Hudbay Minerals (HBM)


Stock price: $4.65 / Market cap: $1.13B / Enterprise Value: $1.75B
Conclusion
Hudbay Minerals is a contrarian play. It’s down 54% YTD. The stock is oversold, and trades below its 52-week low. Despite this, there is 61% institutional ownership, and heavy insider buying. Officers, directors, and the CEO are buying plain vanilla common stock, not exercising warrants or options. On June 21st (2018), the CEO acquired 20,000 shares at $8 worth $160,471. In doing so, he increased his ownership by 12.3%. On August 9th (2018), a director acquired 10,000 shares at $6.7 worth $67,000. Two senior officers acquired 20,000 shares and 7,500 shares on August 10th (2018) at $6.7 worth $131,400 and $50,000 respectively.

Business Overview
Hudbay Minerals is a Canadian mining company. It operates as an integrated metals producer that is responsible for the discovery, production, and marketing of high quality copper and zinc concentrate. The company owns four polymetallic mines, four ore concentrators, and two zinc production facilities in Manitoba and Cusco, and a copper project in Arizona. Its main operations are located in Manitoba, Saskatchewan, and Cusco. Manitoba and Peru generate 100% of the Group’s revenue. The Manitoba segment sells copper concentrate (75% of sales, consists of copper, gold, and silver) and zinc metal (21%). The Peru segment consists of Constancia operations and sells copper concentrate. The Group’s Arizona segment, which consists of the Rosemont Project, is set to start operations this year.

The company has 100% interest and ownership in the Lalor, Constancia, and 777 mines. It owns 92% of the Rosemont project, and 70% of the Reed mine.

Lalor is an underground zinc, copper, gold, and silver mine in Manitoba. Its output increased over time from 2015-2017 in grades for silver and zinc, and held constant for gold and copper. The mineral leases terminate in April and September of 2023, and March of 2033, with annual leases paid to the Manitoba government.

Constancia is an open pit copper mine in Peru. It has 22,516 hectares of mining area. As per long-term contracts with external customers, Hudbay Minerals receives cash payments equal to $400 per ounce of gold, and $5.9 per ounce of silver. In a precious metals stream agreement with Wheaton Precious Metals, the company is subject to paying 100% of its silver, and 50% of its gold. Gold recovery is fixed at 55% for gold mined from Constancia, and 70% from Pampacancha. The mine averaged 79K tonnes per day in 2017, and has a capacity of 90K tonnes per day. While the mine had lower throughput and higher maintenance costs in the first half of 2018, it was due to the mine’s semi-annual schedule maintenance shutdown in May, which was successfully completed as of Q2 2018.

777 is an underground zinc, copper, gold, and silver mine in Manitoba (3,800 hectares) and Saskatchewan (3,300 hectares). The company pays annual rental leases to the Manitoba and Saskatchewan governments for mineral and surface rights. Its leases expire ranging from 2021-2036. The mine has its own ore concentrator at Flin Flon, which produces zinc and copper concentrates, with a plan that specializes in producing high-grade zinc metal. Its output for zinc metal decreased from 2015-2017.

Rosemont is a copper development project in Arizona, with 809 hectares of land that is wholly owned by Hudbay Minerals for exclusivity to surface and mining rights. The company has access to surrounding mining claims of 6,475 hectares, and Associated Fee Lands of 8,215 hectares. 

Reed mine is closing this August. It is located in Manitoba. Its mineral reserves are listed below.

Hudbay Minerals’s processing facilities are in Manitoba. Its primary ore concentrator is at Flin Flon. The Flin Flon facility produces zinc and copper concentrates primarily from ore mined at the 777 mine. Ore mined from the Reed mine, and a portion of the ore mined at Lalor is transported to Flin Flon as well. The processor facility includes a paste backfill plant and maintenance shops & laboratories. The zinc plant at Flin Flon produces special high-grade zinc metal in three cast shares from zinc concentrates, and produced 108K tonnes of cast zinc in 2017, but has a capacity of 115K.

The company’s New Britannia mill is currently on care and maintenance and being refurbished. Once maintenance is complete, the mill will be able to take capacity from the Flin Flon plant, taking Lalor ore for processing. The plant can also process up to 1,500 tonnes per day of gold and copper, and has historically produced gold ore on site.

Revenue Recognition
78% of copper concentrate sales were to third party purchasers in 2017. In 2018, it’s expected to decline to 73%. The majority of copper concentrate products are sold using short-term contracts. Manitoba copper concentrate is primarily sold for delivery to smelters in Canada and Europe. Peru concentrate products are primarily sold for delivery to smelters in Asia. All gold and silver (from 777) contained in concentrate is sold to Wheaton Precious Metals. Cast zinc metal produced at Flin Flon is sold to third party customers in North America. Four countries are responsible for 70.7% of the company’s revenue (Canada: 30.9%, US 17.4%, Switzerland: 11.7%, China: 10.7%).

Production per product every year since 2014

2017
2016
2015
2014
Copper (tonnes)
159,192
174,491
147,280
37,644
Gold (ounces)
108,593
114,296
100,177
73,377
Silver (ounces)
3,487,258
3,755,896
2,791,536
745,910
Zinc (tonnes)
135,156
110,582
102,919
82,542


Valuation
Hudbay Minerals is cheap on basis of PE: 6.9, PTBV: 0.53, EV/EBITDA of 2.9x, and P/FCF: 3.9. I will value Hudbay Minerals on two independent methods: PMV and TBV.

For the first method, I will define PMV as EV/share + the sum of current operating income per share of each segment. As of FY2018, combined operating income for both Manitoba and Peru segments was $1.48 per share. Enterprise value per share was $7.21. Summing the two entails an intrinsic value of $8.70.

In the second method, I will take into account that the company’s earnings power has not been stable in the past, and the company’s decision since 2012 to lever up excessively distorts its earnings power too heavily. Therefore, valuing it on its assets proves a more predictable alternative. A mining company has many valuable assets, some of which are not captured on its balance sheet. Therefore, I will use TBV as a conservative starting point, and will add the value of patented land claims to get intrinsic value. TBV per share is $8.78, and the company owns 2,000 acres of patented mining land. Patented claims provide the owner with both surface and mining rights, and do not require lease payments to governments or land owners. They are exclusive to Hudbay Minerals. In valuing the land relative to the cost of lots being sold near the outskirts of Tuscon, Arizona, the range is approximately $26.14M to $49.42M. Assuming that the land is valued at the highest cost ($49.42M), total intrinsic value adds up to $8.99 per share.

Therefore, I will be looking at a target price between $8.7-$8.99.

Industry Information
For the mining industry, gold production has already peaked as of 2016. Capital expenditure for new mines peaked in 2012, and has been declining since. Industry reports have noted that there won’t be any more growth in mine production for several years.

Significant investments made during the previous boom resulted in substantial overproduction and weak balance sheets. Capital expenditures in 2017 remained at a 10-year low as the industry has been slow to ramp up investment significantly. For the 10 years prior to 2016, the amount of gold discovered declined by 85%. For the first eight months of 2017, silver production had fallen by 20% in Chile, and 19% in Australia. Zinc inventories have been at the lowest levels since 2007. Randgold Resources’s CEO warned that by 2020, the industry will face a dramatic supply shortage.

The copper market recorded supply usage deficits in 2016 and 2017, with declining mine grades and lack of investment in new supply. In 2018, copper prices are at a YTD low. Rio Tinto’s CEO has said that copper deficits are expected to emerge in 2020 as well. With the demand for copper growing at 3.7% per year, the supply for copper in 2018 peaked.

The industry hit a trough in 2016, and is currently in an upswing with recoveries in EBITDA and revenue. Overall, revenues have fallen 40% since 2011.

Financial Analysis
Revenue growth has averaged 29% for the past five years. Growth from 2014-2015 was the highest at 84%, but dropped to 27.4% the year after, and has slowed since to 11.7% in 2017. Since 2013, net profit and operating margins have been very erratic, moving between slightly positive and extremely negative due to pressure from interest expense. Hudbay’s return metrics are as follows: 8% ROE, 8% ROIC, and 4% ROA.

2013 marked a turning point in the company’s financial position. Long-term debt surpassed cash on its balance sheet ($730M in debt vs. $590M cash), leading to a burdensome interest expense on margins in subsequent years. Capital expenditures began to consume operating cash flows, leading consistently negative FCF. Long-term debt peaked in 2016 at a staggering $1.21B. The company’s cash balance hit an all-time low the year before, with only $54M.

In 2017, Hudbay Minerals’s prospects are looking up. It’s paying down debt (decreased its debt/equity from 0.7 to 0.46, and net debt/EBITDA from 2.3x to 1x in 2016 to 2017 alone), and has reduced its long-term debt to $980M. Interest coverage increased from 1.3x in 2016 to 6x in 2017. The company is profitable for the first time in five years. Earnings are recovering, and FCF is growing. Hudbay Minerals was not the same as it was going into 2008. It had around $700M in cash, and less than $4M in debt. Now, it has $350M in cash (growing) and $980 in debt (shrinking). While its financial position is worse off post-crisis, the company is attempting to turn things around. In 2016 and 2017, FCF was $282M and $289.8M, with a yield of 26% for both years. In comparing FCF in 2016/2017 to 2008/2010, FCF was $87M and $102M, and yielded 6%. While the yield is much higher now, and seems unsustainable, management has projected that capital expenditures will continue to decrease, encouraging FCF to continue to grow positively. The company is entering a phase where higher depreciation charges will weigh down earnings, but add to FCF, along with lesser cap ex.

In 2013-2015, capital expenditures were around $800M and depreciation was around $30M. Since 2015, the trend has reversed, and cap ex will continue to decline from $250M, as depreciation increases from $300M. Capital and operating costs per unit (for mining, million, and capitalized stripping) are also expected to decline over time from 2018 to 2022.

Management
Management’s priorities are to complete the ramp up of production at Lalor, to enhance Constancia production through higher recoveries and throughput optimization (70% copper recovery in Q2 2018 vs. 81% Q1 2018), to complete Pampacancha surface rights negotiations, to advance the exploration pipeline, and to see Rosemont through its completion.

Management is also working to extend the life of the 777 mine, even with reconditioning costs increasing because of assets at Flin Flon getting older. They are attempting to identify remnants and increase volume. As of Q2 2018, 777’s projected end life is in 2021. In Q4 2016, it was projected to be in 2020.

In addition, management is putting capital towards the refurbishment of New Brit mill, in hopes of increasing the recovery of gold ores (currently 65% at Reed mine). If gold resources can be converted towards reserves, New Britannia will be open in a couple years.

An updated mine plan shows an increase of the total metal contained and of the estimated mineral reserves and anticipated production in all mines to be increased by 25% from 2022-2025. For mineral properties, despite the downturn in metal prices over the past few years, the company has doubled their owned and optioned mineral properties from 380K hectares to 860K hectares.

Risks
1.     If the company cannot acquire surface rights for Pampacancha, then further mining efforts will be delayed
2.     Excess milling capacity at Flin Flon with the closure of the Reed mine
a.     New Brit won’t be open for a couple more years to take capacity away from Flin Flon
3.     A low PE may be deceptive
a.     What if this isn’t a recovery, but a cyclical earnings & margin peak? It’s hard to compare when earnings and margins have been negative in the past
b.     Earnings may collapse again with higher mining costs

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