Company Profile

Ero Copper Corp (TSX: ERO) is a mining company and is engaged in the production and sale of copper from the Vale do Curaca Property in Brazil, with gold and silver produced and sold as by-products from the same. Ero's business strategy is centered upon aggressively increasing the high-grade mineral reserves, extending mine life and maximizing mill throughput of the operations, leveraging the excess capacity of the installed infrastructure. The Company currently mines copper ore from the Pilar and Vermelhos underground mines.

Investment Rationale

• A recovery in the Copper prices is expected to benefit the company in the near term: Copper prices gained approximately 41% per cent from the year lows as the demand started to pick up. China, one of the world's largest consumer of copper, has opened its economy and allowed the economic and industrial activities to resume, which is supporting the copper demand. Further, copper prices are likely to remain stable in the second half of the year as most of the governments across the globe easing the lockdown restrictions which is likely to result in the resumption of the industrial activities. Quick recovery in the copper prices and surge in copper demand is expected to benefit the company in the near-term.
• Reaffirmed production guidance: The Company reaffirmed its production guidance for 2020. The company expects its copper concentration production to be in the range of 41,000 to 43,000 tonnes from the Curaçá Valley operations. Also, the company expects to produce 38,000 to 40,000 ounces of gold.
• Strong Margin Profile: Despite a challenging first quarter of 2020, the company has reported strong EBITDA margin and operating margin of 46.6% and 31.1% respectively, which was significantly higher against the industry median of 27.4% and 10% respectively. Further, over the last eight quarters, the company has consistently reported EBIDTA margin above 25%, which reflects operational excellency of the management against the competition.
• Ample liquidity: The company has ample liquidity, which seems to be enough to mee the near-term requirement and help the company to navigate through a challenging time. The company bolstered its liquidity position during the period by drawing down its existing USD, and BRL denominated credit facilities of US$14.0 million and R$72.3 million, respectively. The company's cash balance stood at US$44.3 million, which almost doubled from the last quarter.
• Higher Spread between ROCE and WACC: The company has consistently maintained a higher positive spread between Return on Capital Employed and Weighted Average Cost of Capital. This reflects prudent capital allocation and management efficiency of the company. A higher spread suggests that the company is generating a significant return over its cost of capital.
• Risk Associated to Investment: As most of the company's revenue comes from the copper segment, therefore the business is significantly exposed to the volatility in the copper prices. Also, the company is exposed to the next wave of COVID-19 outbreak, as it would lead to a reduction in Copper demand and production hindrance as well. Further, the company is exposed to the foreign exchange risks as a vast majority of the group's earnings come from abroad, primarily from Brazil.

Financial Highlights: Q1 2020 Highlights

Source: Company filing.

During the first quarter of the financial year 2020, the company's revenue from Copper operations decreased by 5.7% to US$56.1 million against US$59.1 million recorded in the same quarter of the previous financial year. The decrease was primarily driven by a reduction in the ore grade and lower average copper prices. Further, revenue from the gold exploration decreased 7.2% to US$11.6 million in the quarter under review from US$12.1 million recorded in the same quarter of the previous year. The decline was driven by decreased production and sales volumes, which was partially offset by increased gold prices.

During the quarter, cost of product sold from copper operations came in at US$30.0 million, slightly lower than US$ 30.9 million reported a year over the period. The cost of product sold includes US$ 9.6 million as depreciation and depletion, US$7.0 million as salaries and benefits, US$4.0 million as materials and consumables, US$4.6 million as contracted services, US$3.0 million as maintenance costs US$1.7 million as utilities, and $0.1 million as other costs.

The company reported a decline in the mine gross profit of the copper operations, which stood at US$24.9 million, 8.8% lower on a YoY basis driven by lower revenues on account of lower copper prices, partially offset by a decrease in cash costs over the comparative period as a result of a significant weakening of the BRL versus the USD. The company also recognized mine gross profit of US$5.7 million in Q1 2020 compared to US$5.3 million in Q1 2019 from its gold operations.

The group reported a lower finance expense during the quarter. Finance expense came in at US$6.7 million as compared to US$6.8 million reported a year over the period. Finance expenses were primarily comprised of interest on loans at the corporate head office of US$1.8 million, interest on loans and borrowings at MCSA and NX Gold of US$0.9 million, loss on interest rate swap derivative of US$1.8 million, the accretion of the asset retirement obligations of US$0.3 million and other finance expenses of US$1.8 million.

The company reported a net loss of US$ 53.0 million in Q1 2020, as compared to a net income of US$15.5 million reported a year-ago period. The decline was primarily attributable to the recognition of unrealized foreign exchange losses on foreign exchange currency dollar contracts and foreign exchange losses on USD denominated debt.

As of March 31, 2020, the company held cash and cash equivalents of US$44.3 million. Cash and cash equivalents are primarily comprised of cash held with reputable financial institutions and are invested in highly liquid short-term investments with maturities of three months or less. The funds are not exposed to liquidity risk, and there are no restrictions on the ability of the company to use these funds to meet its obligations. Cash and cash equivalents increased by US$22.8 million during Q1 2020.  The company generated US$37.3 million as cash from operating activities.

On the production front, copper operations continued to perform well during the first quarter and in-line with the management expectations. During the quarter under consideration, 347,125 tonnes of ore was mined grading 1.39% copper from the Pilar Mine as compared to 433,258 tonnes of ore mined grading 1.73% copper during the fourth quarter of 2019. Further, 234,800 tonnes of ore were mined grading 2.26% copper from the Vermelhos Mine as compared to 185,045 tonnes grading 3.39% copper during the fourth quarter of 2019. In total, contributions from both mines resulted in 581,925 tonnes grading 1.75% copper mined during the period.

At the NX Gold Mine, the ramp-up of mining activity continues to accelerate within the Santo Antonio Vein following the successful transition from the Brás and Buracão veins in late 2019. Production totalled to 7,866 ounces of gold and 4,868 ounces of silver.

Stock Performance

At the last closing price (July 23, 2020, after the market close), ERO shares traded approximately 0.74% lower at CAD 17.32. In a year-over period, its shares tested a 52w high of CAD 25.34 on July 26, 2019, and a 52w low of CAD 8.40 on March 16, 2020. At the last traded price, its shares were traded approximately 106% above its 52w low price level and approximately 32% below its 52W high price level, which reflect that the stock has had strong run-up after March 16, 2020 bottom price level.

1-Year Price Performance (as on July 23^rd, 2020, after the market close). Source: Refinitiv, Thomson Reuters

On a YoY basis, its shares are featuring a negative price return of 30.39%. Further, in the last three months the stock has generated a price return of 23.01% and outperformed the benchmark index by 9% in the same period. 

Top-10 Shareholders

The top 10 shareholders have been highlighted in the table, together holds around 35.16% stake in the company. T. Rowe Price Associates, Inc. and Fidelity Investments Canada ULC holds the maximum interests in the company at 10.06% and 10.06%, respectively. Further, out of top-10 shareholders have increased their stake in the company over the last three months, with T. Rowe Price Associates, Inc. and First Asset Investment Management, Inc.  are among the top investors in the company which have increased their stakes by 6.02 million and 0.27 million, respectively. The institutional ownership in the company stood at 42.69% and ownership of the strategic entities stood at 16.55%.

Source: Refinitiv, Thomson Reuters

Valuation Methodology (Illustrative): EV/EBITDA based valuation metrics

*Note: All forecasted figures have been taken from Refinitiv (Thomson Reuters).

Stock Recommendation:

The group's performance in the first quarter of FY20 was impacted by the outbreak of COVID-19 and a steep fall in the copper prices, which tested a 4-years low level. However, Copper prices have bounced back approximately 41% from those lows and demand is also recovering gradually after China eased out lockdown measure. We expect the copper demand to continue to recover as other countries have also started easing out the lockdown measures and allowing the industrial activities to resume. A recovery in copper demand would help in stabilizing the copper prices, which bodes well for the company's revenue and cash flow. Further, the company has reaffirmed its production guidance for FY20, which is a key positive.

The company has a strong margin profile and consistently generated EBITDA margin and operating margin higher than the industry. Further, the company have ample liquidity with cash balance increased from the last quarter. Further, the company bolstered its liquidity position during the period by drawing down its existing USD, and BRL denominated credit facilities of US$14.0 million and R$72.3 million, respectively. The current liquidity position is likely to meet the near-term requirement. The group’s LT Debt to Total Capital ratio stood at 58%, which is relatively higher than the industry. The debt component is manageable as the company’s interest coverage ratio is significantly high at 6.8x.

From the technical analysis standpoint, its shares traded above the crucial 50-day and 200-day simple moving average prices and 14-day and 9-day Relative Strength Index (RSI) of the stock hovering in a neutral zone.

Therefore, based on the above rationale and valuation done using the above methodology, we have given a "Buy" recommendation at the closing price of CAD 17.32 (July 23rd, 2020), with lower double-digit upside potential, based on the Peer's average EV/EBITDA multiple of 9.51x on the FY20E EBITDA. We have considered First Quantum Minerals Ltd, Southern Copper Corp and Lundin Mining Corp etc., as a peer group for the comparison purpose.

*Recommendation is valid at July 24, 2020 price as well.

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