Description

(All figures in CAD unless noted)

Endeavour Financial was written up just 7 months ago. However, recently the situation has changed dramatically as one of their assets has become worth significantly more than the entire market cap. After a very disappointing 2008/2009, EDV is firmly back on track with the discount to NAV ~(40%+), and we estimate it hasn't been this wide since the recapitalization last March (when they issued 64M shares and 33M warrants on a base of 33M shares). Most importantly, with added asset transparency, a clearer outline of their new gold strategy, and solid proof in the turnaround taking place, there are now strong catalysts for a significant narrowing of the discount to NAV. EDV has a detailed history on VIC so I will just focus on new developments.

Crew Gold

On 1/28/2010 EDV implemented the second leg of their gold strategy by purchasing 810M shares, a 38% stake, in Crew Gold (CRU) for $92M at an average price of $0.11/share (and another 51M shares at $0.27/share in early March). CRU recently underwent a major restructuring (which EDV did not facilitate). Deep in debt with a large convertible coming due in 2010, it sold off non-core assets and restructured the company with debt holders owning 95% of the new shares outstanding in late 2009. EDV acquired their stake through the debt from a liquidating hedge fund. On 2/25/2010, Severstal raised its stake in CRU to 26.5%, adding 6.5% at $0.19/share and announced an offer to buy the rest of the shares at the same price. Severstal is Russia's largest steel producer and since 2007 has been pursuing a strategy to build a side business as a gold producer (through the aggressive acquisition of small struggling juniors like CRU). In play with 2 strategic buyers highlighting its potential, CRU now has a market cap of $1b, or nearly 4 times EDV's cost basis.

CRU's sole asset is the LEFA mine in Guinea. Guinea is a highly unstable country by even West African standards in the midst of military coups, civilian massacres, and attempted leader assassinations. The positive caveat is the mine is located far away from the unrest in the capital, and the country is not focused or intent on seizing mineral assets (what would they do with the mines?). The LEFA mine produced almost 180k oz in 2009 with a notable improvement in the last few months (18k/month in Q4 after about 12k/month beforehand). However, recent costs remain above steady state production at almost $800/oz. Management is targeting 250k oz in 2010 which seems attainable given recent improvements. The LEFA asset has 3M oz in reserves and another 4.6M of M&I resources. Therefore despite current challenges, with proper capital for expansion, there is a lot of potential to grow production, possibly eventually more than doubling current production while maintaining a 10+ year mine life. This explains why Endeavour and Severstal are interested despite current problems. Further, Rio Tinto's development of a $6 billion ore mine in Guinea is evidence that despite the political risk it is feasible to mine in the country.

Endeavour after posturing and securing a higher price is likely to sell Crew Gold

I believe most likely this will play out with Severstal acquiring CRU at a significant premium to their initial bid of $.19/share. Given EDV's 40% stake and 3 out of 6 seats on the board obviously EDV would have to approve the transaction and Severstal knew this at the onset of their initial initial bid.

The following reasons highlight this:

1. EDV is now out of the cash (their recent reduction in their portfolio suggests about $20M on hand) needed to make another significant acquisition and as things stood a month ago they were going to have to pursue other more creative means to continue their strategy. This would include teaming up with another company or raising outside capital. Selling CRU at a large premium would allow them to make 3 to 4 new investments with internal funds.

2. EDV's history is to buy under market (such as alongside private placements). They also know that CRU remains an especially risky company with a lot of problems despite its new financial stability and moderate operational progress. Endeavour's cost basis on CRU is ~$80/reserve oz and I would assume they felt they bought their stake at 25-30% of NAV. CRU now trades for ~$350 EV/reserve oz, ~230 EV/M&I oz which puts it in the low-middle of the range for West African peers. I would consider this a full though if not slightly stretched valuation given the above average risk, still ramp up nature of operations, and single asset. It is certainly not very far below their target value. In comparison referring to my writeup on Golden Star Resources, which has the same market cap, but twice the current production diversified across two mines with similar reserves in the safest West African Country (CRU's advantages are lower long term costs and larger M&I&I resources). Given their contacts and vast industry knowledge, they likely have more attractive and better opportunities.

3. Management receives a 20% profit incentive over an 8% hurdle rate on their gold strategy, but unlike their general investments, they will only receive the bonus on realized gains. Realizing the gain in the range of current prices would result in ~$50M of bonuses (more than double compensation for all of last year).

4. Severstal is looking at CRU as part of a larger portfolio strategy as they started building a gold portfolio in 2007. The firm has a track record for aggressively pursuing transactions with a willingness to pay significant premiums (though they have bid for companies that were trading at highly depressed prices). They are considering an IPO (currently in the range of $1.5 billion) of their gold holdings and CRU would significantly increase their production and reserves.

Etruscan Resources

Before acquiring their stake in CRU, EDV acquired 55% of Etruscan Resources (EET) at $0.33/share for $64M USD, $43M coming from new equity on September 23, 2009 in a private placement. EET operates the Youga mine in Burkina Faso, a 430k oz reserve/720k oz resource mine projected to operate at 80-90k oz that commenced production at the beginning of 2008. The Youga mine has faced ramp up difficulties and still only produced about 60k oz in 2009, though the 2nd half of 2009 was a slight improvement. EET also owns a few development properties also in West Africa, one of which has booked reserves. Nevertheless, EDV bought EET for a price of $100/reserve oz, which heavily discounts the many issues.

EET was suffering from maturing debt, $700 gold hedges among other problems causing severe financial distress compounded by underperforming production at their producing mine. Unlike CRU, EDV stepped in directly as the facilitator of a restructuring plan that was aided by an infusion of capital from EDV. In the transaction, EDV acquired 4 of 9 board seats and has taken over running the financial side of the company allowing management to focus on improving operations. EET sets the model for EDV's gold strategy and highlights their ability to add significant value to distressed junior gold companies, unlocking value and identifying opportunities.

Other Assets/Intangibles

An important consideration for EDV's prospects is that while gold is at all time highs, there are still serious issues in the gold mining industry in regards to access and lack of capital for juniors/developers. While most gold companies lost 70%+ of their value in the second half of 2008, many of which have gone on to recover, there still are many names in their target universe that have yet to recover due to continued financial distress. Therefore, EDV still has a large opportunity set where they specifically can resolve both operational and financial issues and add significant value.

EDV's core business continues to do well and contribute to the bottom line through fees and access to deals. However, revenues of the advisory business are marginal compared to investments and significantly absorbed by employee salaries. There is franchise value that the business brings to the returns of their general investments but for the simplicity of our write-up we ignore this completely.

As others have previously discussed, I find some aspects of how management operates and is compensated less than ideal. I believe this was most evident in the atrociously dilutive capital raise when they traded at over a 50% discount to NAV (share count factoring in warrants more than tripled). Perhaps this was deemed necessary to retain talent, as it effectively reset the high watermark.

 Another main reason for the discount to NAV was the lack of transparency in their investment portfolio. This part of the business is now ~10% of NAV so it should not be as much of a cause for a discount to NAV.

NAV Calculation

I think EDV should trade at least up to tangible NAV, adjusted for accrued profits. Further, the agency and general investment transparency issues, are balanced by the ebitda generation of the advisory business and $50M book value.

Risks

-Management decides to hold onto the CRU investment, which at current prices in my opinion has marginal upside, and does not realize the paper gains. Any hedge of the CRU holdings through a direct short of the stock is desirable at this point. There has been an intermittent borrow.

-Severstal divests their stake and moves on to a cheaper target.

Catalyst

-Higher bid by Severstal/Sale of Crew Gold

-Re-rated market capitalization of portfolio holdings

-New developments to the gold strategy such as raising outside funds