Crocodile Gold (CRK) operates a mill in Australia's Northern Territories and controls 33 nearby deposits with documented resources. Production from new underground mines beginning in 2012 should generate consistent high cash flow.

On December 13^th a large independent shareholder, Luxor Capital Group, declared an intention to make a tender offer for up to 218mm shares of CRK at a price of $0.56/share. If the maximum number of shares are tendered then 15% would still remain in public hands. I believe that the offer significantly undervalues the company and therefore I am posting this idea as a value investment on a one-year horizon rather than an arbitrage.

BASIC FACTS

HISTORY

Production has occurred on CRK's properties for over 140 years. In 1994 Acacia Resources built the Union Reefs mill and expanded it in 1998. Nearby mining ceased in 2003 and the mill was sold in 2004 for $4mm to a joint venture that was later acquired by GBS Gold. GBS Gold went bankrupt in 2008 and Crocodile Gold was formed by Stan Bharti's Forbes & Manhattan merchant banking group to acquire the mill and all surrounding leases for a series of payments totaling $51mm. CRK has since invested an additional $115mm on exploration, capital improvements, and mine development. CRK's current enterprise value is a discount of 43% to the amount the company has invested in the region (EV=$95mm compared to investment of $166mm).

OUTLOOK

Despite the region's abundant gold resources, each operator (including CRK) struggled to make money in a high cost jurisdiction from the relatively low grade surface deposits (1-1.5 g/t). CRK's future plan is based on these elements (extensive documentation is available in the Technical Report filed in April)

• Union Reefs Mill. While performance of the surface mines has been weak, the mill has been operating quite well. Throughput in the most recent quarter was a record 559,447 tonnes (about 6% above target) and metallurgical recoveries of 92.8% were also above their 90% target.

• Surface Mines. CRK's properties contain a very large amount of ore with a grade under 1.5 g/t and exploration could probably grow this resource substantially, but the net value of all that gold is marginal. Each individual deposit has different grade and cost considerations, but I think the example below fairly represents the weak returns:

Restarting production from past producing pits often disappoints because past operators already mined the best rock. Crocodile's basic production in 2011 has come from open pit mines in the Burnside area, about 80km North of the mill. This ore is easily accessed, but low grade and costly to haul to the mill. In early 2012 Crocodile hopes to reopen the “International” pit at Pine Creek, just 15km from the mill. International has slightly better grade and the shorter haul will cut transport costs. But the net present value of all Crocodile's open pit operation is low unless the future price of gold rises significantly more than future production costs (fuel, equipment, and labor).

• Underground mines. Newly developed underground mines will provide higher grade ore that will allow the mill to produce more gold without any increase in throughput. The higher grade allows a bigger profit margin and operations will be less vulnerable to cost inflation. Crocodile's “Cosmo” mine will enter production in 1Q12 and should reach full capacity by 4Q12. Exploration has identified a strong target for a similar underground mine at the Crosscourse site close the mill. Crocodile hopes to drive an exploration decline there in 2012 and could begin production in late 2013. I think the example below fairly represents the superior returns available from the new underground deposits (note that the Technical Report and company projections are more optimistic about every input except grade):

These underground deposits are previously unmined and CRK will be able to access above average ore early in order to maximize the present value of cash flow. The underground operations will also be much less vulnerable to wet season weather disruptions.

To summarize, the mill is operating well. The underground mines will generate significant value and may grow significantly over time as new deposits are identified and developed. Surface operations will provide ore to fill the mill's remaining capacity after the underground ore.

2012 PRODUCTION

2012 will be a transition year. Cosmo will gradually ramp up production from 500 tonnes per day in the first quarter to 2000 tonnes per day in the fourth quarter. The balance of the mill's 6000 tonne per day capacity will be filled by open pit ore from the Burnside complex, the International Pit near Pine Creek following regulatory approvals, and stockpiled Burnside ore during 1Q wet season disruptions. I project Cash Flow from Mining Operations:

VALUATION

Annual Mine Cash Flow from 4Q12	$72mm
Corporate Overhead	$10mm
Operating Cash Flow	$62mm
Valuation Multiple (long-life production with significant growth potential)	5X
Target Enterprise Value	$310mm
Net Cash	$49mm
Target Equity Value	$261mm
Shares	310mm
4Q12 Target Price per share	C$0.87

If Luxor's offer proceeds as currently intended then shareholders have an opportunity to realize an arbitrage profit of 15% within three months. Or they may prefer to continue holding for possible appreciation of 80% if my projections are correct.

PAST DISAPPOINTMENTS

Crocodile management made unrealistic forecasts about production and profitability that proved to be wildly out of line with the actual performance from the marginal surface mines. I expressed my skepticism about the company after it was recommended on this site at a price of $1.42:

“The company over-promised.  15 months ago they forecast 200,000 ounces of production in 2011 at a cash cost of $500/oz.  Last year they were talking about future annual production of 500,000 ounces from a 10 million ounce resource.  The company presentation included an underground river of gold from Cosmo to Howley that was simply geological speculation without confirmation from drilling results.  The story whispered to investors was that the stock would soar once drilling conformed this resource.  Actual results have been mixed.  Some good and plenty of marginal, not bad, but marginal.  It will take time and money to prove whether or not this is going to work.”

Time has passed. Money was spent. The Technical Report provided a very useful independent review of all the company's assets and potential. The CEO was replaced by a new manager who seems quite competent. The business plan now appears simpler and more easily obtainable. And the share price is now quite cheap compared to the potential that always existed.

2011 results were poor and even seemed to deteriorate as the year progressed. The average grade of open pit ore in 3Q11 was only 1.1 g/t which provided barely enough gold to cover cash operating costs. But most of the 3Q ore was mined from the Mottrams pit which only has a resource grade of 1.2 g/t. And page 69 of the Technical Report has a table showing that there has always been some monthly variation between the projected ore grade and the actual mine results. Perhaps the low grade in 3Q was simple a result of this normal variability. Or perhaps ore cannot be profitably mined from Mottrams. The important thing is that Mottrams doesn't matter. Crocodile's real value will be generated by the new underground operations. I was told that 3Q costs were higher than normal due to a much higher than average stripping ratio, a common variable factor in mine operations. Maybe that's true and maybe it isn't. The important thing is that the stripping ratio for the Mottrams pit (and Princess Louise) doesn't matter. Crocodile's real value will be generated by the new underground operations. Commencement of underground operations was slightly delayed but I see that as within the normal range of disappointment for mine startups. And this morning's news explains that the delay has been resolved.

LUXOR

Luxor Capital has been a major shareholder of Crocodile Gold since it was formed as a private company in 2009. Luxor probably acquired a significant number of shares in the March 2009 placement at $0.20 and the June 2009 placement at $0.70. Luxor appears to have had a good working relationship with the Forbes & Manhattan group, including pre-IPO investments in Black Iron and Forbes  Manhattan Coal. Luxor was also a significant shareholder of Consolidated Thompson Iron Mines which was a huge success, rising from $3/share in early 2007 until its acquisition by Cliffs Natural for $17.25/share earlier this year.

Luxor's declaration of intent to tender for CRK shares expressed no opinion about the company or its management. I suspect that Luxor sees the value that I described above and is not looking to significantly alter the future business plan. I suspect they see an opportunity to take advantage of recent price weakness caused by short-term factors that have little impact on the company's long-term valuation.

Crocodile Gold has formed a “Special Committee” to evaluate Luxor's offer and any other alternatives available to the company. I doubt there will be a competing offer due to the company's small size and weak recent results. Chinese buyers have recently been acquiring underperforming assets at bargain prices (e.g. Gold One, Daylight Energy, and Jaguar Mining), but I suspect they would not enter a bidding war. I suspect that the true independence of the Special Committee may be compromised by Luxor's other relationships with the Forbes & Manhattan Group. I suspect the Committee may ultimately make no recommendation and take no steps to hinder Luxor's acquisition of between 50% and 85% of CRK. I suspect that Luxor would be happy to invest at $0.56 and then look to reduce its stake after CRK has established additional high grade production in 2014.

Luxor's bid is likely to require approval by the Australia's Foreign Investment Review Board, but that is unlikely to be a problem.

RISKS

1. Disappointing startup performance at the new Cosmo mine (tonnage or grade)

2. Ongoing disappointment at the old surface mines

3. Manipulation by Luxor Capital (either they don't follow through with their intended offer or they complete the offer and then disadvantage minority shareholders)

4. Price of Gold