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Jubak's Journal
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• 2 more companies pass 'clean stocks' test, 9/19/2003
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| | Jubak's Journal
Bull market in metals is just beginning
Mining companies are in the early stages of a growth cycle as demand for nickel, copper and gold increases. Here are 3 stocks best poised to take advantage.
By Jim Jubak
Which is the better buy now, technology or mining stocks?
Surprise, the winner is mining stocks.
Mining stocks have more momentum: Dull ol mining stocks such as Inco (N, news, msgs) are up 44% in the last six months vs. 36% for the technology-laden Nasdaq Composite Index ($COMPX).
Mining stocks have more upside potential: Cyclical metals stocks are just about six months into a two- to three-year bull market cycle based on accelerating economic growth, while the technology sector has largely discounted its recovery until well into 2005.
And mining stocks are less risky: Even a mining stock like Freeport-McMoRan Copper and Gold (FCX, news, msgs), which is up 98% in the last six months, still trades at just 19 times projected 2004 earnings, well below the 23 to 24 times earnings the stock sees at cyclical peaks. It's also certainly not nearly as risky as PMC-Sierra's (PMCS, news, msgs) price-to-earnings ratio of 174 based on 2004 projections after its 111% run-up in the last six months.
Yet Ill bet that the average investor's portfolio is heavy on technology stocks, especially after the Nasdaq's rally this year, and light on mining stocks. Jubaks Picks, for example, holds one energy stock, Exxon Mobil (XOM, news, msgs), but not a single mining stock.
Time for a change
Well, lets fix that. Here are three mining stocks, Inco, Freeport-McMoRan Copper and Gold and Southern Peru Copper (PCU, news, msgs), for you to research for your own portfolios. Im adding Inco and Freeport-McMoRan Copper and Gold to Jubaks Picks with this column.
Im starting with Inco because the story for mining stocks is especially easy to understand at this huge nickel producer. According to Merrill Lynch, all major excess nickel stockpiles had disappeared around the globe by mid-September. Norilsk of Russia, the worlds largest nickel producer, had sold its 60,000 metric tons of uncommitted inventory. The last big inventory without a buyer is the 36,000 metric tons available for sale on the London Metal Exchange. At the current rate of global drawdown, thats about an 11-day supply. The nickel market is suddenly tight.
Thats led to a roughly 40% increase in nickel prices this year to a recent high of $4.50 a pound. In the last bull market for nickel from 1988 to 1991, the price averaged almost $5 a pound and went above $6 a pound in the peak years of the cycle, Merrill says.
Merrill estimates that the current bull cycle could be even more favorable. Over the next two years, inventories are projected to fall to the levels they hit during the 1988 to 1991 bull run, but global demand is much higher than it was then.
Demand is rising, thanks to a strengthening economic recovery in the United States and continued rapid growth in China. In turn, a lot of that demand is coming from production of stainless steel, which uses about 60% of worldwide nickel supply. Stainless production in the Western economies climbed 7% in the year's first half. Stainless production in China has been growing at 11% annually, which is still well below the massive 29% average annual growth rate for stainless consumption in China since the top of the last bull market for the metal in 1991. The gap between Chinese stainless production and consumption has fueled solid production growth in South Korea and Japan.
Limited supply
Meanwhile, there arent any huge new nickel mines set to come into production before Incos Voiseys Bay and Goro projects in 2006. The first is in Labrador in eastern Canada; the latter is in New Caledonia in the South Pacific.
Using a price of $5 a pound for nickel at the peak of this cycle, which could well be conservative, I get a 12-month target price of $37 a share for Toronto-based Inco.
Inco is a relatively easy mining stock to analyze because the bulk of the companys revenue comes from a single metal and because historical bull and bear prices for nickel are clearly defined.
Freeport-McMoRan is a tougher case because the companys production is concentrated in two metals and its difficult to attach gold prices to booms and busts in the supply/demand cycle.
But Freeport-McMoRan is worth the trouble, because copper shows an even more attractive cyclical picture than nickel, and investor psychology seems to be running in a long-term trend in favor of gold.
Headquartered in New Orleans, Freeport-McMoRan is the worlds low-cost copper producer, largely thanks to the extraordinary Grasberg mine in West Papua, the Indonesian side of the island of New Guinea, and its mind-boggling mix of copper and gold deposits. The mine is simultaneously the worlds second-largest copper mine and the worlds largest gold mine: The combination means that Freeport-McMoRan can produce copper for a cash cost of about 7 cents a pound, compared with the industry average of about 45 cents a pound. Operating margins at Freeport-McMoRan are 30% to 35%.
Low costs, higher prices
Freeports low costs mean that every penny increase in the price of copper adds about five cents a share to the companys earnings, according to Merrill, which forecasts copper prices of 77 cents a pound in 2003. Citigroups Smith Barney recently raised its forecast for the price of copper to 85 cents a pound in 2004 and 90 cents a pound in 2005.
But its the companys gold exposure that gives Freeport-McMoRan its extra juice. The shares now trade at about 19 times projected 2004 earnings per share of $1.77. Thats near the midpoint of the trough-to-peak multiple range for copper mining companies, Smith Barney calculates. North American gold mining companies, on the other hand, now sell for 30 to 35 times earnings. That valuation gap implies that investors can look forward to an improving multiple for the stock as a whole from Freeport-McMoRans gold operations. The company has 44 million ounces of proven gold reserves on its books.
I calculate a very conservative 12-month target price of $40 a share for Freeport-McMoRan. Conservative, because investors are getting a low-cost producer of gold and copper at the early stages of the bull cycle in both metals. Freeport-McMoRan also has one of the best balance sheets among mining companies. (And because it never hurts to be conservative when youre putting money into a company that operates in the very volatile Indonesian political situation.) In 2003, the company has reduced debt, redeemed high-yielding preferred shares and added a dividend on its common shares for the first time since 1998. The company is on track to finish 2003 with cash balances of better than $400 million. Thats quite an improvement from the less-than-$10 million in cash at the end of 2002. Free cash flow is likely to exceed $200 million next year.
Some analysts on Wall Street say the hottest metal now is copper, and investors looking for a pure play in it with a lot of momentum should do their homework on the American Depositary Receipts (ADRs) of Southern Peru Copper.
Down south
Southern Peru Copper is positioned to take full advantage of the turn in the copper cycle. Production is climbing -- up about 17% in the second quarter over the same period in 2002. Costs are falling on higher volumes and on the companys investment in improved smelting equipment. Theres been good news on that front lately with projected capital costs for the next round of smelter upgrades falling well below earlier estimates. Southern Peru Copper recently projected that income will rise to $100 million in 2003 from just $61 million in 2002.
The stock trades at a 10% to 15% discount to the rest of the copper mining group. The big question on the stock is whether thats enough to make up for the extra risk. Peru, the companys sole base of mining operations, isn't the most stable country in the world, and while the company does file regular financial statements with the Securities and Exchange Commission, it can be hard for U.S. shareholders to assess the management of a foreign company. In addition, investors in the companys ADRs are becoming the junior partners of controlling shareholder Grupo Mexico (GMBXF, news, msgs).
Investors who want to concentrate on copper but want to stay closer to home can take a look at Phoenix-based Phelps Dodge (PD, news, msgs) instead. But be aware that shares of the larger company, with its $4.5 billion market cap, are likely to be far less volatile than those of smaller Southern Peru Copper, with its $1.6 billion market capitalization.
And less volatility, while generally a good thing, may not be what you want now in the early stages of a bull market cycle in mining stocks.
Buy Inco
The nickel market is suddenly very tight. Thats led to a steady, 40% increase in the price of nickel year to date to a recent high of $4.50 a pound. But I think were only about six months into a two-to-three year bull market for the metal that could be much stronger than the last, 1988 to 1991, up-leg in the cycle. Thats because demand for the major consumer of nickel, stainless-steel, is soaring thanks to a strengthening economic recovery in the United States and to continued rapid growth in China. And there arent any huge new nickel mines set to come into production before 2006 when Incos Voiseys Bay project in Canada and Goro project in New Caledonia should go into operation. As of Sept. 23, Im setting a $37 a share target price by September 2004 for Inco .
Buy Freeport-McMoRan Copper and Gold
Freeport-McMoRan is the worlds low-cost copper producer, largely thanks to the extraordinary Grasberg mine in Indonesia and its mind-boggling mix of copper and gold deposits. The mine is simultaneously the worlds second-largest copper mine and the worlds largest gold mine: The combination means that Freeport-McMoRan can produce copper for a cash cost of about 7 cents a pound, compared with the industry average of about 45 cents a pound. Freeports low costs mean that every penny increase in the price of copper adds about 5 cents a share to the companys earnings. At current prices, investors are getting Freeport-McMorans gold operations for close to nothing. Pretty sweet, considering that the company has 44 million ounces of proven gold reserves on its books. As of Sept. 23, Im setting a 12-month price target of $40 a share for Freeport-McMoRan.
New developments on past columns
2 more companies pass clean stocks test
No sooner did Expeditors International (EXPD, news, msgs) join the clean stocks list than the company issued an earnings warning for the third quarter of 2003. Earnings for the period would be 28 cents to 30 cents instead of the 33 cents forecast by the Wall Street consensus. The company blamed a fall-off in business in August after solid numbers in July seemed to indicate a pickup in air freight volume. But Id mark the warning down to overly optimistic guidance from management. With the company already facing tough comparisons with second quarter of 2002, when the prospects for a West Coast dock strike led to a surge in business as customers shipped early to avoid the tie up, management seems to have made the problem worse by endorsing Wall Streets very sunny projections after the July data. I continue to like the companys long-term growth potential, although I think the stock was expensive before it tumbled on this announcement. Ill be watching to see if it falls to what I think would be a very attractive entry point in the low $30s.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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