Kerry Smith Stockhouse interview Apr 28, 2000
Mining Analyst Bullish On Zinc, Diamonds - April 28, 2000
By Craig Stanley (cstanley@stockhouse.com)
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Commodity fundamentals appear set to boost earnings for natural resource companies. In a StockHouse interview,
Kerry Smith, small cap mining analyst at National Bank Financial, explains both his bullish outlook for zinc, nickel,
and diamonds, and his targets for Breakwater Resources and Dia Met Minerals that are 90% and 40% respectively
above their current stock price.
National Bank Financial's Kerry Smith says the supply-demand fundamentals for zinc and nickel point towards higher prices.
Among small cap mining companies, the analyst targets zinc-producer Breakwater Resources [T.BWR] as his number one
pick. In the diamond sector, he forecasts long-term growth for both Dia Met Minerals [T.DMM.B] and Aber Resources
[T.ABZ]. And although he feels gold may have some upside potential, he recommends Eldorado Gold [T.ELD], Meridian
Gold [T.MNG], and Miramar Mining [T.MAE] as companies operating profitably in the current price environment.
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StockHouse: What stock is your favorite pick over the next 12 months?
Smith: Of the stocks I cover, Breakwater Resources is my number one pick. I look for companies that are growing, are
profitable, and have big, low-cost ore bodies with long mine lives. Since commodity prices are volatile, these attributes allow
such companies to become very profitable when commodity prices are higher and stay in business when prices are low.
Breakwater has these attributes. It generated $0.29 earnings per share and $0.51 cash flow per share last year. The company
produced 383 million pounds of zinc last year from four mines located in Canada, Honduras, Chile and Tunisia, each averaging
around 100 million pounds. Costs were cut from US$0.47 per pound in 1997 to US$0.40 last year.
In addition, it is growing. In 1995 Breakwater had one mine producing around 60 million pounds of zinc per year. Last year it
had four mines producing 383 million pounds. This year's acquisitions give it six producing 550 million pounds next year, plus it
has just signed onto an advanced stage project in Algeria.
This growth has been achieved prudently. The company acquired one mine in 1996 and two in 1997. The total cost (net of
working capital) was $47 million, with each mine having around a five-year mine life. In 1999 those three mines generated cash
flow of $44.9 million in cash at an average zinc price of US$0.49 per pound. In addition, continued drilling has essentially
replaced the reserves mined.
We recommend the stock a 'focus buy' with a 12-month target of $6.00. This is based on an assumed zinc price of US$0.55
per pound.
StockHouse: Can you briefly discuss the acquisitions?
Smith: In March the company purchased two zinc mines located in Quebec from Cambior [T.CBJ]. These will increase the
production profile up to about 550 million pounds on an annualized basis and will lower its cash cost marginally to around
US$0.40-41 per pound, which places the company in the middle of the world's zinc producers cost curve (i.e., it is neither a
very low nor high cost producer). Pending some final resolutions, the deal is to close at the end of the month. However,
Breakwater has already put in place the debt financing with four banks to cover the US$48 million cost. These two mines
produced about $25 million in cash flow in 1999, giving an acquisition cost of about three times cash flow.
The second acquisition was just announced last week so it's still somewhat preliminary. It is the Oued Amizour project in
northern Algeria, about 10 km from the Mediterranean Sea. The deposit was discovered in 1989 by a government agency.
Breakwater can acquire a 90% interest from this government agency by completing a feasibility study (at an estimated cost of
US$5-7 million), arrange financing (estimated at US$100 million), bring the mine into production, and operating it. The
government requires no up-front cash. The current high-grade resource (which needs to be verified by Breakwater) is
approximately three times that of their Tunisian project and could be mined at a similar cash cost of US$0.36 per pound. The
deal is good both for increasing reserves and increasing profitability
Before this, Breakwater did not have what I consider a long life asset (currently 5-7 year mine life). In addition to cutting costs
and growing, they have now found the one piece of the puzzle they needed.
StockHouse: Does Breakwater foresee any problems with operating in Algeria in light of the political environment over the past
five years?
Smith: The chief operating officer has been there three times and told me it is a place where the company could work;
management does not see it as a difficulty. A number of oil companies are active there, including Petro-Canada [T.PCA].
Breakwater spent time talking with these companies while evaluating the project. Although an issue, I get the feeling from
Breakwater it is not much different from working in Tunisia and the company has been operating there just fine.
StockHouse: Are the commodity fundamentals positive?
Smith: Absolutely. We look at 'visible' inventories held by the London Metal Exchange (LME). Non-visible inventories are held
by merchants, consumers, producers, etc. but cannot be tracked as accurately. Therefore, LME inventories are used as a
proxy. Visible inventories for zinc and nickel have been declining for the past couple of years and are at a level that historically
would lead to higher prices.
For example, nickel is down to around 25,000 tonnes compared to 40,000 at the end of 1999. In a normal price environment,
commodities trade in a contango with the spot price lower than the future price. However, nickel moved into a backwardation
about 6-8 weeks ago, meaning the spot price is actually higher than the 3-month future price. This implies a tightness in
inventories, as there is not enough near market metal to satisfy demand. So these producers have to pay a higher price to
obtain the metal. Since nickel has been trading in a backwardation for a while, one would expect LME inventories to rise;
producers with a metal inventory would sell now instead of waiting for the lower future prices and replace it with another futures
contract. However this is not happening since they are concerned that if they deliver their metal, they will not be able to replace
it. This type of situation cannot last so prices will have to rise.
StockHouse: Can zinc be expected to start trading in a backwardation?
Smith: It is not right now but LME inventories continue to decline. They presently stand at
254,000 tonnes or around six weeks of consumption, down from 282,000 tonnes on January 10
and a peak of 1.2 million tonnes in early 1995. It does take a while for these inventories to be
worked down. But historically, such a situation would lead to higher prices.
All it will take is one supply disruption to put zinc into a backwardation. We saw this with nickel
when there was a strike at Inco's [T.N] Thompson, Manitoba facility. With zinc, this quickly
happened three weeks ago at a smelter in Antwerp. At that time, zinc was trading with a contago of around US$20 a tonne or
US$0.01 a pound. The strike occurred on a Thursday and zinc went into a backwardation on the Friday. The strike ended the
following Monday and the zinc contango is presently at about US$8 per tonne. So even if there is no supply disruption,
dwindling inventories should lead to higher prices. |
