Monday, November 26, 2007

Boliden AB: Significant Upside if Copper and Zinc Prices Stabilize

Within the industrial metal mining (zinc, copper, nickel and lead) universe, the Swedish Boliden AB (Swedish OMX ticker: BOL) share price is down over 50% from its highs this year during the latest credit crunch, from a peak of SEK178 to a current SEK80-odd per share. This unusually rapid decline in the share price compares to relatively flat share price movement during the latest credit crunch for Xstrata, BHP and Rio Tinto, which are all not down more than -10% from their highs. Note however other copper miners such as Teck Cominco and Lundin Mining are down between 20-30% during the last month, but not nearly as severely as Boliden. As long as there is not a firm specific reason for this decline -- and there likely is not, as will be analyzed in this article -- then if there is a sector recovery in industrial metals mining, Boliden, from a value standpoint, has the farthest of the major industrial metal miners to appreciate.

Boliden Introduction:

is one of Europe's largest mining and smelting companies of copper and zinc, with operations in Sweden, Ireland and Finland. Boliden is currently the cheapest of the major zinc and copper producers, which are selling currently (at 11.07) at single digit p/e's, as shown in the chart below.

* Note that KGHM's proven reserves in the table above are total mineral resources and not proven reserves, as KGHM only publishes mineral resources and does not separate out proven and probable reserves.

Boliden has several strengths that make it an appealing long term buy, as long as copper and zinc prices remain at moderate levels (which in turn is mainly driven by new supply from Chile and the economic growth of Asia, which will be discussed below)(however note that of course if copper and zinc prices return to 2001 levels Boliden will be negatively affected).

probable and proven reserves of copper and zinc tripled during the first quarter of 2007, due to capital expenditures to expand proven reserves, ensuring long lasting mine lives for existing mines. Further, Boliden plans to double its volume of recycled electronic waste processed by 2010. Boliden owns and operates Europe's largest mine by volume of material mined -- Attik, which produces low grade copper -- and is the world's largest recycler of electronic waste (mobile phones and computers). By volume, Boliden is also the world's 4th largest producer of zinc metal.

Boliden Recent (3Q 07) Financial Results:

Boliden reported 3Q 07 results, with revenues down 12% to SEK8.2Bn from SEK9.3Bn for 3Q 06, and operating profit down 36% to SEK1.3Bn from SEK2.1Bn in 3Q 06. The largest contributor to lower operating earnings was lower prices for metals (zinc and copper) and temporary lower y/y output from their mines and smelters due to capacity upgrades, which combined to knock off an estimated SEK385M from EBIT, from the 3Q 06. Boliden plans to double the output of its largest mine, Attik, by 2010 and completed most of the expansion in the 3Q 07, so lower output should not (as long as Boliden executes in a timely fashion) be an issue going forward. Lower copper and zinc prices will, of course, be a risk to operating results in future time periods.

The second largest negative contributor to operating earnings was adverse currency movements -- the Swedish Kroner strengthened while the dollar (metals are priced in dollars) declined in the 3Q 07. Currency decreased EBIT by approximately SEK316M. Note that in the future, if the dollar continues to depreciate without a corresponding rise in the price of zinc and copper, Boliden's results will continue to be negatively affected.

The third contributor to lower earnings for the 3Q 07 was cost increases, mainly energy and labor, which increased costs by SEK147M. Energy cost increases, without a corresponding increase in the price of copper and zinc, will negative impact earnings going forward.

Overall, the recent financial results shows that Boliden should be able to post stronger financial results in 2008, as expansionary projects come online, as long as there is not a collapse in metal prices and/or a collapse in the dollar.

Question: Why Haven't BHP and Rio declined with the rest of the industrial metals industry?

As shown in the chart above, BHP and Rio sell at a significant premium in terms of price to earnings and price to revenue than the rest of the industrial metals industry -- note however, that larger mining firms should sell at a premium to smaller firms, but the premium that BHP and Rio command is thought (by the author) to be excessive. The premium that these two massive mining co's have is due to a combination of 1) Very large diversified operations across commodity groups -- note that larger mining firms should command a premium due to more predictable operating performance -- although there does appear to be a lack of awareness by the investing public that both BHP and Rio Tinto obtain a large percentage of their total revenues and profits from copper mining (BHP derives approximately 37% of its operating profit from copper , and Rio Tinto derived 45% of its EBIT for copper for the first 9 months of 2007). 2) a positive sentiment towards mining in Australia, due to an opinion that Asian growth (particularly Chinese growth) will continue. Note, that Zinifex -- the world's largest zinc producer, based in Australia, is also not down significantly from its highs over the last month.

The fact that BHP and Rio Tinto haven't declined significantly, while the North American and European (note, the author has not looked at Asian industrial metal miners) have declined is a legitimate contradiction, because miners receive a world price for metal -- namely, the price listed on the London Metals Exchange (which has declined over the last month, but has always been volitile so could recover quickly). The fact that the Australian group is steady while the rest of the mining universe has declined means that one of two possibilities exists: either 1) the valuations on BHP and Rio are correct, in that Asian growth will continue and metal prices will stay high or 2) the valuations on American and European miners is correct, and metal prices will decline. The author is more likely to agree with 1) -- that BHP and Rinto Tinto are valued appropriately and the rest of the large and mid-tier industrial metal mining group is undervalued.

Some Thoughts on Zinc and Copper Prices:

Zinc and Copper have been quite volatile over the last month -- although perhaps not as volatile as, for example, Palladium, which has gone (historically) from a peak of slightly over $1,000 per ounce in 2002 to a low of $80 per ounce in 2004 (currently at approximately $350). Copper has moved from approximately $7,500 to $6,500 per tonne currently (11.27.07), while Zinc has moved from over $3,000 to $2,400 per tonne. BHP and Rio Tinto both have very interesting commentary on zinc and copper prices -- it serves them well to keep a close eye on metal prices as much of their business is dependent on them. Both firms believe (see commentary here (large PDF warning) for BHP and here for Rio Tinto) that, due to exceptionally low inventories of metals and expected future growth in Asian demand, that prices will be volatile but at relatively high historical levels. The market appears to be assuming currently (at late 07) that industrial metal demand will fall off a cliff due to credit concerns in the US -- and also that there will be vast surpluses of copper and zinc next year (08) as new projects come on line -- and therefore zinc and copper prices are currently moving lower. In addition, Zinifex had very interesting commentary in its last quarter financial results, that the inventories of zinc in particular, is so low that some expected surplus is needed to keep the market functioning -- as continued shortages could cause extreme (even higher than current) volatility and therefore demand destruction. Note that inventory of zinc and copper divided by daily usages is less than 4 days, from historical days to use of over 30 days. The charts of inventories of zinc and copper prices are shown below: (note that each year, world copper consumption has increased by between 3-5%, meaning that inventories should increase as well by 3-5% in order to keep the days inventory constant, but clearly this has not been the case):

Zinc Prices and Inventory:

Copper Prices and Inventory:

Source of above charts: Boliden AB presentations

Proponents of the "Super Cycle" of industrial metals -- such as Goldman Sachs -- argue that a small expected surplus on top of unprecedented low levels of metals will not result in prices returning to pre-2005 levels. As Zinifex would argue, the small surplus would be necessary to keep the metal markets functioning normal and would not therefore represent a "glut" of metal -- supply vastly out striping demand and therefore causing the price to crash. This argument appears reasonable to the author, as long as China and India continue to grow, which is most likely (in the author's opinion) but not 100% certain.

Notes on Chilean Production of Copper:

The future copper price on the supply side is highly dependent on Chilean production, due to the fact that Chile accounts for approximately 35% of world copper production in 2006, according to the US Geological Survey -- the second largest copper producer was the US, at 8% of total world production. Chile is therefore the world's dominant producer of copper. Chile also has by far the largest reserves of copper of any country -- accounting for 38% of world total resources of copper, also according to the USGS.

The largest copper mine within Chile -- and the largest copper mine in the world, majority owner BHP's and minority owner Rio Tinto's Escondida Mine, is set to start declining in 2011, due to exhaustion of recoverable ore (pdf warning). Escondida produced 30% of Chilean copper in 2006. Escibdida originally opened in 1990 with an expected mine life of 37 years, and therefore is becoming more mature with 18 years and counting of cumulative production. Codelco -- Chile's state-owned copper mining firm, which controls 20% of the world's resources of copper -- plans to increase production from its own mines in order to offset the flatlining production from Escondida, but significant uncertainties exist as to whether this goal will be achieved due to the large size of Escondida, and/or the motivation of Codelco, as Codelco benefits from a higher copper price which could be driven by lower supply. (further, it is noted that BHP and Rio Tinto have appeared much more eager to acquire other mining firms in recent years, possibly due to concerns over lower copper production from their Escondida mine). Additionally, the exhaustion of Escondida gives Codelco a significantly larger share of overall Chilean copper production forecast for 2011-2012 -- from a share of 24% of total Chilean Copper production in 2004 to an estimated 43% in 2012 for Codelco (see page 25 of this presentation for reference) -- which means Codelco will have more influence over the world's supply and therefore price. Note that in the past, from 2001 to 2003, Codelco has stockpiled copper in order to support copper prices.

The upshot of this discussion on, particularly, copper prices is that the market is set to become more dependent on one producer in the future -- Codelco, which has a strong self-interest in keeping copper prices high, and this fact is bullish for copper prices on the supply side.

Smelting Verses Mining:

Currently, the market prefers firms with larger mining operations verses smelting operations, due to a squeeze on smelting operating profits -- energy prices are going up (smelting is highly energy intensive) and Asia, particularly China, has invested in Smelting capacity without domestic sources of metal concentrates. Boliden has a large Smelting division -- note that most larger metal miners will have smelting divisions in addition to mining divisions -- although Boliden's smelting divisions are large enough that Boliden only supplies about 60% of the concentrate for the Smelters from its own mines. As the argument that metal mining is more attractive than smelting is reasonable, then how will Boliden's smelting operations fare going forward?

It is reasonable to project that the margin on mining operations will increase going forward verses Smelting for Boliden -- and most other miners for that matter -- but Boliden's smelters have advantages in three respects over typcial smelters: 1) Energy costs: one of Boliden's smelters (of a total of 5) uses hydroelectric power, and two are in Sweden and 2 in Finland which have lower electricity costs that most of Europe, due to investments in the past in nuclear power. 2) Recycling capacity: as mentioned above, Boliden is the world's largest recycler of electric waste and is also one of the largest recyclers of lead batteries, which promises tremendous growth potential by volume -- so revenue growth can be reasonably predicted, if not margin growth (due to mainly to metal price volatility). 3) Boliden's smelters are world class in terms of efficiency and utilization of material -- Boliden is one of the few firms with the expertise to profitably recycle certain electronic wastes, which should help Boliden effectively compete against new smelting capacity from Asia.


Overall, the copper and zinc mining universe has taken a significant hit during this current credit crisis -- with the exception of BHP and Rio Tinto -- and is well positioned with single digit p/e's to rebound if economic growth, particularly in Asia, continues. It is assessed in this article that Boliden has fallen the farthest of the miners/smelters, and has not suffered significant, long term operating deterioration, and therefore could show the strongest upside if there is a recovery in the industrial mining universe.

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