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Xstrata offer for Noranda Income Fund way too low

|Includes: Xstrata Plc (XSRAF)
We recommended Noranda Income Fund (NYSE:NIF) on this web site on May 3rd and forecasted a subsidiary of Xstrata (XTC on the LSE) would probably try to take out the public Priority Unit holders, trading symbol NIF.UN on the Toronto Stock Exchange (OTC:XSRAF).

This morning it was announced that Xstrata Canada had obtained an “exclusivity agreement” with Noranda Income Fund whereby a LOI (Letter of Intent) had been signed with the Board of Trustees, with an associated all cash $3.40/unit (CDN) offering price for the publicly-traded 75% interest.

This offer is way too low and threatens to deprive unit holders of the proper value of their investment.
Perhaps the bid was designed to be entered on a sleepy Friday before a summer long weekend (Monday is a Civic Holiday in Ontario), and would possibly escape under the screen of seasoned value investors? Me thinks not.
Even if the $3.40 carrot is, as usual in these things, just a starting point for negotiation, it represents a slap in the face to investors that bought the units at the 2002 $10 unit issuance price and have suffered zero distribution since they were cut to zero in 2009.
Noranda Income Fund units are currently trading at $3.55, up 49 cents (16%) on 1.1 million traded (1:30pm) after being halted from 10 to noon this morning.

As an aside, this represents an approximate 40% return on our cost since accumulating these units over the past few months. But the units were much higher when the plant was operating at capacity in 2007 and 2008, as it is now.

The “non-binding” offering price of $3.40 per unit (framed as a 33% premium to the July 15 closing price - the day before the letter of intent was presented to the Trustees) includes a 30 day exclusive negotiating  period that the Trustees have agreed to with Xstrata.

The units were extremely depressed due to uncertainty regarding the Fund's $153 million in senior notes coming due November 3rd, as well as the renegotiation of its revolver ($42 million outstanding as of June 30, 2010).
Noranda Income Fund negotiating with its lenders in this credit environment, is is like you and I negotiating for a banana with a 900 lb Gorilla.
The other depressing factor is the Fund management (hired by Xstrata) indicated any future debt renegotiation would entail pre-payments to amortize the debt over the life of the contract between Xstrata and the Fund (see below), thereby depressing the ability to pay distributions.
Xstrata Canada and NIF have a Supply and Processing Agreement that makes them almost inseparable until 2017.  The Fund is dependent on Xstrata Canada for the supply of most of its zinc concentrate and the marketing of its refined zinc.

Xstrata also markets the sulphuric acid and copper cake byproduct of the  plant. In fact, Xstrata is in a position of total power over the ongoing operations of the Valleyfield, Quebec plant. Therefore any bid for NIF by Xstrata must constitute an insider bid and subject to heavy scrutiny.
To remove Xstrata Canada from the Fund’s operations would be like taking the bones out of a chicken and expecting it to fly. Therefore, the Public unitholder is at a disadvantage as the bidder is not at arms length. The Trustees must pay particular attention to their fiduciary duties to the unit holders.
The low-ball $3.40 offer severely undervalues Noranda Income Fund units based on its return to normalized zinc refining production and hefty free cash flows.
Yesterday, the Fund announced that Q2 Cash Flows Before Working Capital Changes (CFBWC) came in at $17.25 million on revenues of $157.7 million. This is after Q1 CFBWC of $17.35 million on $171.2 million in revenues. First half CFBWC were thus $34.6 million versus a valuation of $170 million for the entire company (Xstrata owns 25%, the Public owns 75%).
NIF’s main product (refined zinc) for Q2 was 65,144 metric tonnes versus 66,466 mt in Q1.
Clearly, production of refined zinc is on track to match the Fund’s historical operating rates and guidance for 2010 of 265,000 mt.
This is after bouncing back from the curtailed 2009 production of 228,600 mt. (264,100 Zn was produced in 2008).
Also good news was that Sulphuric Acid netbacks on 95,000 mt produced, more than doubled in Q2 over Q1’s 103,177 mt produced to $46/mt from $21/mt.
Since annualized Cash Flow before Working Capital Changes of the Fund was $77.3 million in 2008 and $81.8 million in 2007, you can see that annualizing 2010’s first half result would produce $69.2 million in cash flow, almost back to normalized levels.
The Fund is expected to spend $25 million in CAPEX in 2010, to maintain and improve its plant.
The Fund spent $24 million in CAPEX in 2009, $28.3 million in 2008 and $26 million in 2007.
Not all this CAPEX is for maintenance and some is for improvements and additions to capacity, but we will consider it all maintenance for the purposes of this discussion.
The Fund’s FCF (Free Cash Flow defined as CFBWC less maintenance CAPEX) on a 3 year average basis (2007, 2008 and 2010) excluding 2009 as abnormally low, equals $49.8 million or approximately $1 per unit.
A conservative valuation multiple of 6 times 3 year normalized average FCF equates to a unit valuation of $6.00, 76% more than the tentative offering price released today.
Given the benefits to Xstrata of absorbing the public unit holders (arbitraging the $193 million debt of the Fund to their lower cost of capital, removing the priority of distributions that the Public Fund priority unit holders currently enjoy, inheritance of non-operating tax losses), we believe an 8 times multiple for NIF.UN is much more appropriate.

That is an $8 valuation for the units and is conservative as it does not consider growth opportunities for NIF's zinc refining operation, which is well-located on the St. Lawrence Seaway just south of Montreal.

Copper and gold mining and exploration are very active in Northern Ontario, Quebec and the Maritimes. Undoubtedly there will be more zinc byproduct from copper/gold mining that will require smelting and refining. Zinc concentrate is brought in from as far as Duck Pond  in Newfoundland, bought by Teck with Aur Resources.

Xstrata Canada itself is developing a new zinc/copper mine with Donner Resources in Matagami, Quebec, which will begin production in 2012 and is expected to produce 80,000 tonnes of zinc and 10,000 tonnes of copper per annum, by the year 2013. That zinc will be refined at the NIF facility in Quebec. So it has important strategic value.

Any finalized offer recommendation by the Board of Trustees must be subject to a public unitholder meeting and vote and require majority affirmation. The obvious conflict of interest position of the Manager trying to buy out the Investors, warrants at least a second 3rd party independent evaluation of the Fund's intrinsic value.

This is a similar situation to the Ford Motor Company attempted buyout of Ford Canada when Ford tried to low-ball the minority shareholders back in 1995. It went to court and Ford was forced to raise its offer by $35/share.

Noranda Income Fund is being advised by Cannacord Genuity and Xstrata Canada by RBC Capital Markets.
Disclosure: Long Noranda Income Fund