Breakwater Resources: A play on zinc
Gold and silver are sexy, sure. But spare a though for plain-Jane zinc.
Zinc is used to galvanize steel to prevent corrosion. It’s used for die-casting, especially in the automobile industry. It’s also used in rubber and paints, for galvanizing iron, for electroplating, electrical fuses, fungicides, cable wrappings…
In a nutshell, where the economy goes, there goes zinc. And with China’s industrial boom still hurtling onwards, zinc demand worldwide seems set to grow apace, with some predicting a major supply gap within the next few years.
Which brings us to Breakwater Resources (TSX: BWR). While the Canadian miner produces other base and precious metals, the company’s focus is zinc. One of the most highly leveraged zinc plays currently, Breakwater has three zinc mines in production – in Canada, Chile, and Honduras – and is bringing a fourth into production, the Langlois mine in northwestern Quebec.
And yet it trades at a significant discount to its peers.
The three main reasons why also make the case for why Breakwater offers the potential for some handsome profits, making it a true value play with many possible events that could quickly start unlocking that value.
First off is the company’s largest zinc asset, its Myra Falls mine in central Vancouver Island, British Columbia. Breakwater’s largest zinc producer, it has also been its most problematic.
In the past the mine has been hindered by poor mining conditions, and a lack of investment by previous owners due to historically weak zinc prices. Last year, Breakwater said production was hurt by a shortage of underground working areas, delays in improving infrastructure, and problems with equipment availability. And while Breakwater has bumped up capital investment to bring the mine up to speed, the work isn’t on schedule. That led Breakwater to recently reduce its production guidance for 2007 significantly, from about 114 million pounds to 84 million pounds. But once the improvements kick in, Myra Falls' output should increase, and its costs should drop.
Second, zinc prices have cooled considerably. The price of zinc more than doubled from about US$3,500 per tonne from roughly US$1,300 per tonne in 2005. But in 2006, the average price dipped to US$3,275 per tonne. And so far this year, zinc has been the worst performing base metal in 2007, with prices having fallen around 10%.
Yet there’s reason to believe the recent pullback isn’t warranted by underlying fundamentals. There's little data to suggest an economic slowdown that would reduce demand for base metals. What’s more, China has been so hot for so long it would be unusual if some weren’t pronouncing the end - at least temporarily - of the party. However, few observers believe China’s economy will do anything but continue to thrive in the longer term.
And if zinc prices do head higher, they will go directly to Breakwater’s bottom line. In addition to being highly leveraged to the price of zinc, its annual zinc production is forecast to rise from 205 million pounds in 2006 to 275 million pounds in 2007.
Third is concern over the generally short mine life of Breakwater's operations. But there’s every sign that Breakwater plans to not only replace its depleted reserves, but also increase them. For example, Myra Falls has a six-year mine life, but Breakwater has high hopes that additional exploration drilling will extend that substantially. Similarly, the reserves at the El Mochito mine in northwest Honduras, which is expected to produce some 61 million pounds of zinc in 2007, are forecasted to be depleted in some two years. However, in the past, the mine has regularly been said to have a short life, but ongoing exploration has consistently extended that life.
Breakwater’s earnings per share in 2005 were C$0.05, and in 2006, C$0.42. One estimate has its EPS doubling by 2008. Breakwater’s market capitalization is C$703 million, and it has just C$0.5-million in long term debt. Profit was C$156.5 million in 2006 compared with C$14 million in 2005.
Despite these numbers, and forecasts of strong cash flow leading to impressive cash balances, Breakwater still has its naysayers. And that’s led to it continuing to trade at a discounted cash flow multiple – around half the 4- to 5- times multiple of its peers.
The Breakwater bears' biggest concern remains that ever-present worry about mine life. But overall, the company plans to spend C$27 million on exploration in 2007. And if that exploration pays off, Breakwater may break out and leave its value status far behind.
Breakwater has a market cap of just under C$900 million. The stock, which has trending upward from the beginning of the year, when it was around C$1.60, has recently been trading at around C$2.20. Breakwater’s 52-week high is C$2.44, and the low, C$0.92. Of seven analysts tracking Breakwater, the average forecasted EPS for 2007 is C$0.48, and for 2008, C$0.58. In a recently published report, CIBC World Markets put a 12-18 month target of C$2.75 on the stock. At the time, it was trading at C$1.83.
Breakwater last week reported net earnings of C$15.3 million or C$0.04 per share for the first quarter of 2007 ended March 31 after recording an income tax provision of C$7.2 million (C$0.02 per share), compared with C$38.3 million or C$0.10 per share after recording an income tax recovery of C$25.7 million (C$0.07 per share) a year earlier.
Breakwater’s conference call is scheduled for today (Monday) at 10:00 a.m. ET. It can be accessed at
http://www.newswire.ca/en/webcast/viewEvent.cgi?eventID=1841620. After the broadcast, an archive of the webcast will be available at http://www.newswire.ca/en/webcast/index.cgi?tab=archive.
