Zambian Government a Worry Everything management can control...

Zambian Government a Worry


Everything management can control seems to be tracking well. EQN says Lumwana's development remains on schedule and budget, a minor miracle in the current environment. Production is just a few short months away, slated for late 2Q08. Contractor Ausenco/Batemen is building a strong reputation after the successful construction of Oxiana's (OXR) Sepon Copper mine. Cash costs should be pretty close to feasibility estimates. The copper price is buoyant, pushing towards record highs fuelled by South American supply concerns. With all these things in EQN's favour, the stock should be making new highs. It isn’t with political tinkering the main impediment.

The Zambian Government says it wants to increase corporate taxes from 25% to 30%. Fair enough, that's what we pay in Australia. In addition, royalties will rise from 0.6% to 3% again similar to here. Talk of a windfall profits tax is a worry and luckily not something we face in Australia yet. Of more concern is that EQN's 10 year stability agreement - which set down key terms like royalty rates and taxes - may not be honoured, raising the real issue of country risk. From a valuation point of view, the impact isn't disastrous. Recent increases in our copper price assumptions coupled with the expectation Lumwana will expand from 20Mtpa to 24Mtpa with little additional capital expenditure offset the tax and royalty hit. The worry is if you can't take the Government at its word. If contracts and investors aren't considered, foreign investment will be threatened to the detriment of the Zambian people. Zambia went down the nationalisation road with its copper mines in the 1970's with disastrous effect. We would support plans for EQN to re-invest Lumwana's enviable cashflows in other parts of the world.

Our base case valuation rises 5% to $4.60ps. Higher short term copper prices and the expected Lumwana expansion to 24Mtpa more than offset the assumed higher tax and royalty rates of 30% and 3%, up from 25% and 0.6% respectively. We have not included a windfall tax. There is no indication of just what form that may take and we’re hopeful EQN and the Zambian Government can negotiate a sensible compromise. If the stability agreement is honoured, there is possible upside. We take the middle ground. Changes to the tax system and dishonouring of the stability agreement are potential fundamental changes. Risk is speculative and it may be prudent to lock in some profits, preferably on the back of some copper price based enthusiasm.

Long term assumptions remain US$2.00/lb copper and an A$/US$ exchange rate of 0.80. We raise the discount rate from 13% to 14%, higher than the standard 10% to account for sovereign and development risk. Use of a standard 10% discount rate would raise the valuation 26% to $5.80. Development risk is falling as construction moves towards completion. Key development hurdles remain commissioning, first concentrate production and the move to full capacity. Sovereign risk is unfortunately rising and has potentially taking some of the heat out of takeover plans. Canada's First Quantum bought about 18% of EQN late last year. We halve the 30% corporate premium and our valuation falls 8% to $5.30 a share. Value investors may not wish to pay the corporate premium which would lower our price bands 15%. EQN remains in our Hold range. The carrot remains juicy forecast FY09 earnings of $1.17 a share assuming US$3.25/lb copper and A$/US$ FX of 0.91. We would dearly love some favourable clarity on taxes and royalties.

The outlook for Lumwana cash costs is better than most. Feasibility assumptions included a US$75/bbl oil price - very conservative at the time - and smelter charges of about US18c/lb. While oil is higher, smelter charges have roughly halved. Labour is nowhere near as tight in Zambia as it is here. Rising oil and labour costs in the rest of the mining world will push Lumwana down the cost curve and widen the moat. As we have discussed in previous reports, the mine, plant and equipment is powered by cheap hydro electricity. Lumwana is less oil intensive than average copper mines.


Sensitivities (+/-10%)


FY08 EPS FY09 EPS Valuation

Copper Price +/- 4.1c +/- 14.9c +/- 65.6cps

A$:US$ Exchange Rate -/+ 1.9c -/+ 6.9c -/+ 46.5cps

Discount Rate(+/- 1.3%) n/a n/a -/+ 33.8cps