Thursday, March 29, 2007

Mining Companies -- Depreciation is Additional Value

Earnings for mining companies that conduct activities in the United States can have significantly higher earnings potential than reported on the income statement. The reason: depreciation reported on the income statement is based on the mining companies' estimate of the Net Present Value (NPV) of the earnings from their mining activities. However, under current US law, mining companies pay a low amount (approximately $2.50 - $5 per acre) for access to the minerals found therein. This financial practice is mandated according to the Mining Act of 1872 ( which has not been significantly amended since its inception.

For the investor, this is hidden value that should be backed out of earnings for a better understanding of the true earning potential of the mining company.

As an example, Phelps Dodge (now acquired by Freeport-McMoRan) reported approximately $450M in depreciation and amortization charges in 2006 -- on net income of approximately $3.0Bn, an increase in cash flow of 15%. However in 2004 Phelps Dodge reported D&A of approximately $500M on net income of approximately $1.0Bn, an increase of cash flow of 50%. -- Note assuming all mining activities of Phelps Dodge are in the United States, which is not 100% accurate, and the author is not aware of the breakdown of geographic NPV's of Phelps Dodge.

Summary: the diligent investor will check deprecation and amortization of mining companies and add that back to net income to get a clearer picture of true earnings potential. Also, a calculation -- even if an approximation -- of NPV of the mining company's ore reserves is a good place to start in approximating the earning potential of the mine, as a P/E measure may not reflect the mining company's true earning potential if the depreciation charge is significantly large.

Further, the question arises: can an investor "back into" the Company's calculation of its NPV from its depreciation change on its income/cash flow statement? As noted in the story from 3/27/07, mining companies (unlike oil and gas firms) are not required to provide an NPV value to investors in their financial statements. In practice "backing into" the firms NPV of all its mines is difficult as the useful life (in years) and the price of the commodity and interest rate assumptions are not provided.

However, at certain times the mining company will independently provide NPV for certain mines, or all the mines and prospective mines in its portfolio. This information can be found on the website, or the investor can ask the investor relations department for the info (however, note again that the mining company is not required to provide this information). The investor can also do a "back of the envelop" estimate of the NPV of the mining projects himself/herself, taking into account reserves, price assumptions, interest rates and production times of each mine.

Last note, each country has different rules concerning how the company can account for deprecation of mineral assets, and the author is not aware of all of the differences. However as a general rule, the most favorable countries (with laws similiar to the US) include EU countries, Canada, Australia and New Zealand. Other countries are most likely less favorable, which is a large impact on the value of the NPV of the mines located in these countries.

Additional Notes on the Subprime Sector

Looking at the subprime sector effectively requires a framework for understanding the problem. Of the analysis on the subprime sector --, Kreisel out of Northern Trust, etc, (there are 100's) -- and note that the Fed (Greenspan) covered the sector in a speech in 05 -- most are based on a few "nuggets" of info with a few charts (no offense to Kreisel for example but that is his style, also the style of Rosenberg out of Merryl and most other bank economists).

I think the Fed is way ahead of most economists -- economists at Goldman and Merryl because every time the Fed issues a statement/report it is evident that they have a team of economists with very sophisticated models -- stress tested -- to back up their statements. You can't get access to their models though so the best I can find is the projection from the report linked in my previous story dated 3/27/07.

That said, what is clear from the projections is that the subprime sector hits the lower income sector harder (hard), and whether that will pull down the rest of the economy, probably not, but best would be to look at the projections to figure this out. Subprime is one more factor to skew income distribution in addition to top heavy pay scales and tax codes (alternative minimum taxes, lower taxes on capital gains, etc). I find the trend disturbing and can see it out here in the Bay Area, no question, plain as day. The contribution of the subprime sector to greater disparity in income distribution was a subject of a business week note here:

Tuesday, March 27, 2007

Possible Impacts of the Subprime Sector on the US Economy

The subprime sector of the US housing market has weighed on equity markets and the economic outlook. This post assesses the possible impact.

- Ideally to calculate the possible impact one would utilize a series of detailed projections, taking into account the total amount of subprime and alt-a loans
and possible at risk loans. The best projection and discussion I've seen on possible subprime impacts is from _whitepaper_021406.pdf (from First American Real Estate Solutions, which claims to be the number 1 source on real estate in the US, used by Moody's)

- FARES projects approximately $300Bn loans at risk over the next 5 years from interest rate resets, and, as losses will represent the loss on collateral, approximately $100Bn of total losses to the financial system, spread over 5 years.

- A weakness of the study is that only the loans made in 04 and 05 are represented, most likely significantly underrepresenting 06 and years before 03. (study completed in 2/06, but I haven't found anything of good quality newer) So one should increase the total at risk amount (unscientifically) by approximately 30-60% to account for the extra years.

- Another weakness of the study is that interest rate reset is at current interest rate levels -- all bets are off if interest rates rise significantly -- but
note that much higher interest rates are not extremely likely.

- Study assumes a level of 30% from the approximate $1 Trillion in loans that will reset at risk, which the author considers "conservative" -- and walks the
reader through his methodology. I would actually tend to agree as the average mortgage and other credit card interest payments to income is currently under 18.20%
(see debt/default.htm)
-- which indicates the average consumer in the US is NOT hurting by any means.

- All in all what is most interesting is that the total amount is manageable, as the total housing stock value is approximately $18-20 trillion, and value of outstanding loans are approximately $10 trillion (according to Moody's). The defaults and losses will be spread over at least 5 years, representing in total 3% of total mortgage value (number from the study, although more like 5% taking into account other years)and losses at 1% of total mortgage loan value.

- Also demographically the subprime sector tends to be inner city -- one study of subprime loans showed that 30-40% of the borrowers were African American. In California -- one of the largest subprime markets -- subprime loans are popular in the farming central area in addition to inner city. The defaults will hit the inner city harder and -- if I can venture out on this -- will also contribute to the increasing disparity trend in income distribution.

- The loans will likely default and be spread over several years, 5 or more, likely leading to a stagnant real estate market in the areas where subprime and
alt-a loans are popular. Perhaps a "two tiered" real estate market will develop --inner city and other lower income areas and middle to high income class

Canadian Royalty Trusts -- Will the Elimination of Tax Free Status be Repealed?

Certain investment advisors have been suggesting that the proposed elimination of the tax free status of royalty trust proposed on Oct 31, 2006 will not pass. Is this an accurate assessment of the situation? Analysis below.

The new tax on income trusts -- a tax to eliminate the Canadian Royalty Trusts' tax free status -- was proposed on Oct 31, 2006, and voting will probably come this year (2007). After the annoucement of the proposed alienation of the tax free status, the trusts market values dropped anywhere from 20 to 30%. If the new law eliminating the tax free status of the trusts does not pass, then it is likely that the trusts will regain some or all of their lost market cap, possibly making them good current investments. The key question then is how likely will the new law concerning income trusts be repealed?

The most important issue is whether the Canadian parliament has enough votes for it to pass. The Lower House of Commons is the branch of government in Canada that has the most influence (the Senate usually rubber stamps the Lower House, according to the description of Canadian politics in the wikipedia, much different system than the US).

A simple majority is needed to pass laws.

Lower House members:
(X means on board with the tax, - means against, ?
means undecided)
Conservative Party (Tories): 125 members X
Liberal Party: 125 seats -
Bloc Quebec: 50 seats ?
New Democratic Party: 29 seats X
Independent: 2 seats ?
Vacancies: 2 (I don't really know how to interpret
"vacancies") ?
Total: 308
Seats from the official Canadian Parliament website.

The Conservative Party and the New Democratic Party have publicly stated that they are for the measure, so that totals 154 votes (50% exactly), assuming they do not change their position, which appears unlikely as the Conservative Party has proposed the tax and the New Democratic Party is left-leaning. Reference:

Apparently breaking party ranks and voting against the party is rare in Canada so it looks that the taxes have 50% support.

Bloc Quebec is for the measure but would like to extend the transition time to 10 years, and would also like more evidence of the need to transition. The Liberal Party has proposed a different measure, no new income trusts but income trusts allowed if they can show a positive impact on Canada -- this is the most reasonable proposal in my view, but they only have 100 votes, approximately 32%.

But in summary, the most important factor is that the Conservatives and New Democratic Party are on board and that is (almost nearly) enough to get the measure passed. I suppose an investment advisor can say "50% is not 51%" but 50% is close enough to 50% with Bloc Quebec still up in the air and independents and vacancies that it appears the tax is likely to go through.

It seems to me, if I were to put percentages on the passing of the tax (from my judgment only, albeit analyzing the issue for a few days), it would be: 60% passed as proposed, 30% passed with some/minor modifications and 10% passing the Liberal Party's recommendation (the passing of the Liberal recommendation would be the main driver of improved investor interest). A 10%-odd chance of the law not being passed does not make investment into the trusts on this basis very attractive -- what would be interesting is an analysis of the trusts assuming the elimination of the tax free status -- perhaps a change to a corporation, and valuation in this form -- but this subject is beyond the scope of this post.

Mining Notes Explained

In the preceding post(dated 3/27/07), I have listed Mining Firms in the Gold, Silver, Copper, Zinc, Potash and Uranium Sectors with their gross reserves (proven, indicated and inferred) and the gross value of these reserves (assuming conservative prices for the metals), and divided the gross value of the metal reserves by the enterprise value (market capitalization plus net debt).

In theory, a lower percentage of the gross value of metal reserves by enterprise value will indicate that the firm is undervalued. But this should be taken as a starting point to research and not as a endpoint in and of itself, for the following reasons:

1) A mining firms lifting costs can vary widely, depending on the grade of ore (higher grade is cheaper to process), labor costs, energy costs and overall efficiency,
2) Future -- to be discovered -- reserves are not included,
3) Prices of the metals may vary in the future,
4) The gross valuation does not take into account hedging and/or the time value of the reserves, meaning the lifting rate of the reserves.

Nevertheless, despite the drawbacks of the gross value to enterprise value measure, it is a useful starting point as mining firms should ultimately be valued on the basis of their reserves of ores. Mining firms, unlike oil and natural gas firms, are not required by the SEC to publish a "Standardized Measure" -- the future discounted value of the cash flows from their natural resource reserves. The Standardized Measure is a vary useful measure in valuing an oil and gas firm (for a fuller explanation of the Standardized Measure see my other blog In the absence of a Standardized Measure, a gross valuation is a decent starting point for the investor.

Some points on the overall mining company stock universe: First, the majority, about 50% by market capitalization, of all mining companies are involved primarily in the extraction of Gold ore. Gold mining has traditionally been the most visible and prominent of the mining stock universe, and the valuations, by the gross metal reserves to enterprise value measure, are consistently in the high 25% to 40% or higher valuation range. The other categories of mining firms, silver, copper, zinc, uranium etc, have historically not been as covered, (but over the past two years have received more attention) and therefore have much different valuations on a gross ore value basis. Uranium, probably mainly because of the scarcity of publicly listed Uranium mining stocks, trade even higher than the gross value of the reserves as a general rule, (although after the significant run up in Uranium stocks during the past 3 years), while Potash mining stocks, such as Potassium Corporation of Saskatchewan, trade at below 1% to the gross value of their reserves. Copper firms typically trade at below 10% of the gross value of their reserves.

Whether this disparity of valuation reflects that the margins are much lower in potash and copper compared to gold and uranium (in my analysis the gross margins are not significantly different to account for this disparity in valuation), or that future expected price appreciation of copper and potash is much lower than gold and uranium, or that investors simply do not value potash and copper as highly as gold and uranium, (or a combination of all reasons), is a matter of debate. As a value investor, I would personally lean toward the sectors with the lowest valuations to gross ore reserves as more attractive investments for future price appreciation.

Geopolitical instability also accounts for significant variations in valuations of mining firms. As a general rule, the firms in politically stable countries -- United States, Canada, Australia -- trade at significantly higher valuations than in those countries such as Venezuela and Bolivia in which taxation and/or outright seizure of assets is a probable threat. Whether the political instability valuation is overdone and/or undone is for the diligent investor to research, although I have noted that several mining firms are VERY conscious in their plans to account for political risk -- meaning that mining firms themselves may place a high risk premium on political instability (and the diligent investor should as well).

Mining firms can also be placing into three categories in terms of size, which have different valuations. There are development stage firms, which have prospect stage mining projects, then intermediate sized firms, which have one or more producing areas, and large mining firms, which have several mining projects. As a general rule, the valuation of the large firms should be significantly higher than the exploration stage firms, as the risk in developing mines is very high. Related, as a general rule, most projects are being delayed, and cost inflation is higher than expected currently (early-mid 2007) due to manpower shortages, political uncertainties and lack of supplies. An investor who exercises caution in investing in exploration stage mining companies has good reason to do so.

A final note on sources of information -- most mining companies provide very accessible and readable investor presentations which outline their projects, risks and timeframes, which are generally found in the investor relations section of their websites -- for an investor interested in a firm, this is generally a second step (after deciding which mining firms look attractive as an investment) toward investing. Very important is the status and quality of the producing mines (if not an exploration stage company) and the quality, timeframe and reliability of the future projects.

Major Mining Companies Enterprise Value to Gross Value of Ore Reserves

Key: Ticker Name: Primary Reserves; 2nd Reserves; 3rd Res; etc
Net Value of Reserves; Enterprise Value; EV/Net Value Resource

---- means other catagories of reserves do not exist
* Development Stage Company **inferred resources not disclosed
Note that many of the reserves and enterprise values (market cap + net debt)
values are from early 2006

Gold Mining Companies:
NEM Newmont Mining: 132 M ounces Gold; 9.5m tons Cu; - - -
$102.9Bn; $23.8Bn; 23.1%

ABX Barrick Gold: 139 M ou Gold; 933M ou Sil; 6.2BlbsCu - -
$109Bn; $29Bn; 26.6%

AU Anglo Gold: 78.9M ou Gold** - - - -
$47.3Bn; $15.3Bn; 32.3%

GFI Gold Fields: 64.8M ou Gold - - - -
$38.9Bn; $10.53Bn; 27%

KCG Kinross: 24.7M ou Gold 24.4M ou Silver - - -
$15.1Bn; $4.07Bn; 27.2%

HMY Harmony Gold: 56M ou Gold - - - -
$33.6Bn; $6.61Bn; 19.6%

AEM Agnico-Eagle Mines: n/a, n/a
$4.24Bn; n/a, n/a

FCX Freeport McMoRan: 43.9M ou Gold 40.3 Bn lbs Copper - -
$147Bn; $12.6Bn; 8.6%

CGR Claude Resources: 178K ou Gold - - - -
$106.8M; $88M; 82%

NCMGY Newcrest Mining (Australia): 59M ou Gold; 5.5M tones Copper - - -
$6.1Bn; n/a; n.a

KRY* Crystallex: 26M ou Gold - - - -
$15.6Bn; $704M; 4.5%

AZK Aurizon Mines 2.83M ou Gold - - - -
$1.7Bn; $360M; 21.2%

TSX:JAG Jaguar Mining 4 M ou – targ 8-10 M ou Gold - - - -
$4.8Bn (at 8 M ou); n/a; n/a

GG GoldCorp: 25.01M ou Gold; 69.7M ou Silver; 1,481 MlbsCu - -
$19.3Bn; $10.6Bn; 55%

BGO Bema Gold: 25.6M ou; 83M ou Silver 1.5Mlb - -
$20.0Bn; $2.81Bn; 14.1%

OPYGY Polyus (Russia): 101M ou Gold - - - -
$60.6Bn; $8.0Bn; 13.2%

GLG Glamis Gold: 22.6M ou; 878M ou; Silver 11.9Blbzinc - -
$40.3Bn; $6.15Bn; 15.2%

Centerra (66% in Kygryz Rep): 12.2 M ou - - - -
$2.6Bn; n/a; n/a

CBJ Cambior: 8.0M ou Gold - - - -
$4.8Bn; $865M; 18.0%

GSS Golden Star: 3.78M ou Gold - - - -
$2.27Bn; $633.5M; 28%

Copper Mining Companies
EGO Eldorado: 9.7M ou Gold - - - -
$5.82Bn; $1.64Bn; 28.1%

PD Phelps Dodge: 23 M Tons Copper; 2bn lbs Molyd - - -
$158Bn; $15.9Bn; 10.00%

NXG Northgate Minerals: 1.88M Tons Copper 8.5 M ou Gold - - -
$15.9Bn; $550M; 3.5%

PCU Soutrn Peru: 33M Tons Copper - - - -
$198Bn; $12.9Bn; 6.50%

ETQ* Corriente: 4.3 M Tons Copper 4M ou Gold 30MouSilver - -
$24.2Bn; $200M; 0.8%

CUP* Peru Copper 20Bn lbs copper; 444 M ou Silver; 758Mol
$57Bn; $468M; 1%

Zinc Mining Companies
TCK Teck Cominco ~20M Ton Zinc ~4M T Copper ~10M ouGld ~7MT Pb 250K TMoly
$86Bn ($125B including Coal reserves); $15.0Bn; 17.4% (12%)

EZM EuroZinc 4.55M Ton Zinc 2.55M T Copper - - -
$13.5Bn; $1.49Bn; 11%

SIL* Apex Silver 467 M Ou Sil 3.7M tons Zinc 1.3MT lead - -
$15.8Bn; $1.6Bn; 10.10%

HL Hecla Mines 49.4M ou Silver 618K ou Gold 185mP 265Z -
$1.86Bn; $584M; 31.4%

CDE Coer’s D’Alene: 230.7M Ou Sil; 1.5M ou Gold - - -
$3.1Bn; $1.12Bn; 36.1%

SLW Silver Wheaton Corp: 144.0M ou Sil - - - -
$1.58Bn; $2.26Bn; 143%

SSRI* Silver Standard Res: 1100M Ou Sil - - - -
$12.1Bn; $1.05Bn; 8.7%

PAAS Pan American Silver: 647 M Ou Sil - - - -
$6.2Bn; $1.5Bn; 24.20%

Nickel Mining Companies
NILSY Norilsk Nickel:8.13Bl ton Nickel;140m ou Pd;40.2M ou Pt;16.M TCu;8.8mou Au $280.4Bn; $19Bn; 6.70%

N Inco (from 2005) 4.5 Bl ton Nickel 2.8M Tons Cu ? Pd Pt - -
$66.3Bn; $11.2Bn; 16.90%

Platinum Mining Companies
AGGPY Anglo Platinum 103M ou Pt 85M ou Pd - - -
$132Bn; $24Bn; 18.20%

IMPUY Impala Platinum 41.8M ou Pt 33.2M ou Pd - - -
$49Bn; $15Bn; 30.00%

Potash Mining Companies
POT Potash Corp Sask 15.1 bn Tons K 122.7M Ton Phos - - - $6 T $10.9Bn 0.20%

Uranium Mining Companies
CCJ Camaco Corp 160M lbs U3O8 - - - - $8Bn $13.3Bn 166%

Reserves include proven, measured and inferred, except if marked with **, no distiction is made for value of proven verses measured and inferred.

Prices Metals (assumed in the calculation of gross ore reserves above):
Nickel: $6.00/lb; Copper: $2.50 lb; Platinum: $1100 ou; Potash: $0.22 lb; Zinc: $1.30 lb; Molybdenum: $10/lb
Gold: $600ou; Silver: $9.50 ounce; Pallidum: $350 ou Uranium: $50 lb Lead: $1,400 ton