Ivanhoe Earnings reveal a seam of weakness
Ivanhoe’s massive Mongolian copper/gold project is about to begin producing – but into a world with lower commodity prices, and only after Ivanhoe has invested heavily in the venture, denting its earnings quality.
It’s a classic pattern among commodity producers of various kinds: whenever the price of oil, natural gas, copper, aluminum or other extractable or refine-able commodity spikes, a wave of new capital spending typically follows as exploration and production companies try to take advantage of those higher prices by ramping up their output to capture the higher prices per ounce, tonne or other measurement. But depending on the commodity in question, it can take years for the new production to come onstream and for the company to begin to benefit from the new stream of income. As long as commodity prices remain high throughout that waiting period, that’s fine; companies will benefit from their spending. But even if the business cycle remains favorable, all too often the onrush of new supply from many if not most players in the industry by itself has a dampening effect on prices, making it hard for the company to turn a profit on its new projects.
This may be what is taking shape at Ivanhoe Mines (IVN.N). The company has a two-thirds interest in the Oyu Tolgoi project in Mongolia, a massive copper-gold-silver mining venture on which construction began in 2010. But copper prices peaked at the end of 2010, as you can see from the chart below, and have fallen almost 30% from their high of $10,610 per metric ton in February 2011 to $7,400 this month. Gold, too, is weaker, having fallen 20% in the last four months alone to only $1,580 this month from a high of an astonishing $1,900 an ounce last September (also shown on the chart below.)
The result? When the Oyu Tolgoi mines begin production at the end of the year, they will be doing so in a radically different pricing environment than existed when the mine was planned and built;
lower copper and gold prices will lead to lower profits for the new venture and for Ivanhoe itself, which, although it also has coal, copper and gold mining operations in Australia, Mongolia and Kazakhstan, has bet its future prosperity on the Oyu Tolgoi project. So perhaps it’s not that surprising that Ivanhoe currently has a poor StarMine Earnings Quality (EQ) model score of 3, indicating that the earnings at the company may not be from sustainable sources.
StarMine uses computer-driven models to analyze the financial statements of thousands of publicly traded companies, and to calculate a proprietary StarMine Earnings Quality (EQ) scores for each of them. The lower the StarMine EQ score, the less likely it is that the company will be able to sustain its past earnings track record. (For a more detailed explanation of this model, please refer to this recent article about the earnings quality of American Express.) This examination of Ivanhoe Mines earnings is the next in a series of articles looking at the earnings quality of companies across North America that rank either especially low or high by our quantitative measure.
Unsurprisingly, the launch of the Oyu Tolgoi project corresponded with a surge in capital spending by Ivanhoe. By the end of the March 2012, the project’s total cost had reached $4.6 billion, largely financed by Rio Tinto, which has a 35% stake in the project (and a majority interest in Ivanhoe itself). Ivanhoe completed a $1.8 billion rights offering earlier this week (backstopped by Rio Tinto), and the proceeds of that transaction means financing for the project (which has an estimated total cost of $6.2 billion) is now in place. It remains to be seen, however, whether this upfront investment can be recovered, given the current prices of both copper and gold. Ivanhoe’s use of equity capital to finance the project means it will need to recoup the cost of that equity in the form of increased operating profits.
Ivanhoe’s cash flow from operations (CFFO) has been negative in the last four quarters, and it has lagged the net income in three of those quarters. The red section of the bars in the chart below represents the amount by which the CFFO fell short of net income each quarter. (Whenever CFFO exceeded net income, the section of the bars is green). In the last quarter, the company reported a net loss of $81 million. Its CFFO was actually an outflow of $113 million, while free cash flow for Ivanhoe Mines was an even larger negative number – a cash outflow of $849 million, reflecting the large capital expenditures.
Those large negative cash flow figures explain the company’s need to raise additional capital via the rights offering. In fact, the terms of that offering were altered between its announcement date and completion to take into account the recent weakness in the company’s share price, the falling commodity prices and the tough economic environment generally. Initially, the company had proposed that each holder of the rights would be entitled to exchange his or her holdings for a price of $8.34 a share. (For every 20 rights, the holder is entitled to purchase 7 shares of Ivanhoe stock.) But a week before the transaction was completed, the deal was sweetened, making the price only $7 a share, at the time a 32% discount to Ivanhoe’s share price. That only increases the cost of equity for the company. Meanwhile, exploration costs continue to climb, hitting $77 million in the quarter ended March 31. Since it is unlikely that Ivanhoe will suspend its quest for new sources of minerals, it is equally unlikely that that it will begin to spend (and expense) less on exploration and development.
Metals prices may not have hit bottom yet, either, given the extent to which the global economy remains on edge and the reduction in demand for commodities from China. Combined with the new supplies likely to come onstream soon, commodity prices may still fall further and taken a still larger toll on Ivanhoe’s profits.
To reflect the importance of the Oyu Tolgoi project, Ivanhoe plans to change its corporate name to Turquoise Hill Resources Ltd. (the English translation of Oyu Tolgoi ). A name change alone, however, won’t suddenly improve the company’s earnings quality, especially given the most recent complication: a growing degree of resource nationalism on the part of the Mongolian government, which is seeking a larger interest in the project. (You can read about that controversy in this Reuters news article.) It will take at least a year – and possibly longer still – for the Oyu Tolgoi project to begin generating solid returns for Ivanhoe’s shareholders, and in the meantime, the StarMine EQ score of 3 offers plenty of reasons to remain concerned about the company’s earnings quality.
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