The Leverage of Earnings

"Around 2000 I left my job and cashed out my pension and put it into commodities," was what a colleague was saying. "I had $14,000 and it is now a quarter of a million."

The commodities bull run created an enormous leverage of earnings. Take Northern Orion, a junior start-up company around the beginning of the bull run and now it has $230 million in the bank. The big players have reported billions of dollars of earning.

Eastern Platinum has gone from a junior start-up to a company with a $1.5 billion dollar market cap. Its earnings are a little on the low side for the market right now, but with 700% expansion of mining production over 5 year planned, high grades of platinum resources and demand for platinum as both an industrial metal and a precious metal, they will have good growth in earning..

Roca is a new start-up that if moly prices remain where they are should make in the range of 25-30c/share in either Q3 or Q4 this year.

Blue Note is also building a new mine and should have earnings of 2-4c by Q3 or Q4 this year. Blue Note will perform nicely this year.

Aur Resources has gone from a $2 stock in 2000 to $23 today with 2006 earnings of $3.23 per share, and 60-70% growth in production planned over the next 2 or so years.

To have been there at the beginning of the bull run, at the period when earnings exploded.

There is one stock I've recently looked at that an unfortunate hedge decision reduced its earnings to about 20-25% of what they would have had without the hedge. The company's earnings were 87c/share for 2006, and with only 40 million shares, taking a $144 million dollar loss and still making money is amazing. $144 million is about $3.60/share of cash flow that they didn't have to put to earnings. There is a thing called taxes that they would have to pay on that, so it isn't quite that good, but it is very sweet overall.

The stock is Quadra and this stock is in a position to see a leverage of earnings much like the early bull run days, indeed, 2007 will be Quadra's bull run.

Quadra's hedge which limited them to an average of $1.72/lb of copper for 2006 hit them at both end, earnings and costs. There is a thing called "price participation" where as the price of a commodity increases, smelter companies get a cut of that increasing price. Quadra had hedged at $1.60 and copper went as high as $3.99/lb on the LME. So, not only did Quadra forfeit 60% of the potential income, they had to pay smelter costs as if they were getting $3.99/lb. So Quadra paid the full costs of the bull run, but had none of the benefits. The average LME price for copper for 2006 was $3.05/lb. Quadra didn't get an average of $1.32/lb of "free" money.

Quadra has even more leverage of earning to come. They ran into a few problems with production and produced 117 million pounds of copper. They believe they've worked out those issues, certainly towards the end of Q4 their recovery rates improved considerably, and they've given guidance of $125 million pounds, an small increase of 7%. But, they are in the process of building a second mine which is planned to start producing late 2008 and will add 75 million pounds of production per year, so a two year growth in production rate of 67%. There are a couple downsides, increased debt to pay for building the new mine, but that is highly preferable over dilution that would limit earning potential forever.

2007 is going to be Quadra's year for stellar performance.

QUA Toronto, QADMF.PK in the US.

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Quadra - When the hedge is over

Quadra is a $350 million, fully diluted, market cap mining company with a producing mine with 2007 production guidance:

• 125 million pounds of copper,
• 60,000 ounces of gold,
• no guidance on molybdenum, 260,000 lb in 2006.

They have just obtained financing to build a second mine for start-up in 2008, guidance 28 million pounds, increasing to 75 million pounds in 2009, bringing the fully diluted number of shares up to 42.7 million. Additionally they have plans to develop a third mine in Chile which will produce 300 million pounds.

Last year copper prices peaked at $3.99/lb and they have come down, slaughtering the earnings for most copper mines. Take Goldcorp, market cap 19.7 billion, earnings crumbled to 11c/share in Q2 from 50c/share in Q4 -- in Q2 Goldcorp's copper earnings accounted for 65% of their total earnings, and enabled them to claim -$123/oz production costs on gold, all from a mere 46,700 lbs of copper sales.

For 2006 Quadra's eps was a mere $0.87, indeed, while Goldcorp was producing its record earnings, Quadra was losing money. Quadra made a hedge, and the hedge ended up costing Quadra $143.9 million in derivative expenses. The average LME price for copper in 2006 was $3.05, but Quadra's average price was $1.32/lb less, $1.73/lb, because of the hedge. $143.9 million in lost income amounts to $3.53/share. After taxes it means that $2.18/share of earning potential was lost to a bad hedge. Without the bad hedge, eps for 2006 would have been in the $3+/share range.

Quadra has shipped the last of its hedged copper and will clear the last of its hedge loss this quarter.

Think of the end of the hedge as an enormous cut to costs. Their income for 2006 was $393 million, and out of that came this enormous $144 million hedge cost, or 37% of their revenue.

Another problem that Quadra had was lower than expected recovery rates, a mere 61% on copper until the last two weeks of December, where it increased back to the 70-80% recovery rate. This problem appears to have resolved now, but it also lowered overall production for 2006.

So, Quadra is going into 2007 with a double leverage potential on earnings, an enormous reduction in expenses, and improved production rates. At $3/lb for copper, $375 million, at $650 for gold, $39 million, and perhap $5 million for their molybdenum, for 2007 revenue of about $419 million, and no $144 million hedge expense.

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