OZMLF - OZ Minerals: Beauty Is In The Eye Of The Pursuer

Summary

• OZ Minerals is overvalued based on metrics we use to assess investments for long-term holdings.
• However, we see qualities in the company that would appeal specifically to BHP.
• We view the rumoured offer price of around A$30 as broadly fair valuation.

Investment Thesis

We were not particularly interested in OZ Minerals ( OZMLF ) at first glance of its headline metrics, but were curious if we could pinpoint what appeals to BHP ( BHP ) sufficiently for them to make a bid for the company. After delving deeper into fundamentals, we reaffirmed our view that to a retail investor its earning potential doesn't justify its valuation, but perhaps it possesses intangible merits which an ideally positioned BHP can unlock.

The Company

Although OZ Minerals states that it focuses on 'modern minerals', it is first and foremost a miner and producer of copper concentrates. Its two major operating sites ( Carrapateena and Prominent Hill ) predominately produce copper, and are both based in the Australian state of South Australia. Whilst less renown than other states for its mining industry , these 2 sites sit either side of the largest mine (also copper-producing) in the region - Olympic Dam, which is run and owned by BHP. For perspective, annually the 2 mines combined have capacity of 134 kt (of OZ's total of 142kt) of copper, compared to Olympic Dam's of 215kt.

OZ Minerals has high regard for its corporate culture which it views as unique among peers. For one, through focusing the majority of its operations in Australia it touts its low jurisdiction risk. Also, it plans for much of its pipeline to be incremental improvements on existing sites, which allows it to explore capacity expansion options of relatively low costs. Lastly, OZ Minerals looks to source capex funding from operating cash flows, and to keep debt to a minimum. Indeed, it reported debt of merely A$25m on its June 2022 balance sheet.

From current production capacity of 142kt a year, the company projects this can be ramped up by an additional 60% by 2026 through organic growth at existing locations. Simultaneously, it is contemplating greenfield opportunities (namely West Musgrave and Kalkaroo), although production for these are not expected to come online until 2025 at the earliest.

Valuation

OZ Minerals reported half-yea r 2022 earnings of A$109m, which represented annualized EPS of A$0.65 and P/E of 40x. Management explained that performance for the period was weak, hindered by a temporary loss of production at Carrapateena which resulted in copper volumes of 58kt (below guidance by 4kt).

We instead looked back to 2021, when copper prices were at record highs and production was within guidance of 125kt, to establish a better sense of earnings potential. Full year earnings of A$531m represent EPS equivalent of A$1.59 and P/E of 16x (at current prices of A$26).

In our base case, assuming copper prices at 2021 levels and factoring in the scheduled pipeline projects, we calculate implied forward P/E at 10x at best. Moreover, the blip in H1 2022 performance highlights the concentration risk with having only two major operating sites. Although lower perceived regulatory risks associated with operating Australian-based mines is valid, they are still vulnerable to disruptions such as equipment failure, labour supply shortages, and inclement weather. This concentration risk is an additional negative weighing on our calculated forward earnings potential.

Briefly addressing future copper pricing, we think that long-term it can be supported by demand from the energy transition movement. However, we share the opinion that not all forward-facing commodities are equal, and therefore we would implore investors to assess the merits of copper relative to other green minerals. Prior analysis indicated to us that copper appears to be more sensitive to macroeconomic conditions.

Factoring all this in, we view OZ Minerals insufficiently attractive and out of scope for our portfolio at current levels, but perhaps feel that if recessionary concerns weigh sufficiently on copper spot prices, the stock price could follow and drop to a more enticing level. Loosely we consider A$15 as an upper bound for acceptable valuation.

However, at this moment the stock price is being supported by a rejected approach from BHP to acquire the company at A$25 a share, with rumors of an imminent improved offer of A$30.

Attractive to BHP

We think that there are circumstances specific to BHP that would justify them offering an elevated buy price.

At first glance, adding more copper would be helpful to BHP's re-position towards a greener portfolio, but already with overall production volumes of 1,574kt (2022), the addition of OZ Minerals' assets would represent a marginal increase of less than 10%.

We think it's more likely that the locations of the OZ Minerals' mining sites are particularly attractive to BHP. The relatively close proximity of Carrapateena and Prominent Hill to Olympic Dam would likely lead to operational synergies of relevance only to BHP.

Also, Olympic Dam is currently BHP's only non-South American copper mine currently operating. In the same manner that OZ Minerals has geographical concentration risk, BHP is similarly exposed through its Chilean copper operations (>80% of production), and recent news of higher Chilean mining royalties likely highlights the unease of this situation. Adding to copper production volumes in its home country would be seen as appropriate risk mitigating action.

The fact that these sites are in operation is also a clear positive. Discovery of high-grade deposits in new locations has not been particularly successful in recent times, and even then, it takes on average 17 years from discovery to production. Therefore it makes sense that OZ Minerals' assets command a valuation reflecting the opportunity cost of exploration, and subsequent development of, a new greenfield mine.

Lastly, OZ Minerals' modus operandi of minimal loan liabilities, and funding of capex through operational cash flows arguably slows its ability to make progress on its pipeline. These projects under a company with significantly stronger cash flows, a higher appetite for debt, and more resources would likely be able to accelerate the realization of future returns. BHP fits the bill.

Conclusion

In our view, from a value perspective OZ Minerals' stock price is well-ahead of its earning potential. Our calculated fair value of A$15 could perhaps be described as a fair value of tangible assets, with the additional premium reflecting intangible value to a potential suitor.

We think it is logical that BHP is interested in an acquisition, as OZ Minerals possesses qualities that BHP is well positioned to maximize. In our opinion, the rumored levels of A$30/share is ballpark an appropriate price for BHP to offer. However, we feel it is unlikely any other counterparty would be comfortable with valuations at these levels, and therefore feel there are downside risks to the stock price should a deal not eventuate.

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