World Economy Slow Down

I am looking forward to the next stream of financial and annual reports that will be coming soon. I predict that the press releases will focus on the annual earnings and completely gloss over the 4th quarter earnings, which I expect will not be rosy for any base metal company. However, the 4th quarter earning are probably more representative of the company's next quarter earning potential rather than looking at the full years.

In a recent post I was asking if base metals would fall off a cliff. There were many indicators that economic growth was slowing.

The US is of particular concern. According to Nobel economist Joseph Stiglitz the US has been drawing down home equity at a rate of $700 to $800 billion per year.

That's a lot of unsustainable US economy. Further, the US consumption economy is about $9.5 trillion. The home equity borrowing has been 7-8% of the consumption US economy. Now that lending standards have tightened, and home equities have declined, that borrowing is not likely to continue at anywhere near the same rate. It has to be a strong US slow down in the economy and the trickle down effects can not possibly be pretty.

Emerging markets are not likely to make up the slack. China's consumption economy is a mere $1 trillion, so $700 billion is 70% of their economy. Anyone who thinks China will pick up the slack is smoking something pretty strong.

This can't possibly be good for base metals. There are a lot of base metals that go into consumer goods. Additionally, commercial construction is rapidly declining as well, and municipal budgets that might do big capital projects that require base metals are in trouble because municipal budgets are in trouble due to declining revenue from declining home prices in the US. Cities are demanding all departments cut budgets.

Mining projects in the process of being developed do not just stop in the middle of hundreds of millions of dollars being committed to them, so increases in supply tend to strongly lag changing economic conditions. Data showing slow downs for material usage tends to be lagging rather than leading. In the US housing starting were going full throttle as late as last March, and all of the materials that go into housing would have continued to be used until some time in the fall or winter, yet by then housing starts had plummeted, but the actually declines in demand from that reduction will not be fully showing up in financial reports until the end of Q1, and it should be significant. So far Q4 earnings are down about 20% for companies that have reported Q4 earnings. That's gigantic and it is crazy to not think that that isn't have an effect on commodity demand.

Base metals have had enormous leverage of earnings from record commodity prices and they've been bid up in price, valuing the base metals stocks like a coca-cola stock, only base metals are at far more risk to supply and demand price fluctuations that demand a low P/E when prices are strong. When the market looks good and the company has good growth prospects I'd never give a second look to a base metal stock with a P/E of 12 or higher. It has room built in for down side risk and a opportunity to exit without wiping you out should the market turn, which it appears to have done.

There are numerous examples now of how the downward leverage affects earnings. From Q2 07 to Q3 07 FNX mining's revenues declined 28.3%, but earnings declined 64.3% despite the fact that "the total tons of ore, pounds of nickel, pounds of copper and ounces of precious metals produced and sold was were higher ... than in any previous quarter," according to the Nov 1, 2007 news release. According to google finance the current P/E is 21.7, but that has earning of $12.5 million (the last report), $35 million, $30.2 million and $19.7 million included. Go four quarters forward based on last quarter and you get $50 million per year of earnings compared to the current last four quarters of $97 million. It means the P/E for last quarter reported is about 43. Average nickel price was $11.65/lb and copper price was $3.57/lb. FNX is still richly valued despite being down 37% from its high. The $24.87 shares earned 15c/share last quarter. Even if you believe they can double earnings, the shares seem richly valued.

Teck Cominco's earnings declined from $2.01/share to $1.16/share for the same two quarters, only Teck Cominco did not get so insanely valued. Their revenues were down about 1/3rd yet earnings were down 42%. Their loss of leverage of earnings was not nearly as drastic as FNX. Teck's current P/E is 6.46 and forward P/E is 10.63. It is down 40% off its high. The $32.51 shares earned $1.16/share last quarter.

It is likely any base metal company examined will show a higher decline in earnings than revenue because of the leverage and it is also likely that all established companies will experience a significant decline in earnings due to the declines in commodity prices, which are at risk to decline further due to the economic slow the entire world seems to be experiencing.

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Currency Contrast of Commodity Prices

I am Canadian and as such when I look at commodity prices I convert to Canadian dollars. Earlier in the year the conversion meant adding as much as 19% onto the US quoted price yet today it means take 7% off.

The change in currency valuation is enormous for the base metal industry. If you look at the mining industry from a world perspective, there are some mines in the US, and for those mines wages have effectively declined as the US dollar has lost value in comparison to other currencies. The US has gone from a high of 1.1875 on Feb. 7 of this year to a low of 0.9323 this past week. At its height earlier in the year the US dollar was “worth” 27% more relative to the Canadian dollar. A $30/hour US wage on Feb 7th was $35.62 Canadian and at the low, this week, it is $27.97 Canadian. Canadian wages have done the opposite. A $30/hour Canadian wage at the height of the US dollar was $25.26 US and now it is $32.18 US.

For US based mining companies wages are fairly fixed relative to the US quoted commodity price. Their might be union contracts that give them an increase, but when you do your back of the napkin calculation on a company using commodity prices you do not need to correct for costs due to currency changes for mines located in the US. That cannot be said for mines located in the rest of the world.

Given that the US dollar has lost ground with almost all other currencies, when the “costs” are converted to US dollars the increases will be staggering, as the wage conversion calculation above shows. I suspect many investors are not going to be prepared for what this does to the value of their investments. The full effect of these increased costs are not going to show up in the third quarter financial reports, although some will. For the third quarter the US dollar averaged around 1.05. As of this week it has declined a further 12%. Only a portion of those wage changes will show up in the next series of quarterly reports. Expect to see costs up in that 12% range for 4th quarter results being reported next January to March.

The margins, or earnings, on base metal stocks are affected by both the costs, which are in the currency of the country and the commodity prices, which are quoted in US dollars. The workers may not have gotten wages, but once the costs are converted to US dollars, they are simply up dramatically relative to the US dollar in most countries. This is not good for investors, especially investors in commodity stocks with high P/Es. In general, I suspect that chances are if a base metal stock has a P/E over about 6-12 right now, depending on other strengths/weakness of the company, it is going to correct downwards in the next year, indeed, if the LME warehouse stock levels continue to rise this estimate may be conservative because of metal price declines due to increasing supply.

The one year copper spot price shows three almost equal peaks in the spot price of about $3.70 US, in April, July and October. In Canadian dollars those “peaks” are about $4.25, $3.85 and $3.60. Today in Canadian the US price of $3.40 is about $3.16 Canadian. In Canadian dollars the price of copper was about 35% higher at its peak. In an earlier blog I looked at the Bingham Canyon mine. About 2/3rds of the revenue when straight to earnings for the period I looked at it. Because this mine is located in the US it is not going to see enormous wage increases, although it will probably see large energy costs increasing. However, this mine will still have exceptionally healthy earnings, although the margin may decline a little. This mine has lots of room that if it saw a 35% hair cut on revenues it is still highly profitable, with probably 40-50% of revenue making it to earnings. Contrast that to a mine with say 20% of revenue with strong prices going to earnings. At 35% hair cut in commodity prices means that the mine is now losing money.

I dislike nickel immensely, and here’s why. Nickel prices peaked in April at around $24/lb US. In Canadian that would be around $27.50, and there is a lot of nickel being mined in Canada. On Friday nickel closed at $14.35 US, which is now about $13.40 Canadian. Nickel peaked at a price over 100% higher. The good thing about nickel is the peak was a short-term spike and that utterly unsustainable price only got averaged into earnings for a very short period. The very, very bad thing about nickel is that a number of nickel stocks have priced in an earnings expectation based on a much higher nickel price than is realistic. The current price is already a strong nickel price and a wise investor would be evaluating their investment at $10-12/lb nickel. I believe to have priced a nickel stock with a high P/E with the outrageous nickel price of $21.65/lb, or $25 Canadian, as investors in FNX mining did in the first quarter will prove to be economic suicide.

In my May 30th post on FNX I pointed out many problems with investing in this company, and in the shorter term the price has gone higher than the roughly $35/share it was at then. But, short-term hype and speculation is not true valuation and this is the type of investment susceptible a wake-up-one-morning to 40-50% haircut. Going back to first quarter, earnings were $30 million (extrapolate to $120 million full year expectation) with an average price of $21.65 and an exchange rate of 1.17. Guidance was that earnings are supposed to decline by $9 million per $1 decline in nickel price, so expect $66 million decline from the contraction of nickel price. A 10% change in exchange will kill another $12.7 million in earnings, so expect another $32 million decline from exchange, or $98 million. That leaves about $22 million for full year earnings, or $5.5 million per quarter. Factoring in the roughly 70% increase in production expected, that would give about $9 million per quarter, or earnings of $36 million per year. Assuming share count has not increase, which is full year earnings of about $0.42/share, outrageously low for a $37 commodity stock. The earnings have gone 36c the first quarter, 40c the second quarter and 15c this past quarter, yet this quarter had record output. Earnings were 24c/share in Q3 the year before. Output increased by 50%, yet instead of a 50% increase in earnings to 36c, earning were 15c, an expectation decline of 58%. The average exchange rate was 1.04 for quarter 3. Now it is 0.93. That 15c/quarter extrapolated to a full year is 60c, but factor in that further currency decline and expect to see next quarter earnings of 10-12c.

Anyone doing a peer valuation of their nickel stock relative to FNX is seriously misleading himself or herself.
I expected the US dollar to decline relative to the Canadian dollar, but never in my wildest dreams would I have predicted 0.9323 this fast. I suspect there is not an analyst report out there that has factored in the drastic loss of revenues, or alternative drastic cost increases, due to the strong changes in valuation of the US dollar.

I don’t have time to look at the degree of change in other commodity prices right now, but my prediction is 100% US companies will perform better relative to companies with operations in other countries because they will only be dealing with how commodity prices affect their bottom line where as other companies will have the huge challenges of how the drastic decline in the US dollar affects either costs or revenues, depending on what currency they do their reporting in.

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FNX Mining - Cashing in on Nickel

"FNX quadruples resource base" boasted the press release, and adding up the
measured, indicated and inferred resources gives 1,087 million pounds of
copper, 1,105 million pounds of nickel and 1,016,000 oz of precious metals.

In US prices at $23.23/lb for nickel, $3.34/lb for copper, and $981 per
ounce precious metal for about $30 billion in today's dollars in the ground,
with stellar grades. At today's prices the average metal value per ton of
these new resources is $389, with the measured and indicated portion
averaging about $460/ton. At today's commodity prices the grades are highly
profitable.

So, how much money is FNX making?

FNX had a remarkable growth in earnings for Q1 2007, an increase of 845%
over Q1 2006, or $30.2 million versus $3.2 million. And shareholder have
done remarkably well, from a 52 week low of $9.05 to a high in the past week
of $35.25, or a 289% increase if perfectly timed.

But, for investors earnings need to evaluated relative to their investment.
FNX has 84 million shares and 2.5 million options give a dilute market cap
of about $3 billion. $30 million of earnings on $3 billion of market cap is
about 1% and extrapolated for a full year is about 4%, or a P/E of about 25.
Commodity prices are strong. A P/E above 12 simply is not a good idea when commodity prices are this strong unless there is a very compelling production growth story.

Taking a closer look at the Q1 earning and commodities prices in US they
realized were:

• Ni $21.65
• Cu $2.67
• Pd $395
• Pt $1530
• Au $771
• Co $31.34

The prices FNX realized for their production resulted in $12.3 million in
revenue above the LME average prices for Q1. They also realized even better
revenue because of the strength of the US dollar in Q1, an exchange rate of
1.17.

Price sensitivity is $1/lb change on nickel will change earnings by $9
million or $0.11/share, a $0.25/lb change in copper will change earnings by
$1.9 million or $0.02/share and a 10% movement in exchange rate will change
earnings by $12.7 million or $0.15/share. Currently commodity gains in
price are being canceled by currency losses.

The Q1 earnings included a 40% increase in production from the Levack
property. Overall production was 2.6 million pounds of nickel, 2.3 million
pounds of copper and 5,961 ounces of precious metals. At this rate they
would produce 10.4 million pounds of nickel, 9.2 million pounds of copper
and 24,000 oz of precious metals.

The year's production is forecast to be 12.7 million pounds of nickel,
10.9 million pounds of copper and 29,500 ounces of precious metal. The full
growth of 2007 has not yet been realized. Looking to 2008, production if
forecast to be about 17.5 million pounds of nickel, 40 million pounds of
copper and 64,000 oz of precious metals.

Further growth is planned through to 2010, for 24 million pounds of nickel,
100 million pounds of copper, and 135,000 ounces of precious metals.
From my way of evaluating an investment, FNX needs to double its earnings
to get to that P/E of 12 for production earning, and it looks doable for
2008 as long as commodity prices remain as strong as they are today. The
growth profile does give protection from downside risk from softening
commodity prices.

In the financial reports is a "comprehensive income" of $11.6 million that
should not be considered towards production earnings, and may result in a
one time only boost to earnings. This is from increases in equity
valuations that they own. To put into perspective of what including it on
earnings is equivalent to, consider a mutual fund. It buys equities that
the managers think will increase in price. The value of a share of the
mutual fund is the value of all the equities divided by the number of
shares.

So, consider the simplest mutual fund, with a single share. It buys an
equity worth $100 and that equity increases to $125, the value of that
mutual fund share is now $125. If that $25 dollars of equity gain was
instead consider earnings and the mutual fund was traded on earnings at that
P/E of 25 and the mutual fund share would be $25x25 = $625.

The value of equity increases to share holders needs to be evaluated the
same way a mutual fund is evaluated for its equity holdings. To evaluate as
earning is to make perilous errors in evaluating the value of your
investment. That $11.6 million dollar equity gain is worth
$11.6/86.4 million shares, or 13c per share, hardly a deciding factor one
way or another on a $34 stock.

The last thing, it never hurts to see what the insiders are doing. Part of
their income is from options so there usually is some selling. The question
is, how much?

Robert Cudney has a relationship to Northfield Capital which has sold
373,000 shares this year and he has personally sold 94,700.

Duncan Gibson shows 50,000 shares sold, Daniel Innes shows 37,987 shares
sold, Paul Makuch shows 33,333 shares sold, Daniel Owen 10,000 shares sold,
Donald Ross 23,500 shares sold.

Overall the insider selling is large and so is the cashing in.

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