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Oct 2006 - Chicken Littles

Chicken Littles heading for a headache

Don’t you tire of the Chicken Littles predicting doom and gloom that the commodity cycle has to have ended and hence the “sky has to fall” or in this case, commodity prices have to collapse back to historically low levels ?

Well it appears that the Chicken Littles are heading for a headache from lost opportunities. Take nickel, I recently read yet another prediction of nickel having to fall US$5.50/lb (US$12,120/t) within about 3 years. Well, in August/September 2006, Xstrata did not pay US$17bn to acquire the remainder of Falconbridge (thus valuing Falconbridge at US$21bn) or CVRD pay US$14bn for INCO - two of the last major world producers of nickel because they expect the nickel price to fall - they expect to make serious mega profits.

We (ERA) have recently completed a report on Sally Malay (SMY, released on 5 October 2006), which showed that the nickel price can be calculated as having averaged ~US$28,374/t in SQ06 or A$37,400/t which is about 40% higher than it was for JQ06. Which means that in SQ06, SMY may have already exceeded its after-tax profit that it reported for the year ended June 2006 of A$15.9m. Even if the nickel price falls from its current level of about US$31,000/t (US$14/lb) and averages US$25,000/t in DQ06 and US$22,000/t in JH07, SMY could realise an after-tax profit greater than A$60m just for the current financial year ending June 2007.

Minara (MRE) released their September 2006 Quarterly on 6 October, stating that they had received an average Ni price of US$29,178/t (US$13.45/lb) or A$38,533/t for SQ06 being 44% higher than their JQ06 average, with Co averaging US$15.21/lb. MRE also stated that their cash at the end of September was A$177m after paying a $58m dividend, implying that their free cashflow may have increased by A$123m just for SQ06 on the 60% attributable of the 9,200t Ni that they produced and sold in the quarter.

MRE also stated that at 30 September, the nickel price was US$31,500/t (US$14.29/lb) or A$42,220/t and Co was US$16.75/lb. At this potential earnings rate, MRE could start taking over some of the small nickel sulphide producers, if no one else does it before them.

Minara’s profits and cashflows are higher than SMY because it is unhedged. Our (ERA) estimated NPAT for SMY provides for a $66m losses due to hedging this year to June 2007 (with fortunately only $8m in FY08 if nickel averages US$15,500/t from July 2007 to June 2008). Most of the hedging that is burning the small producers came with the original financing package that resulted in the development of their mines.

The sky is literally going to fall on the small nickel producers in the form of hedging in 2006/07 and give them a headache, but fortunately after June 2007, most of their historic hedge positions will have been significantly reduced, if not almost gone.

The situation at the end of June 2006, for SMY was ~6470tNi at US$11,780/t in forwards and calls deliverable by May 2008, of which possibly 4,200t at US$11,500/t (A$16,200/t at US$0.71 currency forwards) are to be delivered in the current FY to June 2007. Mincor has forwards of 4,810t Ni at US$14,180/t deliverable by June 2008, of which ~2,920t at US$13,890/t (A$18,860/t at US$0.737) are expected to be delivered in its FY to June 2007. Lastly, Independence has forwards of 6,600tNi at US$12,850/t to June 2009 of which 1,800t at US$11,800/t (A$17,335 at US$0.684) are deliverable to June 2007.

Consolidated Minerals also has some minor nickel hedging that finishes in the current year to June 2007 and in our (ERA) June 2006 report was ~1400tNi at US$17,400/t (A$24,000/t at US$0.725). Jubilee and Minara are unhedged.

Even allowing for the reduced hedging in FY2008 the potential profits for SMY (and the other producers) really are spectacular. SMY should then be mining its >4%Ni Winner orebody at Lanfranchi, and if the nickel price averages US$20,700/t, then SMY could have an after tax profit of A$110m. If the nickel price is still US$31,000/t then SMY could generate an after-tax profit of A$190m just for the year to June 2008, which was only $50m short of SMY's market cap when we released the report.

Why use US$20,700/t in 2008, because that was what you could sell nickel for at the end of September 2006, being US$20,700/t in 27-months’ time (so it is actually higher through the year to June 2008, only reaching US$20,700/t in December 2008).

The impact on the NPV’s (net present values) is just as dramatic. We use 7.5% constant money cashflow NPVs (since they have been found to have the closest correlation with the share prices of base metal resource stocks listed on ASX).

Our (ERA) current NPV based on nickel retreating to US$15,500/t or US$7/lb from SQ07 (we don’t expect it to fall anything like that fast, but applied that for valuation purposes) is A$1.53/share based just on its current existing assets - not including any depth extension to the Sally Malay orebody (it has a clump of drillholes in it but no JORC resource, yet alone reserve), and/or the extensions being delineated on strike through development and likely exploration (following up as yet undrilled anomalies).

SMY's 7.5%NPV at US$25,000/t is A$3.71 (or about triple the A$1.25 share price when the report was released), or it is A$4.57 at US$30,000/t - not that much different from IGO's ~A$4.50 at US$30,000/t applying our 2005 IGO model (with MCR at US$30,000/t and using our 2005 MCR model having an implied value of ~A$3.20). Compared to the closing prices on 4 October of A$4.18 for IGO, A$1.40 for MCR and A$1.25 for SMY, its not too hard to see why Xstrata and CVRD have snapped up Falconbridge and INCO.

Incidentally, although Consolidated Minerals’ (CSM’s) NPV does also depend on what assumptions are made for the manganese price, its nickel division should be generating significant profits at these Ni prices. For nickel at US$30,000/t, CSM’s 7.5%NPV is almost A$5.70, and if the average spot price of nickel in 2007 and 2008 is US$30,000/t, it could result in CSM realizing after tax profits of ~A$110m in 2007 and ~A$140m in 2008. The closing price for CSM on 4 October 2006 was A$1.72, or about 30% of its potential NPV.

If the market continues to ignore what's going on, then it seems inevitable that the small nickel sulphide producers are going to be snapped up in M & A (mergers and acquisitions).

As a major producer, why would you build a nickel laterite operation for US$2.5bn at cash costs of possibly >US$4/lb with all the risk and delays and full production in 8 to 10 years' time, when you can achieve the same through taking over a clump of Australian nickel sulphide producers with potentially the same life, likely maintained high nickel prices, less risk - they are already operating, less cost and make your money now while nickel prices are physically trading at high levels.

However, for as long as the commodity forecasters predict doom and gloom or like Chicken Little (and his followers) that “the sky is about to fall”, share prices could lag their underlying values, presenting opportunities to corporate predators, who could potentially reap the mega profits for their shareholders.

Disclosure and Disclaimer : This article has been written by Keith Goode, the Managing Director of Eagle Research Advisory Pty Ltd, (ERA, an independent research company) who is an Authorised Representative with Taylor Collison Ltd, and with his associates, may hold interests in some of the stocks mentioned in this article. The opinions expressed in this article should not be taken as investment advice, but are based on observations by the author. The author does not warrant the accuracy or completeness of any information and is not liable for any loss or damage suffered through any reliance on its contents.

Figure 1. Daily Nickel Price (October 2005 to September 2006) . Source : Minara Sept Quarterly 2006GDNoct06

  • Written by: Keith Goode
  • Sunday, 01 October 2006

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