Model mining portfolio: Dump and pump

Performance review, April 2013

+ Gold turned sharply higher after the brusque sell-off showing that the sell-off was largely an engineered event
+ The economic recovery in the US continues to bubble along, with sequestration and its effects being the only dampener
+ In copper, the DRC’s new rules and the Bingham Canyon slippage augur for stronger copper prices in the second half
+ The mothballing of several major gold projects would be a welcome development

x Growth in Europe remains sluggish

x Zinc supply numbers from the main industry show too much zinc available in the short term
x
The negative developments at Pascua Lama are tarnishing Chile’s reputation as a mining jurisdiction

Riddle Me This

What if there happened to be an investment bank that knew that some of its largest clients were getting tired of holding a position…. And what if that investment bank then had a flash of brilliance (purely unrelated, of course) and made an apocalyptic call on the future of the asset that made up those positions. It’s sort of a bit cause and effect then… of course investment bank making said call can then position itself as a short because it is “fully disclosed”.

The asset class tanks… (well, is down 14% really “tanking”?). Then asset class bounces off lows, quite smartly in fact… Investment bank shifts to neutral position (meaning it is almost certainly no longer short). Wash and repeat… Analyst gets lauded as genius… bank is so smart…. Client dumps holding which is then bought (in the open market, of course) by investment bank to cover its short.

We have been bearish on gold since it was $1,339 per oz, but what do we know!

Nostalgia for the Feral Life

First a definition:

funk (fngk)
n.
a. A state of cowardly fright; a panic.
b. A state of severe depression.

We can think of no better word for the current state of the TSXV and its many denizens than the word “funk”. For a market usually associated more with irrational exuberance and boundless optimism, the current state of soullessness is a dramatic contrast indeed.

We noted in our recent note on the London capital markets that as an engine room of feral capitalism, nothing could outdo Vancouver at its most fervid. However, like many manias it held the seeds of its own destruction. The triumph of form over substance reached its apogee in 2009/10 with the Rare Earth boom. However did it deserve its current state of being? Some focus on the index of the market but for us the dilemma is much more apparent in the mass die-off of juniors that is currently underway. The feast is turned to famine and those trapped in the besieged city are ending their own children (metaphorically) as a means to survive. It is like a medieval city under siege and while the gates are sealed shut the inhabitants lie unburied in the streets having succumbed to hunger and pestilence.

In times of stress, guilty parties are looked for and none are more guilty that the companies themselves. There has been little introspection in the mining sector in recent years and certainly no “changing of the ways”. It’s been business as usual post-2008 when obviously the climate had changed. Many managements did not want to ponder in what ways they should change because they did not know other ways to operate and calling in McKinsey was beyond the budget of juniors. The only consolation is that majors may have been making bigger mistakes than juniors over this period as things now start to pan out. Management at majors were paid seriously large amounts of money to foresee big trends and manage what they foresaw.

Juniors were just paid to run their exploration campaigns (and hopefully do so as efficiently as possible). The majors managed to create romping inflation in the space, instill all sorts of bad operating practices (e.g. FIFO culture) and indulging in big, dumb, overpriced M&A that was value-destruction rather than value creation. Juniors are mainly guilty of not adapting their hymn books to the changed conditions. The belief that there was always a buyer for their projects if only they could prove up ounces (let us call this the “greater fool” theory though they would call it “project generation).

Post-2008 though there was very little in the way of M&A to whittle down the sheer number of miners that were proliferating in the hands of the promoters let loose with the CPC mechanism. The TSXV had become an asymmetric Darwinian enterprise. Companies were born and yet scarcely any companies died. As any biologist knows overpopulation leads to sudden die-off rather than slow attrition and this would appear to be the point at which we have arrived. The current dire state of things has set off a witch-hunt with someone to blame being the target.

Regulators naturally catch unfriendly fire first and then the TMX (owner of the TSX and TSXV). We cannot however find much to fault in regulators. The main gripe appears to be over access by nonaccredited investors to financings. We would go for a happy medium here and allow smaller investors into deals but only with a maximum on participation to limit losses (say $10K or maybe $20K). An even better solution would be to encourage rights issues, which are the usual practice in the Australian and London domiciled miners. The blame for the currently ponderous rights issue regime lies with the TSX.

However we would note that the paperwork printing and dispatch requirements in Australia are maybe even more heavy on miners’ budgets but that doesn’t stop rights issues being the main funding method. The frustration with what is deemed to be the lack of sympathy from Toronto’s powers that be to the junior sector on the West Coast has engendered nostalgia for the old Vancouver Stock Exchange. As is well-known that structure was literally a rat’s nest and the fondness is for the spontaneity of that market rather than for its excesses. The ideal solution is not to recreate the bad old ways but certainly setting the TSXV free from the dead hand of Bay Street would be a welcome move. Indeed in circles in which we move the idea has sprung up of creating a company-led (rather than broker-led) exchange with a technology back-end provider and instituting a more dynamic and corporate friendly regime. In the past brokers (supposedly) represented their clients’ interests and owned the exchange and (supposedly) kept the companies listed there honest.

Nowadays it’s the companies and their shareholders that need protecting from the brokers so it would be better to have a mutual exchange owned by the listed companies with the lowest possible listing fees. The TMX can either get with this idea (by demerging the TSXV into an independent status) or find its franchise drift away to a competing exchange. The TMX has been much too comfortable collecting fees on listing of stock emanating from financings (3% in some cases) and meanwhile tolerating the proliferation of CPCs which have undermined the value and recyclability of shells. The TMX has acted neither in the interest of investors or the listed companies. Another area that could do with change is the high cost of share registration services for what most institutional shareholders and companies would agree is a VERY mediocre service (e.g. no real lists of shareholders are available and the opacity of statistics on who are top ten or twenty shareholders in a company).

Frankly the TSXV is like a car that has been driven until it quite literally falls apart. The TMX has milked the franchise for all its worth and used and abused the end-users. The final straw for us was the introduction of shorting on a downtick which was clearly a sop to the new bank shareholders of the privatized entity. It is only served as the nail in the coffin of valuations of the already beleaguered listed miners. That the franchise is taken away would not generate too many tears anywhere except within the Maple Group Acquisition Corp.

The Portfolio Move

The market for mining equities was dire to say the least and we now have only two Long positions in the black and three of our four Short positions. The Shorts in Argentex and Avalon have paid off almost
immediately with ATX now below our target price so able to be closed out. The Portfolio had a valuation of $3.973mn on the 1st of April and now stands at USD$3.702mn while cash stayed unchanged at USD$2.003mn. In fact we were surprised the portfolio had not declined more.

Portfolio Changes

We decided to go into “deer in the headlights” mode over the last month and sat tight on the positions we had. Now we have a sizeable cash mountain we might do some averaging down. We cannot think of too many new stocks we would want to add to the mix.

Capstone – the next First Quantum

We are constantly bemoaning the failure of Canadian investors to “get” base metals. That is not true though because at least in copper the last ten years have been pretty good ones for creating new copper majors in Canada. First Quantum with its recent successful roll-up of Inmet is a good example of how to do this, and so is Model Mining Portfolio constituent, Capstone. We have been fans of Capstone as an up and coming aggregator of base metal properties for several years now. Its last deal was the acquisition of Far West Mining several years ago which it undertook with KORES. After delays to getting Far West’s Santo Domingo property into production, the company signaled in November of last year that it would seek producing assets. This week has brought such a deal with BHP Billiton agreeing to sell its Pinto Valley copper mine and a railroad in Arizona to Capstone Mining Corp for $650 million. Interestingly the price paid was way above previous predications with Deutsche Bank having estimated the mine could sell for around $274 million, while UBS estimated it was worth $500 million.

The deal, which is expected to be completed in the second half of 2013, gives Capstone its third producing mine. As forecast production is 130-150 million pounds of copper in concentrate and about 10 million pounds of copper cathode a year, Pinto Valley will more than double the company’s current output. Cash costs at the mine, which restarted operating in December 2012, are estimated at $1.80 a pound. Work is underway aimed at upgrading the 1 billion tonne Measured and Indicated Mineral Resource to extend operations beyond the current reserve life reported by BHP Billiton

The purchase price will be satisfied from Capstone’s existing $200 million Senior Secured Revolving Credit Facility ($176 million available) and from a new 2.5-year, $200 million Senior Secured Reducing Revolving Credit Facility, that are respectively committed and underwritten by The Bank of Nova Scotia, and cash on hand (which stood at a stunning $499mn as at the end of December 2012).

While Capstone doesn’t appear to have bargained too hard on this one, the asset is indeed a key piece in boosting Capstone’s production, reserves and geographical spread. Now it will be producing in Mexico, the US and Canada, with Chile coming down the pike at some stage. It has the look of buying straw hats in winter (except not in the bargain basement). If markets were bubblier, BHP would not be sellers of this asset, so it’s probably a case of being a one-off opportunity combining BHP rationalization with other potential buyers like First Quantum and RTZ being distracted. We reiterate our Long position in Capstone with a 12-month target price of $5.

Parting Arrow

Not being seduced by conspiracy theories (at least as far as precious metals are concerned) we did however find ourselves experiencing a slight twinge in the wake of the collapse of the gold price in recent weeks. As is well known a bunch of hedge funds, the main physical ETFs and at least one large university fund dumped fairly prodigious amounts of physical gold onto the market in fairly short order. Somewhat to our surprise this sparked a rush of buying in Asia. If the media can be believed there were near riots as desperate retail hordes tried to load up on the yellow metals that the great and good were offloading. Thus we had a curious mismatch of very large amounts of bulk gold hitting the market place and lots of odd-lot buyers. We are not surprised when thinking about it that a large amount of ingots in vaults in London should not be fungible with small scale buying from street market gold or jewelry traders in Asian metropoli. The mere transformation of one product to the other would take weeks. Traders themselves clearly had little stock as holding gold merely for on-selling purposes had become
both an expensive and a risky endeavor.

Conspiracy theorists would dust off their old view that the ETFs really didn’t have the gold they claimed to have locked away in a vault in London. This would seem rather unlikely, for even if the ETFs were a Ponzi scheme, it would be much farther along the track of consistent selling that it would become apparent that the vendors had nothing physical left to sell. We would not be surprised though to find that some gold permabears had gone short the metal on the back of a heavyweight Short call and then found themselves very uncomfortably unable to cover when the market bounced so resoundingly. Thus we suspect that the rebound is most probably more to do with a scramble to cover by big players than a deluge of demand from marginal buyers.

If anything it shows that gold is far more a perfect or efficient market and investors should brace themselves for more spontaneous, or induced, “flash-crashes” in gold in the future.

Important disclosures

I, Christopher Ecclestone, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report.

Hallgarten’s Equity Research rating system consists of LONG, SHORT and NEUTRAL recommendations. LONG suggests capital appreciation to our target price during the next twelve months, while SHORT suggests capital
depreciation to our target price during the next twelve months. NEUTRAL denotes a stock that is not likely to provide outstanding performance in either direction during the next twelve months, or it is a stock that we do not wish to place a rating on at the present time. Information contained herein is based on sources that we believe to be reliable, but we do not guarantee their accuracy. Prices and opinions concerning the composition of market sectors included in this report reflect the judgments of this date and are subject to change without notice. This report is for information purposes only and is not intended as an offer to sell or as a solicitation to buy securities.

Hallgarten & Company or persons associated do not own securities of the securities described herein and may not make purchases or sales within one month, before or after, the publication of this report. Hallgarten policy does not permit any analyst to own shares in any company that he/she covers. Additional information is available upon request.

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