Gold Reserve Inc. Overvalued Due To Dilution Overhang, Litigation

Starting today, the share price performance of Gold Reserve (GRZ) will determine the level of dilution that investors will have to endure if the company is to stay solvent. Gold Reserve Inc. is facing a huge challenge in June when its convertible bonds become redeemable by holders. They do not have enough cash, and yet they also do not necessarily want dilution. They are likely to use the option they have to redeem in shares, but that will be based on a formula using the 10 day Volume Weighted Average Price (VWAP) ending June 12th. In addition, the litigation strategy regarding assets in Venezuela appears to be seriously flawed. This company appears particularly overvalued at the current price.

Gold Reserve Inc is a gold exploration company incorporated in Canada. The company's main business was exploration of Brisas gold and copper project in Venezuela until that project was expropriated by the Venezuelan government in April 2008. Since then, the company's business appears to be litigating Venezuela.

Unfortunately, GRZ had also issued $103mm USD of convertible bonds. The bonds yield 5.5% and mature June 15, 2022. The bondholders also have the option to force the company to repurchase them at face plus accrued interest on June 15, 2012. According to the terms of the bonds, the company may redeem in cash or stock.

If cash, the company would have to come up with more than $100mm, which would exceed the current cash balance of $58mm reported in the 10-K dated March 15, 2012 (here). If using cash, the company either would have to issue equity ASAP or face bankruptcy.

The company also has the option to redeem in shares. According to the terms of the convertible bond:

"If we elect to pay the repurchase price or the fundamental change purchase price in common shares, the number of common shares to be delivered by us will be determined by dividing the amount of the payment to be made, and that is not paid in cash, by 95% of the average of the daily VWAP prices of the common shares for the 10 consecutive trading days ending on the third trading day preceding the repurchase date."

Based on this formula, and assuming the VWAP leading up to June 12, 2012, is around current prices, this would result in the issuance of roughly 32 million shares. The formula is as follows: If VWAP = 3.29, 95%*3.29 = 3.08. 100,000,000 / 3.08 = 32,388,664 shares to be issued. If this were to occur, the stock would need to fall by roughly 34% to maintain the same market capitalization post-dilution. In addition, it is likely noteholders will sell in order to lock in some gains, so the selling pressure could easily take it lower considering average volume of the stock is less than 100,000 shares.

This puts the company and the noteholders in a difficult position. Shareholders do not really want that much dilution, bondholders do not want to get stuck holding tons of illiquid stock, and nobody wants a bankruptcy.

On May 17, 2012, the company issued a proposal to noteholders. This can be found here.

The proposal (which has been agreed upon by 87.8% of the noteholders) is as follows:

For each $1,000 of face held, one can elect to receive:

1. $200 in cash
2. 147.06 common shares,
3. $300 of amended notes which will remain outstanding under the indenture governing the Notes, as amended,
4. A Contingent Value Right ("CVR") entitling the holder to a percentage of an award or settlement of the company's ICSID arbitration claim against the Government of Venezuela with respect to the expropriation of the company's Brisas Project and any proceeds from the sale of its mining data, and
5. A cash "alternative election fee" payable based on each holder's pro rata percentage of notes restructured pursuant to the Alternative Election in an aggregate amount of up to $1 million (collectively, the "Alternative Consideration").

As well, the maximum CVR net of taxes and other deductions that will be paid if all holders elect this proposed alternative transaction will not exceed 5.81% of an award or settlement and sale of the mining data.

Shareholders still need to approve the resolution, but it does not really solve the problem. If shareholders approve, and 100% of bondholders agree, the balance sheet will have $18mm in cash versus $30mm of debt. GRZ burns close to $17mm a year in operating costs, so this really only pushes the problem back by about a year. They have been staying afloat by selling equipment, but at 2011 year end, the equipment balance was down to $18.9mm (Note 7 in the 10-K). This means that best case the company has about two years before they have to tap the market to be able to redeem the bonds. However, this is also dependent on actually being able to sell the equipment on the balance sheet. It is likely they have been selling the easiest to sell equipment first, and future sales of everything left might be a lot more difficult. Equipment held for sale is only $7mm, so it is far more likely this cannot last. This company will likely be dead or dilute shareholders significantly within one year.

In analyzing the balance sheet, the company also had a marketable securities portfolio. Typically companies have various municipal bonds or auction rates securities to pick up a little extra yield on deposits that they do not immediately need. However, this company appears to be taking some pretty serious risk. According to note 5 in the 10-K, on a $2.2 mm portfolio, this company lost $403K last year, meaning the company lost almost 20% speculating on securities. This can mean only one thing: the company is speculating in the stock market. This is extremely unacceptable, and management cannot be trusted. What will they do with the remaining cash?

The big question that should be in the mind of investors is what to make of the Venezuela lawsuit and potential settlement. GRZ has done a DCF and comparable analysis of their mine, and have decided that it is worth roughly $2.1Bn, so that is the amount they are demanding from the Venezuelan government. Every gold exploration company seems to have management that believes their asset is worth 10x the current market price, and this is no different. Prior to nationalization, the market capitalization was about 20% lower than it is right now (management consistently issues stock as compensation), so the market clearly had a different view than management.

What is a $2.1Bn lawsuit against Venezuela worth? Certainly not zero. Venezuela does have a number of international treaties, and has paid out claimants in nationalization cases in the past because having international deposits is relevant. I think it is extremely unlikely the court would award $2.1Bn, but it is not as if there is no remedy. However, here is where the company has made a serious miscalculation: GRZ has for the last three years been pursuing the lawsuit in the International Centre for Settlement of Investment Disputes ("ICSID"). The ICSID is part of the World Bank (here). The ICSID is able to use the pressure of the World Bank to manage arbitration of disputes between individuals or companies and states. If Venezuela were to lose, theoretically, it could face certain penalties, and therefore should be inclined to settle. Membership of ICSID is voluntary, though. On January 24, 2012, Venezuela renounced the treaty. The announcement is on the ICSID website here.

It is odd this fact is not mentioned at all by GRZ in its 10-K. According to the announcement, Venezuela will cease to be a member on July 25, 2012. Unfortunately for GRZ shareholders, according to the 10-K, final briefs were filed on March 16, 2012, but "The Tribunal may request further information and in any event may issue its decision thereafter. It is typical for tribunals in this type of arbitration to require six to 18 months (the historical average is approximately 1.2 years) to finalize and issue its decision." So, by the time any opinion is finally issued, it will be too late. The tribunal's findings are wholly irrelevant to Venezuela. It will no longer be part of the treaty.

So who has been successful against Venezuela? For this case we will use Exxon Mobil (XOM). Exxon lost an oilfield due to nationalization, but due to its pursuit in the International Chamber of Commerce and ability to freeze Venezuelan assets in the United States using this court, Exxon was awarded about 1/7th of what they sought. The story can be found here: here. Exxon also pursued the case in the ICSID, but success was achieved via the ICC. In the end, Exxon only received about 3.6% of what they originally sought: here.

GRZ may get something out of Venezuela in the end, but it will not be $2.1Bn, and it will not happen soon. It took Exxon five years to get this settlement. GRZ also does not have the resources of Exxon. As mentioned earlier, it only has a year left to survive, if this deal is accepted, and if it does not, there is still debt ahead of the shareholders. Let's look at the value per share in two scenarios assuming (very liberally) that GRZ gets the same payout as Exxon did.

Scenario A: Shareholders approve the exchange deal, and the company collects in 2 years without going bankrupt.

Scenario B: Shareholders reject the current arrangement and pay bondholders stock. The litigation is successful after two years. This would also dramatically reduce bankruptcy risk since the cash would be preserved.

At least in the second case, the company has the money to fight. Shareholders should be massively in favor of rejecting the exchange offer, but there is almost no reason to own this stock at this price anyway. It is possible that the award could be larger, but shareholders should not be greedy. By being unwilling to take dilution, they potentially risk the company not having the ability to fight Venezuela and struggling for cash to continue the lawsuit. If this is the case, I would also expect bondholders to begin to hedge and the share price to dip. As the VWAP decreases on a pressured share price, the exchange just becomes more dilutive. This is a dangerous scenario.

In summary, any way you slice it, the company is overvalued, and serious problems are coming on June 15, 2012. Shareholders should overwhelmingly reject the offer and take the 34% dilution. At least that's better than bankruptcy in a year. I expect the stock to be under serious pressure, and it far exceeds its fundamental value.

Variant View: GRZ is able to get a big win against Venezuela and collect full payment in excess of my estimate. However remote, this is still a possibility.

Disclosure: I am short GRZ.

http://seekingalpha.com/article/623501-gold-reserve-inc-overvalued-due-to-dilution-overhang-litigation