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Xstrata offer for Noranda Income Fund much too low

|Includes: HBM, NNDIF, TECK, Xstrata Plc (XSRAF), ZINCQ


On May 3, we recommended Noranda Income Fund (OTC:NNDIF) with primary trading symbol NIF.UN on the Toronto Stock Exchange and forecasted a subsidiary of Zug, Switzerland-based Xstrata Inc. (OTC:XSRAF) would probably try to take out the public Priority Unit holders by the end of 2010 and before the tax rules changed for Canadian income trusts on January 1, 2011.

On July 30, Noranda Income Fund (NYSE:NIF) announced that Xstrata Canada had obtained an “exclusivity agreement” with NIF whereby an LOI (Letter of Intent) had been signed with the Board of Trustees to explore a going private transaction with a preliminary and associated cash $3.40/unit Cdn offering price for the publicly-traded units.

In a nutshell, this offer is much too low and threatens to deprive public unit holders of the proper value of their investment. The units have traded above the $3.40 opening bid price and closed at $4.29 today, indicating investors expect the bid price to be raised substantially.

The public owns 75% of NIF in the form of Priority Units, and Xstrata Canada already owns 25%, in the form of Ordinary Units (also called Special Fund Units). The two types of unit are distinguished in terms of priority for distribution payments, and other terms.

The value of the proposed buyout of the public at $3.40 per unit is $127.5 million. The valuation of the entire Fund, including Xstrata’s interest, and $153.5 million in Senior Secured Notes, is $323.5 million.

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 original $10 unit issuance price in 2002, and have received no income since the monthly distribution was cut to zero in July, 2009.

CEZinc and the Zinc Refining Business

Noranda Income Fund’s sole asset is the CEZinc zinc metal smelter and refinery located in Salaberry-de-Valleyfield, Quebec. This is the largest combined zinc metal smelter and refinery on the Eastern Coast of North America, with capacity to produce 265,000 metric tons of zinc metal per annum in various forms as required by customers.

The plant produces almost 500,000 mt of sulphuric acid per annum as byproduct. Sulphuric acid is an essential industrial chemical with broad use from fertilizer manufacturing to water treatment chemicals.

Without a zinc smelter and refinery, zinc mines cannot sell their main product, zinc in concentrate (52-54% Zn) and gold and copper mines with zinc-contained ore cannot achieve by-product revenues to reduce cost. 

Xstrata is the biggest zinc miner in the world (est 800,000 mt zinc in concentrate per annum), followed by China Minmetals subsidiary MMG (est 775,000 mt) and Teck Resources Ltd. (678,000 mt) (TCK). China is the largest zinc refining nation with 4 million mt/yr out of apprx. 12-12.5 million mt in global zinc metal production (International Lead and Zinc Study Group based on 1H 2010 data) and is the largest consumer of zinc metal primarily for galvanized steel production (Source USGS 2008 Zinc Yearbook).

Xstrata’s July 28 “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 the Trustees have agreed to with Xstrata.

The negotiating period ended today and we expect some news forthcoming from the Fund sometime next week.

In my view, NIF’s units have been extremely depressed for most of 2010 to date, due to uncertainty regarding the Fund's $153 million in senior notes coming due November 3, 2010 as well as the renegotiation of its revolving credit facility ($42 million outstanding as of June 30, 2010).

The other depressive 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 SPA contract between Xstrata and the Fund (see below), thereby signaling a reduced or lack of ability to pay cash distributions.

The Fund paid $1.02 per unit or 8.5 cents per month to the Priority Units for every full year up from 2003 to 2008. The total distribution amounted to $38.25 million per year to the public. 
The Fund cut the distribution by about half in February, 2009, to 4 cents, due to declining economic fundamentals, and Xstrata's inability to store the sulphuric acid being produced, requiring a 20% curtailment of the facility. The last distribution payout occurred in July of 2009.

Xstrata Canada also received 8.5 cents per month on its Ordinary Units up until the distribution cut (a total of $12.75 million per year).

Xstrata Canada and NIF have a Supply and Processing Agreement that makes them almost inseparable until May 2017. The Fund is dependent on Xstrata Canada for the supply of most of its zinc concentrate and the marketing of its refined zinc and sulphuric acid and copper by-products.

However, until May 2017, Xstrata must supply the CEZinc plant with no less than 520,000 dmt (dry metric tons) per annum of concentrate containing not less than 52.5% zinc. Recently released Schedule A to the SPA includes detailed terms.

Zinc concentrate comes from three Xstrata mines in Canada – the Brunswick, Kidd and Perseverance mines in New Brunswick, Ontario and Quebec, respectively. Concentrate also comes from the Duck Pond mine in Newfoundland owned by Teck (TCK). And off-shore zinc comes from the Antamina copper/zinc/silver mine in Peru, the second largest zinc mine in the world and owned 33.75% by Xstrata.

Xstrata markets the sulphuric acid and copper “cake” byproduct of the CEZinc plant. The acid is marketed by Xstrata subsidiary Norfalco which collects acid from copper and zinc smelting in Eastern Canada and sells it into the US market. The copper cake is sent to CCR, another Xstrata plant in Montreal, for further refining into cathode copper.  

Xstrata is in a position of power over the ongoing operations of the Valleyfield, Quebec plant. Therefore any bid for NIF by Xstrata must constitute an insider bid and be subject to heavy scrutiny.

The NIF public unit-holder is at a disadvantage as the bidder is not at arms length. However, the public unit-holder is protected by several agreements signed by Noranda Inc. (now owned by Xstrata Canada pursuant to the 2006 takeover) which gave comfort and protection to buyers when Noranda Income Fund was set up to own the asset in the first place.

The Fund’s Board of Trustees must pay particular attention to their fiduciary duties to the unit holders.

In my opinion, the $3.40 offer severely undervalues NIF’s public units based on its return to normalized zinc refining production, hefty free cash flows, and unique position as one of only three operating zinc refineries in Canada.

The CEZinc refinery owned by NIF is sited on an excellent location to receive zinc concentrate from anywhere in the world (the St. Lawrence Seaway at Valleyfield, Quebec).
The CEZinc facility is currently operating at capacity (there is more zinc concentrate available for refining than there is refinery space).

Little Competition

The CEZinc facility has little competition in Eastern North America.
In Canada, we have three other zinc refineries, but two are fully utilized in their areas of operation, and the third was just closed. The slightly larger Trail, B.C. zinc refinery (295,000 mt zinc metal capacity) processes zinc concentrate from Teck’s Red Dog zinc mine in Alaska (30%) as well as zinc from local and international zinc mines (70%). The Red Dog zinc mine is currently in transition as it seeks a new water discharge permit for the Aqqaluk deposit.
The smaller, Flin Flon, Manitoba zinc refinery (115,000 mt metal capacity) handles owner HudBay Mineral’s (HBMFF.PK) refining requirements (66%) as well as zinc from 3rd party mines (34%). HudBay is currently evaluating a new zinc rich deposit (Lalor) and the restart of its Snow Lake Manitoba concentrator.

Xstrata recently closed the third zinc refinery, its Kidd Metallurgical copper and zinc smelting and refining operation near Timmins, Ontario. The plant lacked economies of scale and was high cost. The Kidd Creek mine and concentratoor will continue to operate. The zinc concentrate from the Kidd Creek mine will probably be refined at CEZinc, space permitting.

Zinc metal production in the US tends to come from processing EAF (Electric Arc Furnace) dust collected from carbon steel mini-mill producers and secondary zinc dross and other recycle feedstock. They cannot smelt zinc concentrate and therefore are not available to zinc miners and cannot compete with CEZinc for zinc concentrate feedstock.

The US recyclers tend to produce a variety of zinc products (zinc dust, CZO, zinc oxide) as well as zinc metal used for galvanizing steel. Only the latter is directly competitive with CEZinc’s product.

The zinc metal recyclers of consequence in the N.E. US are the Horsehead Holding Corporation (ZINC) Monaca, Pennsylvania refinery (175,000 mt capacity of which 84,000 is metal) which is 30 miles north of Pittsburgh and U.S. Zinc’s Coldwater, Michigan zinc metal facility.

The Horsehead zinc plant suffered an explosion and fire on July 22, 2010. It is anticipated that it could take several months for production capabilities in the refining facility to be fully restored.

In late 2007, U.S. Zinc was purchased by a private Brazilian natural resources conglomerate, Votorantim, for $295 million US plus outstanding debt. In 2006, U.S. Zinc's five US manufacturing facilities shipped 384 million lbs (175,000 mt) of zinc products, including zinc oxide, zinc dust and zinc metal. Votorantim produces 525,000 mt of zinc worldwide and aims to increase this to 1 million mt by 2012. Votorantim would be a potential buyer of the CEZinc plant. 

The only primary zinc smelter/refinery in the USA is located at Clarksville, Tennessee, and is mid-sized at 125,000 mt capacity. It is owned by Nyrstar BV, which is the largest zinc smelting company in the world (1.1 million tons of zinc p.a.) and is a product of the 2007 merger between Umicore and Zinifex’s refinery assets. 

Two clusters of historic zinc mines in mid and eastern Tennessee (on care and maintenance from time to time due to low prices) were purchased by Nyrstar from Glencore and SPA in 2009, and are currently being restarted with 27,000 mt zinc metal production in the first half of 2010. At full capacity, the mines will provide 210,000 dmt (dry metric tons) of zinc concentrate (with 130,000 contained metal), or slightly more than the smelter's capacity.

Although Nyrstar has expressed more interest in expanding upstream zinc mining rather than refining, they would be a potential buyer of the CEZinc plant.

CEZinc is a critical and not easily replaced asset for zinc refining in Eastern North America. Not only is the location excellent for receipt of zinc concentrate from Quebec and Ontario and abroad, but the land use, zoning, environmental assessments and permitting for air and water emissions for such plants are extremely difficult to achieve. This plant is quite valuable.

Financial Analysis

On July 29, the Fund announced Cash Flow Before Working Capital Changes (CFBWC) for the second quarter ending June 30 was $17.25 million on revenues of $157.7 million. This includes cash flow from the non-controlling 25% interest of Xstrata; which is consolidated in the results.

This performance follows Q1 CFBWC of $17.35 million on $171.2 million in revenues. First half CFBWC’s were thus $34.6 million and annualized constitute approximately $70 million versus a valuation of $170 million for the entire company. The Xstrata initial $3.40 bid values these cash flows at only 2.43 times, for a cash flow return on investment for Xstrata of 41.1%!

One big benefit for Xstrata Canada in privatizing NIF is that it would then have 100% ownership and hence control over the firm’s cash flow whereas currently, it can only receive distributable cash on its Ordinary Units after the public’s Priority Units receive at least 8.333 cents in any given month.

NIF’s refined zinc production in Q2 was 65,144 metric tons (mt) versus 66,466 mt in Q1. 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 for the fund unit holders, sulphuric acid netbacks more than doubled in Q2 to $46/mt from $21/mt in Q1, on 108,290 mt sold versus Q1’s 102,490. Sulphuric acid revenues were $5.1 million versus $2.2 million.

Three quarters of the acid byproduct is sold subject to annual contracts negotiable in November, and the price of H2SO4 has been rising recently as supply has been tight. Demand for acid depends on US industrial activity as well as international trading activity. Acid is currently tight in Europe.

During Q2 the actual selling price of NIF’s sulphuric acid was $106/mt versus the netback of $46/mt. The other $60/mt went to Norfalco, part of Xstrata, to pay for their service to distribute and transport the acid.

Copper by-product sales in Q2 (406 mt) were half of production (822 mt) because they depended on the Kidd Creek copper refinery for conversion to cathode. Kidd Creek was closed in May 2010 so they will be routed elsewhere in the Xstrata Copper network, and sales will probably return to normal. Copper revenues were $1.5 million in Q2 versus $3.4 million in Q1.  

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 and is 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.

The Fund paid $51.0 million in annual cash distributions during 2008 and 2007. Therefore, distributed cash was approximately equal to FCF.


A conservative valuation multiple of six times 3-year normalized FCF equates to a unit valuation of $6.00, 76% more than the tentative offering price suggested by Xstrata.

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, removal of external financial compliance and reporting, inheritance of net operating tax losses, etc) we believe an 8.0 times cash flow multiple for NIF.UN is much more appropriate. Therefore, we believe NIF units are worth $8 Cdn to Xstrata.
As a stand-alone corporation or SIFT, NIF would become tax payable in fiscal 2011, and therefore valuation would be lower. Conversion of the Fund to a Corporation to avoid SIFT taxation would reduce cash flow in the $11.2 to $14 million range from our estimated pre-tax cash flow of $75 million for fiscal 2011. This is based on an estimated 28% current tax rate applied to $40 to $50 million of Net Income before minority interest and income taxes.

As a standalone entity, we would expect the impact of taxes to be a 10-15% discount on the estimated $8 valuation.

As part of the Xstrata group of companies, valuation would be preserved, as the Fund would be converted to a Corporation and it is likely it would be acquired by an Xstrata subsidiary with tax losses sufficient to shelter income from corporate tax. Alternatively, reinvesting the zinc refinery’s cash flow into mine development to increase tax shields would reduce the requirement to pay Canadian cash taxes.

That is an $8.00 valuation for the units and is conservative as it does not consider growth opportunities for NIF’s zinc refining and acid buy product operation. It also does not request a value for the strategic nature of the asset in the Xstrata Canada network.

For example, Xstrata Canada’s Norfalco division is the largest supplier of sulphuric acid in the USA and a quarter of that supply comes from CEZinc.

Xstrata Zinc, headquartered in Madrid, Spain, is a world-wide zinc miner and supplier of refined zinc, and CEZinc is an integral part of that network.

Zinc Feedstock Outlook

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 in the future.

Zinc concentrate is brought in to CEZinc from the Duck Pond mine in Newfoundland, which is owned by Teck Inc, brought in with its 2007 acquisition of 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 mt of zinc and 10,000 mt of copper per annum (both in concentrate) by the year 2013. That zinc concentrate will be refined at the CEZinc facility in Quebec. So it has important strategic value.

Looking forward, a large Xstrata zinc mine will be shuttered (Brunswick next year) whereas other mines are being developed in the prolific Canadian Shield crossing Northern Manitoba, Ontario and Quebec.

The aforementioned Antamina mine in Peru is undergoing a $1.3 billion US expansion which will increase its concentrator daily throughput from 90,000 mt of ore to 135,000 mt by the end of 2011. This will increase the supply of zinc concentrate requiring smelter/refinery services.

Future zinc mine development will depend on the London Metal Exchange zinc price, currently around $2,000 USD/mt, which although soft due to the current economic slowdown, is substantially higher than during the depths of the credit crisis.

Independent Committee

The Fund is governed by a seven-person Board of Trustees overseeing the operating trust. In late 2009, three of the four independent members formed an Independent Committee to evaluate the Fund’s strategic operations, in the wake of the curtailment, and in view of the coming change in SIFT taxation.

For clarity, if th
e Fund does not convert to a corporation or otherwise restructure by the end of 2010, it could be subject to a Specified investment flow-through (SIFT) trust income and distribution tax levied by the Canadian federal government, essentially removing the tax-free flow through distribution of income it enjoys now.

Any finalized offer recommendation for NIF must be pursuant to an objective valuation of the units, be subject to a public unit-holder meeting and vote and require two thirds majority affirmation. Cannacord Genuity has been engaged to prepare the valuation recommendation. The obvious conflict of interest position of the Agent/Manager trying to buy out the public investor 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 Gryphon Partners and Heenan Blaikie and Xstrata Canada by RBC Capital Markets and Davis Ward Phillips and Vineberg.

Post Script: Xstrata raised their offer to $3.90 on August 30 but this was rejected by the Fund and on September 2, Xstrata terminated their acquisition attempt.

A group led by West Face Capital and Clearwater Capital has acquired over 10% of the Fund's units and has requisitioned a special unit-holder meeting for the purpose of replacing the Fund's Board of Trustees.
Long Noranda Income Fund