Summary

During its 85 years of mining history Hudbay (HBM) has developed 23 mines in Canada. Presently the company is in a transition phase again.

The present article summarizes our valuation of the company and shows the influence of metal prices on our results.

The Company

Hudbay produces a diversified mix of metals including copper (46% of reserves and resources), zinc (19%), gold and silver (24%), molybdenum (6%) and lead (5%). The company specializes in exploiting VMS and porphyry deposits.

The down-turn in the resource sector as a whole has also left its mark on Hudbay's balance sheet. This year's second quarterly report showed a $52.7M loss and the company announced cost cutting measures to counteract this trend. These measures also included a reduction of the semi-annual dividend from $0.10 to $0.01 per share. Ouch.

The company has listings on Toronto, New York and Lima Stock Exchanges. At a share price of $8.38 at the time of writing the market capitalization computes to $1.44B. Institutional ownership is about 65%. By mid-year the company had $1.077B in cash and cash-equivalents on its books, plus $669M in long-term debt.

Shares have been trading very much in tandem with the wider copper mining sector represented by the Global X Copper Miners ETF (COPX) in the chart below.

HBM data by YCharts

Transition & Growth

Two of the company's mines in Canada were closed in 2012; and a budget of $1.16B is earmarked for the current year for the development of the Reed and Lalor mines in Canada and the Constancia mine in Peru. That's almost 90% of market capitalization in spending in just one year. There better be a very good reason for a bold budget like this; and there is. The company is projecting immense growth over the next two years: 390% growth in copper production, 115% growth in precious metal production and 30% in zinc production until the end of 2015.

With the cautious resource investor this sets off alarm bells since it sounds very much like the old days of growth for growth sake. Too many mining companies have grown tremendously without increasing value per share at the same time. Too many companies have debt-funded themselves into a hole which they could only escape (if at all) by diluting shareholders beyond proportion.

In order to get a better handle on this morphing company we decided to look at the individual assets and evaluate each one by itself, assuming that the sum of the individual parts will be a conservative estimate for the value of the whole.

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(777-mine, head frame. Photos taken from company website)

The Assets

The company owns two plants in Manitoba: one plant at Flin Flon servicing the 777-mine and the Reed mine; and another one at Snow Lake now servicing the new Lalor mine after closure of the Chisel North mine in 2012.

The attached table gives an overview of Hudbay's operating and development assets and the value we are assigning to them. The following comments provide details of our valuation.

The 777-Mine near Flin Flon in Manitoba is the constant factor in the company's portfolio. The ongoing North-expansion should lift production by 10% starting next year. At present commercial production is underpinned by reserves until 2020. In 2012 Hudbay's result from operating activities in Manitoba amounted to $178.83M. This result included some contributions from mines that were decommissioned during the year. The North-777 expansion will more or less compensate for the reduction in output starting 2014.

For our valuation of the 777 mine we assumed constant results from operating activities at 2012 levels. We used this amount as a basis for a discounted cash flow model. A conservative 12% annual discount rate was applied over the remaining eight years of current mine life. This yields a value of $914M for the 777-mine.

A NI 43-101 report with a PFS on the Lalor Mine in Manitoba was filed in 2012 indicating a marginal project with a negative NPV of $-128.8M and an IRR of 4.3% over a 16 year mine life. In our opinion this mine will serve as a means to keep the processing facility at Snow Lake turning and possibly generate upside from future exploration. By June 30 2013 capital expenditures of $365M had been sunk into the project. It can be assumed that a portion of sunk costs have been realised as value by investors and are baked into the market cap of the company. We are accounting for 50% for sunk costs and value Lalor at $53.7M.

The Reed Mine is developed in joint venture with VMS Ventures (VMSTF.PK). Hudbay owns a 70% interest. First production is expected by late 2013. The ore will be processed at the nearby Flin Flon facility. A PFS was filed in 2012 by VMS and indicates an NPV (8%) of $57.4M for the project with a 5 year mine life. Hudbays share of this value is $40.2M. If we account for 50% of sunk costs again we arrive at a current value of $63.7M for the Reed mine.

Which brings us to the Constancia Mine in Peru, the main growth driver for the company. This mine is currently under construction and $658M had been spent prior to June 30 this year. Commissioning and ramp-up is scheduled to start in mid-2014 and commercial production a year later. A NI 43-101 report for this project is available from SEDAR and indicates an NPV (8%) of $571M. Considering half of the sunk costs as value again leaves us with a current value of $900M.

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(Constancia mine. Processing plant overview)

Sensitivity to Metal Prices

We proceeded to investigate the sensitivity of asset values to changing metal prices.

Considering the past four quarterly reports and the documented realized metal prices and operational results for the Flin Flon mine we determined an estimate for the sensitivity of annual operational results.

For the remaining assets we used the metal price sensitivity documented in the NI 43-101 reports and adjusted the NPVs for different price assumptions. Hudbay's mines are all poly-metallic and we assumed that all metals move in parallel for our assessment. For reasons that will become apparent in the next section we decided to use silver as the bench mark metal in the table below. This table and the following diagram illustrate the present value of the company's mines and projects for various metal price scenarios.

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The Streaming Agreement

A large portion of funding for the growth projects was obtained through a streaming agreement with Silver Wheaton (SLW). As a result Hudbay is receiving $750M in cash to fund part of the construction of the Constancia mine; and in exchange Silver Wheaton will receive silver and gold at a significant discount from production at the 777 mine and Constancia over the life of mine. This funding arrangement has an important impact on the valuation of the company at present.

In our valuation we considered silver-equivalent ounces sold to Silver Wheaton at a price of $5.90. Silver Wheaton expects an annual contribution of 4.2M silver equivalent ounces from the 777-mine and 100% of silver output from the Constancia mine. Silver accounts for 6.9% of gross revenue at Constancia and we considered the yearly revenue schedule outlined in the NI 43-101 report until 2030. The base case for this report used a silver price of $23.61/ounce.

The value of the silver stream depends greatly on the silver price. We therefore computed the stream value for various silver price assumptions. For this exercise we used discounted cash flow models for the two affected mines and applied a 12% discount, essentially the same parameters as for the valuation of the 777 mine.

The results of this exercise are shown in the table and the diagram below. Our model indicates that Silver Wheaton will need an average silver price of $26/ounce in order to break even on the stream.

The described model is conservative in many respects. Besides the obvious argument that exploration upside is ignored, there is also the question of the discount to be applied for future cash flows. The small table to the left shows the silver price at which Silver Wheaton will break even for various discount assumptions. The sensitivity is considerable and illustrates strong influence of the discount assumption not only on this particular model, but on any discounted cash flow model including the models we built for the valuation of the 777 mine.

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Debt

Further $500M in funding was raised through issuing Senior Unsecured Notes at 9.5% due in 2020. The two measures, debt and silver stream, in combination raised $1.25B in total for the development of the Reed, Lalor and Constancia projects. For our financial model we consider annual interest payments of $47.5M. Future payments are discounted at 3%. This leads to a current value of $265M of interest payable until 2020.

Valuation

Subtracting cash and adding debt to the current market capitalization leads to an estimated enterprise value of $1.032B.

The "sum of the parts" listed above (parts being asset value, stream value and interest) for equivalent silver prices from $18 to $35 is listed in the table and visualized in the diagram below.

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Conclusions

The present enterprise value is balanced with asset value at an equivalent silver price of $25/ounce. This would indicate a market expectation of long-term metal prices of 10% to 15% above current levels.

Using asset values based on NI 43-101 reports and a stream value at $23/ounce we compute a total current asset value of $1.026B as summarized in the attached table to the left. This total current asset value is almost perfectly balanced with our estimated enterprise value of $1.032B. We therefore conclude that Hudbay is currently fairly valued.

N.B. Despite our best efforts we view the results from our economic model of this company as ball park numbers at best. Our model includes a number of assumptions which we have tried to introduce conservatively. Playing with these assumptions reveals various sensitivities beside the obvious dependency of the valuation on metal prices. Other factors include foreign exchange rates, capex and opex and also very importantly exploration success and conversion of inferred resources to reserves.