Revenue Recognition Masks Earnings Again - Selloff Unwarranted
Breakwater reported Q3/07 net earnings $0.02/sh, much lower than
expected. The lower result was due to a significant amount of production not recognized as sales in the quarter. Metal production was generally in line with expectations, however, costs were modestly higher.
Operational improvements at Myra Falls are expected to support results going forward as new ore zones are accessed. The recent problems at Mochito appear manageable, however, we have assumed no production in Q4 to be conservative, reducing our EPS outlook.
We view the sell-off in the shares as inappropriate and was likely more of a reaction to the "headline shock" of the reported earnings figures as opposed to a change in the underlying fundamentals of the company. We view this as a buying opportunity.
We continue to rate the shares Sector Outperformer given the company's leverage to zinc, strong financial position and potential for production growth in excess of our forecasts.
Our price target remains $3.75.
Cliff Hale-Sanders, CFA Terry K.H. Tsui, CFA
Stock Rating: Sector Outperformer
Sector Weighting: Market Weight
12-18 mo. Price Target $3.75
BWR-TSX (11/1/07) $2.55
52-week Range $1.46-$3.69
Shares Outstanding 418.2M
Float 313.0M Shrs
Avg. Daily Trading Vol. 2,680,000
Market Capitalization $1,066.4M
Book Value $0.64 per Shr
2007 ROE (E) 9.7%
LT Debt $0.5M
Preferred Nil
Common Equity $267.7M
Convertible Available No
Earnings Per Share Prev Current
2006 $0.27A
2007 $0.48E $0.40E
2008 $0.57E $0.54E
P/E
2006 9.4x
2007 5.3x 6.4x
2008 4.5x 4.7x
Cash Flow Per Share
2006 $0.47A
2007 $0.62E $0.53E
2008 $0.79E $0.73E
P/CF
2006 5.4x
2007 4.1x 4.8x
2008 3.2x 3.5x
Company Description
Breakwater is one of the largest zinc-in-concentrate
producers in the Western World with operations in North
America, South America and Africa.
Q3 Results Weak On Revenue Recognition Issues
Breakwater reported Q3 net earnings of $7.8 million or $0.02 per share compared with net earnings of $0.09 per share in Q3/06. Results for the quarter did not include 70,519 tonnes of concentrate shipped but not recognized as sales for the quarter due to Breakwater’s very conservative revenue recognition policy.
Had these concentrate inventories been included under the provisional
pricing mechanisms used by most mining companies, it is estimated that they
would have contributed pre-tax earnings of $29.4 million (about $0.06 per share
after tax) suggesting earnings would have been closer to $0.08 per share.
Nevertheless, the results were lower than our forecast of $0.12 per share and
consensus of $0.11 per share due to production shortfalls at Myra Falls and El
Toqui, higher exploration expenditures than we had forecasted and higher costs
due to the impact of the stronger Canadian dollar.
The build-up of inventory continued with 111,413 tonnes of concentrate inventory recorded by the end of Q3/07, which was higher than the 78,234 tonnes at the end of Q3/06.
Unshipped concentrate inventories at the end of Q3/07 were about 20,000
tonnes higher than the levels at the end of Q2/07 due to shipping schedules and
logistical issues that have reportedly now been resolved, and inventory levels
should be worked down in the fourth quarter, supporting higher sales volumes.
Operations Review
For the quarter, metal production at all operations except Langlois were slightly
lower than forecast, with total zinc production of 70.7 million pounds. On a per
pound of zinc basis, overall unit costs went up sharply with consolidated cash
costs at US$0.61/lb compared with US$0.45/lb in Q2/07 and US$0.57 in Q3/06.
We had been assuming a modest improvement in cash costs, however, lower
head grades and operating disruptions at Myra Fall, and the mill shutdown at
Toqui due to weather conditions, offset any improvement seen from stronger byproduct
metal credits.
At this time, Breakwater indicated that it is unable to provide production
guidance due to the uncertainties at Mochito. We have assumed the mine is
closed for the remainder of 2007 and will reopen in early 2008 for modeling
purposes.
Myra Falls
In Q3, production at Myra Falls was once again lower than anticipated as ore
production at the mine continued to be constrained by a variety of factors,
namely delays in receiving additional haulage trucks, damage to a drill jumbo
caused by a blasting incident, and delays in hoisting mined material because of
longer tramming distances caused by the plugging of the main ore pass. Also,
mining of some of the higher grade open pit material, anticipated in Q3, was
delayed due to pit wall instability, which has since been addressed.
The copper zone from the open pit has now been mined with the zinc zone to be mined
before year-end, which should support increased production. The company also
expects additional haulage trucks will be put into production during Q4/07.
During the quarter, the new ramp broke through into the Lynx 15 level providing
the long awaited increase in ventilation requirements for the western extremities
of the Battle Gap mine to allow additional haulage equipment into the larger
stoping areas and for development to the north and west.
A new ventilation raise was driven from the Gopher zone up to the 18-155 drift to bring additional ventilation into the Gopher and Main zones, which are expected to be the main
mining areas for the next two to three years. The opening of these zones has
been a critical step to increasing ore production at Myra Falls. With the region
now available for development, the company should be in a position to
commence mining larger working areas thereby increasing ore availability to the
mine and reducing unit costs.
The company is targeting to increase ore production from the 156,000 tonnes in Q3 to over 200,000 tonnes in Q4. Assuming no material ramp-up difficulties, this should put Myra Falls in a position to ramp up mill throughput levels to the 1.2 million tonnes rate over the
next 18 months or so, which should significantly increase metal production
levels.
El Mochito
El Mochito’s zinc production was in line with our expectations for the quarter as
higher ore grades offset the slightly lower tonnage milled. Exploration work
aimed at increasing the resource base at El Mochito continued in the quarter as
the company continued to explore, develop and delineate new mineral resources
and reserves along the northeast extension of the Santo Niño trend and in the
Deep East area.
Surface drilling also continued at El Mochito and the company
continues to test drill on the Big Fuzzy target. Given the ongoing success of the
exploration program we remain confident that the company will be successful in
increasing the overall minable resource and extend the mine life of this
operation.
As previously noted, Breakwater suspended the milling operation at Mochito
following a discovery that water was being discharged from the Soledad tailings
impoundment area on October 18. The discharge has ceased with the lowering
of the pond water levels, and repair options are being assessed. Milling
operations have now been restarted on a trial basis to control copper levels that
would be discharged in the older Pozo Azul tailing pond.
A preliminary evaluation of the situation has determined that recommissioning the Pozo Azul tailings impoundment area, for which permitting remains in place, will be the quickest
method of returning Mochito to full production. That said, in order to provide 24
months of capacity it will likely take 6-8 weeks to put in place a new lift for the
tailings dam wall and given it is the rainy season in Honduras this could take
longer.
If tests to control copper discharge levels are successful Mochito may be
able to ramp up the mill to full capacity prior to the tailing pond expansion being
completed. To be conservative we have assumed the mine does not produce
meaningful quantities of metal in Q4/07 but is back at full capacity in Q1/08.
Longer term, the company has indicated that it plans to use a paste tailing
disposal system to minimize risks of a repeat. While this is a negative we see no
long-term impact on the operation.
El Toqui
Zinc production at El Toqui was lower than forecasted as a result of abnormally
severe winter conditions that caused pipeline freeze-ups that hampered mill
operations in September. As such, ore milled declined to 131,123 tonnes from
137,089 tonnes in Q3/06. Gold and silver production, however, continue to
improve due to higher grades. Zinc and lead grades are expected to increase as
more Concordia material is mined in the last quarter of 2007.
Development of the Porvenir deposit continues as a mining contractor was
selected and excavation work commenced. Porvenir is expected to start
production in early 2009. Drilling also continued on the Porvenir deposit to
increase the inferred resources, and to attempt to delineate the outline of the
deposit, which is currently open to the north-west and south-east. Breakwater
has recently decided to conduct a pre-feasibility study for a 1.0 million tonne per
annum mill at El Toqui. Production is currently constrained by mill capacity as
mining rates continue to be well ahead of the mill. Assuming a positive study, it
would likely take two years to complete the expansion.
Langlois
The ongoing ramp-up at Langlois was ahead of our expectations with 133,000
tonnes of ore milled in Q3. During the quarter, a ramp was started from level 9
to access Zone 97 between level 9 and level 4 as well as a decline to access
Zone 97 between level 9 and level 13. A new ramp from surface was collared
during the first quarter of 2007. By the beginning of the third quarter of 2007,
the new ramp had accessed the upper portions of Zone 4 between the current
mining areas and surface. These new access points should help support the build
up of ore available to the mill to continue to increase production levels going
forward.
Breakwater continues to explore the Langlois area and currently operates five
surface diamond drills that focus to explore Zone 5, the lower portion of Zone
97, the Contact Zone, Grevet B, and Orphee. Drillings at Langlois is expected to
upgrade known inferred resources to the indicated resource category as well as
test a number of targets including the west extension of Zone 97 in Q4/07. As
such, we expect the resources in the region to continue to expand the mine life
of the operation and potentially lead to an increase in the milling capacity at the
site.
Earnings Outlook
We continue to expect Breakwater’s earnings and cash flow to grow significantly
over the next two years as zinc prices are poised to remain at robust levels
given robust demand and limited new supply entering the market. We continue
to view market sentiment towards zinc relative to other commodities as unjustly
negative. Inventory levels for zinc as compared to copper or nickel are at
similar levels relative to their respective market sizes and the so-called surge in
zinc concentrate supplies continues to be underwhelming due to ramp up
difficulties. As such, barring a global pullback in demand we believe zinc prices
should once again trend higher.
On the back of the company’s actual results and new guidance we have updated
our 2007 and 2008 earnings forecasts. Our 2007 earnings and cash flow
estimates have decreased from $0.48 per share and $0.62 per share to $0.40
per share and $0.53 per share, respectively. Our 2008 earnings and cash flow
estimates have been adjusted marginally from $0.57 and $0.79 per share to
$0.54 and $0.73 per share, respectively. In Exhibit 1 we have presented our
production forecast for Breakwater over the next few years that support our
earnings profile based upon our published zinc price forecast of US$1.55,
US$1.60 and US$1.50 per pound in 2007, 2008 and 2009, respectively. We view
our production outlook as conservative as we have not assumed addition
resources to extend the life of El Mochito and no expansion at El Toqui.
While Q3/07 results were slightly disappointing, the sell-off in the shares
appears well overdone and we believe was likely more of a reaction to the
“headline shock” of the reported earnings figures as opposed to a reflection in a
change in the underlying fundamentals of the company. Over the past few
months Breakwater’s share price has been extremely volatile with pullbacks
offering great buying opportunities, in our view. We believe this is but another
one of those times. We continue to rate Breakwater Sector Outperformer given
the company’s leverage to zinc, strong financial position and potential for
production growth in excess of our forecasts. Our price target remains $3.75
per share.
Price Target Calculation
Our price target of $3.75 assumes a premium to our NAV estimate of $2.70 per
share (down from $2.76/sh) given its high leverage to zinc prices and the
conservative nature of our NAV. On a price/cash flow basis, our price target
represents a discount to a multiple of 5.0x our 2008 estimate, which is the
industry average to account for the significant shareholder overhang. We believe
higher share prices are possible once operating uncertainty has been removed
and additional resources have been delineated to expand the mine lives at El
Mochito and El Toqui.
Key Risks To Price Target
The risks to our forecasts are predominantly those associated with the operation
of an integrated mining and metallurgical company. These include
environmental, technical and logistical challenges. Breakwater’s results are also
exposed to changes in the C$/US$ exchange rate.