Did OZ Minerals Issue A False Alarm?

This story features OZ MINERALS LIMITED. For more info SHARE ANALYSIS: OZL

-Digression from expectations raises alarm
-Is it a lack of understanding?
-Cash flow is under pressure
-Developing Malu adds to options
 

By Eva Brocklehurst

Copper/gold producer OZ Minerals ((OZL)) appears to be in the middle of a slippery slide. When you're on the descent you just keep going, regardless. The company has confirmed 2013 production guidance, albeit a substantial downgrade was made not that long ago, but the guidance for 2014 was a great disappointment, if the slump in the shares was anything to go by.

The 2014 production forecast, lower gold output, a decline in resources at Prominent Hill were the features that disappointed Morgan Stanley. What was positive? The company stuck with 2013 production and costs were in line. There was also further clarity on the Malu underground development. Morgan Stanley suspects the share sell off came about because implied earnings under the 2014 guidance scenario diverged greatly from base case estimates. The broker thinks more analysis is required before coming to a final judgment. At present Morgan Stanley sticks by the Overweight recommendation.

JP Morgan thought the sell-off was justified in the context of the digression from market expectations for 2014. With no significant change to medium-term copper production and waste movement, the reduction in the broker's valuation is significantly less than the 30% intra-day drop in the shares suggested. That said, with a return profile now pushed out to beyond 2015, JP Morgan does not expect the stock to outperform in the near term. Investors are expected to stay cautious because of the challenges to the cash outlook and the marginal returns on longer-term production options, such as Malu underground and Carrapateena.

Macquarie remains just plain cautious. Production difficulties at Prominent Hill resulted in the company twice reducing guidance in 2013. Despite OZ Minerals having set low expectations for the first half of 2014, guidance is weighted toward a step change in output in the second half and a material reduction in costs. The improvement in the second half requires the company to meet its target for waste movement in the first half to allow access to the core of the Malu open pit ore body. Macquarie observes this proved difficult in 2013.

Credit Suisse is "astonished". Almost all the news was better than the broker expected, or at least in line. Specifically, 2013 was unchanged and costs were a little lower, 2014 production guidance was broadly in line with models but cost forecasts a little lower. Malu's capex and scale was exactly as the broker modelled but grades were higher. Negative reconciliation issues with the mineralised waste in the September quarter do not appear to be pervasive. The market reaction was all about lacking understanding of what was disclosed in the September quarter, in the broker's opinion. As a consequence of the commitment to Malu and the higher copper and gold grades, Credit Suisse's forecasts for production actually rise in 2016 at a stage when the mine is at full production.

While acknowledging it might have been a little premature to have raised the recommendation recently to Neutral from Sell, UBS hasn't reversed. The broker now models the cash balance to fall to around zero by the end of 2014 but the company is likely to avoid the need for any debt funding by first slashing the exploration budget and corporate costs. No guidance has yet been made for exploration expenditure in 2014 and UBS expects this to happen in early 2014. There's no buying catalysts on the horizon and material cost cutting could provide one, in the broker's opinion.

A critical aspect of the market's disappointment was the resources statement. Based on the minor changes to reserves, UBS is not overly concerned as it's more a function of depletion, but the resources update signified a major downgrade in contained copper. The Malu underground resource decreased by 43%, from an increase in the resource reporting cut-off grade to reflect actual mining conditions as well change in the Malu geological interpretation.

CIMB is not worried about the resources statement and considers the initial sell off overdone. The broker had not previously attributed any value to the resource numbers and thinks the main issue is in the balance sheet, although the pressure is not terminal. Furthermore, although the 2014 guidance for 75-80,000 tonnes of copper production was lower than anticipated (92,000t), there was no prior formal guidance to mark it down against. This divergence from expectations overshadowed the fact that 2013 production is on track and costs are heading for the lower end of forecasts. CIMB expects Prominent Hill to be cash flow positive in 2014 and, while reviewing modelling, retains an Add rating.

Citi was another broker that was not unsettled by the statement. The revised mine schedule was broadly in line with prior expectations. Malu underground will go ahead, although Citi thinks the economics are marginal. The stock is now trading at attractive levels, although the broker does ask whether it might be a value trap. Citi's ratings upgrade goes the full spectrum to Buy from Sell, and the broker looks for a disciplined approach to capital allocation going forward, against an uncertain commodity outlook.

The board has effectively approved the development of the Malu underground with further spending of $71m in 2014 as part of the total construction expenditure. UBS suspects, one of the key reasons for approving the project is to build reserves and extend the limited mine life. Development of Malu extends the mine life of the wider Prominent Hill project and provides a higher grade feed to the mill. Moreover, if Malu was not developed, UBS sees market sentiment towards OZ Minerals deteriorating further as the mine life is shortened. In the current depressed market for resource stocks, equity investors are discounting assets with a mine life shorter than five years. This means developing Malu provides the company more time and options to ride out weak commodity prices and allows more time to further assess Carrapateena.

On the FNArena database there are three Buy ratings, four Hold and one Sell. The consensus price target of $4.03 suggests 35.3% upside to the last share price. This compares with $4.32 ahead of the announcement. The dividend yield on 2013 estimates is 4.4% and falls to 1.8% for 2014.

See also, OZ Minerals Worries Brokers on October 15 2013 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms