TECK – Page 2 – Divestor

The Teck Sweepstakes, Round 3

In today’s episode, “Teck approached by Vale, Anglo American and Freeport to explore deals after planned split, sources say“, in addition to the controlling Class A shareholder releasing a carefully fine-tuned statement to keeping all doors open.

Glencore’s 7.78 shares per Teck Class B share is currently worth about CAD$63 on the market, while Teck shares are trading slightly above this.

What is a potential paper napkin valuation?

Freeport McMoran in 2022 posted an EBITDA of $9.3 billion and sports an enterprise value of US$74 billion, or about an 8x multiple.

Teck in 2022 posted an EBITDA of CAD$10.2 billion, consisting of $1.84 billion on Copper, $1.04 billion on Zinc, and $7.36 billion on coal.

Arbitrarily giving a 8x valuation on copper and zinc, and a 2x valuation on coal (looking at ARCH as a comparator here), gives an EV of CAD$38 billion. Teck’s EV today is about CAD$40 billion.

However, this does not include the impact of Teck’s 70% ownership of the QB2 project coming online, which will fully add a huge amount of contribution margin.

The economics are mostly intact from the 2018 business case, short of copper costs projected to increase from US$1.30/pound to US$1.50/pound in 2024.

The contribution at US$4.00/pound copper is expected to be around CAD$2.2 billion EBITDA at 100% project basis – or about CAD$1.5 billion at 70%. Add in the increased costs and let’s say it levels off at around CAD$1.3 billion.

Add $1.3 billion at 8x and you get another $10 billion added to the EV, or about a CAD$48 billion bid. It’s around CAD$75/share.

There is plenty of wiggle room from the current market price of CAD$65.

One is that coal is undervalued at 2x EBITDA. While it is being discussed as the throwaway asset, it obviously is generating a ton of cash at present. While met coal prices have tapered considerably since 2022, it is still a wildly profitable asset – it is more likely that the operation will be given a higher multiple as the commodity price decreases.

Another is the valuation of the mining reserve pipeline. QB2, for instance, has a huge reserve.

Obviously Teck will want to make its acquisition as expensive as possible. I’m guessing around CAD$70-75 and something gets done.

The Teck Sweepstakes, Round 2

In the second round of the Teck and Glencore corporate soap opera, Glencore responds to Teck’s rejection with the following:

Glencore continues to believe that CoalCo’s combined thermal and coking coal assets would position it as a leading, highly cash-generative bulk commodity company which would attract strong investor demand given its yield potential. However, Glencore acknowledges that certain Teck investors may prefer a full coal exit and others may not desire thermal coal exposure.

Accordingly, Glencore has proposed to the Teck Board to introduce a cash element to the Proposed Merger Demerger to effectively buy Teck shareholders out of their coal exposure such that Teck shareholders would receive 24% of MetalsCo and US$8.2 billion in cash. This valuation is in line with both (i) the implied enterprise value of Elk Valley Resources (“EVR”) and the Transitional Capital Structure owned by Teck shareholders based on the Nippon Steel investment under the proposed standalone separation into Teck Metals and EVR (the “Proposed Teck Separation”), and (ii) the upper end of the valuation ranges of EVR provided by Origin Merchant Partners, in its fairness opinion to the Special Committee of the Teck Board.

Glencore clearly knows that Teck is going to reject this proposal, but they still want to keep in the limelight for the next couple rounds of this drama. There’s more action to come before the April 26, 2023 meeting to confirm (or reject) Teck’s proposal to its shareholders.

My guess is that Glencore will be offering around CAD$70/share for Teck in some very strange contingently valued offer (least of which is that the April 26 meeting no longer take place). Money speaks, and this situation is certainly no exception. It’ll probably be a good time to punch out the clock at that point – this is faintly reminding me of what happened to Potash Corp (now Nutrien) roughly a decade back.

The Teck Sweepstakes!

Glencore: Proposed Teck merger and coal demerger

What the heck is a “demerger”? Rhetorical question.

I see two events going on here. The very public event is the following slide on copper:

Glencore makes a case that there is a strategic synergy to utilizing QB2 facilities to improve efficiencies on its own project (Collahuasi), which you can see on a map are relatively close together:

It is a geographical advantage that the others (specifically BHP) does not have.

But really, this merger is all about coal.

With Teck, Glencore picks up 10 million tons a year of production and this will nearly double its Canadian production.

When working in its entire base of met and thermal operations, if you believe the slide deck, it will generate CAD$14 billion pre-tax cash. Needless to say, this would be a lot of money.

At Glencore’s stock price of about $7.60/share, it prices Teck (Class B) at around CAD$59/share. Notably this is below 10x analyst forward estimates, but given that most of the Capex has already been spent on QB2, Teck’s future free cash flows will be immensely higher in the future.

Thus, the price has to go higher. In addition, after the coal spinoff was announced, the market had Teck go up to around $62/share and I think that will be a psychological anchor point as a minimum.

Because Teck has a dual class structure, there is some inside baseball going on with the Class A shares. It could be possible they will be offered a sweetened deal, especially to the exclusion of Class B shareholders, and eventually agree to it.

There are cases where you hit the sell button after a proposed takeout offer. There are times where you hold on and wait for a better offer. The latter is likely the case.

I’m guessing a deal gets done in the mid to upper 60’s.

If not, there’s a ton of cash flow to be distributed in the future, especially with the Elk Valley spinout – will be interesting to see how much the market puts a price on political correctness.

After that, however, will be a regulatory nightmare that will make Shaw and Rogers look simple.

Teck’s coal spinoff (Elk Valley Resources)

Many smart people have already written about this, and many smart people have traded this. I won’t repeat their analysis.

The key point was this line in the conference call:

Concurrent with the separation, we announced agreements with two of our steelmaking coal joint venture partners and major customers to exchange their minority interest in the Elkview and Greenhills operations or interest in EVR. Notably, Nippon Steels $1 billion cash investment implies an $11.5 billion enterprise value for our steelmaking coal assets.

Given the amount of cash the EVR spinoff is producing at current met coal prices, the EV that they gave the equity stake to is low, which is probably why they got the minority shareholders to subscribe to EVR.

I surmised in my previous post:

What you also do to complete the financial wizardry is that you load the coal operation with debt, say around $10 billion. Give it to the parent company as a dividend, or perhaps give it to shareholders as a dividend in addition to the spun-off equity and the projected return on equity will skyrocket (until the met coal commodity price goes into the tank, just like what happened two seconds after Teck closed on the Fording Coal acquisition before the economic crisis).

It turned out my $10 billion dollar figure was nearly correct, but in the form of a 60% royalty on the first $7 billion of cash, coupled with $4 billion in 6.5% mandatorily redeemable preferred shares. Instead of doing a straight debt deal, this all just goes into Teck’s bank account.

The length of the payout period depends on met coal pricing being sufficiently high – something that I don’t think can be depended on for the majority of the rest of the decade.

Quite frankly, I think they screwed it up and hence the market reaction.

Since Teck is likely to make huge positive cash flows coming forward with their copper operations, they did not need to do a cash grab on the coal operation. If the spinoff was a simple one, I think much more market value would have been assigned to the joint entities.

Also, not being given enough attention is the give-away to the Class A shareholders. This is a very rare situation where you have a dual class structure and the voting shares get a huge payoff. (Looking at Rogers’ stock here!). I will be voting against this arrangement.

A few small observations

A mixed post.

Where I was mistaken

I made a claim earlier that I thought employment around January or February of this year would be shown to decline, presumably due to a slowdown in demand and companies cutting costs. Unless if you were one of the victims of a big tech company’s layoff, wow, was I ever wrong with this! Gross employment trends continue to exhibit strength, consistent with anecdotal reports of employers finding it difficult to source labour.

So where was I wrong here? Is there a demographic issue? Are companies out there finding additional vectors of demand to necessitate employment? Or am I just premature with my prognostication? I’m not sure.

There are some hints on the Fiscal Monitor – income tax collections and GST collections are up over comparative periods last year, and especially corporate income taxes. The government is likely to report an improved fiscal balance as well. This leads me to the second issue, which is…

The progression of QT

Members of Payments Canada (a.k.a. financial institutions parking reserves at the Bank of Canada and earning the short-term rate) continues to hover at the $190 billion level. The recent slab of government debt maturing off of the Bank of Canada’s balance sheet got directly subtracted from the Government of Canada’s bank account at the Bank of Canada, but the GoC is still sitting with $65 billion cash as of February 15, 2023.

What does this mean? The presumed pressure on liquidity is not happening – yet. Banks can still lend out capital, but you have to have an awfully good proposition since they’re not going to give it to you for cheap interest rates. Why should they lend it out to you at 6% when they can keep it perfectly safe at the Bank of Canada and skim their 4.5%?

While there’s liquidity, it’s definitely a lot more expensive. When you combine what I wrote about employment above, coupled with real estate finding its two legs again (helps that there is zero supply in the market), makes me think that the Bank of Canada was incredibly premature to call a pause on rates – March 8th they’ll be guaranteed to stand pat, but perhaps we might continue to see rate increases if CPI doesn’t drop quickly enough in the next couple months. Also, the US-Canada currency differential is also going to widen as the US Fed will be raising rates for longer.

A public market investor at this point is facing a crisis of sorts. Asset prices (unless if you owned garbage technology companies) haven’t deflated that much, so what is trading out there is really not the greatest competition for the risk-free rate. You have cash.to giving off a net 4.89%, and when you look at some average 20 P/E company, one has to ask yourself why you should be bothering to take the comparative risk. Just look at the debenture spreadsheet and the spreads over risk-free rates is minimal.

Commodities

In the middle of 2020, the trade was a no-brainer. Ever since then, it has become less and lesser so, to the point today where it is no longer about throwing capital into random companies and winning no matter what – discretion has been critical from about June of last year. The meltdown in the natural gas market is one example of where an investor could have turned into roadkill, especially with leverage. In general, you can lose less money by investing in low cost structure companies, ideally with as low debt as possible. The problem is if you have a whole bunch of industry participants in a good balance sheet situation – the race for the bottom becomes brutal since they can mostly survive low commodity price environments until some finally do get eliminated due to high cost structures and/or high debt service ratios.

Teck

They explicitly had to disclose they’re looking into strategic options for their met coal unit, which would be a cash machine of a spinoff if they went down that route. Seaborne met coal has rebounded as of late and it would be really interesting to see the price to cash flow ratio assigned to a pure met coal unit. A comparable would be Arch Resources, and they are trading at 4x 2023 earnings. Teck does have considerable competitive advantages, however – better access to the Pacific and a lower cost structure, in addition to being able to pump out more coal. Stripping out the coal business would leave the copper and zinc business in core Teck, and the residual copper business might get a 20x valuation (looking at Freeport McMoran as the comparable here). When you do the math on both sides of the business (especially as Teck’s QB2 project is ramping up this year and will produce gushing cash flows at US$4 copper), the combined entity would be worth well more than $30 billion today. So with a little bit of financial engineering, Teck can generate market value from nothing.

Let’s look at the first 9 months of the year (which is abnormally high for met coal, but just to play along).

I have (for met coal) their gross profit minus capital expenditures, minus taxes, at around $4.5 billion annualized. Give that a 4x multiple and you have $18 billion. On copper, with QB2 at full swing, it should be (very) roughly $1.5 billion total for their consolidated copper operations and at 20x you get $30 billion. Add that together and it’s well over the existing market cap.

What you also do to complete the financial wizardry is that you load the coal operation with debt, say around $10 billion. Give it to the parent company as a dividend, or perhaps give it to shareholders as a dividend in addition to the spun-off equity and the projected return on equity will skyrocket (until the met coal commodity price goes into the tank, just like what happened two seconds after Teck closed on the Fording Coal acquisition before the economic crisis).

Despite the above calculation, I’ve been taking a few chips off the table. My overall position has continued to be of increasing caution, one reason being that I don’t have a very firm footing on what is going on.