KWG Resources Revisited

What is it worth?  I still really don’t know.

Chromite properties in the Ring of Fire area

Data from http://www.mndm.gov.on.ca/mines/ogs/resgeol/rfe/documents/Chromite.pdf

1. Black Thor.  Owned by Cliff’s.  69.6Mt @ 31.9% Cr2O3.
2. Big Daddy.  Cliff’s 70% KWG 30%.  39.5Mt @ 39-40% Cr2O3.
3. Blackbird.  Noront 100%.  11.05Mt @ 34-36% Cr2O3.
4. Black Creek.  Probe Mines 100%.  8.44Mt @ 40-41% Cr2O3.  *Probe’s 2010 NI-43 101 Resource Estimate has higher numbers.
5. Black Label.  Cliff’s 100%.  I haven’t been able to find information on the size or grade of this deposit.

*Note that these figures include Inferred resources.  The actual economic tonnage may be a lot lower.

Economics of the deposits

Cliff’s has indicated that it will mine Black Thor first.  This probably makes sense.  As to which deposit is the most economic, it comes down to various factors:

1. Size of the deposit.  Mines benefit from economies of scale.  A larger mining machine will still require the same number of operators and support personnel.
2. Strip ratio.  I am guessing that the Black Thor deposit is attractive here as it is larger and wider than the Big Daddy deposit.
3. Grade of the deposit.  All of these deposits will have some ore that is relatively high grade (>40% Cr2O3) as well as lower grade ore.  The high grade ore can be shipped directly to a ferrochrome processing facility or smelter without any processing at the mine site.  Lower grade ore will need to be processed at the mine site to increase the concentration of chromite (as transportation costs of the product is very high).  Processing costs will be higher than normal as Cliffs will be using diesel generators to power the processing plant (more expensive than grid electricity).  The lower grade ore will obviously be marginal though it should be possible to turn it into a concentrate product that can be sold profitably.
   I don’t think that there is enough information to determine which deposit is the “highest grade”.  Using a higher cutoff value will increase the overall grade (and vice versa).
4. Impurities in the ore (e.g. silicon, sulfur, etc.).  I can’t find much information here.  I’m pretty sure the companies themselves do have such information (they are probably assaying their drill core for impurities)… they just don’t bother reporting this information publicly.
5. Distance to processing facilities.

Black Thor will probably be mined first.  This makes the other deposits (e.g. Big Daddy) have a lower  present value as they won’t be mined until the future.

Black Thor will likely be mined with a combination of 2 mining methods: open pit and underground mining.  In open pit mining, costs increase as you go deeper and deeper as more waste rock has to be moved aside / the strip ratio increases.  Eventually you hit a point where it makes sense to switch over to a cheap form of underground mining (e.g. Cliffs is thinking of blasthole stoping).  The cost of underground mining should be relatively steady after the initial capital costs.

What I think will happen is this: Cliffs will mine Black Thor as an open pit, then it will start mining Big daddy as an open pit.  Eventually (at least 10-15+ years from now) both will be mined with an underground method.  Cliffs may also be interested in Probe’s deposit (it sits between Black Thor and Big Daddy).  Maybe Cliffs will mine it too as an open pit operation before switching to underground mining at Black Thor.  However, Cliffs hasn’t shown much interest in Probe as it has not done a private placement with Probe nor has it tried to acquire Probe (unlike KWG and Spider).

Size of the mine

A larger mine will have lower operating costs due to economies of scale.  And there is a lot of chromite in the region that could support a very large operation.  However, the overall size of the chromite deposit is so huge that Cliffs would risk flooding local markets and therefore getting a lower price for its chromite.  (As transportation costs to the customer are very high, I would expect chromite to be somewhat of a local market.)  Cliffs has to determine what mine size would be appropriate based on its expectations of the elasticity of chromite prices to supply, inflation, the appropriate discount rate, etc.

In 2010, the USGS reported worldwide chromite ore production to be 23.7 million metric tons.  Cliffs has indicated that it may produce “up to” 2.3 million metric tons of concentrate per year.  This would be roughly 10% of the world chromite supply.  (Technically you have to normalize the figures for the different grades between Cliffs’ concentrate and the USGS assuming 45% Cr2O3.)  If Cliffs mines at half the rate, then it might only account for 5% of world supply.

There is also the risk of a competitor opening a chromite mine, thus increasing local supply and driving costs down.  When Cliffs bought out Spider Resources, it became the operator of the project and didn’t have to worry about a combined Spider+KWG becoming one of its competitors in the region.

History

Cliffs bought out Freewest after a bidding war with Noront.  At the time, Noront was trying to use its shares (which were worth a lot at the time) to buy out Freewest.  After Noront’s share price fell and Cliffs sweetened its offer, Cliffs eventually won out.  (Some of the press releases in that bidding war were a little acrimonious between the two parties.)

This gave Cliffs 100% ownership of Black Thor and Black Label.

Later on, Cliffs offered 13cents/share for Spider or KWG.  Spider and KWG decided to merge instead.  Cliffs ultimately won the bidding war by offering 19 cents/share for Spider.  Subsequently Cliffs took a stake in KWG via private placement but it did not try to buy the entire company.

Option agreement between KWG and Cliffs (formerly Freewest)

As it currently stands, KWG has a 30% stake in the Big Daddy deposit.  Since Cliffs bought Spider, it then took control of the joint venture.  This puts KWG in a bad spot.  As I understand it, Cliffs doesn’t have to bring the deposit to production.  Or it can start production at Big Daddy and then decide to stop it.  If Cliffs decides to mine Black Thor over Big Daddy, then it takes a small hit financially while its JV partner would take a huge hit financially.  So Cliffs could hold its JV partner hostage.

(The worst case scenario is if Big Daddy isn’t mined at all, or if Cliffs decides to mine it after Black Thor has been exhausted.)

The other problem that KWG faces is that it would need to put up its share of capital if Big Daddy goes into production.  If it doesn’t, its interest will eventually be watered down to a 0.5% NSR on base metals.  (Thus its 30% stake in Big Daddy would be worth far less than the 1% royalty it held on Big Daddy, Black Thor, and Black Label.)

In a way, KWG and Cliffs are frenemies.  It makes sense for them to co-operate and at other times they end up in disputes with each other.

Trying to get back in the game

KWG is in a dispute with Cliffs over whether Cliffs has the right to build a road to the chromite deposits.  I am not a lawyer so I do not know where KWG stands.

KWG also has staked railroad claims and performed engineering studies on how much a railroad to the deposit would cost.  I honestly don’t know enough about the economics of a railroad versus an all-season road to know whether or not KWG’s railroad scheme makes sense.

Cliffs has indicated that the economics of a railroad doesn’t make sense.  So ultimately I don’t think a railroad will be built as they are considered to be in the “driver’s seat” in the transportation route to the chromite deposits.

KWG has a presentation on its website that provides some numbers on the relative costs between a railroad and a road.  Adjusting their figures for a mining rate of 12kt/day instead of 10kt/day and the ore being concentrated to 60% of its original weight, the railroad would save around $84M/year.  At a discount rate of 0% (and ignoring savings from flowthrough shares and possible cheap financing from the Canadian government), the mine life would need to be 23.74 years to recoup the investment on a railroad.  At a mining rate of 12kt/day the mine life might only be 13.7 years.  I don’t think that there is enough tonnage in the Ring of Fire area to justify a railroad.  There is a really small chance that KWG obtains really favorable financing for the railroad that might justify its economics.

Mine life

Certainly I think that the mine life will be much longer than Cliff’s lets on.  6,000 – 12,000 tonnes/day of ore X 330 days = 1.98 – 3.96 Mt/year.

Black Thor – 69.6Mt  (@25% cutoff, which may be too low)

Big Daddy – 39.5Mt

Mine life could be potentially 13.7 to 27.5+ years.  (Technically not all of those tonnes will ultimately be mined offset by any expansion in reserves.)

Value of KWG’s assets

Its main assets are:

1. 30% stake in Big Daddy.
2. Cash.  $13.5M in cash, $16.3M in current assets.
3. Railroad assets.  Likely worth 0 if it is unsuccessful in its claim against Cliffs.

#1 is the hardest to value especially when KWG’s PEA is wildly off (it estimated $900M for the railroad which now costs $2B) and therefore I don’t really trust it.  Regardless, the deposits will generate billions in revenue.  If you don’t think that Cliffs will chase a profit margin of less than 10%, then the implied NPV of KWG’s 30% stake in Big Daddy would likely be something very very high.  Ultimately I think that if Cliffs does offer to buyout KWG, it will be in the ballpark of 13 cents/share (its original offering price for KWG).  Since the original buyout offer, the 30% Big Daddy stake is worth more now whereas the $13.5M in cash would be worth less than the 1% royalty that KWG used to hold.

That’s a big if.

Cliffs might let KWG flail in the wind for a few years and KWG will bleed a little from all of its overhead costs.  Cliffs could mine at 6,000tpd so it will be several years minimum before it makes sense for it to start mining Big Daddy as an open pit.  It doesn’t have to buy out KWG… so they will have the advantage in negotiations.  KWG’s only alternative is to firesale itself to a senior miner with deep pockets or to somehow raise a huge amount of equity to maintain its 30% stake.

Junior Mining Round-up May 2012

Right now there is a lot of carnage in my portfolio.

Mineral processing notes

Metallurgical recovery

Oftentimes metallurgical recovery may be (intentionally) overstated.  Actual recoveries when mining commences is often lower than figures given by management.

Misleading context

A mining company will always run tests to determine the optimal amount of mineral processing.  More expensive mineral processing techniques will yield higher recoveries.  However, the higher recovery may not be economically justified.

Company management may quote the highest recovery achieved in initial testing.  However, this may not have anything to do with actual recoveries as the additional mineral processing may not be economically justified.  Also, the recovery figure may only be applicable to the high grade ore in a mine.  The recovery for high grade ore may be higher for lower grade ore.

How mining companies guess future recoveries

#1- Compare the ore to similar ores in other mines.

There are obvious methods of cheating here.  It is possible to cherry pick higher numbers from mines with higher recoveries.

The author of a preliminary economic assessment may also conveniently “forget” that the ore has problems that make it difficult to process (these ores are usually referred to as refractory ores).

I would not take this method very seriously in any type of economic assessment.

#2- Run tests on drill core

One method is to take drill core and to form 2 samples: one from high-grade ore and one from low-grade ore.  High-grade ore may have higher recoveries than low-grade ore.

Tests may look at:

• Energy needed to grind the ore to particular sizes.
• Grind size versus recovery
• Usefulness of different mineral processing techniques

#3- Take a bulk sample

The problem with small scale tests is that they may not necessarily extrapolate to a full-scale operation.  For example, milling equipment in a lab scale behaves very differently than a production-scale model.  You can run tests using a production-scale mill, but it requires a lot of ore.  If it is not possible to obtain that much ore (or production-scale equipment does not exist because it uses new processing techniques), then an engineer can run tests at various scales and build a model to predict how a full-scale operation would behave.  These models are never perfect.

Mining companies may obtain a bulk sample by digging a trench and mining a small amount of ore for testing purposes.  Or they may sink an exploration shaft if the ore is not close to the surface.

The bottom line is that larger scale tests are usually more accurate.  However, they are not necessarily economically justified for a given stage in mine development.

The things to watch out for

1. As previously mentioned, economic assessments should include information from more reliable methods of metallurgical testing.
2. Refractory ores and ores that are difficult to process.  A simple check is to skim through the technical report and look for the word refractory.  Unfortunately this may not be enough.  Ideally, you should know potential problems for that particular mineral or that type of ore.
3. Marginal low-grade deposits.  In these deposits, mineral processing will likely be critical to the economics of the project.  This information depends on a number of different factors and information that may not be available without expensive testing.  Mining companies will perform such testing in feasibility studies before building a mine.  However, they may not necessarily release such information to shareholders.  (Personally I don’t think that these types of projects are good investments because insiders can have such a huge information advantage and usually have incentives to promote the stock.)
4. New cutting-edge mineral processing techniques.  You don’t really know what exactly will happen unless the company runs a large-scale test.  Bench-scale/lab-scale tests may be wrong.  It is rare for mining companies to emphasize the risk involved.  Sometimes this is because a mining company badly needs to raise capital and to promote itself.  Sometimes it is simply a matter of professional pride or ego.  Some people may not like to say: “Actually we don’t really know if our science project will work on a production scale.”

Does focusing on the recovery figure really make sense?

In my opinion, not really.  There is always a balance between higher recovery and lower mineral processing costs.  This balance isn’t well known until a feasibility study is run.  A lower recovery may be a good thing.  However, management may prematurely cite recovery figures and these are usually overly optimistic.

What investors want to know is the predicted future cash flow of a particular project.  And these predictions are heavily dependent on engineering data such as grind size versus recovery, energy costs for particular grind sizes, mineral processing costs, and a large number of other factors.  “Knowing” the expected metallurgical recovery (which may change or be totally inaccurate) doesn’t necessarily help an investor predict the future cash flow of a given project.

QXM/XING: I am probably wrong

Originally my thesis for investing in these related stocks were:

1. It’s undervalued.  (Unless it is a fraud.)
2. Insiders will try to inflate earnings and to promote the stock.

I am probably wrong on both counts.  As far as promoting the stock goes, investor communication has been terrible (e.g. website not updated in ages) and insiders have not responded to Shah Capital Management’s letter to the board.

As far as undervaluation goes, the stock will likely ultimately be a zero if insiders are intent on stealing (almost) everything.  The mining companies that were merged into XING may be a fraud considering Riu Lin Wu’s history with Real Gold (see posts on chinaminingblog.com).  QXM hasn’t released new models of cell phones in a long time and there is little information on what happened to its VEVA stores.  I don’t believe that QXM has a cell phone business that is really operational right now.

So unfortunately for my net worth, I was incredibly wrong on these stocks.  Perhaps there is some residual value in these companies from cash that hasn’t been misappropriated yet.  I suppose I will find out when these companies undergo forensic audits.

Aberdeen (AAB), Pinetree (PNP), Northfield Capital (NFD.A)

All three companies hold mining/resource stocks and (likely) trade below the liquidation value of their assets.  All three are buying back stock.  Of the three companies, I like Northfield the best.  Management-wise, Northfield is clearly the best.  G&A is the lowest, insiders aren’t paid ridiculous salaries, and Robert Cudney (the CEO) has an incredible track record (compounding at over 20% AFTER tax).  While Northfield doesn’t necessarily trade at the biggest discount to its assets, superior management suggests that it is the stock to own.  It is the one-foot hurdle.

Aberdeen:  Too hard to figure out.  In addition to owning stocks in junior mining companies, they own warrants on them (because they originally bought the stock + warrants in a private placement) as well as loans, royalties, performance shares, and private companies.  They may be valuing their royalties too high, but I am not entirely sure because I haven’t looked into the expected mine life of the mines underlying the royalties.  And, the investments in private companies and the performance shares and the loans are hard to figure out.  But personally I don’t really like to see loans to their private companies since the loans may be propping up otherwise dead companies.

I don’t understand the dividend as it reduces the value of insiders’ options.  Not only that, insiders would make more money if the dividend wasn’t there.  With more assets under management, they have an excuse to charge higher salaries.  They also have more capital to invest in companies owned by Aberdeen… insiders serve on the board of directors of these companies and get to collect fees again. I’m confused by the dividend especially since Aberdeen’s presentation claims that they want more assets under management.

As a business model, Aberdeen seems to expose shareholders to a set of fees at the Aberdeen level and are hit again with fees in the stocks that Aberdeen owns (Stan Barti, the CEO of Aberdeen, is on the board of most of those companies).  Perhaps it is not surprising that Aberdeen come to market around 2007 at 80 cents (80 cents bought you a share and a warrant) and still trades below 80 cents.  And for some reason, the CEO was selling in January 2012.

Pinetree:  Pinetree has a “shotgun” approach and invests in a large number of junior miners and junior resource stocks.  Most of these companies are on the TSX Venture exchange and are highly volatile.  A sane person would not go past 100% leverage.  Pinetree… does.  This is why Pinetree’s portfolio crashed in 2011 and why they had negative retained earnings at the end of that year.

Management charges high fees and G&A is rather high.  If G&A were 0 historically then retained earnings would actually be positive.  So far, insiders have made money and shareholders haven’t really made money.

Northfield:  Of the three, Northfield by and far has the best investment track record and has lower G&A.

Historically, there hasn’t been a lot of transparency (e.g. stocks weren’t market to market and management didn’t really help investors understand that) while the CEO was simultaneously buying boatloads of stock on the open market.  The CEO no longer buys Northfield shares (he does personally buy shares in other companies which are more liquid) and the annual report does mention non-GAAP Net Asset Value, which highlights Northfield’s undervaluation.

Historically Northfield invested in private companies (wine, glass, environmental products, etc.).  Northfield is getting out of that and the only private business it is involved in is an unprofitable winery.

Northfield has almost always been undervalued and trading below liquidation value (theoretical liquidation value anyways… a lot of its holdings are in illiquid smallcap/microcap stocks).  Northfield stock is extremely illiquid and there are entire months where no trades occur.

Disclosure: Long Pinetree (only 200 shares currently), long Northfield (a lot more so than Pinetree).  Figuring out Aberdeen is not worth my time.

How to lose money in resource stocks

Outright scams

There are many pump and dump penny stocks on the OTCBB… many of these are simply outright scams.

Some “companies” issue misleading press releases that try to trick investors into thinking that there will be an actual producing asset.  A mining “company” may buy ore concentrate (this part will be divulged somewhere in their many pages of financial statements) and simply resell the ore concentrate.  They will try to make people think that the ore concentrate sales were a result of mine production.  I believe that this is what is currently occurring at Gold Resource Corporation (GORO)… of course the short sellers know this and the borrow on the stock is incredibly tight (I am not shorting it because I fear the buy-in).

Flawed assets

Sometimes mining companies will purchase mining assets with some kind of subtle flaw.  Typically investors are not very savvy (e.g. look at the market cap of GORO, Uranium One) and don’t spot the outright scams.  In less outrageous examples, there is actually a mine but some subtle kind of flaw to it.

Political risk is a big one.  Foreign companies rarely get treated as well as domestic companies.  Even in politically safe jurisdictions like Canada, foreign companies aren’t treated as well (e.g. evil foreigners weren’t allowed to buy Potash Corporation of Saskatchewan).  And of course there are many countries where there is corruption and where mining assets are stolen/nationalized.  Many of the most successful resource companies like Contango Oil & Gas and Altius Resources do not invest in foreign countries.

Some mines have veins that are extremely high grade.  However, the company won’t be so quick to point out that the high grades are in extremely narrow veins.  To actually mine the vein, you have to also mine and process significant amounts of waste rock around the vein.  This dramatically reduces the economics of the deposit.  Excellon Resources is an example of a mine with high grades that aren’t as economically attractive as one would hope.

Some mines are marginally (un)economic.  In that situation, everything matters.  There are many factors that determine whether or not a mine may be profitable.  Political risk, size of the deposit, grade, mining dilution, recovery, processing costs, cost of the proposed mining method, infrastructure, impurities, quality of final product (e.g. fines in iron ore), etc. etc.  Subtle changes in key assumptions can have a cumulative effect and make the deposit look way more attractive than it really is.  And I don’t believe that anybody will suffer serious consequences for making aggressive engineering assumptions and overstating the mine’s economic viability.  (You don’t even get thrown into jail for running an outright scam like Uranium One or Gold Resources.)  It’s simply way too hard to evaluate these deposits and these companies are almost certainly fudging the numbers.

“Production is going to follow this parabolic curve”

The proper way to build a mine is to do a lot of exploration upfront so that the engineers can build an appropriately-sized mine for the deposit.  And then you build your mine to a specific capacity that maximizes the net present value of the deposit (perhaps taking into account a reasonable internal rate of return).  Higher capacity mines benefit from economies of scale.  It rarely makes sense to build a mine and then realize that you should have built a higher-capacity mine in the first place (which is expensive and makes you less money than doing it right in the first place).

Also: In any mine, the highest grade ore will almost always be mined first so you can expect grades and production to fall in the future.

There are exceptions.  Many iron ore and potash deposits have huge reserves.  The mine operator may not even bother exploring the entire property if they know that there is already at least 15-30 years of reserves.  But because the price of both iron ore and potash has gone up so much, it can make sense to expand mine capacity.

The other situation is that very deep drilling may not be performed as it is very expensive.  The cost per ft increases the deeper you go.  Not only that, drillholes go more and more off course the longer it is.  There comes a point where it does not make sense to waste money on drilling.  But when the mine is built, it is possible to perform exploration from within the mine (and it’s cheaper to drill deep when the drill rig is located deep in the mine).  The mine operator may discover more ore.  A larger reserve and higher commodity prices could warrant a mine expansion.

But generally speaking, most mining companies that say that production at a mine will increase are making stuff up.

“We have all these reserves in the ground”

It’s so common for an oil & gas company to claim that they have a lot of reserves that they haven’t drilled yet.  Guess what?  Exploration is risky because it’s highly uncertain what’s in the ground.  A lot of oil & gas companies overstate their reserves.  When the property is drilled, there is much less uncertainty as the property will produce oil/gas.  However, it isn’t clear what the decline in production will look like in the future.  The engineers have to make an educated guess.  And of course there is room here to make extremely aggressive assumptions to fudge the numbers.

Related party transactions

Chesapeake Energy Corporation (CHK) would be an example of a larger capitalization stock with shady management.  Manual of Ideas has a good writeup on Aubrey McClendon’s shenanigans and how he has been lining his own pockets at shareholders’ expense.  I’m surprised that many value investors have gotten suckered into this stock (e.g. Longleaf, various VIC writeups like this one, etc.).  I’m sure some people have made money in this stock but you are better off holding something else in my opinion.

Bottom Line

I would listen to Warren Buffett:

1. Stick to what you understand.
2. Look for the “one foot hurdle”.  Stocks that are wildly mispriced with a large margin of safety.

If you can’t be bothered to read a mine engineering textbook, then why bother investing in mining stocks?  Just go to the mall instead and invest in Apple and McDonald’s (their founders also have biographies that are easier to read than some engineering textbook!).

Personally I think that resource stocks aren’t a great sector in general.  There are a lot of shenanigans going on and investors don’t always make as much money as they should.

Portfolio Update March 2012

By largest positions first:

#1 – QXM and XING (see writeup).

Very shady, very undervalued if it isn’t a complete fraud like most Chinese reverse merger stocks.

#2 – Premier Gold (PG.TO)

I own this because Hardrock Resources was taken under by Premier.  I plan on selling everything at a higher price than what it is now.  I don’t really see crazy undervaluation here and this is a bet on higher gold prices.  I am happy to make that bet, though higher gold prices haven’t worked out well for those who own gold stocks… not yet anyways.

#3 – KWG Resources (CVE:KWG)

Cliff’s (CLF) bought out Spider Resources after a bidding war with Noront (there is bad blood between the two companies… they snipe at each other in the press all the time).  Cliff’s was also trying to buy out KWG and they are almost certainly in negotiations to do so.  In the future, I would expect Cliff’s to buy out KWG and Noront to consolidate the area.  Noront is moving towards a plan to build a winter road to its nickel deposit with a slurry pipeline to move ore concentrate.  It is probably more economic for one party (e.g. Cliff’s) to consolidate the area and to build a railroad to Noront’s nickel deposit and the chromite deposits in the area.  According to a PEA (Preliminary Economic Assessment, which are usually fudged) the railroad would cost somewhere around $900 million.  Now KWG is saying that it will cost $2 billion.  So who knows what the NPV of their deposit really is.

However, Cliff’s has presumably done due diligence when it bought Spider Resources.  KWG has also sold a royalty to the chromite deposit to Anglo Pacific Group for $18 million… so there’s another party that has likely done its due diligence.  In my unqualified opinion, it is extremely likely that the deposit will turn into an economic mine (several years from now).

I like the management at KWG.  They are actually buying back shares, though they probably won’t buy back very many shares and have said so (because junior miners always find themselves undercapitalized).  Selling the royalty is a good move as it raises capital without diluting shareholders while the share price is so low.

#4 – Canada Lithium (CLQ.TO)

Their asset is a marginal lithium mine.  Hardrock sources of lithium typically have higher costs than producing lithium from brine sources.  In theory, Canada Lithium is highly leveraged to an increase in lithium prices.  If electric vehicles with lithium batteries proliferate, then demand can outstrip supply.  With only a few dollars worth of lithium in every car battery, there is a lot of headroom for the price of lithium.

As for the company itself… there is a lot of drama.  Its original resource estimate was performed by Michelle Stone.  (I get the feeling that companies hire her because she is very aggressive at fudging the resource estimates higher; just look at East Asia Minerals.)  Canada Lithium later had to issue a press release stating that there would be a “material reduction” in the resource estimate (and then the press release didn’t say much else… basically regurgitating old facts).  This happened not so long after Canada Lithium raised a huge amount of capital.

Currently, they have a lot of cash on hand and you aren’t paying a lot for the deposit.  Canada Lithium has been able to secure a $70 million loan to finance the project… presumably it is economic.

#5 – Long natural gas through shorting HND.TO

This is a large position because I have been getting killed on my short.  This is mostly speculation on natural gas prices.

#6 – Selwyn Resources (SWN.TO)

Their 50% share in their Yukon project may be worth $100 million.  (Their Chinese JV partner paid $100M for a 50% stake, though they sort of own more because they have certain rights in regards to concentrate sales as they own smelters and want to process the ore.)

Selwyn paid $10M for its project in Nova Scotia.

$100M + $10M = $110M.  Selwyn has a market cap of around $60M.

The CEO has been successful before (Selwyn split off from Yukon Zinc; Yukon Zinc was bought out and its project turned into an operating mine) and has previously bought shares of Selwyn on the open market.

#7- Northfield Capital

Excellent management… better than 99% of mutual funds.  Trades at around a 30% discount to liquidation value.

#8- Stocks I sometimes own

Contango Oil & Gas (MCF):  Excellent management.  The CEO invested his life savings of $400K into his company and now his net worth is a few hundred million.  Unfortunately, natural gas is getting killed and Ken Peak (the CEO) hasn’t been able to put capital to work.  If he has his way, he would’ve gone crazy drilling in the GOM and sold off producing assets (Contango’s historic bread and butter).  They were supposed to spud one of their wells several months ago.

Apple:  It’s hard to find a company that has grown faster than Apple (even in small cap land).  For a growth stock, Apple is cheap on a PEG basis.  At the Eaton Center here in Toronto, Apple and McDonald’s are the two companies with stores that are consistently jam packed (Sephora too is very busy).  Yes most of the people in the Apple store are there just to steal free Internet.  But, every employee is talking to a potential customer (unlike all their competitor’s stores).  They are the market leader and it’s usually the market leaders than make almost all of the money in a given industry (and have long periods of consistent earnings growth).  And unlike their competitors, people will line up to buy Apple’s latest products.  They have the strongest brand.

If I was smarter I would have bought Apple LEAP options when volatility was cheap and held onto them.

#9- Short term trades

POT calls.  Bet on the agricultural boom (with higher crop prices, more fertilizer increases yields and makes economic sense).  People in India and China will eat more food (more meat, which takes more farmland to produce) as wealth increases.  And the growing use of biofuels will increase demand for crops.
The economics of potash mines are attractive with potash prices so high… every potash miner is expanding their mine.  Eventually there will be a wave of overbuilding but I think that it is several years away.

RIMM.  They will lose to Apple and Android.  Their products aren’t getting as good reviews and they will lose the app/software ecosystem race because their platform is difficult to develop for (they are already losing the app race).  The Playbook has very mediocre reviews and was released too early.  But there is a price where a second-rate company is undervalued.  The ex-CEO is buying… and I am copying.  RIM generates strong free cash flow relative to its market cap (I ignore RIM’s reported profits as its patent settlement should be expensed, not capitalized).  And for a while it will probably continue to grow with the growth in the smartphone market.  If the company goes into harvest mode and returns earnings to shareholders, then shareholders should be able to make a reasonable amount of money.

QMI.TO (Queenston Mining).  Agnico Eagle has a strategic stake in Queenston (bought at $5.30) and their deposits will likely turn into a mine.  I dislike that management gave away free money by extending warrants.  I’m probably going to sell this if it goes higher and buy more KWG.

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Short positions

#1 – St. Joe (JOE) puts.  Read David Einhorn’s presentation on the company.  I have nothing to add.

#2 – AGNC puts.  If interest rates go up or down a lot, they will lose money (it says so in the 10-K).  Otherwise their magical 17% yield will continue (after the 1% management fee; of course insiders aren’t going to put their own skin into the game and chase these magnificent returns).  This is a longshot bet.  Unfortunately for me, they keep raising capital and the party continues.

#3- TLT common stock and puts.  Short long-term US treasuries.  Duh.

—The following are very small positions—

#4- Tesla Motors (TSLA) common stock.  The negative rebate sucks.  Shorting this unprofitable company and trying to short the US consumer, which can no longer use their house as an ATM.

#5- Imax (IMAX) common stock.  RealD has a product with superior economics.  (An Imax setup has much higher capital costs and reduced seating.)  So how is Imax making money?  Free cash flow is very weak, insiders are selling, and Imax historically has negative retained earnings.

#6- DLR, IOC, PSUN, GMCR common stock.

QXM and XING

Ugh.  These are Chinese reverse merger stocks.  (A reverse merger is a ‘bootleg’ method for companies to quickly get listed on US exchanges.  For whatever reason, most reverse merger stocks are frauds.  I haven’t seen any insiders get thrown into jail due to the complications of international law.  Regulators and exchanges shouldn’t allow this… but they do.)

The history is that originally XING IPOed an interest in its cell phone business in an IPO (which is QXM).  Later on, the stock price of QXM tanked and there was a lawsuit over the accounting practices at QXM (the financials had to be restated to show that QXM was not profitable in its early years).  Oh yeah… insiders steal from this company… read the related party transactions.  When XING was trading below the value of its ownership stake in QXM, insiders decided to merge XING with a mining company owned by the chairman.  Now if you read the financials carefully… you’ll notice that they capitalize the stripping costs of the mining operation.  This is rather inappropriate as stripping costs should be expensed; capitalizing them inflates earnings and EBITDA in the short term.  Management points out the EBITDA figure when XING bought the mine… but EBITDA is a terrible method for valuing any mining asset.  The most appropriate method would be Net Present Value (though it is easy to fudge NPV values).  Projections of expected production, grades, and free cash flow over the expected mine life would also be appropriate (though few people ask for these figures).

Riu Lin Wu and Real Gold (HKG:0246)

Riu Lin Wu is the former chariman of XING (he has now been replaced by his eldest son).  Real Gold is another Riu Lin Wu-related entity (Riu Lin Wu is the majority shareholder and pretty much controls the company).  There is a huge ongoing scandal with Real Gold because it has been secretly lending money to Riu Lin Wu’s companies.  The interest rates that it has been charging were presumably insufficient to compensate for the credit risk involved.  The auditors at Real Gold have resigned.

Now back to QXM and XING.  QXM is a cash rich company… so why do its financials show that it is borrowing money?  To be fair, there might not be anything shady in this department.  But I am a paranoid kind of person.

There are a lot of shenanigans going on with the various convertible debentures at XING and QXM.  The related party ones have been terrible deals for XING/QXM shareholders.

The underlying business

Unlike other Chinese reverse mergers, I believe that there is a real company here.  (Though I can definitely be wrong.)

VEVA makes high end cell phones.  There are user reviews of their cell phones on the Internet.  Here is one of their infomercials:

The infomercials are pretty slick actually.  The one above features Pace Wu (Pace who?), who is apparently a minor star in China (read the Wikipedia entry for her).  Veva has also hired Zhang Ziyi, who is definitely a star inside and outside of China.

QXCH (owned by XING, not QXM) makes indoor phones.  It has been losing money (or “losing” money) and has been sold.

Why I am long QXM and XING, not short

My original thesis was that insiders would try to pump and dump these stocks onto institutional investors, similar to how QXM was originally IPOed.  It seemed to make sense at the time because insiders sold the mine to XING for shares, not cash.  XING was also going to perform a take-under (or fake takeover?) of QXM, but this proposed transaction failed.  Unfortunately, insiders have not been trying to pump and dump these companies and the stock prices of both have fallen by about three quarters.  The websites for both companies are badly outdated and there has been little communication with shareholders.

Shah Capital Management is a major shareholder of both companies and has not been pleased with management (read their unhappy letter to the QXM board).

I have been in a world of pain because of these two stocks.

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.