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.


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