Callinan Mines CAA.V
February 23, 2010 - 12:44pm EST by
2010 2011
Price: 1.25 EPS $0.30 $0.23
Shares Out. (in M): 45 P/E 4.1x 5.6x
Market Cap (in $M): 56 P/FCF 17.4x 10.2x
Net Debt (in $M): -13 EBIT 8 13
TEV ($): 43 TEV/EBIT 5.1x 3.3x

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We believe that Callinan is conservatively a double, and likely a triple from here with near term catalysts. Callinan Mines is a Canadian base metals exploration company that also owns a Net Profits Interest ('NPI') and per-tonne royalty in the world-class 777 mine operated by HudBay Minerals in Flin Flon, Manitoba, Canada. 777 is a zinc mine with copper credits and to a much lesser extent gold and silver credits.

Investment Story (C$)

We believe that Callinan is conservatively a double, and likely a triple from here with near term catalysts. Callinan Mines is a Junior Exploration Company with a twist: The Company generates significant free cash flow via royalties from HudBay, a $2.1bn market cap mining company. While we believe that the ~$3.8m quarterly payment from HudBay is enough to take a long position in this name, Callinan's court action against HudBay and their 100% owned War Baby claim make Callinan a logical acquisition target for HudBay at any price below $3.90 per share (~200% upside). With recent developments in the court case we believe the catalyst time line has been compressed and that the current price represents an entry-point that could be a distant memory in the not-to-distant future.


Court Action Against HudBay With Significant Successful Milestones

The steady stream of payments from HudBay did not come easily. After stonewalling Callinan for years, HudBay finally began paying the NPI due to Callinan only after Callinan commenced a very public court battle. In fact, Callinan filed a Statement of Claim with the Manitoba Court of Queen's Bench at the end of the first quarter of 2007 and the first NPI check showed up representing monies supposedly due for the third quarter of 2007. Since then the payment stream has grown. We believe however, that the aggregate NPI payments from HudBay are lower than what they ought to be by close to $50.0m while some estimate that Callinan has been underpaid by almost $100.0m (including NPI from the old Callinan Mine from which Callinan received no NPI). With Callinan's market cap at only $55.7m, this is a compelling proposition, but one that needs further explanation.

Callinan Mines, Ltd. and The Hudson Bay Mining and Smelting Company, Ltd. ('HBMS') finalized an agreement in 1988 whereby if HBMS ultimately developed and mined the Callinan claims they would pay to Callinan a 25¢ per tonne royalty in addition to a 6 2/3% Net Profits Interest on the sale of any metals derived from ore mined onsite. The catch is that HBMS would be able to recoup all initial and subsequent capital expenditures, an administration fee on those expenditures of 11.0%, the milling cost in respect to the ore, and an interest charge applied to any negative cumulative cash flow for the project. Between 1997 and 2004 (initial commercial production), HBMS spent $435.0m developing the 777 mine. In December of 2004, HudBay Minerals purchased HBMS from Anglo American.

We estimate that all of HBMS's initial expenditures, fees and interest related to developing the mine were roughly $600.0m ($435m + fees and interest). We also estimate that cumulative cash flow from the mine paid back these charges against NPI sometime in mid-'06. Even if we assume that Callinan was not entitled to a royalty for any of the year 2006, a strong year for commodities, we estimate that the cash flows since 2007 were such that Callinan should've been paid roughly $70.0m. Actual payments however, have only been $25.0m on a cumulative basis (1), the delta being $45.0m. The issue is that it's very difficult to arrive at the exact number because HudBay refuses to reveal how it's calculated. We did however, gain a measure of confidence in our calculation after speaking with a HudBay representative who offered that he believed an adverse decision in the case would cost HudBay $25.0 - $50.0m to settle the claim (but that they believed they would win and that Callinan's claims are without merit - the party line).

Each year the HBMS (and now HudBay) auditors, Deloitte and Touche, provide Callinan with a statement of NPI and royalty of the Callinan Mine. Up until 2002, these statements were prepared in accordance with Canadian GAAP.  In 2003, six months before the 777 mine went into commercial production, Deloitte began preparing statements with a disclaimer that the numbers for the year are not prepared in accordance with Canadian GAAP. Callinan's management was given no reason for the change.

Callinan is naturally curious as to how NPI is being calculated but HudBay has been very tight lipped - so much so that Callinan filed a Statement of Claim in March of 2007. Callinan's claim was brought to compel HudBay to open the books on the assumption that if HudBay has nothing to hide they'd want to avoid a highly visible court case and let Callinan's forensic auditors in (which the '88 agreement provides for). The route HudBay has taken thus far has been to continue to stonewall Callinan and fight every step of the way. As such, Callinan has pursued the legal avenue and has won every major ruling in the case to date (as recently as 2/1/10).

Court Case Timeline

2007-03-02     Callinan files an action against HudBay to compel HudBay to provide access to books and records and provide clarity on NPI calculations

2007-10-18     Master orders Callinan's motion to be heard by a Trial Judge. Referred to Justice Scurfield.

2008-02-12     Justice Scurfield orders the matter be heard by expedited trial.

2008-02-14   Callinan applies to Justice Scurfield for an order compelling full and complete disclosure of all relevant documents

2008-03-26     Justice Scurfield sides with Callinan and issues his Reasons for Judgment

2008-05-14     Justice Scurfield outlines the terms of the Order associated with his judgment

2008-06-02     Judgment entitling Callinan to direct access to HudBay's books, records and accounts relating to the 777 mine. In addition, an Order compelling HudBay to provide an affidavit of documents disclosing all information.

2010-02-01     Judgment affirming the validity of an affidavit filed by Callinan's auditor (Mark Lotz) indicating the need for Deloitte's working papers.

2010-02-25     (Pending) Hearing on working papers.

2010-03-14     (Estimated) If hearing on working papers is successful, estimated date that Callinan's forensic audit team will receive working papers. (We believe that Callinan will appoint either BDO Seidman or Grant Thornton to audit)

2010-04-15     (Estimated) Completion of working paper audit. (The first audit took a matter of weeks. We believe that the timeframe would be similar)

We believe that the recent ruling is a key step toward bringing to light the truth behind the NPI numbers. While HudBay may appeal and otherwise drag their feet, we believe it's only a matter of time before Callinan's forensic auditors have access to all the information they need to verify their hunch: that HudBay has been shorting them on the NPI payments. In addition, we believe that the working papers may shed light on the cash flows of the old Callinan Mine for which Callinan wasn't paid a cent of NPI. Without going into detail, the old Callinan Mine produced for years but HBMS was not a public company so there were no public financial statements for Callinan to reconcile with.


Valuable War Baby Claim

As it stands today, the 777 mine being exploited by HudBay has been in commercial production since 2004 and is expected to produce until 2019. 777 is a world-class producing asset, is HudBay's principal producing asset, and thus one that HudBay will likely look to expand as they've done with other projects in the past. Interestingly, Callinan owns the War Baby claim (subject to a 10% back-in right to Bison Gold Resources (BGE CN)) which is largely considered host to the down plunge extension of the 777 ore body. The ore body is deep and situated under the town of Flin Flon and so it's likely to be best exploited from HudBay's access point. As Flin Flon is a mining town and people have been hung for claim-jumping, we're hearing that there is a large X marking War Baby in the 777 mine shaft as a warning to HudBay's operatives. Nonetheless, it seems a logical potential extension to the 777 mine, conceivably extending 777's production to 2029. The only holes drilled were in 2000 by Callinan and while there is no detail one could postulate that it'd produce at the same grade as 777. We believe War Baby is a valuable hidden asset as the claim was written off of Callinan's books in 2006 due to inactivity.

War Baby's size and proximity (adjacent) to the 777 mine, it's ease of access through 777 and it's initial drill samples which render grades similar to 777 all point in the direction of War Baby being a likely extension of the 777 mine's life. These factors, taken together could equate to a value of $25.0m - $50.0m.


Perfect "Tuck-In" for HudBay Even at Much Higher Prices

Just looking at Callinan's potential accretion to HudBay's earnings, we believe that an acquisition of Callinan at any price below $2.30 (assuming a 10% hurdle) would be attractive. Here's how we arrive at that figure:


HudBay Brings NPI Back In-House  
Royalty (TTM) (C$mm) 10.00
Tax Rate 28.6%
After Tax 7.14
HudBay's P/E (FY+1) 14.12x
Enterprise Value 100.78

+Net Cash

Market Value 113.28
Value Per Share 2.54
Return to Callinan Shareholders 103%

Notice that the royalty rate used is $10.0m. This is the number that HudBay used to calculate their Cost of Goods and differs from the amount that is paid to Callinan because...well, we don't know yet. Applying HudBay's forward P/E ratio to the after tax value of this royalty figure however, results in a potential acquisition being accretive up to $2.50 in share price. (As an aside, HudBay's implied payments to Callinan have already totaled $7.5m in Callinan's first two fiscal quarters for a $15.0m fiscal 2010 run rate. Using a $15m annual payment gets you to 3.67 per share, a 190% return to HudBay at current prices).

But there's more. Callinan is not only seeking back NPI and royalties for the 777 mine. They're also seeking NPI and royalties from the old Callinan Mine as well as general damages for breach of contract and fiduciary duty and aggravated and punitive damages, interest and costs. In light of these additional liabilities, the value of a Callinan acquisition balloons quickly.

What's more, if HudBay were to acquire Callinan, they'd also be getting rights to the War Baby claim which we believe is a logical move to extend the life of the 777 mine. HudBay has close to $900.0m of cash and no debt on their balance sheet. While they'll be using maybe $300.0m - $400.0m for the much ballyhoo'd Lalor Project, they'll still have a nice cash surplus (unless they blow it all on the Fenix nickel project). Seems like a perfect fit, right?

We believe that HudBay's failure to acquire Callinan to date is due to several factors. First, HudBay's CEO quit amid a proxy battle for control of the company and dissatisfaction from shareholders as he failed in an attempt to buy Lundin Mining. We believe that HudBay's first priority is securing new leadership. Also, HudBay literally founded the town of Flin Flon in 1927. This court fiasco has been highly embarrassing and HudBay has done all they can to try and stop the juggernaut that is Callinan's legal counsel. We believe however, that the days of stalling are coming to an end (potentially quickly).

In light of the above, we believe that Callinan is worth significantly more to HudBay. Put more concisely:


HudBay Buys Their Way Out of Trouble  
NPV of Payments from 777 ($10m Through 2019 @ 8%) 72.47
777 Back NPI+Interest 50.00
Callinan Mine NPI+Royalty & Interest 10.00
War Baby 25.00
General and Punitive Damages 5.00

+Net Cash

Market Value 174.97
Value Per Share 3.92
Return to Callinan Shareholders 214%


Expected Spin-off of Exploration Assets

We also contemplate the value of Callinan in relation to a potential change in corporate structure. In-depth discussions with management reveal the intention to spin-off the exploration properties and operations (with the exception of War Baby). We believe that this is a significant catalyst for the stock and somewhat time-bound as we expect Callinan will begin paying taxes in the next one to two quarters (which is the impetus behind the proposed change).

For the purposes of this discussion let's call the two future potential entities CAA-R (royalty) and CAA-X (exploration). A spin-off would leave shareholders with one share of CAA-R, a pure-play royalty company and a fraction of a share of CAA-X capitalized with a few $million of cash from CAA-R.  CAA-R would retain a small percentage ownership (below the consolidation threshold). CAA-X would be established as a pass-through entity for tax purposes meaning that investors (in this case CAA-R and Canadian shareholders) could recoup up to 40% of their losses in CAA-X. This structure not only leaves a clean royalty company (CAA-R) but also provides a tax-shield for income. While Callinan left as a whole would be able to shield even more tax we believe there would be a net benefit to shareholders in this structure because the royalty company, unburdened by the exploration assets, would command a higher multiple while still retaining a tax shield in the exploration business which also has value. On a combined basis we arrive at a value of $3.37.  


Value of CAA-R  
Revenue 15.72
Opex 1.49
EBT 14.23
Margin % 90.5%
Tax (Assuming Shield)                      2.38

Adjusted rate %

Net Income 11.85
EPS 0.27
Comparables (Bloomberg) FY+1 P/E
Franco-Nevada 54.94
Royal Gold 30.70
International Royalty 35.74
Average 40.46
Liquidity Discount 70%
Implied Multiple for CAA-R 12.14x
CAA-R EPS 0.27
Per Share Value of CAA-R 3.22


Value of CAA-X             
Mineral Properties 13.79
Cash from CAA-R 3.00
Total Book Value 16.79
CAA-X Shares @ 0.5:1.0  22.30
Book Value Per Share 0.75


Comparables (Bloomberg)                    P/TBV
MacDonald Mines 0.44
Kobex Minerals 0.84
Canadian Zinc 0.77
Average 0.68
Liquidity Discount 70%
Implied Multiple 0.20
CAA-X Book Value / Share 0.75
Per Share Value of CAA-X 0.15


Combined Value of CAA-R & CAA-X      3.37
Upside 170%




Capitalization 9/30/09       Earnings 2010        Cash Flow 2010        Ratios  2010 
Shares 44.59   Revenue 15.72   Net Income 9.33    P/B 2.04
Price 1.25   Opex 1.78   D&A 0.02    P/S 3.55
Mkt. Val. 55.74   EBT 13.94   Stock Comp 1.00    P/E 5.55
      Margin % 88.7%   Operating CF 10.34    P/FCF 10.18
Cash 12.50                EV/S 2.75
Debt 0.00   Taxes 3.89   Exploration (4.87)    EV/EBITDA 3.10
Ent. Val. 43.24   Tax % 27.9%   Equipment 0.00    EV/EBITDA-Capex 4.76
      Net Income 10.05   Free Cash Flow 5.48      
Tan. Book 27.37   EPS 0.23   Margin % 34.8%    Cash % Mkt. Val. 22.4%

Callinan receives a 25¢ per tonne royalty and interim 6 2/3% NPI payments based on 75% of HudBay's full year estimate. The full-year estimate is adjusted each quarter and the final balance paid subsequent to HudBay's fiscal year end audit. 

Callinan has a $55.7m market value. Back out $12.5m(1) net cash and the enterprise value is $43.2m. We estimate that NPI plus royalty payments will equal $15.7m for fiscal 2010 (June). We model SG&A (excluding stock compensation) of  1.8m resulting in pretax earnings of 13.9m. Callinan has shielded earnings with NOLs to date but, because we expect they'll run out soon, we model a fully tax burdened $10.1m net income (excluding stock compensation) or roughly 22¢ per diluted share. It should be noted that Callinan is spending $200-300k per year in legal fees which will conceivably go away and potentially be recouped if their battle against HudBay is successful.

Callinan has $3.0m budgeted for their winter drill program and we believe that management will remain prudent with respect to exploration spend. Nonetheless, we'd prefer them to spend nothing on exploration.



Mike Muzylowski has been in the mining and exploration business for over 40 years. He's worked for HudBay, the antagonist in the Callinan story, serving as their Chief Geophysicist, Senior Project Geologist and Assistant Superintendent of Exploration and Development. He also worked for Granges Exploration. In his capacity as CEO he both grew the company and oversaw the eventual sale to MIM. Muzylowski has had significant success discovering ore bodies having been involved in fifteen discoveries, the majority of which are in the province of Manitoba.

Mike likes to dig. He's been doing it for 40 years however, and is likely ready to take a step back. We believe that the tunnel he's boring through the veil at HudBay to reveal the real numbers behind the NPI payments will be one of his best and last holes. He took the job at Callinan in 1996 and has been fighting this battle ever since. As he's been to the other side (i.e. worked at HudBay in senior roles) he knows the games that are played with respect to calculating NPI and we're confident that he's the guy to see this case through.

It's close to the finish line and we believe that the NPI dispute and spin-off are two projects he'd like to see through before handing the reigns over to a new CEO providing for yet another, somewhat time-bound catalyst.



As Callinan benefits directly from the profitability of HudBay's principal producing asset, there is naturally a high correlation between the financial performance of both companies. As such, we believe that shareholders may be able to hedge out commodity price exposure and 777 mine operation risk through an offsetting short position in HudBay. The idea would be to distill the 'optionality' of a legal victory, acquisition, or spin-off.


Hedge Ratio Analysis                             
  CAA.V HBM.TO Hedge Ratio
Shares 44.6 154.1  
Price 1.25 13.78  
Mkt. Val. 55.7 2,123.0  
Cash 12.5 880.3  
Debt 0.0 0.0  
Ent. Val. 43.2 1,242.7  
EV/MV 0.8 0.6 1.33



A legal defeat in the NPI case would likely drive some investors out that have been anticipating this catalyst. We believe however, that this would have no effect on the continued stream of NPI payments and an acquisition of Callinan to bring this back in-house would still be an accretive proposition (and potentially more likely if the legal dispute were settled).

HudBay has no CEO and a large chunk of it's cash earmarked for other projects. An acquisition of Callinan likely isn't HudBay's first priority. We believe that it should be, however as it doesn't make sense for a company of this size and stature to ignore this significant risk to their flagship asset when it can be taken care of with relatively small dollars. What's more is that Callinan has NPI and royalty payments tied to the performance of HudBay and so will continue to generate healthy cash flow.

Callinan is a small, illiquid company trading with wide spreads on the venture exchange. If the market crumbles and investors want out, this stock could see quite a bit of near-term volatility. There are 5 institutions with roughly 4.0m shares a piece representing almost half the float. Management owns another 10.0% with the largest holdings going to Mike Muzylowski who hasn't sold any shares. There are also some smaller individuals who have been in this stock for years and are holding tight. Therefore, a large portion of the shares are held by quality holders and we don't believe there would be large volume sellers into weakness even if the market were to fall off.

As mentioned above, Callinan continues to spend money on exploration which not only burns cash but also spooks potential investors and robs the stock of a pure-play royalty multiple. We believe however, that management will remain prudent with respect to exploration spend and that they're looking at ways (e.g. a potential spin-off of the exploration assets) to distill the royalty business which may provide a royalty-type multiple as well as a continuing tax shield.

If an investor were to hedge a long position in Callinan with a short in HudBay, a major risk would be a significant new discovery at HudBay sending shares up for a piece of business unrelated to Callinan. HudBay has announced an increase in its exploration budget which could render such a discovery. Further, HudBay's Lalor project will be coming on in the next several years assuming metal prices hold up and so again, the stock would be fundamentally more detached from Callinan going forward. Another risk related to HudBay as a hedge is the potential for the business to be taken out by a larger player as has been rumored (Vedanta as a potential acquirer).

Finally, Callinan could receive a premium bid for the company that is well below our target price. We believe however, that management will not "settle" this case through a takeout until they gain full clarity in order to maximize Callinan's value potential. Any premium bid then would likely serve as a floor in the stock price as the investigation continues.


Summary of Valuation Scenarios and Reward to Risk

If the world falls apart and HudBay begins paying Callinan a per annum rate less than 1/3 of the $15.0m in fiscal 2010 for the rest of the mine life, we believe the value of Callinan would fall 33%


Year NPI+R

8% Discount

2010 4.75 4.75
2011 4.75 4.40
2012 4.75 4.07
2013 4.75 3.77
2014 4.75 3.49
2015 4.75 3.23
2016 4.75 2.99
2017 4.75 2.77
2018 4.75 2.57
2019 4.75 2.38
NPV (No Terminal Value)   34.42
+ Net Cash   12.50
Mkt. Val.   46.92
Value Per Share   1.05
Liquidity Discount   20%
Value Per Share
Downside %   (33%)


Summary of Valuation Scenarios                         
Scenario Price Return % Rew / Rsk
HudBay Brings NPI Back In-House 2.54 103% 3.16
Callinan Spins Off Exploration 3.38 170% 5.21
HudBay Buys Their Way Out of Trouble 3.92 214% 6.55
Double-Dip Recession, Commodity Prices Implode 0.84 (33%)  



(1) To September '09, though a payment has come in for the December quarter for which neither Callinan nor HudBay has yet reported full results




Expected Action Dates Related to the NPI Case Against HudBay (assumes no significant snags or upsets in the case)

  • 2010-02-25 (Pending)     Hearing on working papers
  • 2010-03-14 (Estimate)    Date that Callinan's forensic audit team would receive working papers
  • 2010-04-15 (Estimate)    Potential completion of working paper audit

Callinan Will Likely Beat Estimates

As far as we can tell, one analyst at Global Hunter Securities covers this name and is expecting Callinan to do $12.5m in sales in fiscal 2010 ended June. Based on the payments that have already come in from HudBay during the first two quarters we expect Callinan to report revenue of $7.5m which indicates an annualized $15.0m in NPI, well above Global Hunter's estimate.

Potential Spin-Off of the Exploration Assets

We believe there is a high likelihood that Callinan will undergo a change in corporate structure in the second half of 2010 which could be time-bound by both Muzylowski's stepping down as CEO and Callinan's impending taxable position.


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