The hedge-funds craze for leveraged stock buybacks is getting a test at

Phelps Dodge

( PD).

Phelps, which has ridden the rally in copper prices to a 49% gain over the last 12 months, this week found itself under assault by 10% holder Atticus Capital, an $8 billion hedge fund known for its agitator role at the Deutsche Borse last year. Atticus is pushing the world's second-largest copper miner to commit to share repurchases that are beyond what it could finance through available cash, a prospect the company labels "reckless."

Borrowing money to buy back stock is an increasingly common theme in the recent history of corporate finance. It was the ultimate resolution of activist campaigns by Carl Icahn at

Mylan Labs

(MYL) - Get Report

and

Kerr-McGee

(KMG)

last summer, and a variation played out last month at

Affiliated Computer

( ACS) where, after private-equity investors passed on a buyout, the company decided to raise about $5 billion in the leveraged-loan market to repurchase half of its stock. A more conventional example is

Amgen

(AMGN) - Get Report

, which sold $5 billion of convertible bonds this week, mostly to retire shares.

Phelps Dodge is an extreme case in that, unlike most of the above companies, its stock has been an impressive performer, running from about $97 in February 2005 to a recent quote of $144.76. What bothers Atticus could be a more recent interval: over the last 10 trading sessions, Phelps Dodge is down 13%, victimized by a downgrade from Prudential and a poorly received first quarter.

The price action and news have suggested to some observers that the rally in copper and copper stocks has run its course. That possibility might also have occurred to Atticus, the company's biggest single shareholder, which said in a letter registered with the

Securities and Exchange Commission

that Phelps Dodge is "significantly overcapitalized" and must "return excess capital to shareholders" or face the consequences.

Atticus couldn't be reached to comment for this story.

"What those guys want is to be bailed out," says an analyst who covers the company. "They figured the stock had a good run. It's not going to go up anymore, and so they want the last dollars before they sell. That's what hedge funds do."

Phelps Dodge reported $1.92 billion of cash on Dec. 31, up from $1.20 billion a year earlier, and its debt-to-equity ratio is a very conservative 0.1. In its response to the Atticus letter Wednesday, Phelps Dodge noted that of $1.5 billion in dividends and buybacks it authorized last October, it has used $900 million and is committed to using another $600 million by the end of 2006.

Stephen Whisler, Phelps CEO, expressed his own distaste for Atticus' plan in a statement Wednesday.

"We believe

Atticus' demand to add a substantial debt burden to Phelps Dodge at this point in the metal-pricing cycle to fund an additional stock buyback program represents a reckless bet that could threaten the company's future," Whisler said.

To be sure, Atticus has never publicly demanded that Phelps Dodge load up on debt to carry out its plans -- Whisler's statement, which he said was based on conversations with the hedge fund, is the main source of that intelligence. Phelps Dodge spokesman Peter Faur expanded on the logic in an interview with

TheStreet.com

.

"There is not a specific figure, but Atticus obviously is looking at a buyback that would exceed the shareholder capital-return program we already have in place of $1.5 billion," Faur said. "You'd have to ask them what figure they have in mind, but certainly, it's substantial, and our sense is

Atticus favors substantial debt to accomplish this share buyback."

What does Atticus say will happen if Phelps-Dodge doesn't agree to its plans? Its statement on the potential consequences is ambivalent. In one section, the hedge fund says ominously that Phelps' assets must look attractive to its competitors who find themselves bathed in excess capital and in need of something to spend it on.

"A significant buyback of stock is not only the right thing to do for your shareholders; it is your surest guarantee of independence from a cash-rich, copper-poor competitor," Atticus said.

On the other hand, if no further buyback is pursued, Atticus said it is just as happy "to work with other shareholders and/or potential acquirers in order to maximize value for the owners of the company."

Phelps' resistance to Atticus's demands is understandable. The company was hammered in the last copper downturn, losing a combined $600 million in 2001 and 2002 -- a time when some analysts raised the possibility of a bankruptcy filing. It wasn't until about halfway through 2003 that Phelps restored order, closing down mines in a successful effort to return to profitability just in time for copper's rally.

Had the company been heavily leveraged during that period, the outcome might have been different.

"When you have a cyclical company, especially in copper and nickel, with violent price swings and conditions outside your control, you're better off not having financial leverage," says Charles Bradford, analyst at Soleil-Bradford Research, who has a sell rating on the stock.

In its letter, Atticus spends a lot of time discussing the urgency of keeping Phelps-Dodge "independent," a goal that should be taken with a grain of salt when voiced by a hedge fund. For Phelps-Dodge shareholders, the question is how far the company's capital structure should be pushed before the concern becomes solvency.