Bid in the copper pipeline?

PORTFOLIO POINT: Instead of being the hunted, Sandfire Resources could become the hunter as it gains market ground while its major shareholder OZ Minerals loses traction.

Not all minerals are behaving as poorly as iron ore. Copper is looking as good as at any time in the past five years, with the price up, stockpiles down, and a nifty twist emerging in a local takeover tale.

Sandfire Resources, and a handful of early-stage explorers, have been the biggest winners, so far, from the 15% rise in the copper price over the past three months, with Sandfire aided by the start of production at its DeGrussa mine in WA.

OZ Minerals, the oft-named bidder for Sandfire, has been heading the other way, losing ground even as the price of its primary product rises.

The net result is a possible reversal of roles.

Rather than OZ building on its 19.8% stake in Sandfire with a full-blown bid, the target could soon be in a position to buy its predator – a situation which should cause investors to reconsider how they see the two because it is always best to buy the target and sell the bidder.

The numbers tell the story.

Copper has risen from $US3.30 a pound in mid-June to hit $US3.80 a pound late last week. It is currently trading at $US3.75/lb.

The stockpile of copper on the London Metals Exchange is down significantly over the same period, perhaps being offset by a rise in warehoused metal in China, though accurate data on Chinese copper is not available.

Sandfire, which has the benefit of a new and very high-grade copper project, has reacted strongly, rising from $7.25 in mid-June to $8.80, with that latest price a small contraction after the stock hit an all-time high of $9.06 on Monday as news of a first ore through the DeGrussa processing plant hit the market.

OZ, on the other hand, has fallen from $8.73 to $7.12, and earlier this month hit a 12-month low of $6, burdened by rising costs and little fresh news from its only producing project, the Prominent Hill copper and gold mine in South Australia, or its proposed new copper mine at Carrapateena, also in SA.

Share prices are one window on the world of OZ and Sandfire, with OZ actually being the biggest beneficiary of Sandfire’s rise thanks to its 19.8% stake in the stock and top spot on the share register.

What those share prices boil down to is a rapid “closing of the gap” between the market value of OZ and Sandfire.

Whereas OZ was once a much bigger company than Sandfire, and had its chances to acquire the smaller stock, the shoe might now be on the other foot, especially if Sandfire keeps growing and OZ keeps shrinking.

Little more than three years ago Sandfire was a “penny dreadful”, trading at less than 20c and capitalised at around $10 million, taking off only after news of the rich DeGrussa discovery reached the market. The orebody averages a world-class 5% copper, and with sections grading more than 25% copper – good enough to ship directly to customers, and enormously profitable.

Back when Sandfire was an explorer looking for a discovery, OZ was a copper producer, with its shares trading at around $7, and on their way to $16 by late 2010 – a price which valued the stock at close to $5 billion.

The major assets of OZ in 2010 (and today) are the Prominent Hill mine, and a pile of cash which remains at $651.1 million, earmarked for takeover activity, if/when the right target is found.

But since hitting its share price high, OZ has disappointed, unable to decide on a takeover target. It has acquired Carrapateena and is planning to develop it, but at what cost is not yet known. It also has its 19.8% stake in Sandfire, and has started looking for copper deposits in South America.

OZ is, however, a company which looks like it has missed several boats. This includes a chance to snap up Sandfire when it was much cheaper, providing it with a second source of revenue, though admittedly from a mine which currently has a relatively short life expectancy of around eight years – roughly the same life left in Prominent Hill.

It is the lack of urgency at OZ, and the benefit enjoyed by Sandfire in developing a rich, new, mine which has been the major cause of the gap closing with Sandfire. The one-time target is itself starting to look for additional assets, either through a hectic ($20 million a year) exploration program, or via acquisition.

The most recent movement in the share prices of the two companies illustrates that closing gap. In mid-June, when OZ was trading at $8.73, it had a market capitalisation of $2.65 billion. At the same mid-June point, Sandfire was valued at $1.1 billion.

Today, the market value of OZ has fallen to $2.16 billion (down $490 million), while Sandfire’s market value has risen to $1.33 billion (up $230 million).

The rise of Sandfire has been remarkable and while it is a genuine “one-trick pony” inasmuch as it has a single mine which has just started production, so too is OZ a one-trick pony, and an older and less profitable pony at that.

Comparing the production profile of OZ with Sandfire produces numbers almost as interesting as the converging market values.

Prominent Hill, the primary OZ asset, is a bigger mine than DeGrussa, but lower grade and producing at higher costs.

In the current year, Prominent Hill is forecast to produce up to 110,000 tonnes of copper and up to 150,000 ounces of gold, but with cash costs rising sharply from US70.4c per pound of copper in 2011 to between $US1.10/lb and $US1.20/lb.

The rise is attributed to the start of underground mining at what, until now, has been an open pit operation.

Sandfire is expected to produce 84,000 tonnes of copper this year (a number boosted by the direct shipping ore), plus 31,000 ounces of gold and 273,000 ounces of silver, at a start-up cost of $US1.33/lb, falling over the next three years to US89c/lb.

Profitability is equally interesting, with OZ’s profit tipped to slide from $322 million in 2011 to $129 million this year, and then down to $86 million in 2013. This outlook has put the stock on the sell lists of a number of brokers, including UBS and Goldman Sachs, but with Macquarie maintaining a buy tip and RBS and Merrill Lynch advising investors to hold.

Sandfire, thanks largely to the high-quality of the DeGrussa orebody, is tipped to book a profit in the current year (its first year as a producer) of $202 million, declining next year to around $185 million – which is why most brokers have the stock as a buy.

The problem for investors with an eye on OZ and Sandfire is judging whether one has run too far, too fast, and whether the other has been overly punished for missed opportunities, rising costs and the tag of one-trick pony with too few growth options.

Goldman Sachs has been particularly critical of OZ, slashing its earnings-per-share forecast in an August 29 advisory note over the next three years by a 5.3% this year, 16.4% next year and 20.3% in 2014. This is due largely to rising costs, which it estimates will reach $US1.27/lb higher than OZ’s own increased cost estimates.

UBS told clients that: “The clock is ticking for Prominent Hill and there’s still no sign of exploration success or an acquisition. The valuation gap should continue to widen the longer nothing happens. Downgrade to sell”.

It could have been very different. If OZ had moved when Sandfire was in its infancy it would be a company with two mines, one old and one new, and with rising (not falling) profits.

As it stands, OZ is being treated by the market as a declining force in Australian mining, even though it does have life left in Prominent Hill, and a new development emerging at Carrapateena.

What OZ probably needs is an injection of more aggressive management, and who better than the people who turned Sandfire from the status of penny dreadful into a stock with a position among the 150 biggest on the ASX (125^th as at today) and closing rapidly on OZ, which has slipped from a top 50 position to 84^th.

Rather being a predator, as it was when it emerged from the wreckage of two predecessor stocks (Oxiana and Zinifex), OZ is becoming a target – and that could be just what is needed to inject life into its share price.