Update: Analysts deride HudBay-Lundin merger

Vancouver – Almost across the board, analysts downgraded HudBay Minerals (HBM-T) on its proposed merger with Lundin Mining (LUN-T, LMC-N) to create what the two companies hope will be the next major global diversified mining company.

 

The proposed deal would see Lundin holders receive 0.39 HudBay shares for each Lundin share held, turning Lundin into a wholly-owned HudBay subsidiary. The share ratio values Lundin shares at $2.08, representing a 32% premium over Lundin’s 30-day, volume-weighted average trading price. The resulting HudBay would have 306 million shares outstanding.

 

In addition, HudBay is loaning Lundin $135.8 million for immediate use towards financing capital investments. HudBay will recoup the funds in the form of 97 million Lundin shares at $1.40 a piece, representing 19.9% of Lundin’s outstanding shares.

 

On Nov 21, when the deal was announced, Lundin investors moved 18 million shares but left the company’s share price almost unchanged, up 4¢ to $1.05. HudBay shareholders, however, were much less impressed – the major lost $2.07 or almost 40% to close at $3.16, on 20 million shares traded. HudBay’s share price has not dropped below $4 since 2005.

 

Analysts seemed equally concerned about the move; many spoke out against it sharply in research notes. And the news was enough to prompt one shareholder – Toronto-based Jaguar Financial (JFC-T) – to launch an attempt to take control of the company to get it out of the Lundin merger.

 

The merger is a surprise for two main reasons. Until a few months ago Lundin was a rapidly-expanding company with multiple mines in operation and double-digit profits, a company that no one would have predicted would cease to exist anytime soon. So the first surprise is how quickly that has changed – the company’s mines are now barely or not profitable, the company is carrying almost $300 million in debt, and president and CEO Phil Wright admitted that Lundin is facing serious liquidity problems.

 

The second surprise is that HudBay not only wants to take on Lundin’s problems and risks but that it is paying a premium to do so. HudBay is a low risk operator – its operations are all in North America, primarily in Manitoba – and it has almost $900 million in the bank. Lundin, known for taking risks on unstable countries, is certainly an odd partner.  

 

Since the deal involves two major mining firms many analysts issued research notes on the merger and all but one disliked the plan.

 

“We believe the HudBay-Lundin merger has poor odds of success, will entrench the board, and will not provide a return to shareholders for at least three years,” wrote analyst Catherine Gignac of Wellington West Capital Markets. Gignac even prefers Jaguar’s offer to take over the company, sell off its assets, and divide the cash to the Lundin merger.

 

Along similar lines, Greg Barnes of TD Newcrest acknowledges that the new HudBay could be an interesting company once global growth resumes but wonders why the deal had to happen now: “Given that it is now evident that Lundin is facing serious liquidity problems…it seems to us there is a real case to be made that HudBay could have acquired the company or its more attractive assets without paying a significant premium,” he wrote.

 

And George Topping of Blackmont Capital entitled his research note Why Now? Awful Deal. “We are very disappointed with this surprising bid and would move to a “sell” recommendation [for HudBay] were it not for the strong likelihood that a third party…emerges with a premium offer,” he wrote. Later he added, “HudBay had very little downside, trading at its cash value of $5.50 per share, whereas Lundin would very likely have continued to get much cheaper…Lundin may well have become a penny stock.”

 

The only voice in support of the deal came from RBC Capital Markets analyst Adam Schatzker. He wrote that the merger will turn HudBay into “a solid mid-tier producer, with a strong balance sheet, that is well-positioned to develop its pipeline of high-quality projects and/or make strategic, accretive acquisitions.”

 

The merger news comes only a week after Lundin announced a $200-million third quarter loss, related primarily to writedowns for recently-acquired assets with deteriorating worth. Though at the time Wright denied a need for cash, in announcing the merger he changed that tune.

 

“The injection of cash we get through this deal is a welcome injection,” he said. “It doesn’t take a rocket scientist to see that some of the provisional pricing settlements coming through now are considerably lower than we had anticipated even last week and that will take a toll on revenues.”

 

HudBay’s situation is quite different. At the end of September the company had $844 million in the bank; with metal prices tanking and immense uncertainty surrounding the global credit system, cash in the bank has become a key asset of late. However HudBay’s production profile was set to shrink over the next two years, particularly with the company’s recent decision to delay development at the Fenix nickel laterite project in Guatemala. The merger would certainly reverse that decline. And the major was focused on zinc; the merger would diversify its production profile.

 

The opposite side of the odd-couple pairing is that both companies would see better geographical diversity. Most of HudBay’s operations are in the Flin Flon greenstone belt of northern Manitoba, where it operates the 777 zinc-copper mine, the Trout Lake zinc-copper mine, the Chisel North zinc mine, and a concentrator-zinc plant-copper smelter complex. HudBay also owns a zinc oxide facility in Ontario and a copper refinery in Michigan.

 

Lundin, on the other hand, has no North American operations. Its producing operations include the Neves-Corvo copper-zinc and Aguablanca nickel mines in Portugal, the Zinkgruvan zinc-lead mine in Sweden, the Galmoy zinc-lead mine in Ireland, and the Aguablanca nickel mine in Portugal. The company also owns a 26% interest in the massive Tenke copper project in the Democratic Republic of Congo, being built by partner Freeport MacMoran (FCX-N).

 

Combined, the companies produced 187,115 tonnes of copper, 278,289 tonnes of zinc, 44,560 tonnes of lead, 3,270 tonnes of nickel, 102,587 oz. gold, and 4.18 million oz. silver in 2007. While 2008 numbers will be similar, 2009 production rates will be lower as Lundin recently put its Aljustrel zinc mine in Portugal on care and maintenance while HudBay was forced to mothball its two-year-old Balmat zinc mine smelter in the summer.

 

Barnes calculates that the combined company would have a market capitalization of $1.6 billion, making it the third-largest Canadian mining company behind Teck Cominco (TCK.B-T, TCK-N) and Cameco (CCO-T) and pushing First Quantum Minerals (FM-T) to fourth place.

 

“On the financial side this new company is extremely powerful and very flexible,” says Allen Palmiere, CEO of HudBay. “We are going to build the next diversified major and we will continue to evaluate opportunities very stringently – we certainly expect that the current environment will continue to create opportunities.”

 

Though HudBay’s main lifeblood has until now been zinc, the new entity shifts the focus to copper. Copper production would account for almost 60% of the revenue in the combined company, with zinc bringing 27% of revenues to the table and the rest divided between nickel, lead, gold, and silver in that order.

 

In a conference call to discuss the announcement one analyst questioned the deal from HudBay’s perspective, pointing out that HudBay only just closed its takeover of Skye Resources. In that deal HudBay acquired the Fenix project, which is home to a huge nickel deposit but also carries a $1-billion development price tag. When HudBay closed the Skye deal nickel prices were hovering above US$10 per lb. The metal is now going for more like US$4.50 per lb and the major has delayed development until prices recover.

 

Other analysts voiced serious concern over HudBay was paying such a premium in the deal, given the current market and given Lundin’s debt load and need for cash. Against all attacks Palmiere defended the deal by saying that even under the most bearish outlook the Lundin acquisition adds value to HudBay.

 

“We looked at the downside scenario: we took current metal prices and ran forward to ensure that even with this scenario for five years the deal is still accretive,” he said. “Even under that very bleak outlook our cash position grows.”

 

And Palmiere says that statement stands even if zero value is attributed to Tenke, which is in a country ravaged by civil war and where mining contracts with the government are being re-negotiated. Lundin just made its final payment on phase one of development at Tenke, which should take it to production within a year. Over 2008 Lundin contributed US$264 million to the project.

 

“I feel extremely comfortable in terms of the values given to Lundin’s assets and feel their assets support the premium we’ve provided,” said Palmiere. “The reality is today’s market is volatile at best so really we have to look at asset value rather than equity value. Equity values today don’t represent the underlying health of companies – there’s no relationship whatsoever.”

 

Jaguar Financial certainly disagrees with Palmiere’s valuation of Lundin’s assets. The merchant bank, which manages $8 million and is currently trading at 7¢, announced it is preparing an offer to buy all of HudBay’s shares in order to dissolve the company in two steps. First, Hudbay shareholders would get their share of HudBay’s cash holdings. Then Jaguar would sell off all of HudBay assets and divide that cash among shareholders.

 

Jaguar Financial’s chairman and CEO Vic Alboini called the HudBay-Lundin marger “an embarrassing value-destructive transaction.” To complete his plan Alboini’s firm needs 50%-plus-one of HudBay’s shares. The big question, aside from whether Jaguar Financial can manage such a feat, is whether or not HudBay could withdraw from the merger deal. The company signed an agreement to purchase, which legally binds it to the merger provided the deal passes scrutiny from the securities commissions and Lundin shareholders. Palmiere said Lundin would have the right to sue if HudBay tried to reneg on the marriage. Nevertheless, Jaguar Financial says its offer for HudBay is conditional on the company cancelling the transaction.

 

The boards of both companies have approved the plan. HudBay shareholders will not have a say in the matter, as acquisitions do not require shareholder approval. Lundin shareholder will have to approve the merger, by a margin of at least two-thirds, and have been advised by its board to vote in favour. A 40% vote in favour is already assured, as 21.1% of Lundin’s shareholders have already agreed to support the deal while HudBay will vote in favour via its new 19.9% holding.