CIBC World Markets Metals UpdateWith year-end window dressing over, base-metal equities have shown a
marked pullback on the back of a significant decline in copper prices, due to
concerns over a slowing US economy and rising inventory.
As noted in our December 18 report, we had been anticipating a period of
consolidation/correction in the early part of 2007, due to the significant
price appreciation in late 2006 and seasonal factors; however, the
correction occurred sooner and has been sharper than anticipated.
undamentally, the markets remain very well positioned, with low inventory
levels and limited new supply coming on stream prior to 2009, leaving little
slack in the system. As such, assuming demand remains firm, we believe
metal prices are poised to remain at robust levels.
Even if metal prices pull back 20% from our current price deck, the names
in our coverage universe would still, on average, have close to 40% of their
current market cap as net free cash by the end of 2008. As such, we view
this pullback as a buying opportunity.
Metal Prices To Stay High Despite
Fear of Slower Economic Growth
Over the past week or so we have seen a significant correction is base metal
equity prices and to a lesser degree, excluding copper, commodity prices on
rising concerns of a slowing global economy in 2007, lead by fears of a US
housing market melt-down, slower manufacturing data in the US and rising LME
inventory levels for copper, the industry bellwether. That said, we would note
that the overall market fundamentals remain unchanged, with global demand
growth expected to surpass 4% in 2007, limited new supply coming on stream
and low inventory levels leaving the industry vulnerable to supply shocks (labour
and/or operational disruptions). As such, we believe that the current correction
was, in a way, a self fulfilling prophecy given the sharp rise in equity prices
toward year end 2006 and likely some window dressing by funds at year end.
As we aim to show in this report, we do not believe that these issues, while
important, are likely to mark the end of the longer-term secular bull market for
base metals and why we view this correction as another bump in the road and a
buying opportunity.
We believe that metal prices remain positioned to remain well above historical
averages until at least 2009, as metal supply growth remains restricted during
this period, barring a collapse in demand. Inventory levels are also expected to
remain at near-historic lows which should once again support high prices, given
the potential for ongoing supply disruption.
Fundamental Outlook – Unchanged, Waiting
For Chinese Buying
While the current price cycle was initially a supply-driven rally as inventory
levels declined, we continue to believe that the future of the metal prices rally is
now a function of demand, with supply additions appearing to be limited in the
short term. As a result, the duration of the current price cycle is expected to be
sustained for a significant period of time. In almost all markets (excluding
aluminium), demand continues to outstrip available supply such that some level
of demand destruction has or will need to occur in the coming years to match
available supply to demand.
Over the last few months, the market has become focused on state of the global
economy and the resultant impact on demand for metals. The market is once
again questioning the ability for the Chinese economy to continue to grow at
over 10% per annum and the possibility of a recession in the U.S. In Exhibit 5,
we have presented the historical OECD and Chinese leading indicators as
compared to the LME price index. While both appear to be softening to a degree,
they remain at relatively robust levels, which we feel will be supportive to metal
prices.
Much press has also been attributed to the state of the U.S. housing market and
its potential impact on metal demand, in particular, for copper and to a lesser
degree aluminium. While a significant slowdown in U.S. homebuilding is clearly a
negative for metal demand, we would note that residential housing construction
represents only around 10%-15% of U.S. copper demand (13% of global
demand) and so, by itself, would not derail global demand growth or even U.S.
demand for that matter.
As we have stated before we, are not overly concerned about a slowing US
economy, assuming it does not slip into an outright recession. We continue to
believe the outlook for the base metals markets remains driven by China and
other emerging markets such as India, as these countries look towards greater
urbanization and industrialization. Chinese economic growth has remained
strong and the World Bank has forecasted that China’s economy will grow 9.6%
in 2006 and an estimated 10.4% in 2007. The National Development and
Reform Commission of China is also predicting another strong year in China,
with 10.5% growth in GDP for 2006. As China is improving trade ties with
countries other than US, China’s dependence on exports to U.S. is declining. As
a result, Chinese metal demand has grown significantly such that China is now
the largest consumer of all the base metals as shown in Exhibit 6.
Hudbay Price Target Calculation
Our price target of $28.00 based on the mid-point of our NAV of $20.16 and a
multiple of 5.0x our 2007 cash flow estimates, which implies a target of $31.95.
While this results in a discounted valuation relative to some of Hudbay’s peers,
we believe this approach accounts for the risk associated with Hudbay’s current
short reserves and uncertainty over the what the company is likely to do with
the cash its generates in 2007. That said, higher valuations are possible if the
market moves to more relative or even a premium valuation approach due to
the scarcity of zinc equities available to the market.
Hudbay Key Risks To Price Target
The key risks to our price target are actual future commodity prices, foreign
exchange rate fluctuations (specifically a stronger-than-expected Canadian
dollar), operational disruptions, higher-than-expected operating costs, ongoing
environmental risks, closure costs and the success of the company’s exploration
program to extend the life of the operations.