Once in while a non-dividend paying stock crosses my radar and I just can’t ignore it. Such is the case with this week’s analysis of Capstone Mining (CS.TO).
Capstone Mining is a well run company that reopened and operates a single copper (with zinc, lead and silver) mine in Mexico which has recently more than doubled its production. The results of this production increase were starting to be evidenced in the financial statements last fall, but this spring and summer should produce even higher numbers because of the increased price of copper.
The Major Highlights of Capstone Mining
- Capstone continued its share buyback plan and purchased an additional 219,900 common shares on the open market at an average price of CDN$2.78.
The shares have been returned to treasury and canceled under its normal course issuer bid.
- At March 31, 2008, Capstone had working capital of $56 million and no bank debt. In addition, the fair market value of Capstone’s share ownership of Silverstone Resources Corp. is approximately $65 million, which is not included in working capital.
- Copper production during the quarter was 6.0 million lbs compared with 2.8 million lbs for the three months ended February 28, 2007.
- Record operating profit of $15.9 million or $0.20 per share.
As you will see further on in this analysis, Capstone’s management have pulled out all of the stops in making this a very profitable long-term investment for shareholders. Certainly, nobody knows what the future holds for copper prices and while the immediate future looks bright, Capstone’s management is focused on keeping the mine profitable for many years to come. So, how do they make sure that their shareholders are rewarded…they tackle the future right now!
Capstone Has Hedged Their Bets
CS hedges 20% of their copper production with forward contracts … in simple language, for each year until 2011, they have already sold 20% of their copper at an average price of $3.18. They do this to cover the majority of their production costs.
This is critical to mines because it means that if copper prices dive, they will be guaranteed to generate enough cash flow to stay open. It is really just an insurance policy for shareholders.
Capstone is obligated to report the difference in value of these future contracts to the current market price (called a mark to market calculation) in their income statement as a non-cash item. So here’s how that works.
For 2008, they have forward contracts to sell 7 million pounds of copper at an average price of $3.38/lb. The math for the contract reads … 7,000,000 lbs x $3.38/lb = $23.7 mil. Now, at the end of the last quarter, on March 31/08 the price for copper that day was $3.84/lb. The value of that 7 mil pounds of copper at that price would be 7,000,000 lbs. x $3.84/lb = $26.9 mil.
Soooooo…for this year’s forward contracts alone the loss on paper is $26.9 mil – $23.7 mil = $3.2 mil. Add to that by the other 3 years that they have forward contracts for and you end up with about $12 million in recorded NON-CASH losses that they have to record in this quarter.
What We Must Understand
Capstone did not actually “lose” any of that money. They simply lost the $12 million worth of additional profit that they could have made over the next 4 years if they had not pre-sold 7 million pounds for each of the next 4 years. What the report tells us is that for those future sales, they could have made an extra $12 million over the next 4 years If, and this is big “if” Copper prices remain at or above $3.84/lb.
We must also remember that those forward contracts only represent 20% of their production … so the other 80% will be sold at market price.
You Still With me?
OK, so for those of you who are real keeners here’s how the future is calculated.
Contracts have already been brought into the income report at a value of $3.84/lb. Therefore, any future variation in price will work off of that price. So, even though the real price of the contracts average $3.18/lb, the next report will calculate a gain/loss based on the already calculated price of $3.84/lb.
Therefore, if Capstone just keeps the contracts that they already have, which on paper now reads as a value of 28 mil lbs (4 yrs x 7 mil lbs/yr) valued at $3.84/lb, and copper goes down $.10/lb by the end of next quarter on June 30. In this case, their income report would show a profit of 28,000,000 x $.10/lb = $2.8 mil. Basically, they will have gained back some of their “non-cash” loss from this quarter. If copper continues to rise, they will report another loss of potential.
So you see, the loss they have to report this quarter is not a real loss. It’s a loss of potential assuming that the price of copper is $3.84 when they actually sell those 7 million pounds each year to fulfill those contracts.
Bottom line … the real Operating Profit (which does not account for the forward contracts or future possible income tax) … is $15.9 mil … or $.20/share for the first quarter of this year.
Now for the real keener keeners…
Let’s assume for a bit, that copper prices drop in the next 3 quarters. CS sells 80% of their copper at market price so they will be generating less revenue. However, as we’ve seen from the calculations above, when the price of copper drops, those forward contracts report an increase in value from one quarter to the next. So these gains will help offset the drop in production copper sales. This is how hedging smooths the fluctuation in commodity prices for the producer.
At a quarterly profit of $.20/share, the annual earnings could easily be $.60-.80/share. That’s an EPS of 4x-6x.
Generating Their Own Cash Flow
Capstone has also made certain that they are getting the most bang for their buck with regard to their silver production. This may be the smartest move that a mining company has ever pulled off in terms of generating cash flow. You see they spun off a silver producing company, of which they still own 20% of and are selling their silver production to them. Here is an excerpt from another article that explains the situation rather well.
Silver mining companies receive much higher multiples (e.g. P/E ratios) than base metal mining companies (e.g. 20 to 1 vs 5 to 1). Capstone has leveraged this by selling its silver production to Silverstone Resources (SST.V). SST.V is a company which Capstone spun-off and IPOed and which should ultimately receive the ratios of a silver producer. Capstone has 23 million shares of SST.V. SST.V is reputed to be undervalued relative to comparable companies and to have a considerable growth coming.
A huge consideration is that cold hard cash and shares in Silverstone (SST), another undervalued company, make up 45% of their market share price!
Besides their solid production, cash, profitability, and their ownership of 20% of SST, CS will benefit from higher copper prices which showed a surge testing the $4.00 level. Remember, CS has already presold 20-25% off their next four years’ production at $3.18, but the other 75-80% is going to benefit from market surges. Plus, from the volume action of late, it looks like CS is still utilizing that massive mound of cash by buying their own stocks back to further strengthen their share value.
You know you are on to something when management says this during their conference call:
[With regard to cash on hand]…”We would love to purchase another mine if we could find one as profitable as our own”.
I would venture to guess that this means they will continue to buy back their own shares until they find a profitable investment elsewhere. This is certainly not a bad decision for a mining company.
Honestly, I have not seen a company managed so intently with shareholders in mind for a long time. Capstone could have easily gone out and bought another mine that was not as lucrative because they have too much cash, but they didn’t. This is prudent management and it is refreshing to see.
Full Disclosure: The author does have a position in Capstone Mining (CS.TO).