Hudbay vs Blue Note, experience vs new

Hudbay Minerals is Canada's third largest producer of copper and zinc and also produces some silver and gold. They are highly integrated in that they own a copper smelter, a zinc plant and they convert some of their zinc to zinc oxide. Their product is marketed by Considar Metal Marketing, of which they own 50%. Being fully integrated gives them autonomy over the entire process.

Fully diluted warrants and stock options they have 129,284,210 shares, and at today's closing price of $20.77, it gives them a fully diluted market cap of $2.69 billion. Hudbay has a history of successful mining production, and their financial reports fully breakdown their costs and production.

By contrast, Blue Note is a small soon to be producing mine acquired from Breakwater when zinc price was down. Breakwater had spent $100 million on infrastructure and shut down in 1998 due to zinc prices and recovery rates. Blue Note has refurbished with mining technology developed since then. Their mine is scheduled for start-up in June/July and their unproven production plan relative to their market cap is stellar, but as a start-up it is still unproven.

Blue Note has 312,930,175 shares and Breakwater has the option to convert a $15 million debenture into 41.7 million shares, or 20% of the Cariboo and Restigouche mines. Additionally a $30 million debt offering adds an additional 4.5 million shares. For comparison purposes, it works out to about 360 million shares fully diluted. At today's close of 46c, the fully diluted market cap is about $166 million.

The market currently values Hudbay at about 16 times that of Blue Note.

Mining Production to Concentrate

Hudbay has 4 producing mines and with one increase production this year. The totals are from the financial reports but the reports do not specifically break down production by mine, so the estimates are mine based on given recovery and production rates given. They give a general picture of production.

	Zinc (lbs)	Copper (lbs)	Silver (oz)	Gold (oz)	End of Mine *$ (millions)
Mine 777	120,000,000	84,000,000	725,000	75,000	2017 $527
Trout Lake	57,000,000	40,000,000	236,000	24,000	2009 $242
Chisel North	51,000,000				2011 $77
Balmat*	20,000,000				2014 $30+$75 +$82
Total	250,000,000	125,000,000	963,000	96,000
Market Value* (millions)	$375 + $75*	$425	$12	$65	Total $952

*Production to about 70 million pounds for 2007 and 125 million pounds for 2008.
*Prices I used are $1.50 zinc, $3.40 copper, $13.50 silver, $680 gold, and $0.85 lead.

Additionally, Hudbay buys other concentrates that they process through their smelter and zinc plants, further producing from concentrate about 70 million pounds of copper, 10 million pounds of zinc, 2,000 oz of gold and 380,000 oz of silver.

What they mine and what they produce from concentrate needs to be evaluated separately.

Blue Note has one mine set to start producing this year. Their first full year production plan is:

	Zinc (lbs)	Lead (lbs)	Copper (lbs)	Silver (oz)	End of Mine
Cariboo	104,000,000	57,000,000	1,300,000	1,300,000	2011
Market Value* (millions)	$156	$48	$4	$18	Total $226

Contrasting mining production only, Hudbay has 4.2 times the gross revenue potential from mining production.

In both companies the end of mine life is of concern for future income. Trout Lake has 3 years of operations left which is 20-25% of production. Whether there is opportunity to extend this LOM was unclear reading the reports. Their next mining project will not be a growth project but will be a replacement project.

Hudbay has significant exploration potential around their 777 mine. According to a 2004 technical report, "on average, mining reserves have increased 2.5 times over the initial resource and reserves estimate." Trout Lake has had 10-fold increase in estimates over its mine life, but whether there is more potential to extend the mine life at this point is not clear. Their Flin Flon/Snow Lake area also has exploration potential.

Blue Note's current plan is a 5 year LOM plan. Their mining plan goes to depth of 300 meters and they have some drill results to indicate that they will be able to continue their mine to 900 meters giving their mine a life of up to 14 years. This is a significant exploration potential.

Mining Production from Concentrate

Blue Note does not have facilities to smelt or refine their concentrate.

Hudbay has more refining and smelting capacity from concentrate then they get from their own mines. They purchase additional concentrate to utilize their capacity. This part of the business gives them some income stability from declining mine production in that when a mine stops producing they can continue this income stream by switching to purchasing more concentrate.

Financial reports have to be evaluation to determine how this part of the business adds to revenues.

Looking at Financial Reports

Blue Note does not have an earning history to look at and evaluate. It is a speculative stock based on its new mine production. The pre-tax earning potential according to their reports for 2007 is $25 million and that is with zinc priced at $1.44, lead at $0.52, silver at $12.50 and copper at $2.80, and that is based on 2007 projected production of 68 million pounds of zinc, 35 million pounds of lead, 0.8 million pounds of copper and 0.85 million ounces of silver. Current commodity prices suggest they will exceed this projection if they meet their production goals.

Hudbay had a record year for earnings and revenues. Revenues were $1.13 billion. What is highly confusing, and perhaps misleading, is how they came up with earnings of $5.32/share for 2006.

On page 28 of the Management and Analysis is the following table for 2006 (my totals):

	Q4	Q3	Q2	Q1	Total
Revenue	313,110	346,203	261,727	207,963	1,129,003
Earnings before taxes	134,636	151,582	94,590	61,643	442,451
Net Earnings	165,788	169,381	152,836	75,986	563,991
Basic EPS	1.32	1.37	1.71	.89	5.29
Diluted EPS	1.29	1.33	1.30	0.70	4.62

Problems

1. A minor problem is that their Key Financial results on page 5 of the report say $5.32 and $4.69 whereas when I add the quarters I get $5.29 and $4.62.


2. A big problem that I see is when you look at the difference between the basic and diluted EPS you see that for Q3 and Q4 the difference between the two values is about 2-3%. However, if you look at Q2 the difference between the two is 51c, and .51/1.30*100% is 39%, and for Q1 the difference is 27%. Without looking further, this tells me there was dilution and the true earning potential is overstated in the financial reports because of the dilution.
   
   They are doing this calculation using the net earnings divided by the number of shares at the time. If you redo this calculation using the today's diluted share count you get 564/129 for $4.37 eps based on today's fully diluted market cap. This is 93% of their diluted eps of $4.69 that they reported, and 82% of the undiluted $5.32 eps being promoted.


3. An even larger problem that I see is that is that earnings before taxes is less than earnings after taxes. Once you pay taxes earnings are supposed to go down, but somehow their earnings go up, very significantly. I saw this problem as so significant when reviewing the financial reports, I immediately checked insider activity.
   
   Upon a closer look at the financial reports I found that they had put $125 million of future tax into earnings and it says that as this is "drawn down, ... it will be reflected as a mining tax expense."
   
   When I take their earnings before taxes and divide it by the 129 million fully diluted shares I get $3.43 eps, which is 64% of the $5.32 eps, or more than 1/3rd less. It is an earning rate of 16.5% of the current share price, without paying taxes.
   
   I am not an expert, but I read the "reflected as a mining expense," as not a good thing. I read this as meaning that not only will future years bear their tax burden, but they will have this extra expense of writing off this future tax asset.
   
   I do not profess to understand how this future tax thing works, but from what I've seen in other financial reports in other industries is that it seems to result in highly overstated earnings in earlier years at the expense of plummeting earnings in later years.
   
   And my look at insiders going back to July of last year, they appear to have significantly reduced their positions. Anderson has taken a gain of about $185,000 from options, Axworthy about $252,000 from options (he still has about 6,000 shares), Deitrich sold 3,300 of 10,000 shares at $23.37, Gordon took a gain of about $2.2 million from options, Hair took a gain of about $950,000 from options, Jones took about $4-5 million from options, Palmiere sold options for a gain of about $525,000, Rood took a gain of about $300,000 from options, Swinoga took about $970,000 from options. Lawler is the only director that is holding significantly in the company, with 193,000 shares.

The average prices received for product for 2006 for Hudbay was $1.53/lb for zinc, $3.15/lb for copper, $603 for gold and $11.13 for silver. They are most price sensitive to zinc and copper.

I haven't studied how the money flows through smelting and refining companies. As commodity prices go up, what they pay for concentrate goes up, and the same is true for when commodity prices decline. This means that earnings from this part of Hudbay's business should remain relatively constant and is not subjected to the speculative risk of starting new mines, doing exploration for new deposits, etc.

A quick look at this part of the business is that it looks like it made up for about $250-300 million of the overall revenue. Operating expenses increased by about $120 million from 2005 to 2006, or 25%. If you examine the individual cost of operations you see far smaller price increases of 2-10% in the operating expenses. The biggest hit for the operating costs is in the smelting and refining part of the business because of buying the concentrate. A 2004 report breaking down the employment numbers shows that 558 were directly employed at mines and concentrators and 485 at smelter and zinc plant. So the mining part of the business is bringing in 75-80% of the revenue with about 54% of the workers directly employed in those operations.

The financial reports state what they averaged for final product, but they do not actually say what the average cost was for the concentrate they purchased.

The bottom line to me is that the 70 million pounds of copper, 10 million pounds of zinc, 2,000 oz of gold and 380,000 oz of silver produced from concentrate simply does not contribute to earnings the way that production from mining operations do.

My look at the two companies suggests to me that Blue Note has significant potential to outperform Hudbay. The risk with Blue Note is how successful they are in getting their new mine started. I see the handling of taxes and the loss of production from Trout Lake as the risks with Hudbay. I personally do not see how Hudbay can increase earnings this year over last year despite increased production because of Balmat and potentially higher commodity prices because of the $125 million added to earnings last year from future tax benefits. But I don't profess to be an expert, that's just my take on it.