Analysis of Lundin’s Bid for Rio Narcea

A few weeks ago, I penned an article titled “Theft of Two Nickel Producers” describing the attempted takeovers of LionOre [Toronto: LIM] and Rio Narcea (RNO). Readers pointed out that Rio Narcea has quite a bit of cash that was not taken into account for the approximate purchase price. In this article, a refined analysis of Lundin’s (LMC) net purchase price is presented, followed by a review of commodity price assumptions and ending with analysis of the market reaction to the Rio Narcea buyout offer.

Refined Purchase Price

A new attempt was made to estimate the net purchase price for Rio Narcea in Tables 1, 2 and 3. The first Table shows the purchase price and also cash liabilities of the bid. In US dollar terms the price of the bid has gone up with the recent surge in the Canadian dollar. Short and long-term debt was included as these are debts Lundin will have acquired. Table 2 includes the sale of the Tasiast gold mine to Red Back Mining, Rio Narcea’s cash at the end of 2006 along with the value of their investments and the projected 2007 earnings through to the end of the expiration of the offer at the end of May.

The primary asset Lundin will be purchasing is the Aguablanca nickel mine. Rio Narcea’s projected nickel production in 2007 is 16 million pounds. Nickel is currently trading at $23/pound. On an annualized basis, Lundin is attempting to purchase Aguablanca’s $368 million revenue stream for $350 million or below 1X sales. Considering present nickel prices result in cash flow in excess of $200 million, the takeover offer premium is now well below 2X cash flow. According to Rio Narcea’s financial advisor, this premium represents fair value for the company.

Fair Value?

In the press release April 4th announcing the takeover, the following was stated to comfort shareholders:

Rio Narcea's financial advisor has provided an opinion to the Board of Directors of Rio Narcea that the consideration to be received by the Shareholders under the Offer is fair from a financial point of view to such Shareholders.

Lundin is attempting to purchase Rio Narcea at less than 2X cash flow. LionOre may be taken over at 4.5X, Inco was purchased at 9X, Falconbridge at over 15X cash flow, how could anyone possibly judge the offer as being fair to Rio Narcea shareholders? It depends on the assumptions of the financial model used to determine what constitutes fair value. In the scientific community there is an old saying, “garbage in, garbage out”. Rio Narcea shareholders have not had the privilege to see the analysis of how the Lundin offer is fair. What can be safely assumed is analyst projected average commodity prices were used to form a fair valuation opinion.

Shareholders can be comforted that the financial elite from Wall and Bay Street use the most sophisticated analysis tools available to accurately predict the future of commodity prices, or can they? Table 4 shows four base metal commodities. The values shown are the average price estimates for 2006 predicted by analysts at the end of December 2005. To their right, is what actually occurred in 2006.

The clear conclusion from Table 4 is commodity analysts are extremely poor at predicting commodity prices. What makes the figures more striking is the analyst consensus was at the end of 2005. One would think that analysts would be able to project prices with good accuracy. How can any investor consider a financial opinion to be fair when the most basic of assumptions, the price for which a company receives for its product, is seriously flawed by those giving the opinion? It should be pointed out that in late September 2006, analyst consensus for the 2007 nickel average price was $7.44: case closed!

The Wall Street Journal used to have stock picking contests between selected analysts and those provided by a dartboard. After a couple of years, the Journal dropped the contest. Whatever the reason for dropping the contest one thing was clear; the dartboard beat the guest analyst’s stock picks most of the time.

Wall Street has a penchant for rewarding cost cutting measures at companies. Perhaps brokerages ought to consider reducing their commodity research staff because of their poor predicting capabilities. In fact, this spawned an idea for a new MasterCard commercial: One hundred pounds of bananas and a dartboard: $80. Brokerage executive admission to the local Zoo: $30. Watching apes throw darts resulting in better prices than your former million-dollar commodity analyst: priceless.

Market Reaction to the Lundin Offer

A dozen trading days have passed since Lundin made its offer for Rio Narcea. A total volume of 132 million shares have been traded representing 80% of outstanding shares. Nearly all of the shares have traded over the bid price of C$5.00. Last Friday’s close was a 4% premium to the offer at C$5.20. Lundin needs 66.7% of all the shares outstanding (110 million) to effectively takeover Rio Narcea. Only 5% of the shares were tendered at the beginning of the offer. Lundin now needs 102 million additional shares to be tendered to the offer. With a huge number of shares that have been traded, well over the bid price, does not bode well for the success of the offer. How many of the new shareholders will be willing to take a loss on their investment?

The market has also been keeping its eye on sector developments and the price of nickel. Since the offer was proposed, Nickel has hit another lifetime high. LME storage levels continue to hover around a single day’s global consumption. Short, medium and long-term sentiment continues to be bullish. One of the more bullish developments in the nickel mining sector was summarized in a press release last Friday:

SHERRITT TO ACQUIRE DYNATEC

“Based on yesterday’s respective TSX closing prices of $17.15 for Sherritt and $25.46 for FNX, the consideration is valued at $4.88 per Dynatec common share. The consideration represents a premium of 29% to Dynatec’s closing share price on April 19, 2007, or a 39% premium based on the 20-day volume weighted average share prices for the three companies from that date.”

Sherritt has shown to the market its bullish view for the future of the nickel market by purchasing Dynatec at a significant market premium of 29%. What is most striking is Dynatec’s primary nickel asset does not begin production until 2010. So why is Rio Narcea with a producing mine at full production being offered a 3.7% premium?

It’s ultimately up to the shareholders to determine if Lundin’s bid represents what Rio Narcea is worth. Unlike many takeovers, the Lundin offer is not dependent on casting of votes. Investors either tender their shares to Lundin or they do not. If an investor should do nothing at all, it is not counted as a tendered share. No one can tender an investor’s shares without their authorization. Hence, if a Rio Narcea investor wishes to effectively say no to the offer, all he or she needs to do is nothing. Otherwise, if an investor wishes to participate in the offer, they need to contact their broker and instruct them to tender their shares to the offer.

Disclosure: The author holds positions in Rio Narcea and will benefit from its stock price increase.