Introduction
In this article I'll have a closer look at Lundin Mining (OTC:LUNMF) which is a Canadian mining company with assets all around the world. I will start with a brief overview of the company's projects, after which I'll discuss the strength of the company's balance sheet and operating results. As Lundin has operations in several countries, I will explain the political risks and also the more general risks of an investment in Lundin Mining. Finally, I will provide my opinion about the outlook for 2014, which will lead to my investment thesis at the end of this article.
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As trading on the US exchange is quite limited, I'd highly recommend trading Lundin Mining through the Toronto Stock Exchange, where the company is listed on the main board with ticker symbol LUN.
Executive Summary
Lundin Mining is a diversified mining company focused on base metals as it generates most of its revenue from copper, zinc and nickel. I will explain why I think Lundin is a good investment for the 'believers' in base metals with a strong heart. At this moment, in excess of half of the company's operating cash flow comes from a very impressive project in the Democratic Republic of the Congo (DRC).
However, Lundin made two interesting investments this year which will be accretive from 2015 on, and will diversify the company away from the DRC. It bought a stake in a cobalt refinery and acquired the Eagle project from Rio Tinto (RIO) for a combined total of $435M. This sounds expensive, but the Eagle project alone will generate in excess of $200M per year in operating cash flow from 2015 on, which will predominantly be used to pay down the credit facility the company just announced. By the end of 2015, I expect the share of the DRC project to have dropped from 53% to 'just' 30% of the consolidated operating cash flow.
As Lundin is currently trading at less than 7 times 2015 operating cash flow, the company is priced quite attractively, and this could be a very good entry point for investors in base metals who believe a sustainable partnership in the Democratic Republic of Congo is possible.
A short summary of the company's operating assets
1. Tenke Fungurume, DRC
The company's main project is its 24% stake in the Tenke Fungurume copper-cobalt project in the Democratic Republic of Congo (DRC) which is one of the world's largest Cu-Co projects. The mine produced 350 million pounds of copper in the first nine months of the year at an average cash cost of $1.23/lbs, and is on track to produce at least 425 million pounds this year. As Lundin has a 24% interest in the project (with Freeport McMoRan (FCX) and state-owned Gécamines holding the balance), this project is of utmost important to the company, as it generated cash flow of almost $120M in the first 9 months of this year.
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And it doesn't end here. The Phase II expansion has just been completed, and the joint venture partners expect to add a second sulphuric acid plant which should increase the production rate even further. As the Tenke life of mine is at least another 60 years (based on all resource categories, including the inferred category), the project could be considered to be a strategic asset for Lundin Mining as the ultimate plan is to produce 1.1 billion pounds of copper per year (265M lbs attributable to Lundin Mining).
2. Neves Corvo, Portugal
The company's second important asset is the underground Neves Corvo copper-zinc mine which is located on the western end of the Iberian pyrite belt and is easily accessible through existing road infrastructure. In the first three quarters of this year, the Never Corvo mine produced 90 million pounds of copper and 85 million pounds of zinc at a (high) cash cost of $1.96 per pound of copper. That cash cost increased 10% over FY 2012 as Lundin Mining recorded a very bad Q3 at Neves Corvo in terms of production costs. This was caused by lower copper production, due to lower than expected grades and a lower recovery rate. However, zinc production will be much higher this year as Lundin accessed a higher-grade portion of the resource.
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The company is also investigating the possibility of expanding the existing shaft capacity which would obviously be beneficial for the total output and production costs. But I'd like to see some studies first about the tradeoff. If the Internal Rate of Return of a shaft widening would be below 10-15%, I think Lundin shouldn't bother doing it but keep producing at the current rate.
3. Zinkgruvan, Sweden
The third project I'd like to highlight is Lundin's Zinkgruvan project in Sweden, an underground operation which is producing zinc at a very low cash cost of just $0.30/lb (the cash cost was in fact just $0.06/lbs in Q3 of this year). This is quite remarkable, given that the Zinkgruvan mine is currently mining ore from a depth of 3700 feet. The operation is obviously helped by the high average grade of the ore body which consists of a ZnPb grade of in excess of 12% and also contains almost 2% of copper as a by-product.
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As the mine has an output of just 1 million tonnes per year, the remaining life of mine is approximately 12 years based on the current reserve estimate. The mine life increases to 20 years if one takes all the resources into account as well.
As most of my readers know by now, I'm quite bullish on zinc, and it's good to see that Lundin Mining has a low cash cost zinc mine in a safe region with a relatively long life of mine.
How does Lundin's balance sheet look like and is the company profitable?
Let's now have a look at some numbers to determine the strength of the company's balance sheet. In this environment of low zinc and nickel prices, it'll be extremely important to have a very robust balance sheet so sudden production or cost shocks can be absorbed by the balance sheet.
As of at the end of September, Lundin had a working capital position of $140.3M of which $137M was held in cash. The company's current ratio is a healthy 1.85 (keep in mind a current ratio higher than 1 means the company has sufficient current assets to cover its current liabilities). So everything is looking good for the short term. I'm also particularly pleased with the company's low longer term debt and liabilities position. At the end of Q3, in excess of 83% of the balance sheet total consisted of equity, and the total amount of debt and liabilities was just $725.6M. This healthy balance sheet position allowed Lundin Mining to close a $600M debt facility which will be tapped to fund the construction work at the company's high grade Eagle mine in the USA (see a later paragraph for more details about the Eagle project). As the Eagle project only required an additional $400M, the company is now fully funded to bring the Eagle project in production.
One thing that concerns me about Lundin's balance sheet is the fact it has almost $170M in goodwill on its books, and I think a mining company should gradually write any value attributed to 'goodwill' down to zero. However, this also has a positive side, as by writing down the $170M will allow Lundin to pay less taxes as well.
There's also something else which bothers me. According to the balance sheet, the company has recorded the value of its 24% stake in Tenke Furuntume at almost $1.93B, which is in fact more than half of the company's book value. So should something happen in the DRC and Lundin loses its asset, it will have to take a huge impairment of almost $2B, destroying its book value, which would drop from $6.16 per share to just $2.79/share. So investors who are relying on the book value of mining companies should definitely be aware of the impact of geopolitical problems at the Tenke Fungurume.
Moving over to the financial results, Lundin was able to show a net profit in Q3 of this year, as the company recorded a profit of $27.9M, or $0.05 per share. But as I said in several previous articles, in the mining sector it's more important to look at the cash flow statements instead of the bottom line. In the first 9 months of this year, Lundin had a net operating cash inflow of $215M (this includes its own operations and a $116M distribution from the Tenke-partnership). This is very good, but the company was free cash flow negative because it invested $561M in new projects ( the majority went towards the acquisition of the Eagle project ($318M) and $116M to the acquisition of the Kokkola Cobalt refinery).
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If the company wouldn't have acquired these assets, it would have recorded a positive free cash flow for FY 2013 of almost $80M after spending its planned $210M in capital expenditures.
The risks
The first risk is obviously the commodity price risk. As Lundin is focused on base metals, any (further) decline in the base metals price will have an immediate and huge impact on Lundin's cash flow. It will be extremely important for the company to keep its cash costs at Neves Corvo under control, as every 5% increase in production cost reduces operating cash flow by at least $15M per year. I hope the production problems in Q3 will be non-recurring.
A second risk is the geopolitical risk. Over 54% of the operating cash flow came from the Tenke Fungurume project in the DRC. Should the Congolese government decide it's time (again) to nationalize large commodity assets, Lundin will definitely feel an impact as it would lose half of its cash flow and it would have to record an impairment of almost $2B. And as you can see on the next image, the DRC isn't exactly the perfect example of an excellent country to work in, as it ended up on the 160th spot of the world corruption perception index. It shares its position with Libya and is ranked just ahead of Zimbabwe.
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My outlook for 2014 and beyond
I don't expect any significant production changes for 2014, but I do hope the company can get its Portuguese cash costs, copper head grade and recovery rates back under control. Investors should be focusing on the company's expanded production profile from 2015 on, as Lundin's Eagle mine in the USA should be up and running by the end of Q4 2014.
The Eagle project is a high-grade nickel-copper project with an estimated production of 51M pounds of nickel at a C1 cash cost of $2/lb. As the current nickel price is approximately $6/lb, the Eagle mine will add $200M in operating cash flow in the first three years of operations (please note, this operating cash flow does not include sustaining capex, exploration expenses and G&A expenses). An additional $200M in cash flow results in additional cash flow per share of $0.34, which is obviously a big deal for a company trading at $4.12 per share.
This also means that based on the expected cash flows in years 1-3, Lundin Mining will be able to fully repay its $600M debt facility with the cash flow coming from Eagle, resulting in a relatively high rate of return.
If we look further ahead from 2015 on, Lundin Mining will generate approximately $350M per year in operating cash flow (at the current commodity prices). This will allow the company to pay back its credit facility in just two years as Lundin's operating cash flow per share will end up close to $0.60. If the Tenke-partners are indeed able to expand the production again by 2016, Lundin could be very well on track to generate in excess of $400M in operating cash flow from 2016 on.
Investment thesis
If you're a believer in the price of copper, zinc and nickel and in the stability of the Democratic Republic of Conge, Lundin Mining is an excellent investment opportunity. I'm glad the company was able to secure a debt facility of $600M which will allow Lundin to get the Eagle project up and running. As the Eagle project is a critical asset for Lundin (it will increase its annual cash flow by more than 50% in the first 3 years of operation), I'm very happy with this debt facility.
However, investing in Lundin Mining isn't for faint-hearted people, as the company's cash flow and book value relies on the massive high-grade copper-cobalt project in the DRC. This geopolitical risk is also the main risk for Lundin Mining's future, and investors should hope for a continuing good relationship between Gécamines, Freeport and Lundin Mining.
Should everything continue to go smoothly and should Lundin be able to bring its Eagle mine in production by the end of next year, we're looking at a company which is currently trading at less than 7 times its operating cash flow. And it's not very likely Lundin will receive a cash call for the further expansion plans at Tenke, as the Tenke joint venture currently has a working capital position of in excess of $500M, and this could grow if the joint venture partners decide to keep more cash in the partnership instead of distributing it to its stakeholders.
Because of the geopolitical risk associated with investing in the DRC, Lundin is a bit too expensive for me right now, but it might be a good idea to write some put options (on the Canadian exchange). I'm particularly looking at the P4 January 2014 for C$0.13, the P4 April 2014 for an option premium of C$0.25 and a P3 July 2014 at C$0.15. So while I wait for a lower share price, I collect the option premiums.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
Additional disclosure: I currently have no position in LUNMF but might write out of the money put options depending on the option premiums.
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