Capital costs killing off junior exploration stocks: Stockhouse TickerTrax

NAU has far reaching implications

Stockhouse Ticker Trax is equity specific research (Canadian listed and market cap < $300 million) published every Monday to paid subscribers. Our free Friday column may feature companies previously featured to paid subscribers (with a minimum one month delay) or discuss topics of interest to the general investment community and relevant to overall portfolio management.

Industry cost over-run disasters changing the face of junior exploration

Note: I believe there is some valuable insight here (especially if you speculate on the small mining stocks), but if nothing else, be sure and read the mess thatNorthland Resources is creating for many small companies hoping to raise exploration or mine development capital.

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As an equity analyst that has specialized in small companies (micro cap or penny stocks) for 30 years, this is not a subject I like to write about. Unfortunately, it is a harsh reality we have to face because this entire business of speculating on junior exploration companies has changed dramatically this past year.

Because of this reality, I try to focus only on exploration companies with very large bank accounts but also look at tech, oil, and other industries (recently I introduced an industrial water treatment company to paid subscribers). I am not doing so because there is excessive money flowing to some of these sectors, but because we have no choice but to diversify.

A major shift in the valuation of junior exploration companies started in the spring of 2011, hit bottom the summer of 2012, and now after a small recovery, hasturned back to those dreadful summer 2012 lows.

Many investors have lost so much money speculating on these companies that they have thrown in the towel – and from the retail side this has pulled a huge amount of money out of the system. On the brokerage side, most are happy just to put their clients into an ETF or Mutual Fund. From an institutional side, these funds are looking at the huge capital costs of developing a mine and only financing the cream of the crop.

Case(s) in point

1) The Rio Colorado potash mine in Argentina owned by Vale is a $6 billion project experiencing significant cost over-runs. Vale keeps cutting back on construction plans and the Argentina government keeps threatening that investors from the Arab Emirates or China could assume control along with the government. High inflation and a weak local currency make the economics questionable.

2) The giant Mongolia copper gold project (Oyu Tolgoi) controlled by Rio Tinto is now turning into a financial mess. Not only is the Mongolian government causing them grief (not a big surprise), but the project could be facing billions in cost over-runs. Russia and China have a very heavy hand in Mongolia and they would love nothing more than to get their hands on the world’s largest copper mine. You can bet this is far from being resolved or going into production.

3) Barrick’s Pascua-Lama gold/silver project in Argentina is also facing major financial problems. Barrick has already spent $2.8 billion but cost estimates run as high as $8 billion. This would be one of the largest, lowest cost gold mines on the planet but it is not helping the bottom line of Barrick. Chile was planning to build a $5 billion power plant that would supply power to this project but now that has been shelved.

And the flagship of the junior disasters – Northland Resources (TSX: T.NAU,Stock Forum; 10 cents)

The top three are blue chip examples – Northland is the Poster Child of junior mine development disaster. The mismanagement of Northland is putting a dagger in the heart of exploration and development financing for small companies - in case it wasn’t struggling enough.

Northland is an emerging iron ore producer in Sweden. Since December 2010, they have raised over $1 billion(over $400 million in 2012 alone when you would have thought they had a grip on cost controls).

On January 24, 2013, the company announced that they are in serious financial trouble and because of cost over-runs, will need “at least” $400 million more!!

On February 8, they filed for creditor protection in a Swedish Court.

In theory this may go the route of many other companies where the bond holders take full control and the common shareholders watch their investment destroyed (quite possibly worse than it already has been). No matter how you slice these, the bondholders carry the big stick.

In addition to the financial disaster, Northland managed to drag 15 large institutional shareholders into this mess and they have research coverage from 16 different (very embarrassed) analysts.

Imagine what this is doing to the industry as a whole for small companies hoping to finance mine development or exploration. It has far reaching implications.

Simply take a look at Champion Iron Mines (TSX: T.CHM, Stock Forum; 50 cents). This week they released an attractive Pre-Feasibility study on their Canadian iron ore project. The problem is, capital costs are close to $1.5 billion. The market sold off on the news. Not because the economics were poor, but because they will likely have a terrible time trying to finance this.

This is a harsh reality facing many (if not most) smaller companies that have spent millions (and often years), reaching the point of Feasibility Study. Not only will your operating costs need to look very attractive, but your capital costs of construction will be the deal breaker.

Previously investors would take a “long term” approach to financing. That is not the case anymore and when it comes to mining in particular, bankers and large private investors are scrutinizing these deals like never before. If they don’t, they risk losing their job. And few are prepared to risk their career for a small cap or micro cap company. That is also why it is so hard to find proper coverage of small companies.

And it’s not just the obvious building, equipment, and labour costs of developing a mine. Companies are facing more hurdles with respect to the environmental and escalating costs of power, roads, water, etc. And because mining is often associated with less developed countries, government risk has increased along with labour disputes and disruptions.

When the smoke settles – it is a very different world we are living in since the financial crisis of 2008. And the impact this is having on the junior exploration game cannot be under-stated. No longer can a small company just walk into a brokerage office and plan to raise millions in high-risk capital.

Financings will be smaller, lower priced and require the added bonus of warrants (which fuels excess dilution and share price volatility).

And for those fortunate enough to have cash from two or three years ago, they better manage it well because now it is worth its weight in gold. It may allow the cash rich ones to pick and choose higher quality projects.

Where does this leave the lower quality projects and public companies?Likely adrift in a sea with very few rescue boats.

There is literally hundreds of low quality or mediocre exploration projects publicly traded right now. And hundreds more looking for something. All of these companies hope to raise capital from a shrinking pool of financiers or investment banks willing to take on the risk, and we also have fewer retail investors willing to speculate (because many have lost a huge percentage of their portfolio on these stocks over the past 18 months).

In the junior mining space I personally won’t look at anything that doesn’t have a strong balance sheet, a very high impact exploration project, or grossly discounted proven reserves. And if the company’s share structure is a mess, then that is another serious concern.

Taking this approach means a person will miss out on gains from well promoted stories. But those are few and far between right now. And at some point the valuation has to be justified or the stock will come crashing back down once insiders decide the promotional party is over – or reality sets in that the sector was overhyped (graphite in Q1/12 is just one good example).

Right now valuations are back down to summer 2012 lows and those were some of the lowest valuations we had seen in junior exploration stocks in over two decades. Quite likely this signals that we are near a low again (when pessimism is running rampant).

Whether we bounce back short term or not, the issues I discussed above will weigh on these small companies for (at least) the next year or two. The old way of thinking (and speculating) needs to be thrown out the window as this is an entirely new investing environment.

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Disclosure: Danny Deadlock owns (Nil) shares in the companies discussed above.

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