The list of mining stocks doing well over the past year is quite short, and HudBay Minerals (NYSE:HBM) isn't on it. Thumped by a large-scale move of investor funds out of mining and declines in commodity metal prices, HudBay has further worried investors with its upcoming capital needs, the possibility of a dividend cut, and more general product/cost issues.
On the other hand, tough times don't last but tough companies do. Very few mining companies are looking at the sort of production growth potential that HudBay has over the next three to five years. What's more, while I don't think investors can sleep on the risk that the bottomless pit that once was China's appetite for basic materials has, in fact, found a bottom (meaning that the "super-cycle" is over), no analyst is currently projecting a long-term copper price whereat HudBay can't make money.
The valuation process for mining companies is slippery and inexact. That said, even using relatively low multiples on EBITDA, low price inputs into a NAV calculation, and the company's tangible book value suggest that these shares are undervalued. Unless you believe HudBay will actively destroy value by staying in business, these shares look at least 30% undervalued and may in fact be worth 70% to 100% more than today's price.
Quality Assets In Quality Locations
HudBay has long focused on base metals, with a corporate mining history that goes back about 80 years in Manitoba. Nowadays, the company is largely about copper and zinc (combined, they make up close to 90% of expected revenue), with some gold and silver in the mix as well.
While the 2012 closures of the Trout Lake and Chisel mines took HudBay briefly down to having one operating commercial mine in Canada (777), Lalor Lake is now running at commercial scale and the company has two quality copper, zinc, and gold mines up and running, along with the necessary concentrators, smelters, and so on. HudBay still needs to invest millions more into the Lalor Lake mine to get it up to its full potential (probably a 2015 event), but the company is looking at twenty years of production from a mine that should offer solid economic returns.
The 777 and Lalor Lake mines are producing today, but HudBay's Constancia copper mine is a big part of the company's future. Although Constancia isn't the world-class asset that First Quantum/Inmet's Cobre Panama looks to be, it nevertheless should produce upwards of 85kt of copper a year for up to 16 years at attractive per-pound cash costs. Constancia isn't going to be like Freeport McMoRan's (NYSE:FCX) incredible Grasberg mine (which has historically yielded up copper at a cost of $0.21/lb), but an estimated cost of $0.93 to $1.33/lb, Constancia fits in between the current world-wide average cost (approximately $0.93/lb) and the estimated cost of the "incremental 10%" at about $1.55/lb.
While Constancia is only about 25% complete as of the first quarter 2013 update, HudBay also has the Reed project in Manitoba to develop - an asset with high-grade copper relatively close to the surface. HudBay also owns a 16% stake in Augusta Resource Corp. (NYSEMKT:AZC), which has the Rosemont copper-gold project scheduled to go into production in 2015.
All told, HudBay management has spoken of its plans to increase copper production by 390% (from 2012 levels) over the next three years, while also more than doubling its precious metals output and increasing its zinc production by 30%. That maybe not quite up to the level of what First Quantum may achieve over the next three to five years, but it's still very impressive in its own right.
But What's It Going To Cost?
One of the biggest challenges for HudBay is getting from here to there. Although the company ended the last quarter with more than $1 billion in cash, the capital budget for 2013 calls for almost $1.3 billion in spending, and there will be further capex demands in 2014, 2015, and likely beyond.
As you might imagine with the shares of leading mining companies like Rio Tinto (NYSE:RIO), BHP Billiton (NYSE:BHP), Vale (NYSE:VALE), and Freeport all so weak, this is not a great time for a mining company to need capital. Even so, HudBay has made some deals lately that should largely de-risk its funding situation for the next year or so.
HudBay recently priced a $150 million offering of 9.5% unsecured notes at a yield-to-maturity of 9.11%. The company also reduced its revolving credit facility by about $200 million, and got easier covenants on its debt ratios (which should significantly reduce the risk of a dividend cut) in doing so. Last and not least, the company received a vendor financing commitment from Caterpillar (NYSE:CAT) for $130 million. Net-net, HudBay still likely needs another $100 million to $200 million or so in capital, but the immediate pressure is off, particularly as the company received another $250 million tranche under its agreement with Silver Wheaton (SLW).
In the meantime, HudBay hasn't been helping itself with the results of its current mining operations. Revenue was down by about a third in the most recent quarter, and production has come in below expectations in the last few quarters, due in part to lower grades from the 777 mine. While quarter-to-quarter variability in mining is nothing new (it happens to the large miners too, but you just don't notice it very often in the consolidated numbers), it's not helpful. Likewise, investors haven't been too pleased with the higher-than-expected production costs nor the lower-than-expected operating cash flow.
Weighing The Bull And Bear
The bull case for HudBay is that management gets the expansion of the Lalor Lake and the construction of the Constancia mines finished on time and on budget. What's more, a stronger (or at least stable) pricing environment for copper, zinc, and gold would be most welcome, with the first two likely predicated on a resumption of demand growth in China. Last and not least, there is the possibility that Constancia works out better than expected - it's likely never going to be a Cobre Panama-type asset, but bulls will note the possibility that follow-on exploration in the area improves the reserve base (both in quality and quantity).
The bear side is a little more straightforward and boilerplate. Lalor and Constancia represent large portions of HudBay's zinc and copper reserve base (respectively), and there's little chance of the company meeting its production or financial targets if management can't get the necessary capex in place and on time. In addition, there are the standard risks that go with every mining company - the risk of costs rising more than expected and/or commodity prices dropping further than feared.
All told, though, I believe HudBay's current price is discounting some pretty harsh assumptions. On the basis of $4 copper in 2015 (and about $3.35 long-term, versus today's $3.16 price) and $1.25 zinc, I believe the NAV of HudBay is between $12 and $13 today, with more than $7.50 of that coming from the Lalor Lake and Constancia mines. In this calculation, the Reed project is worth about $0.60/share today, with an additional $0.40 or so from other exploration projects. For those who are interested, I'd note that sell-side analyst NAVs run the gamut from about $11/share to over $20 right now, and my own NAV estimate would drop to $10 if I used today's copper and zinc prices.
Corroborating a NAV estimate with EBITDA and book value also suggests that these shares are undervalued. If I give HudBay the same 5.5x multiple to 12-month EBITDA as the rest of the copper sector, it suggests a fair value of about $8.50, and I'd note that that multiple really gives no credit to what I believe are above-average growth prospects. Along similar lines, HudBay currently trades at a discount to tangible book value (about 0.75x as of this writing) and I'd argue that's too much of a discount even accounting for the risk of further declines in copper/zinc prices and the need to invest capital to develop those assets.
The Bottom Line
If we're going to value mining companies at less than 1x tangible book value, the sector is in serious trouble. With that in mind, I'm pretty comfortable with the idea that HudBay is worth at least 30% more than the current share price, particularly with a lot of the near-term financing (and dividend) risks out of the way. And while I realize that NAV estimates for mining companies are "black boxes" subject to a lot of estimates and individual judgment, I don't think it's ridiculous to say that HudBay could be worth 90%+ more than the current price. Splitting the difference between EV/EBITDA, TBV, and NAV, I'd go with a target of about $10.50, or almost 65% above today's price.
There is no particular shortage of potentially cheap mining stocks today. Whether you look at First Quantum, Freeport, Vale, Teck (TCK), or the coal miners, a lot of stocks appear to be trading well below fair value barring serious ongoing commodity price declines. Even with abundant choices, though, I think HudBay is worth serious consideration from aggressive investors willing to bet on an eventual recovery in the sector and having the patience to let that play out.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.