Mistakes that institutional investors should have avoided

Here are two: RX Gold and Veris Gold

RX Gold:

One big-name institutional investor got burned by this company.  USA Silver and Gold should have never merged with RX Gold.

At the time, RX Gold’s flagship property (Drumlummon) was being mined at a loss.  In general, if a mine doesn’t have positive cash flow… it is almost certainly uneconomic.  (There could be exceptions.  Sometimes you have to move rock or overburden out of the way first to get at economic ore.)  The lack of cash flow was a huge red flag that indicated that Drumlummon was going to be uneconomic.  I guess somebody got distracted by the high grades and didn’t realize that the veins in the deposit aren’t wide enough to be economic.  Currently, the Drumlummon mine has been shut down.

Veris Gold (formerly Yukon-Nevada):

For whatever reason, this company is written up on VIC a lot as a long position.  The latest writeup is on April 2013.  And it so happens that Deutsche Bank and the money manager I mentioned previously were involved in financing this mess.

So here’s the story of Veris Gold:

  1. The mine was shut down because it wasn’t making money.  When a mine is already operating, there isn’t much mystery as to the future economics of the mine.  The mine will deplete and the economics will get a little worse over time.  This is why immediately restarting production was idiotic.  Yet it happened anyways when new management took over in 2009.
  2. Enter Robert Baldock.  He convinces investors to inject capital into the mine and restart it.  It loses money for years.  Investors should have realized that they got taken for a ride.  But no, this saga does not end here.
  3. Yukon Nevada renamed itself to Veris Gold (in 2012), brings in “new” management (company employees were promoted), and still continues to raise capital.

To be fair, there is a small chance that Veris Gold might actually make money.  If they get extremely lucky and discover a lot of gold in the underground mine, it’s possible that the mine might actually make some money.  But it’s highly unlikely.  The expected value of this project is probably negative.  In my opinion, institutional investors have a duty to their clients not to do dumb things.  They should have learned their lesson the first time around and never have given out their money in the first place.  My prediction is that this will end badly.

Why this project is uneconomic:  The ore is refractory and extremely expensive to process.  As well, underground mining is more expensive than open-pit mining (originally Jerritt Canyon was open-pit).  These details make a huge difference.  An open-pit heap leach operation can be economic with grades (well) below 1 gram/ton.  A deposit like Jerritt Canyon may be uneconomic at 5 grams/ton due to the refractory ore and the costs of underground mining.

Mining fundamentals

    1. Pay attention to free cash flow.  GAAP earnings can be manipulated by aggressively capitalizing expenses.  (Miners can inflate GAAP earnings by capitalizing stripping expenses and mine development expenses.)
    2. A mine isn’t profitable if it doesn’t have positive free cash flow.
    3. Mines deplete.  The most economic ore tends to be mined first (to maximize the NPV of the future cash flows), so free cash flow will start off strong and slowly decline.
    4. The appropriate financial metric is discounted cash flow, not EBITDA or P/E multiples or the number of ounces supposedly in the ground multiplied by some arbitrary number.
    5. It is easy to fudge NI 43-101 technical reports.  Everybody does it and regulators rarely do anything about it (e.g. regulators were late in protecting those who traded Barkerville Gold; so far nobody has been punished).

I’ve started to form the opinion that institutional investors don’t know what they’re doing when it comes to mining.  And this scares me.

*Disclosure:  I never had a position in these stocks.  I did not short them.

2 thoughts on “Mistakes that institutional investors should have avoided

  1. Pingback: Sprott Resource (SCP.TO) – Trading below NAV but I’m not buying it | Glenn Chan's Random Notes on Investing

  2. Pingback: Kingsway Financial’s activist battle with Kobex Capital | Glenn Chan's Random Notes on Investing

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