Copper, zinc, silver and gold miner Kazakhmys has low market rating
When you look around investor-oriented online discussion forums, Kazakhmys Plc (KAZ) gets a lot of attention from individual investors. The London-listed company is fairly well covered by analysts’ research, partly due to its size (capitalised at £3.3bln). However, Kazakhmys has other attractive attributes. The company operates a commodity business which ensures a well understood business model. It also operates in an emerging market, which allows for diversification as well as potentially higher absolute returns. Finally, it is strategically located to supply two large markets for its wares - China and Europe, this gives perception of strategically competitive edge.Kazakhmys is a copper producer located in Kazakhstan, a former Soviet Republic bordering China (company is one of ten largest producers in the world). Although copper is its main product (80% of revenue in 2008), the company generates some 20% of revenue from the sale of by-products: zinc, silver and gold. The business is drummed up by the company’s marketing office in London selling about 80% of production through annual supply contracts with the rest going through the spot-market. The sales are fairly evenly split between buyers in China and EuropeOver the last several years the management has taken steps to attempt some diversification of core business. Currently, adding to existing copper assets (consisting of 20 mines, 10 concentrators, 2 smelting facilities and a zinc plant) Kazakhmys also owns five gold and silver mines in Kazakhstan and several neighbouring countries, as well as a 602km2 block with petroleum exploration rights (seismic testing complete, currently interpreting data). In May ’08 the largest power plant in Kazakhstan, Ekibastuz, was acquired for just over $1bln. Also during ’08, additional 11% of ENRC Plc (ENRC) (London-listed, Kazakhstan based natural resources company) has been acquired for just under $1bln (Kazakhmys currently owns 26% of ENRC).All in all operating assets clocked up revenues worth $5.2bln in ’08, fairly flat on ’07 and ’06. Gross profit margin has slipped from 46% in ’07 to 34% in ’08 due to increase in the prices of raw materials, mainly fuel and steel, employee expanses, production overheads and higher depreciation. Additionally to this, higher operating expenses and a whopping $400m impairment charge have resulted in diluted EPS of $1.85 a share ($3.04 in previous reporting period), a reduction of 39%. Needless to say, the management is ridding the shareholders of the year-end dividend. The profitability takes a decisive nose-dive with Return on Capital going from 22% in ’07 to 9.4% in ’08. One of the stated long term goals of the management is "to earn above our cost of capital". With cost of capital being around 18% the company has got an uphill journey ahead.Over on the balance sheet the total assets have gone up to $10.7bln ($7.4bln in ’07) mainly through increases in plant and equipment and investment in associate (ENRC). The cash is up by 23% on previous reporting period to $540m. Equity ended up $1bln higher in ’08 (increase in share premium account to $2.6bln, retained earnings up to $4.2bln, but disappointing $2.6bln impairment charge in associate, ENRC). Current liabilities almost trebled to $977m, mainly due to $500m of current borrowings. Long term liabilities are up by $1.6bln all due to long term debt. The company is not however overly leveraged; Debt to Capital ratio equals a comfortable 23%. Liquidity is also acceptable, Current Ratio equals almost 2 and available cash covers short term borrowings.Cash Flow from operating activities is flat on last reporting period at $1.1bln due to improved working capital management (despite greatly reduced net profit). Because of almost $2bln of expenditure on acquisitions, equity holders ended up with negative cash flow to equity at end of ’08. Since acquisitions were financed with debt, cash flows from financing activities were augmented by just over $2bln worth of new debt.Considering that Kazakhmys listed in London in Oct ’05 at £5.40 a share and that the price today is £5.91 a share we have got an almost 4 year absolute return that does not even beat inflation. This coupled with the fact that we are looking at a business with volatility being more than double the market average, points to the fact that investors seem to pay for a lot of risk with nothing to show for it. The stock, however, goes for half its book value these days and many investors consider it too cheap to pass up. This may be true, and Kazakhmys’ intrinsic value may be around double the current price, but only if the net income margin is maintained at 17-18% (industry average), ROC does not decline drastically from the current 18% and re-investment does not spiral out of control (assuming gradual decline from current 100% of income to some 40% of income in 10 or so years time when company reaches its maturity). Kazakhmys is undoubtedly capable of doing it; its margins and ROC exceed those of larger and more diversified Xstrata and Rio Tinto.Points of consideration to throw into the mix would be as follows. Kazakhmys’ share price seems to be fairly well attached to the price of copper, we are therefore looking at a fairly volatile business (copper prices declined in ’08 by some 56%). The company wants to diversify and having acquired the Ekibastuz power plant it declared that "the power division has excellent potential with clear need for capacity and prices to rise in Kazakhstan". However, electricity consumption in Kazakhstan is heavily dependent on large industrial customers, who reduced their consumption in ’08 due to lower metal prices. If and when it does come to increasing capacity at Ekibastuz an additional $1bln of capital will be required. Moreover, electricity prices in Kazakhstan are controlled by the Government, increasing these, therefore, may not be without much effort. The company also has a pretty dire health and safety record with 32 fatalities in ’08. The management promises improvements in this department. There is also a new tax regime being implemented in Kazakhstan beginning from 2010 (details as yet unknown), under the new rules the Government will tax revenues and not profits, this may impact the value of the company negatively.Kazakhmys’ stake in ENRC is today worth some $2.2bln. Kazakhmys’ own capitalisation is $3.3bln making its assets excluding ENRC worth just over a billion; this appears comparatively cheap. With management reducing costs this year by some $200m, as well as un-essential CapEx by $250m, with reserves lasting at least another 20 years and the company chairman owning around 40% of equity, Kazakhmys may just prove right those investors who are now ramping up the company all over the web.