OZ Ups The Ante, And The Risk

This story features OZ MINERALS LIMITED. For more info SHARE ANALYSIS: OZL

– Strategic review surprises
– No mine life extension
– Dividends improved
– M&A risk stepped up
 

By Greg Peel

Higher underground grades at Prominent Hill meant OZ Minerals ((OZL)) posted a better than expected March quarter production result on much lower than forecast costs. The focus of the release was nevertheless on the accompanying, long awaited strategic review.

The problem for the wizards at OZ is that the Prominent Hill copper mine is generating very healthy cash flow, which is great, but the resource will expire in only three years, which is not so great. OZ needs to grow, and needs to secure growth options sooner rather than later.

The frustration is that in Carrapateena, OZ is sitting on a world class copper resource. Developing an operation at Carra would be, however, a very costly business, requiring in excess of $2bn in capex. On current spot copper prices, such an investment does not make commercial sense unless the company can find a funding partner. The door has been open for a long time now, but no one’s looked in. Thus OZ will take Carra to the pre-feasibility stage and then mothball it until the outlook changes.

Analysts were thus assuming the strategic review would address ways to extend Prominent Hill’s mine life. But this has not proven the case. Rather, OZ intends to step up its production levels at the Hill, targeting high grade copper specifically at the expense of gold, and has raised its FY15 production guidance accordingly. Once the open pit resource expires, stockpiles and underground ore will be processed.

Then it’s all over. Hence in order to grow, OZ must make an acquisition. Or two.

The company certainly has the balance sheet to pursue M&A, and indeed management has been keeping its eye out for a long time now. But given strict self-imposed acquisition criteria, no viable target has to date presented itself.

So now the shackles have been released. Previously management was targeting a copper mine of 50-150ktpa capacity with a ten year plus mine life in a low to medium risk jurisdiction. Now OZ will look for opportunities in lead, zinc and gold as well as copper, of any capacity and any life, anywhere.

There’s a bit of a hint of desperation here. The good news for shareholders is OZ has tweaked its dividend policy, setting a payout based not on 30% earnings as was previously the case, but on 20% of cash generation. This should lead to higher dividends. But there is a trade-off.

The bad news is that while OZ boasts a strong balance sheet with no debt and plenty of M&A capacity, the board will cancel the dividend if necessary to pursue the right acquisition.

For analysts this means OZ has become a more risky investment. The right acquisition might be a winner and provide an alternative to three years of nice dividends but given the board has widened its search area, M&A risk has intensified.

“The introduction of near-term M&A risk might prevent some investors from owning the stock,” JP Morgan contends. Beyond that, the broker believes there are few visible catalysts for OZ other than a rise in the copper price, hence a Neutral rating is retained.

UBS sees investors drawn towards OZ’s positive free cash flow and dividend, but given Prominent Hill’s short mine life believes “the pressure to acquire an asset could weigh on investor sentiment”. The broker retains a Hold rating.

Also on Hold is Deutsche Bank, who suggests the main outcome of the strategic review appears to be that the medium term outlook for OZ will be improved by M&A. The rating reflects “operational uncertainty and acquisition risk”.

On the other hand, both Citi and Morgan Stanley cite OZ Minerals as their preferred copper play. Citi is encouraged by an accelerated M&A quest and expects action in the next 12-18 months. Morgan Stanley expected the strategic review to outline greater mine plan changes but is happy that the overall impact of the step-up in throughput at Prominent Hill adds value to the stock. Citi retain Buy and MS Overweight.

Upgraded production guidance has led brokers to upgrade earnings forecasts but there has not been a lot of movement on the valuation front, with FNArena’s consensus target price rising only to $5.14 from $5.03, although that still implies 24% potential share price upside. There have been no ratings changes, with five Buy or equivalent ratings meeting three Hold.
 

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