HudBay And Lundin Kill Merger Plans

VANCOUVER — HudBay Minerals (HBM-T, HBMFF-O) and Lundin Mining (LUN-T, LMC-N) have officially cancelled their merger plans. The move, however, is no surprise because the deal had already been essentially strangled by a precedent-setting decision from the Ontario Securities Commission (OSC).

In January, the OSC ruled Hud- Bay needed shareholder approval to issue the 157.6 million shares it needed to acquire Lundin, which would have diluted its outstanding count by just over 100%. HudBay’s share price, which had fallen 40% on news of the Lundin deal, gained 24% on the ruling. And now, after spending months listening to share-holders lambaste the takeover, Hud- Bay and Lundin have accepted that the deal is dead.

“The decision to terminate the transaction was not an easy one for the board,” said HudBay CEO Allen Palmiere in a statement. “However, after hearing from many of our shareholders over the last three months and considering the market reaction to the OSC decision, we believe this is in the best interest of the company.”

On news of the deal’s demise, HudBay’s share price gained 60¢ to close at $5.38. Lundin’s share price fell 7¢ to close at 73¢, setting a new all-time low.

By cancelling the deal before HudBay shareholders cancelled it for them, the two companies gave themselves the opportunity to massage some remaining details. The key detail is that, directly following the takeover announcement, HudBay bought 19.9% of Lundin for $135.8 million. In cancelling the takeover, the companies agreed that not only will Hud- Bay retain its ownership position, but as long as HudBay owns more than 10% of Lundin, it is entitled to a seat on the Lundin board.

Moreover, HudBay has the right to maintain its current level of ownership in Lundin through the course of any equity financing. And for the next six months, HudBay has a right of first offer on anything Lundin decides to put up for sale. Finally, the two companies have released each other with respect to any claims that might have arisen from the takeover termination.

HudBay had planned a shareholders’ meeting for March 25 to approve the Lundin transaction. While that is no longer necessary, the meeting will still occur and shareholders will instead consider whether to remove HudBay’s existing board of directors and replace them with a slate proposed by SRM Global Master Fund, a hedge fund out of Monaco that owns 11% of HudBay.

A board challenge is no doubt significant, but things are considerably more serious for Lundin. The company is set to release its fourth-quarter financial results on Feb. 26, just after this paper goes to press, but Canaccord Adams analyst Orest Wowkodaw forecasts that the company ended 2008 with US$134 million cash on hand and US$239.5 million in debt.

In addition, the company has US$150 million in capital expenditure commitments for 2009 and has to repay US$38.6 million of its debt in the fourth quarter. Given those requirements and using forecast metal prices of US$1.50 per lb. copper, US$5 per lb. nickel, and US63¢ per lb. zinc, Wowkodaw expects Lundin to run out of money in the fourth quarter: “To maintain a reasonable working capital position of around US$50 million, we estimate that Lundin will need to secure an additional US$50 million of funding this year.” If metal prices fall further, Lundin’s need for cash grows.

And there are important but unanswered questions about the company’s debt arrangement. Specifically, Lundin has a US$575- million existing line of credit, from which it had drawn US$187.7 million at the end of September. But the company has refused to answer questions about the covenants controlling that debt, which makes it impossible to know not only whether the rest of the credit line is available, but how close the company is to breaching the debt requirements. Violating debt covenants usually gives the lender the right to immediately demand repayment of the drawn funds in full. During the November conference call announcing the HudBay takeover, Lundin’s management made comments indicating that the company was treading close to the covenant line.

“While the recent private placement by HudBay no doubt helped, Lundin’s balance sheet remains relatively weak,” Wowkadow writes. “We forecast that, without another source of funding, Lundin is likely to run into significant balance sheet stress by the end of this year. The situation could get materially worse if the company violates covenants on its existing credit facility.”

Lundin has already made moves to improve its financial lot. On Jan. 22, it announced it would close the Galmoy lead-zinc mine in Ireland by May; on Dec. 23, it sold its Aljustrel zinc mine in Portugal; and in November, it suspended zinc production at its Neves-Corvo mine, also in Portugal, leaving the mine producing only copper concentrate.

The only bright spot ahead for Lundin is its 24.75% stake in Tenke Fungurume, the massive copper-cobalt mine in the Democratic Republic of the Congo (DRC) that is almost ready for commissioning. Freeport-McMoRan Copper & Gold (FCX-N), which holds 57.75% of the project, is acting as operator; the rest belongs to DRC state mining company Gcamines. The partners recently announced that they expect to begin commissioning in the second quarter of 2009 and plan to produce the first copper cathodes before the middle of the year.

The Lundin-HudBay takeover saga began in late November, when the companies announced a friendly takeover deal. The deal valued Lundin’s shares at $2.05, a 103% premium to Lundin’s closing price the day before the announcement and a 32% premium to its 30- day volume-weighted average price–and this, to acquire a company with almost US$200 million in debt and a portfolio of mines with narrow to no profit margins.

HudBay’s share price immediately plunged 40% and outraged shareholders started making noise. HudBay’s board vehemently defended the deal, saying it gave the company a rare chance to triple its zinc reserves, double its copper reserves, and dramatically broaden its geographic diversity at a discounted price.

But, as is so often the case, the devil was in the details. As the company being taken over, Lundin was required to get shareholder approval for the deal. But HudBay shareholders were not going to be given any say — even though the company was going to double its outstanding share count, HudBay was simply making an acquisition, which does not require a shareholders’ vote.

The Toronto Stock Exchange agreed and approved the deal. But HudBay shareholders brought it before the OSC, which did not agree. In its ruling, the commission concluded that the fair treatment of investors is more important than a company’s ability to close a deal cleanly and even went so far as to say that the market itself “would be significantly undermined by permitting the transaction to proceed without the approval of the shareholders of HudBay.”

The OSC wrote that its decision was “a matter of first instance” for the board, suggesting that it might set a precedent for similar cases in the future. The OSC also noted that the TSX is currently considering whether there should be a specified maximum dilution above which shareholder approval for a transaction would automatically be required.