Southern Copper: Possible Opportunity for Risk Tolerant Investors

By Tsee Lee & Bob Finkelstein

Copper is golden right now, despite having surged from a low of $1.25 per pound in 2008 to around $4.30 now. But a look at Southern Copper Corporation Company (SCCO) shows an investment in SCCO may bring higher risk than in certain other producers.

SCCO mines and refines copper and its byproduct, molybdenum, as well as much smaller amounts of zinc and silver. SCCO is almost as pure a play on copper as it gets. It is based in the United States, but 80 percent of its common stock is held by Americas Mining Corporation (AMC), a private, Vancouver, Canada-based company that is in turn a wholly-owned subsidiary of Grupo Mexico (hereafter referred to as “GMex”), traded on the Mexican stock exchange. To make things more complicated, AMC is seeking to go public.

Did I mention the still private AMC also made a non-binding all-stock offer for the rest of SCCO last July (see the fresh-off-the-press prospectus)?

The SCCO board has been evaluating the offer for the better part of a year. Until AMC becomes a publicly traded company, shareholders may not know whether the offer is just and proper. Unlike most merger proposals, this one has kept a lid on the stock price.

The complicated corporate structure affects returns in other ways. GMex’s shareholding gives it the power to dictate major decisions at SCCO, and its interests may differ from those of other SCCO shareholders.

Furthermore, AMC is the parent company of Asarco, for which GMex has secured $1.5 billion in financing; and as it stands, Asarco is lagging far behind other parts of GMex. (Does the merger make sense now?) Approximately $837 million of the financing remains outstanding, and SCCO noted that GMex can extract dividends or other funding from the company to help pay off the loan.

In fact, that may be happening right now, with SCCO sporting a dividend of around 6.3%, and a generous payout ratio of 115% (most sites have not updated the trailing EPS to $1.94). That means for every dollar of profit it makes, the company is paying out $1.15 in dividend. To be fair, SCCO is still cash flow positive on an annual basis. (Remember, corporate accounting uses the accrual method, booking sales and expenses when they are made, instead of when cash is received or paid out.)

Then there are the macro risks, such as politics. SCCO operates in two countries: Mexico and Peru. The former is fighting a vicious war with narcotic gangs. The latter is undergoing a presidential election. One leading candidate, Humala, is causing some concerns because of his formerly close ties to Venezuela, although he is running as a responsible, mature candidate. Industry watchers also worry that a new administration may impose or increase royalties and taxes on resource companies, thus discouraging investments. The fact that two populists survived the first round has not soothed investors: Humala had attempted a coup before against the Fujimori regime, while Keiko Fujimori is widely expected to pardon her convicted father should she win the election.

Conventional wisdom had expected Humala to lose the run-off, but CW is fallible. Indeed, recent polls show Humala slightly ahead.

In addition to the election risk, SCCO has been forced to suspend the stalled Tia Maria project, after a UN report found serious concerns about its impact on the environment and water supplies. Violent clashes that followed led to the death of a protestor at the hands of police protecting the installations. The Peruvian government was forced to cool the tensions by suspending the project. Expected production was around 120,000 lbs of copper, which is the same as Southern Copper's total production in 1Q 2011.

Industry-wide, high copper prices have led to concerns users will substitute the metal with aluminum, a practice that becomes profitable when copper is above roughly $3.50 per pound. Global or regional economic growth may stall, reducing demand. As well, stockpiles have been quite high at the major exchanges, although some say that is a result of users cutting back on inventory.

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Historically, SCCO has outperformed its much larger rival Freeport-McMoRan Copper & Gold (FCX). But the trend reversed recently. Will the relative underperformance continue?

With a billion dollars at stake with Tia Maria, one would expect some deal to be struck. How much that would benefit SCCO, if at all, remains to be seen. Risk-tolerant investors should watch this stock for entry opportunities should Tia Maria be revived. Although the stock has retreated around a quarter from recent highs, and seems to have found a footing following weeks of sell-off, political and organizational risks are still too high for the typical investor.

Disclosure: I am long SCCO.