Time to Look at Copper Plated Bonds?

Jeremy Glaser: Is it time for investors to look for copper-plated bonds? I'm Jeremy Glaser with Morningstar.com. I'm here today with analyst, Dan Rohr, to look at Southern Copper and their financial position.

Dan, thanks for talking with me today.

Daniel Rohr: Thanks, Jeremy.

Glaser: So I guess the overarching question first is, what's been happening with commodity prices in particular, copper and what kind of impacts that can have on Southern?

Rohr: The market for copper, like that of a lot of base metals like nickel and zinc, has really been behaving like a man with a broken leg. He's leaning very heavily on this crutch of Chinese demand while he's waiting for the broken leg, the European, U.S., Japanese demand to recover to pre-crisis levels. The risk here is that some jerk comes along before the leg has healed and kicks the crutch out from under him.

Prices for copper are right around $3, give or take a few cents depending on which day you look. If Chinese demand remains strong, continues on its growth trajectory, and European, U.S. Japanese demand recovers to pre-crisis levels, we could be looking at copper prices quite a bit higher.

Now on the flip side, if Chinese demand growth falters and drops before we see a recovery in OECD demand, we can be looking at a significantly lower copper price potentially.

We like Southern Copper from a credit perspective because of its cost position, which insulates creditors to a certain extent from the volatility that you're naturally going to see in copper prices. I think a few numbers really put that into perspective. Over the past few years, we've seen copper range in price significantly from high above $4 a pound in early 2008 to below a $1.50 a pound in early 2009.

Southern Copper's cost structure is such that over the past three years, their average cost per pound has been $0.19, so regardless of copper is above $3 where it is today or goes back to the bottom, the lowest that we saw in the depths of the financial crisis, this is a company that's going to be cash flow positive.

Glaser: So big decline in prices might hurt profitability, but certainly they'd be able to survive it from a…?

Rohr: So you would naturally see the equities take a beating and that certainly what happened with Southern Copper shares as copper prices went south, but we think creditors would have a pretty good cost cushion in Southern Copper's operations to mitigate the downside risk and protect the principal of their investment in the bonds.

Glaser: Often times, commodities become heavily politicized issue. We've seen even recently in Australia, which I think people think of as a very stable market and there was a lot of hoopla around potential mining tax. Southern only operates, I believe, in two countries, Mexico and Peru, how do you account for that kind of potential uncertainty that you think you might…?

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Rohr: That's a really good point. Frankly our two biggest concerns with Southern Copper are one that commodity price volatility that can send your profit through the roof and through the floor, and then second just as you said the country risk.

So while we're looking at a company with very little leverage, massive profitability, there is always that worry out there this tail risk that something unforeseen could happen in Peru or Mexico, whether that's creeping expropriation of assets, big labor strikes, something could happen to diminish the company's financial health.

Glaser: And then when you think about the total financial health, how would you categorize it? Can you give us the metrics that show the strength of company right now?

Rohr: Yeah, Southern Copper unlike many of its mining peers went into the downturn with very little leverage, and unlike most folks or rather a lot of folks, Southern Copper wasn't forced to go hat in hand to the market to raise additional capital to stay afloat. So they are coming out of the downturn in a very strong position.

As we speak, they've got about $2.8 billion in debt, and we are projecting the company to generate $2.8 billion in EBITDA for 2010. So we are looking at one-for-one debt-to-EBITDA ratio, which is pretty stellar. Now that's quite a bit better actually than the average BBB plus credit, which is what we rate Southern Copper. But back to your previous point about country risk, it's that type of thing that's weighing on our credit rating a little bit.

Glaser: So when you think about those two issues and you look at the actual bonds that are trading, do any of them look like they are buys today?

Rohr: Yeah, we think Southern Copper bonds are undervalued. When you look at the spreads they trade against treasuries relative to the average BBB plus credit, Southern Copper spreads are a little bit fatter. In particular, we like Southern Copper's 2020 issues because that tends to be a little bit more frequently traded, a little bit more liquid, so the pricing you could get on that might be a bit better, and if you should need to exit the position, that liquidity once again could help you exit.

Glaser: And if you wanted to take a rider on say that Chinese growth is going to be great and that copper prices are going to $4 or $5 a pound or whatever it might be. Does the equity look good right now?

Rohr: Yeah, well, frankly we don't see $4 to $5 a pound copper, so the equity looks relative fairly valued. I think it's around $29, $30 per share as we speak, so right in line with our fair value estimate. If you wanted to take an equity play on copper, we think the shares of Southern Copper's peer Freeport-McMoRan look relatively undervalued at the moment.

Glaser: Dan, thanks so much for talking with me today.

Rohr: Thanks, Jeremy.

Glaser: For Morningstar.com, I'm Jeremy Glaser.