in 2003. Through MVC, Amerigo Resources produces copper and molybdenum by reprocessing tailings from the El Teniente mine ("El Teniente tailings") as well as the Colihues tailings impoundment ("Colihues tailings"). Both are owned by Codelco, Chile's state copper corporation and the largest copper producing company in the world. MVC's production is limited to 175,000 tpd due to the capacity of the launder that transports tailings from MVC to their ultimate location, El Teniente's Caren impoundment. ARG pays Codelco a production royalty that varies between 10% and 30% depending on the tailings source and copper content as well as copper and molybdenum prices.

The company has a strong balance sheet with net cash of $13.0 million and produced operating cash flow (excluding change in working capital) of ~$12 million in 2012 despite numerous headwinds. During 2011 and 2012, ARG spent ~$45 million on plant capacity expansion, repairs and the construction of an oxide pilot plant as well as ~$13 million to pay down the majority of their debt ($1.0 million outstanding as of March 31, 2013). Accordingly, maintenance capex is expected to be relatively light going forward; Management guides to $7.2 million during 2013. In March 2011, Management reinstated its dividend and during 2011 and 2012 paid semi-annual dividends of CAD$.02 a share (8.3% dividend yield at current prices). At the time Q1 2013 results were released, Management decided to defer the decision on the payment of its dividend until Q3 2013.

Operations

Following is a map of their current operations:

(click to enlarge)

ARG currently processes tailings from two sources (the El Teniente mine and the Colihues tailings impoundment) with imminent access to a third (the Cauquenes tailings impoundment).

El Teniente

El Teniente has been in operation since 1904 and is the world's largest underground copper mine. It contains over 3 billion tonnes of reserves and, at the present production rate, is estimated to have more than 60 years of life remaining. Approximately 130,000 tpd is delivered directly from El Teniente to ARG's processing facilities via a 40km launder. In 2012, ARG processed 45.0 million tonnes of El Teniente tailings at a grade and recovery rate of 0.126% and 22.3%, respectively, to produce 27.8 million pounds of copper. ARG's current contract with Codelco began in 1991 and runs until December 31, 2021. The contract specifies a minimum tonnage per day to be delivered to ARG as well as the minimum amount of copper to be produced over the life of the contract. Management is working to extend the life of this contract in parallel with negotiations for access to Cauquenes, which we expand on below.

(click to enlarge)

Colihues

MVC also has the right to process tailings from the Colihues impoundment, where El Teniente mine tailings were deposited from 1977-1987. Approximately 35,000 tpd are currently being mined from the Colihues deposit with hydraulic monitors and delivered to the processing plant via pumps. During 2012, MVC processed 11.1 million tonnes of Colihues tailings to produce 23.9 million lbs of copper. With a grade and recovery during 2012 of 0.283% and 34.4%, respectively, Colihues tailings yield 2-3x the amount of copper as El Teniente tailings.

(click to enlarge)

Cauquenes

ARG is currently in negotiations with Codelco to gain access to the Cauquenes deposit, which contains tailings deposited from the 1930s to the 1970s. According to Management, terms have been substantially negotiated and the contract is due to be presented to Codelco's BOD, with approval expected in the very near future. The deposit contains approximately 360 million tonnes or ~16 years of reserves at Management's target production rate of 60,000 tpd. The economic viability of processing Cauquenes tailings was confirmed through a feasibility study completed in April 2013.

Given the relatively inefficient extraction techniques used during the mid-1900s as well as the amount of time the tailings have been sitting dormant, Cauquenes tailings are expected to have more recoverable copper and to cost less to process than El Teniente or Colihues tailings. Management anticipates Cauquenes operations will lower aggregate cash costs by $.30-.40/lb. In our analysis, we have assumed the reduction in aggregate cash costs is at the lower end of the range at $.30/lb.

Cauquenes engineering and permitting has amounted to $4.2 million as of March 31, 2013 and is expected to be completed by this summer for an additional $2.4 million. In the event Cauquenes negotiations fall through, Codelco has agreed to reimburse ARG $3.8 million. Build-out is anticipated to cost approximately $140 million and last two years, with incremental increases in production expected within the first year. The project will be financed mainly with debt; Management has indicated that the project has received strong interest from Chilean banks and they expect a quick close subsequent to the contract award from Codelco. It bears mentioning that we feel the value of ARG's infrastructure - with an estimated replacement cost in excess of $200 million - is further validated by the Chilean banks' willingness to provide funding for the Cauquenes operation.

As the processing of Cauquenes tailings ramps up towards full capacity, ARG plans to maximize the grade of its 175,000 tpd processing capacity by (( A )) suspending Colihues production and (( B )) depositing approximately 15,000 tpd of the lowest grade tailings from El Teniente into the Colihues impoundment (130,000 tpd from El Teniente - 15,000 tpd into Colihues + 60,000 tpd from Cauquenes = 175,000 tpd capacity). Management guides to full capacity production of 90 million lbs of copper per annum, which we have incorporated into our analysis.

Molybdenum

ARG currently has processes in place to extract molybdenum alongside copper. Management is conducting an economic review of molybdenum operations and plans to shutter them if they are found to be unprofitable at current prices. We've included molybdenum production in our analysis and leave as upside any benefit from its elimination.

Revenue / Cost Structure

The MD&A found on ARG's website does a great job of breaking out the cost structure, but we'll go through it briefly here as well as discuss any recent abnormalities. We'll focus on Royalties and Production Costs, which comprise approximately 85% of reported total costs.

Royalties

Royalties were $.85/lb in 2012. ARG pays Codelco the following royalties on copper and molybdenum production:

(click to enlarge)

Pursuant to the terms of the contract with Codelco, royalties for El Teniente copper tailings are paid in Chilean Pesos (( CLP )) at the Dolar Acuerdo conversion rate ("Agreed Rate;" fixed daily by the Chilean central bank for a limited number of its own transactions) as opposed to the prevailing spot rate (the Dolar Observado rate). For example, $100 of royalties would be first converted to CLP at the Dolar Acuerdo rate of ~700 / $1. ARG would pay a royalty of 70,000 CLP, which, at a spot rate of ~450 / $1, equates to $156. Effectively, a widening of the spread between the two rates increases the royalty ARG pays on El Teniente copper tailings. This occurred in Q4 2012, when royalties rose to $.92/lb from $.80/lb in Q3 2012. In our analysis, we assume the spread stays at the widest point it's been within the past year.

Concurrent with the Cauquenes negotiations, Management has been pursuing a number of changes to the royalty structure. The current arrangement dates back to the inception of the El Teniente tailings contract in 1992. The $.80 floor was based on ARG's operating cost plus depreciation at the time. The cost structure has risen since then and ARG could now conceivably be required to pay a royalty while operating at a loss. Changes in the contract are expected to bring this $.80 floor more in line with ARG's current cost structure. Management has also indicated that they've made significant progress toward striking the Dolar Observado/Acuerdo clause from the contract.

However, management doesn't anticipate achieving any meaningful reduction in overall royalties. Accordingly, we continue to estimate royalty payments for El Teniente and Colihues tailings using this structure until further information is available. The royalty structure for Cauquenes has not yet been finalized but Management anticipates paying an amount similar to Colihues royalties at current prices, but with more downside protection. In our analysis, we assume Cauquenes' royalty regime is the same as Colihues'.

Production Costs

Production cost is comprised primarily of electricity costs, grinding media and labor costs, but also includes expenses such as industrial water, copper reagents and subcontractor services.

Electricity

Electricity is the largest component of production costs, at $.98 of the $2.48/lb in 2012 cash costs. Due to a two-year drought which severely affected the hydro-dependent electricity supply in Chile, power costs rose from $.16/kwh in 2010 to $.19/kwh in 2011 and 2012. A new fixed cost electricity contract, which began on Jan 1, 2013, locks in energy prices at approximately $.10/kwh for the next five years (subject to an annual inflation adjustment). This translates to an estimated power cost reduction of ~$.46/lb, or ~$27 million, from 2012 to 2013 (Management has guided to $20-25 million - however, with recently lowered production guidance, we expect power cost reduction to be in the $27 million area). A reduction of $.45/lb has already been achieved in Q1 2013.

(in 000's)

FY2010

FY2011

FY2012

FY2013E

Power Costs

39,836

45,366

50,677

23,705

$ / kwh

$0.16

$0.19

$0.19

$0.10

Power Costs / lb

$0.85

$1.04

$0.98

$0.52

The fixed cost contract covers enough electricity for current production levels; if production increases significantly (i.e. if Cauquenes negotiations are successful), ARG would need an additional source of electricity. Management has received interest from multiple providers of nonconventional energy (e.g. wind, solar) that would deliver power under a long-term fixed price contract at approximately $.10-.12/kwh.

Additionally, management is looking into several similar arrangements to replace the current fixed power cost contract upon its expiration in 2017. With this combination of alternative power sources and new contracts, Management expects to fix its energy costs at the $.10-.12/kwh level on a long-term basis.

In 2009, ARG purchased two used generators in an effort to offset high energy costs. The generators produce electricity at a cost of ~$.18-.19/kwh. When the market cost of electricity is greater than the cost of running the generators, ARG produces electricity to sell back to the grid and effectively lower its own power costs. Generators produce enough electricity to cover approximately 60% of current production or ~30 million lbs. The generators produced earnings of $2.4 million in 2012 and $0.7 mm in 2011. Given the futility of predicting energy prices, this effort is left as upside and no value is ascribed to the generators in our analysis.

Labor

A new labor agreement was negotiated with unionized MVC workers last year, resulting in the payment of a $4.6 million signing bonus in July 2012 and a labor peace anticipated to last at least four years. Signing bonuses are customary in Chile and have been relatively high in recent years due to the shortage of skilled workers.

All-in Sustaining Cash Costs

While the company reports cash and total costs, we prefer to look at ARG's expenses on an all-in sustaining cash cost basis, which we calculate as reported cash cost plus royalties, G&A and maintenance capex.

(click to enlarge)

Since a portion of royalties is pegged to copper prices, all-in sustaining cost moves in tandem with them as well. Our estimate of the breakeven copper price in terms of all-in sustaining cash cost is approximately $2.70/lb without Cauquenes and $2.05/lb with Cauquenes.

Current Status

While Q1 2013 was strong from a production standpoint, a landslide in the current production area (Zone 3) at Colihues is expected to lower production from Colihues by approximately 20% in Q2 2013 and Q3 2013. Production in the next extraction area (Zone 4) will be accelerated, but is not expected to reach full capacity until Q4 2013. Additionally, Zone 4 contains lower grade tailings deposited from El Teniente in 2006 during infrastructure repairs to Codelco's primary Caren tailings impoundment. As a result, grade is expected to be lower in that zone. Colihues production and grade is not expected to recover until Q4 2013 at the earliest.

As a result of the lower grade ore, landslide and downtime at El Teniente, Management has reduced 2013 production guidance to the lower end of a range of 45-50 million lbs of copper, down from the 51.7 million lbs of copper produced in 2012.

Following is our production estimates for 2013.

(click to enlarge)

Dividend

In light of the latest production setbacks, Management recently decided to defer the decision on the payment of its dividend until Q3'13. We expect dividends to be reinstated in 2015 after the Cauquenes operation is fully up and running. Based on our projections with Cauquenes operations, distributable cash flow beyond 2014 (calculated as unlevered FCF less interest and debt amortization) is expected to be in the $30-40 million range. Assuming ARG dividends out 50% of this distributable cash flow, according to our estimates, an investor could expect annual dividends of ~9-11 cents a share or a ~20-25% dividend yield at current prices.

Valuation

Even with lower levels of production and a decline in copper prices, we expect EBITDA to nearly double from $10.1 million in 2012 to $18.5 million in 2013 primarily due to lower power costs and the absence of a signing bonus.

(click to enlarge)

Excluding the potential benefit of the Cauquenes contract, our NPV10 analysis creates ARG at $.90/shr, or an estimated 88% above current prices.

Assumptions include:

  1. 10% discount rate.
  2. $3.25/lb copper price; $11.00/lb molybdenum price during 2013, then grown at 3% inflation post-2013.
  3. Terminal multiple of 6.0x.
  4. Royalties - Dolar Acuerdo and Dolar Observado spread kept at the widest point it's been in the past year.
  5. $7.2 million in annual maintenance capex, $2.4 million in engineering and permitting costs during 2013, $3.8 million reimbursement from Codelco.
  6. Costs grown at 3% inflation.
  7. Electricity prices assumed to remain at approximately $.10/kwh past 2017.
  8. Dividend reinstated in 2014 at 50% of FCF after interest and debt payments.

Following is our estimated production schedule, without Cauquenes tailings.

(click to enlarge)

Following is a projection and valuation summary without the Cauquenes contract:

(click to enlarge)

Following is a sensitivity table showing estimated intrinsic value per share at various copper prices and discount rates:

If Cauquenes negotiations are successful, we expect the project could be worth another $.93/shr, or $1.83/shr (280% upside).

Additional assumptions include:

  1. Cauquenes production reaches full capacity of 60k tpd in Q4 2014 (115k tpd of El Teniente tailings).
  2. Cauquenes grade and recovery of 0.29% and 47%, respectively (Management guides to grade and recovery of 0.29% and 50%, respectively).
  3. As per Management guidance, ~90mm lbs copper production annual run rate.
  4. Improvement in blended production costs by $.30/lb (lower end of Management's $.30-.40/lb guidance).
  5. Cauquenes' royalty structure same as Colihues.'
  6. As per Management guidance, $140 million in Cauquenes build-out capex and $12.2 million in annual maintenance capex.
  7. $140 million of debt; 10% interest; 5-year term.
  8. New nonconventional sources of power keep power costs at $.10/kwh for annual production past 50mm lbs of copper.
  9. Dividend suspended until 2015.

Following is our estimated production schedule, with Cauquenes tailings.

(click to enlarge)

Following is a projection and valuation summary with Cauquenes access:

(click to enlarge)

Following is a sensitivity table showing estimated intrinsic value per share at various copper prices and 1) reductions in aggregate cash cost due to the Cauquenes operation as well as 2) discount rates:

Catalysts

  1. Cauquenes contract award.
  2. Rising copper prices.
  3. Positive news out of China.
  4. Increased economic activity in the US and Europe.

Risks

  1. Declining copper prices - ARG is a high cost producer.
  2. Dependence on Codelco.
  3. Hard landing in China.
  4. Continuing production difficulties.
  5. Executing Cauquenes build-out - 20% cost overrun and full ramp up a year later in 2015 would lower our target price by about $.26/shr to $1.57/shr.

Upsides

  1. Possible access to Barahona Tailings Pond (est. 200 million tonnes).
  2. Elimination of molybdenum production.

Disclaimer

We had long exposure to ARG at the time of submission (5/30/13). We have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained in this presentation. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained in this presentation

Disclosure: I am long [[ARREF.PK]]. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

See also Coca-Cola: Short The Market's Oversight on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: A , ARG , B , CLP

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