Description
What if I gave you a small-ish Canadian metals and mining company as an investment idea, trading at under C$2…would you be interested? What if I pitched the same company, but also told you that you could buy the company's stock for nearly the value of the cash on their balance sheet and their holdings of a much bigger and more liquid publicly-traded mining company, in effect getting all of their operating assets for almost nothing? Would you continue reading then?
Dynatec's (ticker DY CN) last close of C$1.42 is merely C$0.03 above the C$1.39 of value on DY's balance sheet that is in cash and its stake in FNX Mining (ticker FNX CN in Canada). Said another way, you can purchase DY today and only pay C$14mm for a set of assets which includes: an ongoing Mining Services and Metallurgical Technologies operating business (amongst the best in the industry, which I value conservatively at approximately C$41mm); a West Virginia coal-bed methane asset that contains an estimated 65Bcf (at C$1.00/Mcf, say C$65mm); and, DY's interest, today at 75%, in the Ambatovy Nickel Project located in Madagascar - a mine which has the potential to become one of the world's largest and lowest unit operating cost nickel and cobalt mines in the world (the real swing factor in terms of upside, but probably not worth less than zero).
[Note, all $ amounts will represent C$ unless otherwise stated, from this point forward.]
History of Ambatovy
In February 2005, DY acquired the interest in the Ambatovy project held by subsidiaries of Phelps Dodge Corporation. Later the same month, DY released the results of the feasibility study, which confirmed the potential for annual production capacity of 60,000 tonnes of nickel, 5,600 tonnes of cobalt and 186,000 tonnes of ammonium sulphate, at expected cash operating costs for nickel, after credits, of US$0.67 per pound for the first 10 years after two years of ramp up. Proven and probable reserves, and additional low-grade material, are believed sufficient to support a project life of approximately 27 years, with the potential existing to extend the project life through additional drilling. At the time of the first feasibility study, capital costs for the project were estimated at US$2.25bn. The feasibility study resulted in an estimated IRR of 11.1% and NPV (10%) of US$168mm in the financial base case (ie US$3.50/lb nickel, US$10/lb cobalt), and IRR of 16.4% and NPV (10%) of US$1,038mm in the average metal prices case (spanning 1980-2003, US$4.07/lb nickel, US$18.65/lb cobalt). It also stated that due to the low operating costs, the Project had a positive rate of return at nickel prices above US$1.70/lb. Nickel prices are currently in the US$6-7/lb range and should remain in that range for the next couple of years per Street consensus.
Implats of South Africa (world's #2 platinum producer) signed an agreement with DY in May 2005, under which they would split ownership and development costs; these ownership percentages dropped to 37.5% each when Sumitomo, one of Japan's largest integrated and investment business enterprises, joined the project with a 25% interest in August 2005. At the time, Sumitomo also provided DY with a sub loan facility and a project completion cross guarantee with respect to a substantial portion of DY's financing guarantee related to project debt for which DY was to pay Sumitomo 10.2mm common shares (payable annually in arrears in four equal installments commencing on December 31 of the year in which the project debt financing closes). Subsequent to this, Implats formally withdrew from the project, as announced December 1. The company cited rising costs for mine development and the smelter expansion as the reason for the withdrawal. Expansion to Madagascar and nickel was in line with Implats' strategy of diversifying away from platinum and South Africa, but it appears that they were not prepared for the kind of financial commitment that Ambatovy would entail, and furthermore, nickel-focused projects of this size (ie not platinum with nickel by-product) may have been outside of their comfort zone. As a result of Implats' withdrawal, DY's ownership has increased to 75% and Implats paid DY US$12.1mm (in January). In any event, Sumitomo and DY have announced that they remain committed to the project and will release a revised feasibility study, targeted for completion by the end of this month. They also continue to work towards adding a third partner and "discussions with interested parties are progressing"; it was also reported that the Japan Bank of International Cooperation (JBIC) has expressed "strong interest" in the proposed project debt financing.
My view on Ambatovy: worst-case scenario is that DY/Sumitomo do not find a third partner, get expensive financing, and still go ahead with Ambatovy into a nickel market which weakens substantially and with cost over-runs. Best-case (not incl a sale of the asset) is that they find a third partner - I assume that they announce a deal with a Chinese metals producer, eg MinMetals or similar, in the next 3-6 months - the project comes in below the estimated capital costs which should be released at end of April, and nickel stays at the upper end or above the prices assumed in their feasibility study. The end result will likely be somewhere in the middle, though I think there is a decent likelihood they do find a partner (most likely Chinese) and that their feasibility study, while accounting for higher capital costs, has a new base case using C$4.00/lb nickel and still shows positive NPVs and respectable IRRs.
Other Assets
While the value ascribed to Ambatovy is critical in understanding the upside in DY (though I'm content to own the stock as long as I can get comfortable that the value is greater than zero, which I do believe), the other assets contain enough value to justify the stock price DY trades at today and still make this interesting. (Note, for the values below I am using a FD share count of 312.8mm which excludes the 10.2mm to be paid to Sumitomo over 4 years in exchange for the cross guarantee…including these shares changes the values by ~$0.02/share.)
Cash - Cash on hand + marketable securities as of December 31 is $152mm or $0.48/DY share.
FNX - DY acquired the stake in exchange for its 25% interest in the Sudbury Basin Joint Venture and 50% interest in Aurora Platinum Corp. The two companies also entered into a mining services agreement through which DY will continue to perform mine development and operating work on the SBJV properties until at least the end of 2007 (work will be cost-plus and DY will also receive additional fees totaling $15mm to be paid in two installments on December 31 2006 and 2007). I will not go into FNX in much detail here as you could choose whether or not to short out the relevant stake in DY to create the stub, but for more information on the SBJV, check DY's site:
http://www.dynatec.ca/op_sudBasin.html
The FNX stake is worth $282mm or $0.90/DY share. I'd also mention that FNX was pitched by Oscar Shafer in January's Barron's Roundtable and he specifically mentioned two of the properties that DY sold to FNX (Levack, part of SBJV and Aurora). Again, for the sake of this posting I'll reserve any opinions on FNX as one could choose whether to keep it through DY or sell it.
Mining Services and Metallurgical Technologies - DY reports these as two separate divisions but I will describe them together. Mining Services' activities include contract mining, mine shaft sinking, lateral mine development, mine construction, and others. Through this segment, DY has worked on mines for companies such as Inco, Franco Nevada, Barrick, and Goldcorp. In fact, the segment's largest contract is to operate Goldcorp's Red Lake Mine, one of the world's largest and lowest-cost gold properties. Metallurgical Technologies Division was once part of Sherritt International and joined DY in 1997. As DY describes, "it is retained by mining and refining project owners to assist in the evaluation, design, implementation and operation of proprietary processes for the treatment of metal-bearing materials." By most accounts, this group of engineers and the company's proprietary technologies are behind the company's status as a recognized world leader, especially in hydrometallurgy. Clients include companies such as Stillwater, Outokumpu, and WMC (check the company website for a 13-page list of clients/projects). Combined, these two divisions generated EBIT in 2005 of $19mm; for a more appropriate and conservative run-rate, I have deducted all the corporate and other costs from these two segments' income ($3.9mm) as well as the receipt of a license fee of $6.1mm, leaving you with $9.0mm. At 4.5x LTM EBIT (not EBITDA; D&A adds another $3.6mm), the value of this business can be estimated at $41mm or $0.13/DY share.
CBM - DY has leased CBM rights on 42k acres in West Virginia. The pilot program for this asset continues and management has guided to all pilot well units getting to production in Q2. This asset will either start production and generate cash flow or be sold. At $1.00/Mcf applied to the 65Bcf gas-in-place (3P), this is worth $65mm or $0.21/DY share. One could debate with the value of $1.00/Mcf (or US$0.87) for 3P reserves but given where other unconventional gas resource deals are pricing these days, giving fuller credit to probables and possibles, I feel comfortable with this estimate.
Issues? Of course there are issues, the critical ones being Implats' withdrawal from DY (covered above), DY's share issuance in November, and the shareholder rights plan the company adopted in December. Taking the rights plan first - it is clear that management has noted its vulnerable position and trading value relative to intrinsic value. The plan is a standard Canadian protection and allows the company / Board additional time to consider an unsolicited bid ("Permitted Bids" must remain open for 60 days, for example). This is not likely to prevent a motivated bidder. As for the share issuance, DY raised $118.8mm in November at a $1.35 share price, in order to have the necessary equity requirements to fund Ambatovy. While it is disappointing that they'd sell shares at that level, the company did need the capital to ensure that a) they'd have the required capital and b) their partners, potential lenders and host country would see their commitment to the project. This all considered, the value and optionality in DY allow me to overlook many problems. Either the market will value DY's assets more appropriately or a bidder will correct the situation. The latter is especially plausible given the fact that the valuation is accounted for mostly in cash and publicly-traded shares, meaning that a bidder could finance a takeover in a straightforward manner.
Catalyst
Feasibility study for Ambatovy later this month
New Ambatovy partner
Commercialization of CBM
Bid on the company?