hunley said buy

Perilya Limited (PEM)

Merger brings much needed cost savings
Recommendation: Buy 04/04/2008



Note: Marker indicates price of $1.08 at publication date.

Investment Rating
Perilya produces zinc, lead and silver from the historic Broken Hill underground mine. A pipeline of growth projects, exploration upside and leverage to zinc and lead prices attract. The balance sheet is strong with net cash of $137m underwriting expansion or acquisition plans and provides a degree of insurance against volatile cashflows. High cost, unreliable production makes PEM a speculative investment and only suitable for risk tolerant investors seeking production growth. Development, commodity and single mine risk need consideration.


Result Description
Perilya (PEM) and CBH Resources (CBH) will finally merge.


PEM will offer 1 share for every 3 CBH shares – a generous deal for CBH. Only six months ago PEM traded at over six times CBH. CBH shareholders also receive 1 free $2.00 PEM option for every 20 CBH shares, expiring December 2010. PEM will own 41% of the combined entity and CBH 59%.


Impact
A merger has long made sense, though the terms are somewhat surprising. A 50/50 split seems fair but CBH extracted a premium, suggesting PEM’s Broken Hill mine is struggling more than was already known.


Close to $200m in operating and capital cost savings should come from Broken Hill by FY11. Use of PEM’s spare capacity will avoid $70m to build a separate mill for the Rasp mine. CBH will not need to recruit a separate new workforce.


We now expect FY08 Broken Hill production of 89kt zinc and 54kt lead at a cash cost of US$0.93c/lb, down from previous guidance of 95kt-105kt zinc at US$0.80c/lb. A strong improvement was expected in FY09 but that now looks unlikely and we downgrade to 100kt zinc.


Recommendation Impact (Last Updated: 04/04/2008)
Buy.
Price data based on previous close.
Previous Close Market Cap
$1.03 $203 (million)
52 Week High/Low
$5.39 - $0.96
Sector
Materials


Intrinsic Valuation
$1.95




Year 6/06A 6/07A 6/08E 6/09E
NPAT ($m) 80.30 82.50 -13.50 21.80
EPS (c) 42.10 43.10 -6.70 10.80
% Change -- 2.40 -115.50 --
DPS (c) 5.00 11.00 1.00 3.00
Franking (%) 100.00 100.00 100.00 0.00
Dividend Yield (%) 3.20 2.80 1.00 2.90
PER 3.70 9.30 -- 9.50


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Event Analysis



PEM/CBH Merger

Perilya (PEM) and CBH Resources (CBH) will finally merge. Broken Hill will have unified ownership for the first time. The merger is all scrip, via scheme of arrangement. It’s conditional on an independent expert concluding the merger is in the best interests of CBH shareholders and a CBH shareholder vote. PEM will offer 1 share for every 3 CBH shares – a generous deal for CBH. Only six months ago PEM traded at over six times CBH. CBH shareholders also receive 1 free $2.00 PEM option for every 20 CBH shares, expiring December 2010. PEM will own 41% of the combined entity and CBH 59%. Merger documentation is expected in early April with the vote and final court approval set for July. Prior to the merger, CBH will spin out ‘non-core’ exploration assets into Kimberly Metals. Shareholders will get a Kimberly share for every 9.2 CBH.

A merger has long made sense, though the terms are somewhat surprising. A 50/50 split seems fair but CBH extracted a premium, suggesting PEM’s Broken Hill mine is struggling more than was already known. PEM shareholders are paying the price for management taking its eyes off the core business. This has seen a lukewarm response from PEM analysts and the media. Regardless, it’s a better than average corporate deal. Significant value will be created and it makes sense for both sides. New Rasp ore will help reduce reliance on PEM’s troubled Southern Mine and fill the Broken Hill mill.

We reaffirm our Buy recommendations on both stocks individually and preferably with the merger to proceed, looking for a recovery in the zinc price, cost savings from Broken Hill and Endeavor and growth from Panorama. High cash costs make both companies unsuitable for conservative investors. The zinc price is close to the marginal cost of production and some miners are hurting. On that basis, there is potential for substantial uplift in earnings and valuations but a prolonged zinc price depression would threaten the business. The conservative combined balance sheet provides some protection and we don’t expect zinc to fall out of bed. Nevertheless that risk must be acknowledged. This deal makes the most sense for both companies and its unlikely a competing offer will come forward. The more probable play would be a takeover after the merger, though significant progress would need to be made on cost savings first.

Our combined valuation is $1.95 a share for PEM and 68c for CBH, conservatively assuming no synergies from the merger. Broken Hill has deteriorated for PEM due to a number of production issues. The merger should help solve the problems, with real benefits from FY10 onwards. Forecast FY08 and FY09 output is reduced while cash costs and depreciation estimates rise. We now expect FY08 Broken Hill production of 89kt zinc and 54kt lead at a cash cost of US$0.93c/lb, down from previous guidance of 95kt-105kt zinc at US$0.80c/lb. A strong improvement was expected in FY09 but that now looks unlikely and we downgrade to 100kt zinc. Our CBH valuation is slightly higher than the PEM merger implies as CBH is pre the spinout of Kimberley Metals. We assign a nominal $25m to Kimberley Metals. Long term assumptions for both companies remain US$0.90/lb zinc, US$0.70/lb lead, an A$/US$ exchange rate of 0.80 and a 10% discount rate. Forecast combined EPS is 1.5c in FY08 and 14.7c in FY09 per PEM share which equates to 0.5c and 4.9c per CBH share respectively.

The deal is unanimously recommended by CBH’s board and largest shareholder Toho Zinc. PEM’s chairman Patrick O’Connor will chair the combined group while CBH’s CEO Stephen Dennis will become Managing Director. Current PEM MD Len Jubber has retired effective immediately. The board will include four PEM and three CBH directors. PEM is bringing a strong balance sheet while CBH brings a better pipeline of exploration and development opportunities.

Close to $200m in operating and capital cost savings should come from Broken Hill by FY11. Use of PEM’s spare capacity will avoid $70m to build a separate mill for the Rasp mine. CBH will not need to recruit a separate new workforce. Rasp production will be brought forward to June 2009, dependent on receipt of government permits by October 2008. Some high grade ore on the lease boundaries will be accessible for a modest near term production uplift. Post FY11, expect ongoing operating cost savings of at least $30m a year. Potential for additional savings will be explored with more likely to be found. PEM previously indicated a US20c/lb zinc cash cost saving from running its Broken Hill mill at full capacity. This suggests operating cost savings closer to $50m a year.

The combined group will be capped at around $500m. The balance sheet will be strong with $313m cash and $243m debt, most of which is convertible notes which will convert. Proforma 2007 production was 220kt of zinc and 72kt of lead. Diversification will reduce operating risk with ore sourced from five mines. The merged group will have a reasonable pipeline of exploration and development options. Combined group resources and reserves are 10.3Mt and 4.1Mt of zinc equivalent respectively.





Sensitivity (+/- 10%)* FY08 eps FY09 eps Valuation
A$:US$ FX -/+ 1.4c -/+ 6.5c -/+ 72.4cps
Zinc Price +/- 1.9c +/- 5.7c +/- 45.4cps
Lead Price +/- 0.3c +/- 1.4c +/- 16.2cps
Discount Rate (+/- 1%) n/a n/a -/+ 16.5cps