A bird in the hand is worth two in the bush

Mariyam Zhumadil, CFAJuly 04, 2013

Kazakhmys’ Board chose to back the low-ball offer from the consortium of bidders in the absence of other feasible alternatives to realize the value of the ENRC investment. Although disappointed, we have to agree with the Board’s arguments and we expect Kazakhmys shareholders to approve the sale. We have revised our valuation to include the sale of the ENRC stake and have lowered our commodity price forecasts. We lower our 12-month target price to 315GBp and upgrade the stock to a ‘Hold’.  The main short-term share price catalyst is the approval of the ENRC offer by Kazakhmys shareholders, while the downside risks are the rejection of the offer, further decline of copper price, and eruption of a social conflict in Zhezkazgan.

The ENRC offer receives backing of Kazakhmys Board in the absence of other alternatives
Kazakhmys’ Board chose to back the low-ball offer from the consortium of bidders in the absence of other feasible alternatives to realize the value of ENRC investment. Based on the negotiations held with the consortium, the Board concluded that there was no prospect of receiving improved offer terms, while the risks of further decline in value of the ENRC investment were considerable. Although we agree with Kazakhmys’ Board that the risks of further decline of ENRC value are considerable, given the ongoing SFO investigation, the company’s high leverage, the risk of exclusion from FTSE-100 and possible equity dilution, we are disappointed with the passive position Kazakhmys Board has pursued in managing the ENRC investment since its acquisition and the fact that the negotiations with the consortium did not translate into a higher bid.

Kazakhmys: implications of accepting the offer
If Kazakhmys accepts the offer, the miner would receive $887mn in cash and 77mn of its own shares. The cash would be used to reduce the KAZ’s growing leverage (HF 2013E net debt at $2.3bn) and 2013 Net debt/EBITDA would improve from estimated 12.2x to 7.6x. The shares received by Kazakhmys would be cancelled, reducing the total outstanding number of shares by 14.7%, which would have a positive impact on the per share value. Following the closure of the transaction, Kazakhmys’ free float would increase by approximately 62.1mn shares or from 37% to 58%. We believe the increased free float would help boost liquidity and would help limit the power of dominant shareholders in running the company. 

With the acceptance of the offer, we estimate that Kazakhmys would have to record an impairment charge of approximately $760mn on its books. Although the expense is non-cash, it would have a negative impact on the bottom-line. Recall that in 2012 the company already impaired the value of its ENRC investment from 575 GBp to 375 GBp per share.

  Revenue Revenue growth EBITDA EBITDA margin Net income Net debt ROE After-tax ROIC EPS FCFF
  ($ mn) (yoy, %) ($ mn) (%) ($ mn) ($ mn) (%) (%) ($) ($ mn)
                     
2012A 3 353  (5,9) 628  18,7  (2 271) 707  (27,4) 2,8  (4,34) 502 
2013E 2 862  (14,6) 191  6,7  (54) 2 325  (3,2) (2,0) (0,10) (1 811)
2014E 2 870  0,3  114  4,0  (287) 3 776  (7,5) (2,8) (0,64) (1 582)
2015E 3 312  15,4  281  8,5  (231) 4 553  (6,9) (1,7) (0,52) (872)
Sources:  company data, HF Research estimates  

The terms of the ENRC offer remained unchanged
On June 24, ENRC shareholders received a revised conditional offer at 234.3GBp per share ($2.65 in cash and 0.230 of Kazakhmys share). The terms of the offer remained broadly unchanged compared to the offer made in the previous month, but its value declined by 7.4% due to a 20.4% decline of Kazakhmys share price. In order for the offer to become unconditional as to acceptances by the minority shareholders, the proposal needs to be approved by 75% of the votes. Therefore, the vote of Kazakhmys with a 26% holding is decisive.

Kazakhmys shareholder vote mechanism
In order for the offer to go through, an approval of Kazakhmys shareholders on three separate resolutions is required. The second and the third resolutions would be the most challenging to receive approval. The second resolution requires support from 75% of the votes out of 73.4% of shareholdersas the Government of Kazakhstan, which is a member of the consortium and a shareholder of Kazakhmys with a 26.6% holding, cannot vote. The third resolution needs to be approved by 50% of minority shareholders only.

Figure 1. Summary of required Kazakhmys shareholder approvals
Resolution Parties excluded from voting Nature of vote (threshold)
Approval of the disposal by Kazakhmys of its ENRC shares to Eurasian Resources, the Share Repurchase and the publication by Kazakhmys of a prospectus Eurasian Resources and the members of the ENRC Consortium and their associates (26,6%) 50%
Approval of the Share Repurchase in accordance with the terms of the Share Repurchase Agreement Eurasian Resources and the members of the ENRC Consortium and their associates (26,6%) 75%
Approval of the Rule 9 Waiver Eurasian Resources and the members of the ENRC Consortium and their associates (26,6%), and Kazakhmys Concert Party (35,9%) 50%
Source: Kazakhmys data  

The receipt of approval under the first resolution should not be a challenge for the consortium, as the consent of the Kazakhmys Concerty Party (Kim, Ogai and Novachuk), who cumulatively own 35.9% of the company’s stock, has already been received. Kazakhmys shareholder vote may be undertaken in August at the earliest, according to the company.
In our view, the offer has high chances of being accepted by Kazakhmys shareholders, in the absence of other alternatives and given the troubled position of ENRC. We expect the ENRC buyout to close before year-end at the latest, subject to receipt of all required regulatory approvals.

Following the transaction closure, assuming that the Government of Kazakhstan (GoK) is not putting in cash to finance the buyout, we estimate that the consortium members will have approximately equal ownership of ENRC. The GoK will effectively exit the shareholder structure of Kazakhmys, while Kim, Novachuk and Ogai will increase their KAZ shareholding from 36% to 42%. The free float would be boosted by about 20% to 58%, which would improve shares liquidity and could help increase minority shareholder protection.

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The impact of Zhezkazgan copper smelter closure on valuation is neutral at this stage
On June 20, Kazakhmys announced the closure of Zhezkazgan copper smelter as early as September 1 due to reconstruction. The present electrosmelting technology used at the plant does not fit for smelting concentrate from the new growth projects, Bozshakol and some smaller ones, which are scheduled to start production in 2015, according to the company. Kazakhmys initially announced that out of the total 1767 workers employed at the smelter, 200 workers will be transferred to the Balkhash facility, 61 workers will be engaged in loading of the concentrate, while the rest will participate in the reconstruction works. Despite the company’s assurance that no worker will be laid off, on June 24th about 100 workers and residents of Zhezkazgan gathered in front of the smelter demanding answers from the company’s management and drew up an appeal to the President to nationalize the plant.

We believe the decision to close the plant now is not motivated by the urgency of plant reconstruction, but most likely is due to the smelting economics, which is unprofitability at the current copper prices. We expect the plant closure to have a neutral impact on the company’s operating costs as significant cost cuts are unlikely due to the resistance of the local workforce. The company maintains its 2013 production guidance, while the share of concentrate in the total product mix will increase with part of the concentrate redirected for smelting to Balkhash plant. Meanwhile, the company estimates the total cost of the Zhezkazgan plant renovation at $130mn, which is well below our average sustaining capex forecast for 2013-2015 of $376mn. At this stage we assess that the impact on valuation is neutral.

Valuation updated
We have updated our valuation to reflect the revised commodity price forecasts and the sale of the ENRC stake.
We have lowered our copper price forecasts due to the slowdown of the economic growth in China, which means one digit base metals consumption growth compared to the double-digit annual growth in the past. The recent liquidity tightening in China and the expected surplus in the market over 2013-2014 may support short to medium term weakness of copper price. We have maintained our copper price forecast post 2015 as in the long-term horizon we believe that prices will have to be high enough to induce the development of new lower grade, higher cost mines, to satisfy the future demand.

Figure 4. Revised commodity price forecasts
  2013E 2014E 2015E 2016E
Copper, $/t        
-previous 8 290 8 367 8 389 7 000
-new 7 300 7 200 7 100 7 000
% change (11,9%) (13,9%) (15,4%) 0,0%)
Gold, $/oz        
-previous 1 700 1 650 1 600 1 300
-new 1 400 1 388 1 342 1 385
% change (17,6%) (15,9%) (16,2%) 6,5%)
Silver, $/oz        
-previous 34 30 25 23
-new 24,8 23,2 23,0 23,0
% change (27,2%) (22,7%) (8,0%) 0,0%)
Zinc, $/t        
-previous 2 000 2 200 2 300 2 050
-new 1 973 2 056 2 141 2 233
% change (1,4%) (6,5%) (6,9%) 8,9%)
Sources: HF research estimates  

We have also lowered our price forecasts for gold and silver as investment demand for precious metals fell, while physical demand is insufficient to cover the shortfall. The tapering of QE3 by Fed, expected in September 2013, would push bond yields higher, strengthen dollar, and gold ETF redemptions would accelerate. We expect gold to be in surplus over 2013-2014 due to weak investment demand, while physical demand may pick up on low prices.

With $887mn from the ENRC stake sale and a reduced share count, we estimate that the fair value of Kazakhmys stock is 276GBp per share, which implies that the stock is fairly valued now. We believe that the market now may be not pricing in fully the ENRC stake sale, and once the transaction is closed, this would serve as a positive catalyst for the stock, and we would see a short-term rebound in the stock price. The sale of Ekibastuz GRES-1 is another positive catalyst, which could provide upside to our current valuation. However, in the medium- to long-term we keep our cautious outlook on Kazakhmys due to high cost inflation, deteriorating grades and limited production growth opportunities until 2015. 

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