This week we look at a seven-year Yankee bond from HudBay Minerals (HBM), an integrated mining company primarily focused on the discovery, production, and marketing of base and precious metals in North and South America that currently trades several points over par, yet still offers about a 8.25% yield to maturity while providing excellent cash flow from a high 9.5% coupon that pays semi-annually. Despite the lower B3/B- credit ratings assigned to these bonds by Moody's or Standard & Poor's, the following review shows why we believe these medium-term high yield notes are a sound choice for two of our high yield managed income portfolios, Fixed-Income1.com and Fixed-Income2.com.
A Look at the Issuer
HudBay Minerals Inc., an integrated mining company, together with its subsidiaries, primarily focuses on the discovery, production, and marketing of base and precious metals in North and South America. It produces copper concentrates containing copper, gold, and silver; and zinc metal. The company owns 100% interest in the 777, an underground copper and zinc mine that covers an area of 3,800 hectares, including approximately 500 hectares in Manitoba and approximately 3,300 hectares in Saskatchewan; the Lalor zinc, gold, and copper project situated near the town of Snow Lake in the province of Manitoba; and the Constancia copper project covering an area of approximately 22,516 hectares located in the Province of Chumbivilcas in southern Peru. It also has interests in the Reed Copper project located near Snow Lake, Manitoba; and exploration properties in North and South America. The company was originally founded in 1927 at the Flin Flon orebody in Northern Manitoba, and is currently headquartered in Toronto, Canada. HudBay has about 1,300 employees in Northern Manitoba, having an average of 19 years of service.
HudBay Minerals is listed on the Toronto (TSX) exchange, the New York Stock Exchange (NYSE), and in late 2012 also listed on the Bolsa de Valores de Lima, the Peru stock exchange. The company is a member of the S&P/TSX Composite Index and the S&P/TSX Global Mining Index. It has a robust production and solid financial profile, and its experienced management and operation team appear to be implementing a disciplined low-risk growth strategy. HudBay's copper production is projected to grow 390% through 2015, while precious metals production growth is estimated at 115% and zinc production estimates project a 30% growth by the end of 2015. For the nine months ending Sep. 30, 2013, copper represented about 37.4% of total revenues (compared to 48.9% in the same period of 2012), while zinc, gold, and silver represented 40.5%, 18.3%, and 2.6% respectively. The mine life expectancy of its South American business CGU (cash generating unit) is 24 years.
Having developed 26 mines in the Flin Flon Greenstone Belt (FFGB), HudBay's team has become particularly adept at driving underground ramps and leveraging core competencies in design, permitting, financing and building. Hudbay's 2013 capital investment forecast was approximately $1.24 billion, including $1.16 billion in growth initiatives. Currently, it is developing three properties into producing mines, Lalor and Reed (both in the Flin Flon Greenstone Belt), and Constancia (in southern Peru, with initial production expected in late 2014). In addition to the initial $500 million raised in January 2013 for the first tranche of its 9.5% 2020 bonds, another $100 million was raised in a second placement last month (December 2013). More recently, HudBay announced a $150 million bought deal (equity) financing with its stock being priced at CAD$8.25/share. This is expected to close on January 30, 2014.
During August and September 2013, HudBay entered into copper and zinc hedging transactions intended to manage the risk of adverse changes to operating cash flow as it approached the expected completion of our Lalor and Constancia projects in the second half of 2014. In copper, it has entered into costless collar transactions on approximately 69 million pounds of copper for the period of October 2013 through December 2014, inclusive, at an average floor price of US$3.00/lb and an average cap price of US$3.46/lb, and in zinc, it has entered into costless collar transactions on approximately 103 million pounds of zinc for the period of October 2013 through December 2014, inclusive, at an average floor price of US$0.80/lb and an average cap price of US$0.97/lb.
We like companies that are profitable
Revenues for the nine months ending Q3 2013 were CAD$380.7 million (US$348 million), while gross profit was CAD$65.7 million ($60 million.) Earnings before interest, tax, depreciation, amortization and exploration (EBITDAX) was CAD$61.7 million (US$56.4 million).
Interest Coverage Ratios
Long-term debt interest expenses for Q3 was CAD$16.5 million (US$15.1 million), giving it a somewhat less than ideal 2:1 interest coverage considering its same period EBITDA earnings of CAD$29.5 million (US$27 million). However, we also recognize that HudBay is plainly in a capital-intensive transition phase between the end of life closing of previous highly-profitable mines and the growing production of young new mines, the largest of which will not attain commercial production status until 2015, after which we expect to see this ratio improve substantially.
We like companies with lower debt to cash ratios
Cash balance on September 30, 2013, was reported being CAD$792.5 million (US$723.3 million), while long-term debt was CAD$657 million (US$600 million). While this remarkably low ratio has undoubtedly changed given the ongoing capital intensive expenditures of developing new mines, the additional US$100 million of bonds issued in December of 2013, and the projected increase of its cash holding by over $100 million in January 2014's equity offering, we are very impressed with the efficiency and effectiveness of HudBay Minerals' overall plan for sustainability, profitability and continued "low-risk" growth.
We like companies that have good balance sheets
HudBay's long-term liabilities/debt of US$600 million appears to represent about 47% of the near US$1.288 billion enterprise valuation currently given to it by the equity markets. Considering that the company is in the midst of a secondary stock offering, there remains little doubt that the markets are amenable to provide additional capital should it be needed.
The default risk is HudBay Minerals' ability to perform. Considering the company's operating experience, its fundamentally strong balance sheet and excellent cash position, and its sound cash flow, we see the performance risk as being minimal relative to its high yield and superior cash flow.
The company's profitability and cash flow is affected dependent on the price of copper, zinc, gold, and to a lesser extent, silver. However, we think HudBay's management has significantly diminished this risk with the implementation of recent copper and zinc hedging transactions.
The company also has execution and market risks dependent on the success of mining, processing, exploration and development activities, as well as the accuracy of geological, mining and metallurgical estimates. These are common risks associated with other exploration and development mining companies.
We view these bonds as having other risks similar to other lower or unrated high-yield short to medium term Yankee bonds that we have recently written about, such as the 8.8% AvangardCo Bonds, 9.66% Dana Gas Sukuks, 8.45% Camposol Bonds, or the 10.76% Myria Agro Bonds.
Summary and Conclusion
HudBay Minerals appears to be a very seasoned and well-managed company that has successfully designed and implemented a lower-risk growth strategy. Included in this, is a prudent utilization of both the equity and bond markets, as well as tapping precious metal stream transactions with Silver Wheaton. While it would not surprise us to see its cash balance decline further as it nears the completion of several major capital expenditures this year, we also expect its cash flow and profitability to be radically improved next year (in 2015.) The bonds are callable at par in 2018, but it is far too early to speculate on whether or not the company would be in a position to redeem or replace them at that time. Overall, we think these medium-length, 7-year, Yankee bonds represent a savvy opportunity for outstanding cash flow (over 9%) and very solid returns that are well over 8%, and it is why we have targeted this issue for addition to our Fixed-Income1.com and Fixed-Income2.com portfolios.
Yield to Maturity: ~8.53%
Yield to Worst: ~8.23% (2018)
Disclosure: Durig Capital and certain clients may have positions in HudBay Minerals 2020 bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail clients.