Surviving Inflation with a copper stock with a P/E of 0.3!

Silver Stock Report

by Jason Hommel, May 3, 2007

It's easy to recognize that in an era of inflation, you want to get rid of paper dollars as fast as possible.  However, holding dollars is not the only thing to avoid.

Personally, I avoid futures contracts.  The reason why is because I recognize the risks of counter-party default.  In other words, others may fail to pay me "silver in the future" that may not exist.  In fact, I recently ordered silver from a local dealer who ordered silver from Gold Dust Coins, in Chicago, IL, who came highly recommended.  They promised that they had 150 Englehard 100 oz. bars in possession and ready to ship, and they did not.  They shipped 100 bars in the first two days, then shipped 7, then another 26, then another 7, and then the final 10 bars over a week later, and 35 of the bars were not even Englehards, but were Johnson Matthey bars.   I'm still waiting on the final 17 bars of silver.  This dealer got lucky this time, because the price of silver dropped a bit as they had to search for a week for bars from other dealers.  But what if the silver price started rising by a dollar per day or more during this time?  We will never order silver again from Gold Dust Coins, in Chicago.  Thus, the dangers of pre-selling things you don't have, when prices can rise, is self evident.

Furthermore, trade consists of win/win transactions, which is unlike futures contracts, where there is a winner for every loser.

Many mining companies still fail to recognize the benefits of free trade and the free market, which stands in stark contrast to hedging with futures contracts.

In a free market, nobody has an advantage.  Nobody "locks in" prices in long term contracts.  Bidding is available to all, and product is available to all.  They call that, the "spot" market, as opposed to the "futures" market.

About a year and a half ago, Apex Silver pre-sold zinc for 7 years at less than $.50/lb..  Now that zinc has risen to a high of $2.10/lb., and stands at $1.75/lb., that was clearly a very stupid, and costly, decision.  I estimated their hedging losses to be as high as $1.3 billion with zinc at $2/lb.

It is often claimed that "the miners are required to hedge" by the banks to get the necessary funding.  

But this is a lie.  

Apex had already raised $600 million through issuing stock by the time they borrowed the "final" $200 million.  And up to half of Apex's hedges were voluntary, and were not required by the terms of their $200 million debt financing.  Instead of borrowing and pre-selling zinc, silver and lead, Apex could have bought silver at $6 per ounce while they were waiting for higher silver prices, and they would have made far more than the extra $200 million that they borrowed from the banks!

At the time, pre-selling zinc at $.48/lb. may have seem smart, as zinc was up 37% from $.35/lb. from less than 2 years before.  But in a world of inflation, prices can continue to rise relentlessly, because it is the dollar that is going down. 

Miners today are in a highly advantageous position, but many do not realize it.  The world is awash in dollars that need viable investments for protection from the ravages of inflation.

Many miners with depressed stock prices understandably want to avoid share dilution and are thus tempted to try to "beat the system" and borrow money and accept the terms of a hedging agreement.  But hedging can be folly, not only for them, but the entire mining industry.
Most resource investors are perplexed as to why the share price of Barrick mining has not outperformed gold, but underperformed.  But it should be no surprise to those who know that Barrick still has about 9.5 million ounces of gold hedged (even after their "dehedging" announcement this week), and thus have an ever-growing hedging loss of about $3 billion as gold continues to rise.  Lackluster share prices of the hedged majors such as Apex, Barrick, and others continue to cause a lack of investor excitement, and downright bewilderment. 

It may seem tempting to miners to want to lock in copper prices of $3.75/lb., given that copper prices hit a low of $.75/lb. just a few years ago.  

But what if copper hit $16 or $20 per pound in a few more short years, and all other associated mining costs, energy, labor, etc. rise similarly, or even faster, due to inflation?  Then any copper miner who hedges today will look like a fool, and will certainly destroy shareholder value, and perhaps even risk bankruptcy.

Investment professionals in the mining industry know there are very few quality projects available.  We know this because when we talk to each other, we are already quite familiar with many or most of the companies on each other's lists!  We are fortunate that some of today's investment opportunities even exist, as some are projects that have been drilled up and proven up years ago, but have only recently become economic (and highly profitable) due to higher metals prices.  But old projects are not nearly enough to meet the commodity needs of today's world, and certainly not tomorrow's.

One such old project that should now be highly profitable, is Baja Mining.  (BAJ.TO, BAJFF.PK)

It's a copper/cobalt/zinc project in Baja, Mexico.  They should be completing a bankable feasibility study in about 2 weeks, by mid May, I hear.

Pre-feasibility showed that they can produce over 132 million pounds of copper per year, at negative cash costs, and I'm sure that was by using very low and conservative prices for copper, cobalt, and zinc.  Since then, cobalt has risen from about $10 to $30/lb, and is one of the "hot" commodities in dangerously short supply.

The mine life is probably in excess of 100 years.  The metallurgy of this particular project has apparently now been solved as evidenced by successful test mining, and metallurgy reports.

With a market cap of $255 million fully diluted, a depressed (but rising) stock price, and needing to raise about $500 million, the question of the day for Baja Mining is, "What is the best way to raise capital?  Debt and hedging, or share dilution?"

I asked my paying subscribers, in our forum, "How would you rather your company raise money to build a mine?".  The results were clear.  Twenty voted for issuing stock, nobody voted for debt and hedging.

The danger for Baja is that Baja has already lined up about 19 investment banks who may soon be bidding against each other for the right to loan them money. 

Fortunately, Baja has recently acknowledged that if their share price rises above $2.55/share, they would rather issue stock, than borrow money and hedge copper.  This should give the market (and even investment banks) a good incentive to bid the stock up to $2.55!  IE, why loan money at 10% if you can earn up to 41% in a few weeks by buying the stock at $1.80 today?

Baja's share price will rise, because money will continue to pour into the entire mining sector.  And copper is especially hot right now, as I explained on May 1:

Look at the copper chart of the past 5 years.  You see copper took off from $.75 to $4.00/lb.  Then, it dropped back to $2 something.  That happened when China stopped buying for about 8 months.  Then, about 3 months ago, China started buying again, and inventories started dropping, and for the past 3 months, copper prices have been moving back up again, and stand at $3.76/lb!  Seems to me that copper could rise to $6/lb or higher, very quickly, within months perhaps.

Baja's project economics will continue to look better and better in our world of inflation.

Baja Mining's annual production may be at about the following:

132 million pounds copper/year @ $3.75/lb. = $495,000,000/year
6.8 million pounds cobalt/year @ $30/lb. = $204,000,000/year
79 million pounds ZnSO4 slat (a zinc byproduct) /year @ $1.20 (about 75% percent of the zinc price of $1.60) = $95,000,000/year
Total operation costs are approximately $65,000,000/year

EBITA would be about $729,000,000/year (at today's prices)

Cash flow would be about $800 million / year.

With potential profits in excess of $729 million per year or more with higher metals prices, the forward P/E of Baja Mining right now is about (255/729) 0.3, or way less than 1. 

I recently caught up with a multi millionaire friend of mine from college, who taught me a lot about investing 9 years ago.   We hadn't spoken in over a year.  I told him about Baja's forward P/E, and he was shocked!  He asked, "How do you find such companies?"  Well, as you know, I do this full time, and I review a lot of deals.

I calculate a forward P/E ratio is about 1.24 at $2.55/share.  Let's assume that Baja raises $540 million at $2.55.   Let's assume that the company issues 212 million shares (no warrants).  Add in existing shares and warrants of 142 million to get 354 million.  Times $2.55/share, that gives a market cap of $902 million.  Earnings could be as high as $729 million, or higher, with higher copper prices.   (902/729 = 1.24.)

(By the way, MGN, Mines Management, a company with a copper/silver project, just raised $30 million at $5.00/share while it closed yesterday at $4.50/share.  So, MGN raised money at above their current stock price!)

With Baja Mining's bankable feasibility study due in about two weeks, that could mean bankable profits for stockholders, if the study confirms the pre-feasibility studies.

As for me, if I see that Baja Mining engages in any copper hedges in the next few months, and if copper rises beyond where they hedge, I can merely sell my stock, hopefully at at least a 50% to 100% profit from today's price level.

That may seem a bit overly harsh against the company, or overly cautious, but that's what makes a market.  

And just as I can say "Sorry, I don't need you," to a company that hedges, any company should similarly be able to say, "Sorry, I don't need you," to any banks that demand hedges for loans. 

That's what being a strong investor is all about.  The mining companies ought to trust in the free market, trust in a rising stock price, and trust in their shareholders without selling them out, and in that way, any company can avoid the pitfalls of doing business in a world of inflation.

In my opinion, Baja does not need loans, they need investment; and they need their investors, and they need to invest in acquiring investors.  

Finally, the free market requires marketing.  You have to tell people about your edge over your competitors.  Mining companies ought to buy ads to promote their story on the internet at precious metals web sites, or buy email blasts from industry sources.  (My write-ups are not for sale!)

Fortunately, Baja mining did an excellent interview with BNN, on April 26th, which tells the company story very well.
Disclaimer:  I own 588,700 shares of Baja Mining that I have purchased on the open market, and Baja Mining has not paid me to write this article.  Further, I do not sell any stock for at least 1 week after writing about it (I usually wait much, much longer).  I also don't own Apex Silver or Barrick, although I used to, about 3-4 years ago, when I didn't know any better.

Thank you.

P.S. I let my paying subscribers know about Baja Mining in a special alert on April 25th, when the stock was trading at $1.70/share. If that could have been valuable to you, please consider subscribing.

Please comment on this article at my free forum.