Junior Mining Rant

The junior mining industry is for the most part a crooked casino.  I don’t entirely have a problem with people engaging in high-risk and hopefully high-reward activities.  Entrepreneurs do that every day.  If I don’t have a problem with the small business casino, then should I really have a problem with the publicly-traded mining casino?  But where the junior mining industry fails is in allowing insiders to get away with egregious behaviour.

Giving away free money

Junior miners on the Canadian exchanges are sometimes allowed to give away free money by extending the expiration date on options or by lowering the strike price on them.

Insiders usually paid too much

Especially the board of directors.  Their hourly rate is incredible even if you factor in unbillable hours.

Liability insurance

Junior miners often purchase insurance that indemnifies the directors and officers against lawsuits.  Why should shareholders be paying for this?  The directors and officers shouldn’t be doing unethical things in the first place.

To be somewhat more fair to the junior companies, the officers will sometimes get sued for things that may not be their fault.  In the case of Bear Lake Gold, the geologist decided to commit fraud knowing that he would get caught (as far as I can tell… he falsified assay data entry as he entered the results into the database).  Insiders were sued and I am guessing that the insurance company settled out of court to avoid a costly legal battle.  Even if the insiders committed no wrongdoing (I believe this… but who knows), they could lose the court battle because the other legal team may make some emotional arguments (e.g. junior mining companies are a huge scam, this is like bre-X, etc.) that the judge would go for.

But I would still rather see the company provide legal indemnity to its officers and directors… they do not have to pay an insurance company for this.

White Pine Resources / Northfield Capital

Robert Cudney is the CEO of both companies.  Apparently it is allowed for Northfield Capital to buy shares of White Pine in a private placement deal.  In my opinion, there is a potential conflict of interest here because it can be in Mr. Cudney’s interest to dilute White Pine’s shareholders in favour of Northfield’s shareholders. And this is not the first time that Mr. Cudney has done something that is potentially unfair to shareholders… several years ago, Northfield’s book value was understated (its stocks were not marked to market) and Mr. Cudney was buying fistfuls of Northfield stock selling below liquidation value.  Now that he isn’t buying Northfield stock, transparency has gone up a lot (e.g. the financials are easier to figure out).

To be fair… Northfield right now is one of the most honest companies on the TSX Venture exchange.  Insider compensation is very low (Mr. Cudney could be charging 2% of AUM and 20% of profits especially given his track record), there are no egregious related party transactions, the company doesn’t waste money on promotion, and the company does not pay liability insurance.

(*Disclosure: I own shares in both companies, though I own more of Northfield.  I’m not sure why I own White Pine shares though.)

Value creation

In an idealized world, junior miners could create value by finding really good exploration geologists / prospectors and giving them capital.  Most of the value in the resource extraction industry is created by the explorationists.  It is one of the riskiest parts of the resource extraction industry and it is an area where there is a huge range in talent.  Some explorationists are superstars while many of them will never find an economic deposit in their entire professional careers.  They may not have opportunities to make more money than with their current employer… an exploration company could step in and give them equity and give them an opportunity to make more money and to leverage their talents.  (What I’m describing here is maybe what White Pine is doing now under Robert Cudney.  It is exactly what Contango Oil and Gas did in its early days and what Altius Resources does.)

But that isn’t what actually happens in practice.  Juniors will often explore outside their home country, exposing them to political risks because they are foreigners (all countries in the world discriminate against “evil” foreigners more than non-foreigners).  In politically sketchy countries, it is easier to find more gold and higher grades of gold… which makes the junior mining company easier to promote… but such gold is less economic due to the political risk.

And what happens if a junior miner has marginal drill results?  There is an incentive to continue drilling and to pretend that the drill results are a lot better than they are.  Then there is an excuse to raise more money and insiders will have high-paying jobs for a longer period of time.

For various reasons, junior miners will do all sorts of dumb and crazy things.

Fraud

There is the outright Bre-X style fraud where people just make stuff up.  Still happens.

And then there are various forms of exaggeration.  Mine engineering and geology is not a precise science.  Small errors (often intentional) can be cumulative because the economics of a mine is based on a series of assumptions.  This makes early-stage plays very, very, very difficult to evaluate.  Companies will spend millions of dollars on feasibility studies before building a mine, and even then the feasibility studies may be wrong.  Within all this is the opportunity to exaggerate the economics of a deposit.

Under capitalized

Almost all junior miners put themselves in a position where they HAVE to raise money.  They often have to sell shareholders out at a low price to raise money to continue drilling and to continue paying insiders’ inflated salaries.

Marriot Vacations (VAC)

Some very quick observations… it looks like the main goals in the spinoff were:

  1. Financial engineering to boost profits.  By adding leverage to the spinoff company, the debtholders (ok, they actually own preferred shares) shoulder taxes that the shareholders would otherwise have to pay.  There is a tax arbitrage here in that the debtholders probably have preferential tax treatment compared to the shareholders.
  2. The parent company wanted to get rid of a company that may have negative growth and/or lumpy earnings.  This allows them to make their company easier to understand and hopefully it will attract a better share price (buyers tend to pay more for situations that are easy to understand and have steady profits).

So if you look at the spinoff carefully, the spinoff has issued preferred shares with a ludicrously high interest rate.  This, in a way, overstates book value at the spinoff.  The spinoff is also obligated to pay royalty payments to the parent… I am guessing that this liability is recorded with a book value of 0.  Again, book value of the spinoff is overstated.

Economically, leveraging the spinoff isn’t necessarily the greatest move since the timeshare business may get killed in a recession and the debt levels may become dangerous.  On the other hand, it could very well be a safe level of leverage.

I like to see spinoff situations where management is actively trying to get investors to sell the spinoff too cheap.  This can create the potential for some very nice gains and I think it will happen to MFC Industial Ltd (NYSE:MIL).  However in the case of Marriot Vacations, management is trying to dump the toxic waste into the spinoff much like the Seahawk/Pride spinoff (Seahawk is now in bankruptcy… though this has a lot to do with the Deepwater Horizon disaster, low natural gas prices, and the low cost of shale gas compared to offshore gas).

Disclosure: I used to own Marriot pre-distribution and sold after the spinoff.  I own neither the parent nor the spinoff.