No Magic At OZ

This story features SANDFIRE RESOURCES LIMITED, and other companies. For more info SHARE ANALYSIS: SFR

– OZ production disappoints
– Guidance down, cost guidance up
– Costs to reduce quickly
– Is OZL cheap?
 

By Greg Peel

OZ Minerals ((OZL)) is effectively a pure-play copper producer, albeit gold by-product is sold to ensure lower net costs. As a copper pure-play, OZ is Australia’s largest. In November last year the OZL share price was $8.50. It was at this point, roughly, that the Australian stock market began its strong rally into 2013.

But not OZ. On Friday afternoon OZ was trading at $4.80. Following yesterday’s release of the company’s March quarter production report, the shares closed at $4.30. You don’t have to be a wizard to appreciate OZ has been hit by the recent sharp fall in the copper price. But price is one thing and production is another.

During the quarter, the south wall of the Malu pit at Prominent Hill suffered a slip. To reopen access to the high grade ore beneath, OZ must now remove the fallen waste rock which will cost time and money, perhaps up to four months and $20m. Such are the risks associated with mining. As a result, management has been forced to lower FY13 copper production guidance.

Yet even taking the slip into account, some analysts were caught out by the weakness in the quarter’s production despite having already offered up pessimistic forecasts ahead of the report. Others claimed 20.5kt of copper with 31.8koz of gold by-product to be in line with expectations, but Goldman Sachs, Deutsche Bank, BA-Merrill Lynch and Citi were all expecting more.

On the other side of the ledger, OZ’s net costs were higher than analyst expectations. Lower copper output and an adverse currency influence led to a cash cost for the quarter, net of gold sales, of $1.85/lb. OZ had previously guided to an average FY13 cost of $1.50 to $1.65 but this has now been raised to $1.65 to $1.80. Production guidance had been set at 90-95kt but with no thanks to the wall slip, this has been downgraded to 82-88kt.

The published cost of $1.85 is also actually misleading, due to the imposition of a new mining accounting standard. Previously, OZ would count its “stripping cost”, that is the removal of waste rock, as an expense within cost of goods sold (COGS) but now it will capitalise the waste (which miners often stockpile for later extraction of low grade metal) and depreciate its value over time. The new standard provided OZ with a cost advantage this quarter, such that the apples to apples cost of production was actually $1.97/lb.

That’s the production story. Then there’s the small matter of the copper price.

It has been a disappointing few months for investors in copper producers. Of all the metals and minerals, copper was previously considered a standout given a lack of global supply development, unlike other products, meeting ongoing demand from China in particular. It was previously assumed copper would be in global deficit this year. But in the ensuing period, commodity analysts have changed their minds. Copper supply will not be as constrained as was previously assumed. Demand from China is weaker than previously assumed, as echoed in the recent, weak GDP result. Copper is now expected to be in surplus.

Falling commodity prices are never good for any producer, but for OZ Minerals such falls deliver an even greater impact. Not only is OZ a pure-play, but the company’s famous Hill is not just Prominent but also lonely. There’s potential for more localised exploration success, and there’s also the Carrapateena asset which OZ is yet to quite decide what to do with, but ever since Oxiana and Zinifex got together in OZ and stripped the company down to one producing asset and a vault full of cash, OZ Minerals has been looking for an acquisition or another promising exploration site to develop. And looking. And looking. While cash is nice, it doesn’t offer a great return by gathering dust.

OZ is therefore, currently, pretty much a one trick pony with no real growth projects to speak of. At least other commodity producers which have been similarly beaten down, such as Newcrest, can offer longer term growth options. The company’s cash balance makes valuation a simpler task, but it also means value is very much beholden to the prevailing price of copper. As to whether OZ Minerals is now cheap, following a significant price fall, depends on one’s copper price forecasts.

JP Morgan’s OZL analysts are, by their own admission, battered and bruised. They have maintained an Overweight rating even as the share price has fallen, and fallen. Yet they remain steadfast in believing the second half of 2013 will see a rise in the copper price. They also believe OZ Minerals’ recently poor operational track record can be turned around in 2014. JPM thus retains Overweight, albeit the analysts have applied a 15% discount to their valuation to account for market sentiment, which by now is very negative. This means a drop in JP Morgan’s 12-month target price to $6.30 from $7.80.

CIMB is in the same camp. The analysts point to recent disruptions in global copper supply in suggesting copper may yet hit a global deficit in 2013. The copper price has fallen 12% this year while the OZL share price has fallen 35%, CIMB notes. Even taking into account money to be spent from 2014 on Carrapateena, OZ is undervalued on simple cash flow, say the analysts, in retaining an Outperform rating. CIMB’s target has only fallen to $7.70 from $8.00.

If there is to be a rebound in the copper price, the good news is it will meet a simultaneous reversal in the company’s net costs. The “strip ratio” is a major cost determinant of an open cut mine. The higher the ratio, the more waste has to be stripped away before the good stuff can be extracted. Notwithstanding the unfortunate slip at Malu last quarter, Malu’s strip ratio will halve by 2014 and, overall, OZ’s cash costs should peak this year and fall each year thereafter. It is on that basis the likes of CIMB sees OZ as “cheap” at this point.

For the market, it’s a tough call to make. After reducing production guidance, increasing cost guidance and paying for the slip damage, OZ will now make a loss in FY13. Citi believes OZ is trading at a level which implies “attractive value for patient investors who back management’s ability to deliver strategic targets in a value accretive way”. While dropping its target price to $5.25 from $5.70, Citi has upgraded to Buy from Neutral.

Merrills concurs with the valuation argument, but believes there remains a risk June quarter production and costs could further disappoint. The analysts have lowered their target to $5.70 from $7.00 and suggest waiting until operational performance is seen to be improving. Merrills retains Neutral.

UBS believes that after the sharp share price fall, OZ Mineral’s valuation looks “interesting”. Interesting enough, at least, to upgrade the previous Sell rating (well done team) to Neutral. Not enough to go to Buy, nevertheless, given UBS remains concerned over the absence of a significant discovery or acquisition or a decision to mine Carrapeteena. Outside a rise in the copper price, OZL could be a “value trap”, the analysts warn, despite dropping their target price to $5.00 from $6.90. UBS prefers PanAust ((PNA)), Sandfire Resources ((SFR)) and Blackthorne Resources ((BTR)) in the copper space.

Deutsche Bank also prefers PanAust and Sandfire, despite retaining a Buy rating on OZ. Deutsche has dropped its target to $5.80 from $6.20. Credit Suisse’s target falls to $8.40 from $9.00, and the analysts suggest “investment in OZL cannot be justified on near term earnings” given forecast losses. Rather, the analysts’ Outperform rating is based on the aforementioned reduction over time in stripping ratio and subsequent halving, each year, in stripping cost.

Outside of the FNArena database, Morgan Stanley has retained an Overweight rating and Goldman Sachs has stuck with Sell.

Which doesn’t help to paint a clear picture. Nor does it help that broker target prices, as the reader by now has no doubt noted, sit in a very wide range. After two upgrades, the ratings score now sits at five Buys and three Holds (or equivalent) in the database, with targets ranging from $5.00 (UBS) to $8.40 (Credit Suisse). The consensus target is $6.52, suggesting 50% upside from the last traded price. The target range suggests an upside range of 15% to 94%.

Dust Bowl or Emerald City?
 

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