In an interview on TNM TV about mergers and acquisitions in the junior mining sector, MGI Securities investment advisor Peter Besler discussed why it’s difficult to find good advice on investing in junior miners, and how to evaluate potential takeover targets with Mining Markets editor Alisha Hiyate. The interview was based on the recent Mining Markets articles: How to fish for profits in takeover targets and How much should you pay for that junior. Here’s a transcript of Part 1 and 2 of the interview.
Mining Markets: Today we’re going to talk about M&A in the junior resource space, but first we’re going to talk about how difficult it is for investors to get good advice when it comes to investing in junior resource stocks. You have a couple of ideas of why that is so difficult.
Peter Besler: I think a lot of investment dealers discourage their advisors from advising their customers to buy junior resource stocks partially because they’re a nightmare to supervise from a compliance point of view. There tend to be a lot of client complaints if things don’t work out, and the trades tend to be smaller in nature so they’re less profitable for the dealer. So clients are not often exposed to these ideas by their advisor. Also, a number of advisors just don’t have the time or energy to perform the required due diligence into these type of stocks, so if you can find one that does, you should cherish that advisor.
MM: So what is the investment rationale for retail investors to look at this space?
PB: Well it’s all about return. The potential in a junior resource stock, if it works out, is enormous — far greater than any other space that is in the market today.
MM: We all know that valuations for junior miners are very depressed right now, so what’s the rationale for looking at investing in potential takeover targets?
PB: Takeovers tend to occur at two phases during the market cycle. One is at a top, and one is at a bottom. Given the severe decline we’ve seen in the junior resource space, clearly we’re not at a top, we’re closer to a bottom. So when an investor buys into one of these stocks, or a group of these stocks, they are buying at a bottom and you still have the same type of upside potential if not more than had you bought at a top, but you’re assuming far less risk.
MM: Majors are being very careful with their money right now and they’re taking 10% or 20% stakes in juniors rather than buying them outright. What kind of juniors are likely to inspire a full-on takeover offer?
PB: Certainly the seniors and the larger mining companies are in fact being very tight with their budgets and very careful as you said. I think that the issue is that there is a shortage of projects of merit. These are companies that have high-potential, low-cost discoveries in jurisdictions that are favourable to mining. So when one comes along, even if there are budget constraints in the big picture, it’s still sure to attract a lot of attention from the majors.
MM: How should investors start the process of selecting potential takeover targets?
PB: Again, the key is to find a project of merit, and then evaluate it using some simple techniques to determine how that company is valued relative to its stock price in the market. To look for differences and undervaluation in the market and using calculations to do that.
So for example, what is key is to look at the size of the deposit, apply some simple mathematics – basically I would recommend that as a rule of thumb, investors take 5% of the measured resources, and add to that 2% of the indicated resources, and add to that 0.5% of the inferred resources, and then multiply that by the recovery rate. So if a mining company can only recover 90% of the metal from the rock, then you take 90% of that calculation and multiply it by the spot price of gold if it’s a gold-mining company, and you’ll come up with a valuation. And then you simply look to see whether the market is pricing the stock above that or below that.
The second thing is to look for companies that have low capital costs, because raising money today is very challenging, so an acquirer would have great difficulty swallowing a company that is going to require a lot of capital to go into production, but a much easier time raising money for companies that require low capital to go into production. It’s less dilutive to their stock price, so companies that have low capital requirements will attract far more suitors than ones that do not.
MM: At this point in the cycle, what kind of premiums can we expect in takeovers?
PB: I think at a market top, typically we see 38-54% premiums to market. Recently we saw with the New Gold (NGD-T, NGD-X) acquisition of Rainy River Resources (RR-T) a 42-64% premium, depending on how it is measured. At a market bottom, the premiums tend to be higher because the suitor must attract the shareholders to sell and many shareholders today are at a severe loss and therefore they want a higher price, at least to get their money back or make a small profit. So at a market bottom, I would expect the pricing to be 50-60% above where the stock is trading at.
MM: You listed 12 potential takeover targets in your article that you wrote for Mining Markets. Do you want to take us through a couple of those?
PB: Yes, three of my favourites—one would be a company called Lydian International (LYD-T). It’s gold in Armenia, near the Iraq border, so it’s actually in a politically unstable part of the world. Another disadvantage the company appears to have is that it is still in the feasibility stage, so investors are uncertain how much money the company will have to raise, or at what share price it will have to do that raise at. And the third disadvantage is management tends to be exploration focused in this company, and to take it to the next step they would have to replace management with someone who’s more engineering focused.
So those three disadvantages give investors a reason not to buy the stock. But I’m looking at it as a reason to buy, and the reason is that the stock is already pricing all of those negatives, and in fact what investors are not paying attention to is that the deposit is an oxide deposit, meaning that it will be easy and cheap to extract the gold from that deposit with low capital costs and a high internal rate of return, a short payback period. That makes it attractive to an acquiring company because it won’t cost a lot of money to put it into production. And then the second part is, there is still some exploration potential with this company, and the third is that management recognizes the fact that they are exploration focused. So all three of these things together counteract the three negatives and the market is not valuing this stock anywhere near where it should be.
The second company there’s already been some activity on and that’s a company called Probe Mines (PRB-V). Probe is gold in northern Ontario and recently, Agnico Eagle Mines (AEM-T, AEM-N) invested $15 million for a 10% interest in the company. Agnico, I believe or
I’m at least hoping, will likely buy the rest of the company once further drilling reveals that the deposit could be substantially larger than originally thought. This type of activity where a major buys a 10% interest in a junior is called a creeping takeover.
The third company I’d be interested in is a company called Canada Lithium (CLQ-T).
Canada Lithium is really a chemical company that is mining its own raw material to produce the chemical, and the chemical they produce is basically lithium compounds for the battery industry. That company will be an interesting target for another chemical company rather than a mining company, and Canada lithium has just started production, and they will require some fine tuning in their process, and I believe that once that process is proven feasible, that a chemical company will come in and buy it. I believe they’ll pay somewhere around a 50% or higher premium to the market because of the rarity of this type of deposit.
So these are my top three picks today.
MM: You also have your eye on a couple of silver companies, MAG Silver (MAG-T) and First Majestic Silver (FR-T, AG-N). Do you want to tell us about those?
PB: I think that both those companies represent excellent value. In particular, First Majestic has five producing mines today and over the next several years will increase that to seven producing mines. Their production is approximately 12 million oz. of silver today, and that should increase to about 16 million oz. over the next few years, so their production is rising, meaning their earnings will rise. As an investment, I think the stock could do well on its own, regardless of a takeover. But then when we look at their reserves, we find out that they have almost 5 oz per share in silver in the ground. We’re talking about US$100 worth of silver for an $11 investment in the stock, and I like that risk-reward ratio, so that’s my top pick of those two.
MM: Do you want to tell us about MAG Silver as well?
PB: MAG is kind of a special situation in that it has been a target of a takeover before, which was fought off, and that takeover price is just a little bit below where the stock is trading now. I believe that that company is the subject of a creeping takeover by Fresnillo (FRES-L), the major Mexican silver mining company, so at some point I believe that there’ll be a friendly deal struck between the two companies.