Should you buy Sandfire?

With a secular bull market in the United States, there is hope that the Australian stock market will follow. Last year saw strong gains in large blue-chip stocks, such as the banks and Telstra (ASX: TLS). This year could well be the time for a broader range of cyclical stocks to participate.

Traditionally the first commodity to enter a bull market is copper. It’s at the heart of industrial development, as it is used widely for cables, building products, wiring, pipes and various alloys for cars, etc. The largest Australian producers of copper are BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO), both of which derive most of their copper from mines overseas.

Sandfire Resources (ASX: SFR) is one of a few mining companies that has successfully made the transition from explorer to developer and economic producer of copper. The DeGrussa Copper-Gold mine in Western Australia is a high-grade copper deposit with substantial reserves. It was discovered in 2009 and transitioned to a working mine in 2012.

During the last financial year, cash flow turned positive, with Sandfire generating 163.2 cents per share. It is now producing 30,000 tonnes copper. BHP produces over four times that amount but, due to its exceptionally high grade ore, Sandfire is a lower cost producer than BHP or Rio.

Oz Minerals (ASX: OZL) is also a single mine producer. Last year Oz produced 70,000 tonnes of copper at Prominent Hill, South Australia. For the fourth quarter 2013, Oz stated that its cost of copper was 179.6 cents/lb, compared with Sandfire’s cost of US$1.29/lb.

Like all base metal miners, Sandfire is a price taker with the spot price fixed daily by the London Metals Exchange. Currently the price is US$3.30/lb. It has fluctuated between US$2.00 and US$4.50 over the last five years.

It is also useful to consider the supply side of the copper market by examining warehouse holdings. Currently the London warehouse level is 325,000 tons. It has varied between almost 200,000 tons and 650,000 tons during the previous five years. It is fair to say that with a relatively low warehouse holding, which is in fact trending lower, the spot price for copper is firm at US$3.30/lb. In fact, based on a decreasing London warehouse level, the copper price should keep improving.

It’s unclear where demand is going in the short term, but it is my view that over the next decade and beyond, China, India and southeast Asian nations will hold up the price of copper as their respective economies outperform those of countries like the United States, Europe and Japan. If Sandfire can continue to be a low-cost producer, it will reap excellent returns as the price of copper holds firm, and even improves in the long term.

Foolish takeaway

If you believe that China, India and southeast Asia will continue to grow their economies strongly for the next 10 years and beyond, then those companies that produce copper should be very well positioned to prosper. As a low-cost producer with substantial reserves, Sandfire is an excellent choice for the long term.

The stock is quite volatile, having ranged between $4.92 and $8.25 over the last 12 months. Currently the price-to-earnings ratio is a very attractive 8.19. The return on equity is looking very positive at 41.6. As earnings grow, due to increasing production and improved copper prices, the share price should follow in the long term. As a long-term holding, I would add Sandfire to my portfolio at $5.50.

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Motley Fool contributor Chris Koenig does not have shares in the companies mentioned.

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