Baja Mining Corp. (OTC:BAJFF) [BAJ.TO]is a stock we have been following quietly and with much interest for some time. Its Boleo copper project in Mexico has recently moved into top gear, as the company has recently succeeded in obtaining all the permitting and financing necessary to put the plan into action. The mine will have a life of at least 25 years, it will become reality in around 2 years from now, and there is little blocking the way of BAJ apart from constructing the facility on time and in budget and caring for a few protected cacti on site that need specialists to respectfully relocate them (and quite right too).
The share price has been reacting favorably to recent developments, and by the looks of things there is more to come. Management holds a touch under 30% of all stock, and must therefore be doubly pleased with progress in the last 12 months.
Disgruntled shareholder with a public voice
However, the smooth progress of BAJ suffered a jolt yesterday as the chart below clearly shows (with industry standards Souther Copper Corporation (PCU) and Freeport-McMoran (NYSE:FCX) shown as context). BAJ.to slumped 8% when newsletter writer and minority shareholder Jason Hommel decided to make public his view that any hedging of future production would be a disaster for the company. Mr. Hommel, who declares owning some 588,700 Baja shares, published the evening of the 16th a fractious e-mail exchange that he previously had with the CEO of Baja, John Greenslade.
In it, Mr. Hommel strongly criticized Mr. Greenslade for the company’s plan to hedge copper production for the first 5 years of mine life. Some of the language used included:
What could possibly explain your incompetence?
Are you just ignorant of all things financial?
I can’t believe you were this stupid, after our discussions, where I warned you of the dangers of hedging.
Our players come from different backgrounds
Strong words to use against any CEO indeed, but are they deserved? Is Mr. Greenslade really incompetent, ignorant and stupid? Is Mr. Hommel within his rights to advise a CEO on business matters and then berate him with such venom when he does not heed that advice? Let us examine the credentials of both people in this spat.
First, Mr. John Greenslade, whose experience and reputation in mining, legal matters relating to mining and financial matters relating to mining is, frankly, second to none. He holds three separate university degrees in applied science, engineering (masters) and law. He has over 35 years experience in mining (often in world class companies), has worked as a mining legal expert for many years and has been closely involved in various financings of different mining projects. He has been the central figure at the Boleo project since 1994 and will soon be the CEO of a very large (and almost certainly highly profitable) copper, cobalt and zinc mine.
We believe that it is more than difficult to justify calling somebody with such a background incompetent, ignorant and stupid.
As for Jason Hommel, he is the owner of a silver stock picking website with (according to Mr. Hommel in an interview this summer) 800 paying subscribers and 55,000 recipients of his free newsletter. He has a BA in psychology from University of Colorado, Boulder. He has apparently made his small fortune by investing in mining companies. He is the author of newsletters that predict the imminent demise of the US dollar, and has recently predicted that silver will “easily” reach $30 in early 2008, and will then go on to break U$8000 (yes, that’s thousand) in the next 15 years. His arguments to back up such radical statements include the following:
I have a well-researched religious belief that the world will return to using gold and silver as money, before Jesus returns at the rapture before the tribulation.
[When people argue that] "the dollar will never be destroyed, because the U.S. is too big," I will refute this argument by saying that the U.S. is not bigger than the world, just like the Titanic was not bigger than the ocean.
And there are plenty more where those two came from. We find Hommel’s metaphors and the combination of religion and modern finance interesting, to put it diplomatically. We certainly have the utmost respect for all religions and we do not doubt Mr. Hommel’s devotion. That said, the language he recently used to describe his neighbour was not exactly Christian. Perhaps he was having a bad hair day and should wear a hat more often (possibly made of tin?).
The hedging issue is nothing out of the ordinary
So much for our cast of characters, but why is hedging presently an issue at Baja? On September 12th BAJ announced that it had secured up to U$515m financing in a 12 year deal with a large European banking group to develop its Baja project. Along with a subsequent $45m placement (which has just closed successfully), this money should be enough to fund the estimated $568m construction costs at Boleo. However, as part of the deal the financiers want BAJ to hedge at least part of the first 5 years of copper production at Boleo in order to guarantee the funds needed to pay back the principle of the loan. This is not something that BAJ has kept quiet about, as it was made public on the very same day that the $515m financing accord was made public.
It is clear that Hommel objects to any sort of hedging, as he seems to argue that the dollar and other fiat currencies are doomed and all commodity prices are about to go not just up, but into the stratosphere. He therefore complained to the company that if the price of base metals rises, they will miss out on the extra income. He gives an example, saying that if copper rises U$3 to U$6.50/lb by 2009 and stays there, the proposed hedges would cost the company U$1.8Bn. In his communication with BAJ.to, he also cites the example of Apex Silver (NYSEARCA:SIL), a company that hedged 5 years production of zinc at 0.70/lb and has seemingly lost extra revenue, as zinc now sells at around U$1.40/lb.
As for Baja’s take on the hedge, its situation is surely different to that of a minority shareholder with less than half of one percent of the company. We do not know if they would willingly hedge production at today’s prices, but what we do know is that they want to build a mine! Baja’s number one priority today is to build, and it has managed to secure an agreement to finance the construction in somewhat difficult times for financing deals. However, when bankers offer to lend large sums of money they do not take any chances. The people who are putting up the cash want to know that they are going to make a profit on the deal. This is normal.
In the end, no mortal can predict the future with 100% accuracy. The price of copper may continue to climb in the next few years. It may stay where it is. It may even drop. There are plenty of analysts and speculators taking sides on this issue every day. But we can say that the prices that base metals are fetching today are extremely profitable for mining companies, and that there would be little damage and to hedging a proportion of production for 5 years, especially when one considers that 25 year minimum mine life.
So let us be clear; this hedging proposal is a standard-type deal that should not be a surprise to anyone. When bankers put down over half a billion dollars on the table they do not take risks. They see excellent profits being made in the sector at present and they want to make sure they make their money on the back of them. 100% sure. No ifs, no buts, no market forces to blame later. And let us be clear about a second issue; $3.50/lb copper is a totally different kettle of fish to the 0.70/lb zinc hedge at Apex silver. One helps to cover costs and the other makes an awful lot of money no matter where copper goes in the next 7 years.
If Hommel does not realize this, then he should stop trying to extrapolate the future price of silver from US M3 figures and take a basic course in business. In this particular case, the money people are asking BAJ.to to lock in the current high price of copper on (we believe) no more than 50% of its production to ensure the company can quickly pay back the principle. The deal does not involve the revenues from at least 50% of copper and also the secondary products of zinc and cobalt scheduled to be produced in the first 5 years. The hedge does not cover the full 12 year term of the financing deal. We could add that Baja may well be able to earn even more revenue in future years from the commercialization of its manganese content at Boleo, but the point should be made by now. The hedging deal is a fair one, the bankers will make their deserved profit and Baja will make plenty of money no matter where copper trades in 5 years’ time and with or without a short-term partial hedge to guarantee income for the backers.
Profits seem guaranteed
So as hedges go, not too heavy. And one of the things that makes it palatable is the size of the Boleo project itself. Scheduled to produce between 50,000 and 60,000 tonnes of copper per year when fully functioning at a cash cost of zero or less (thanks to the metals credits), the money loaned will be paid back very quickly. According to the Baja Mining 43-101 compliant final feasibility study, if copper is held at $3.50/lb for the next 5 years along with the current prices for zinc and cobalt (a logical figure for the proposed copper hedge, with spot currently fluctuating between U$3.60 and U$3.70/lb), this would create a total net cash flow for the period of U$1.26 Billion. That works out at an average of U$253M net per annum.
If we arrive at production with 250M shares fully diluted (again perfectly logical, as the company has been sensible in its financings to now and has by no means over-diluted), that would be an EPS of $1 and a PE of 2X at current valuations. When one considers that current copper producers are running PE ratios of 10X to 12X, the value offered by Baja Mining is clear.
So in the end, Baja is obviously cheap even without the tin foil hat discount offered up yesterday. Be that as it may, we are going to take full advantage of the short-term discount that has been has gifted to us. The company has a top class management team that holds 30% of stock and will want to maximize shareholder value. It is on a sure footing business-wise and trades at a remarkably low multiple when one considers it has both permitting and financing already in place. We therefore recommend a long position in BAJ.to and we are adding the company to our Latin America model portfolio immediately. We also think that Hommel needs a lesson or two in good old-fashioned manners and owes an apology to his subscribers, to John Greenslade and to all the management at Baja.
Disclosure: The author has a buy recommendation on Baja Mining for clients