Thursday, November 1, 2018

Update on Hudbay Minerals

Today, November 1st, 2018, marked an intraday gain of 13.6% for Hudbay Minerals on the NYSE. Within the past five days the stock has gained 23.5%. Normally, this would be happy occasion to see gains like these for something as unpopular as a copper miner.

However, there are right reasons for a stock to soar, and there are wrong reasons. Unfortunately, Hudbay's gain is the result of pure speculation and fatal assumptions made by general investors.

As I listened to the quarter 3 conference call earlier today, I found a few things unsettling.

1. Was this the same management I'd listened to before?

Even though management hadn't changed, it seemed that their priorities had gone astray. Unfortunately, they were going down the path of "diworsefication" (coined by Peter Lynch). Simply put, this describes the process of making dumb acquisitions that will ultimately destroy value.

Hudbay Minerals is set to buy Mason Resources, a Canadian mining company, in order to gain access to its undeveloped copper project. The arrangement values Mason at $31M, and Hudbay is buying it for $24M, so in theory, the acquisition itself is accretive by a few million.

The problem is, in the long-term, this acquisition will ultimately send Hudbay back into the same hole it was in a few years back: too much debt. One can only guess how much it will cost to set up mining infrastructure in undeveloped land. At present, Hudbay's $400M or so in cash is up against $900M in debt.

How will they fund it? I suppose they'll issue debt, which will only increase the interest burden substantially. If not, then the issuance of common shares will only dilute value for existing shareholders.

Acquisitions, especially debt-ridden cyclicals, are a bad idea. As we come to the end of the era of global asset inflation, it makes me more nervous to think about what a recession would do to this company's fundamentals post-acquisition.

2. Not only that, management announced that they're planning on spending $1.1B in capital investment for the Rosemont project.

The era of declining cap ex is over for Hudbay Minerals. Before, management had touted a decreasing in cap ex in the coming years as a way to grow FCF. It was one of the things I found attractive in the company, because the growing FCF could be used to pay down debt.

Investors seem to be overlooking this, and are instead assuming that positive and growing FCF will be the norm until 2021 at least. Of course, I'm much more pessimistic now, as the plans for investment in Rosemont is shedding light on the cyclical nature of the mining business. I would have felt better had there been a bigger cash cushion and no acquisition.

In summary, the thesis which made Hudbay Minerals an attractive investment was:

Management prioritizing the maximization of value from existing assets and paying down debt to grow FCF. By doing so, the market would realize the value of Hudbay's high quality assets and the significance of the turnaround. These were the reasons I bought into the stock.

Now, they're changing the game plan to expand their empire with a cavalry of 400M in cash versus what could end up being a few billion in debt.

If anything, that's painting a scary portrait, and I'm surprised that others haven't taken much notice. (Well, except maybe one group: Waterton private equity)

To close, I'd like to share my three reasons to sell a stock:

1. It has appreciated to the target price.
2. The fundamentals have deteriorated.
3. Some catalyst has been disrupted and/or an unfavorable event has changed the long-term prospects for the business.

Hudbay has ticked off #3, and I'm sure #2 is soon to follow.