The Discount is Too Steep for This Congomerate

By Peter Epstein - August 8, 2012 | Tickers: FCX, TCK, WLT | 0 Comments

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Experienced investors know that companies with multiple business segments frequently trade with a, "conglomerate discount," i.e. the sum-of-the-parts is worth more than the whole. Also well known is that the discount can remain quite wide for longer than seems appropriate. In other words, conglomerates can be value traps. Teck Resources, (NYSE: TCK) may be a value trap for now, but the quality of its assets is increasingly difficult to ignore. In industries like mining that throw off huge cash flows, the conglomerate discount shouldn't be so steep.

Teck consists of 4 parts. It has the 2nd largest premium low-vol coking coal business in the world. From about 24 million metric tonnes today, organic growth will take them to 27-28 million tonnes within 3 years. [actually up to 31 million tonnes in total, but some of it is not premium low-vol coal]. Sell-side analysts value the coal franchise at about $18-$24 billion.

Teck's coking coal can earn cash margins of about $100 per tonne even with mediocre global prices. That's $2.75 billion at the mid-point of 27.5 tonnes. This high margin business warrants a 6x multiple, making it worth 6 x $2.75 = $16.5 billion. To be conservative, I ignore the 3 million tons of other coal production which is valuable, just not as valuable as the premium low-vol coking coal. Walter Energy, (NYSE: WLT) and Teck are the 2 largest premium low-vol coking coal producers in North America. Walter has operations in the U.S. and Canada. While the Canadian operations are very high cost, Walter can earn $100 cash margins from its U.S. operations. The quality of these 2 company's coking coal commands a premium price.

Teck's Diversification is a Valuable Attribute in Mining

Teck has excellent copper and zinc businesses. The Company's assets are high quality, long-lived and located in safe jurisdictions. Unlike peer Freeport-McMoRan, (NYSE: FCX) who's over exposed to copper and is experiencing ongoing problems in Indonesia and the Democratic Republic of Congo, Teck's operations in South and North America are comparatively safe. This is extremely important going forward as new projects are considered. Lower country risk means a lower discount factor applied to the NPV of a project.  

In a recent Bank of America research report, the analyst calculated an NPV for Teck's copper business of $9 billion. I refer to this number because I largely agree with the analyst's assumptions on costs and long-term copper prices. To be more conservative, I value this business at 2/3's of the analysts' $9 billion NPV, or $6 billion, to incorporate the conglomerate discount. Teck is also a large player in zinc, with an NPV of about $6 billion according to the same analysis. I assume 2/3's of that figure as well to get $4 billion.

Oil Sands Provide a Natural Hedge Against Cost Inflation in Teck's Other Mining Segments

Part 3 of the TCK conglomerate is oil sands. As a Canadian domiciled company, it's no wonder that Teck is getting into the oil sands business. There are over a dozen players in the oil sands, (not including juniors). Teck's foray into oil sands is a natural hedge for its coking coal, copper and zinc businesses. If oil prices spike, Teck's gain in its oil sands segment will offset cost inflation in its other segments. Teck controls over 1 billion barrels of oil through its oil shale holdings. I attribute a value of just $1.5 billion about half what the Company believes the assets are worth. 

Part 4 of the valuation is the, "other" category, largely containing reserves of copper, coal and zinc that have in-the-ground value even though they won't be extracted anytime soon. Think of these reserves as assets that could be sold to other mining companies to be exploited sooner.  Analysts peg these reserves at about $5 billion. I  use half of that value to be conservative.  Therefore, the sum-of-the parts valuation is $16.5 billion for coal, $6 billion for copper, $4 billion for zinc and $1.5 billion for oil sands = $28.0 billion. Subtracting net debt and the NPV of annual SG&A, the Net Asset Value is about $25 billion, or $42 per share. As a reality check, the highest 2 price targets I see are $58 and $70, and the lowest in the upper $30's to low $40's.

Look to Buy Teck on a Dip

Given the headwinds in the commodities space, especially in coking coal, investors should look to Buy Teck on a dip. I think there's a good chance the stock will see $26 per share this month. The Foolish should pick their own entry points, but a Buy at $26 offers 60% upside to my sum-of-the-parts valuation of $42 per share.     

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