Description

Marret Resource Corp. (the “Company” or “MAR”, traded on the TSX) is one of the most asymmetric risk/reward investments I have ever seen in my career. It is small, illiquid, which may make it only suitable for personal accounts, but the return profile is so enticing that it is worth picking up some shares for managers of smaller funds.  

Investors can purchase MAR (at C$0.395/shr) below liquidation value today (C$0.463), with your downside completely protected, and upside potential of over 37x your capital invested.

Executive Summary

• MAR started off as a publicly traded investment company focused on resource companies, but due to a confluence of factors (changes in tax regime, poor performance, and high percentage of portfolio in illiquid securities) became orphaned and suffered from significant redemptions.

• Throughout its downfall, the manager of MAR refused to write-down the value on Cline Mining, which owns a metallurgical coal asset called New Elk Mine in Colorado. This culminated in threats of litigation from activist shareholders, a nasty annual general meeting with press coverage, and the eventual undertaking by the manager to liquidate the portfolio.

• Today, MAR is completely orphaned and forgotten with a market cap of just C$7mm. There is approx. C$8.2mm worth of net cash and liquid, publicly traded high yield bonds on the balance sheet. Thus, MAR is currently trading below liquidation value.

• Furthermore, MAR still owns approx. 22% of Cline Mining, which underwent a CCAA facilitated debt-for-equity swap.

• Met coal prices have rebounded significantly since late 2016. Based on an NPV10 interpolated from the Company’s NI 43-101 feasibility study, Cline is worth C$142mm near the current benchmark met coal price of US$165/ton. At US$200/ton, Cline is worth C$1.16 billion (translates to MAR share price of C$14.91).

• The latest disclosure in MAR’s most recent quarterly report suggests that the manager is actively engaged in strategic alternatives for Cline Mining in the current strong met coal environment.

• In any case, investors are paying less than nothing for Cline Mining, and thus the investment thesis does not hinge upon a commodity call on met coal or steel markets.
  
  

Business History

Marret Resource Corp. is a publicly traded investment company whose primary business is investing in public and private debt securities in a broad range of natural resource sectors.

The manager of MAR, the publicly traded investment company, is Marret Asset Management Inc. (“Marret Asset Management”), a Toronto based fixed income money manager who was acquired by CI Financial in Corp. in September 2013.  

MAR was originally envisioned as a closed-end fund with permanent capital that Marret Asset Management could invest and earn fees from. MAR entered into a management services agreement with Marret Asset Management in Dec. 2010 and raised C$75 million in equity capital in 2011.

At the same time, Marret Asset management introduced three other publicly traded investment funds, these being Marret High Yield Strategies Fund (“MHY”), Marret Investment Grade Bond Fund (“MIG”), and Marret Multi Strategy Income Fund (“MMF”). In total, Marret Asset Management raised over a billion dollars for its publicly traded investment vehicles.

Over the next few years, each of publicly traded investment companies ended up in trouble due to a combination of:

• Change in tax regime – on March 21, 2013 the Canadian Minister of Finance announced new anti-avoidance measures on “character conversion transactions” whereby funds converted income into capital gains by using forward purchase derivatives with a counterparty to obtain exposure to an underlying reference portfolio. MHY, MIG, and MMF were engaged in these character conversion transactions and marketing the tax advantageous nature of their income based investments. With this announcement, they were no longer allowed to enter into new contracts after their existing derivatives rolled off.

• Poor performance – all of the publicly traded Marret investment companies suffered from poor performance to varying degrees in 2011-2012. For example, MHY had  a return of 1.4% in 2011 and 3.2% in 2012 (compared to the Merrill Lynch U.S. High Yield Master II Index which had a return of 16.2% in 2012).

• Cline Mining – unfortunately, the publicly traded Marret investment companies made one of their largest investments ever at exactly the wrong time to a metallurgical coal company called Cline Mining. As performance weakened, the manager refused to mark down their level three assets.  I will get into this into the next section of this report.  

• Trading at a discount to NAV – as a result of the street’s skepticism around Cline Mining and NAV calculations, they began to trade at a significant discount to NAV.

• Significant redemptions – This all culminated in significant redemptions in 2013. MHY received redemptions for 31.2mm units, representing 44% of units outstanding.

Cline Mining – the Straw That Broke the Camel’s Back

In Q4 2011, several Marret vehicles (those being MAR, MHY, and MMF) participated as a syndicate and provided Cline Mining Corp. (“Cline”) with $50 million of Senior Secured Bonds.  Cline is a metallurgical coal exploration and production company, headquartered in Toronto, Ontario with its key asset, the New Elk Mine, located in Colorado.

Cline focused on New Elk and brought it to production in December 2010, right at the beginning of a protracted downturn in global met coal markets. For context, met coal prices dropped from almost $330/ton to under $100/ton in 2014.

By July 2012, Cline had largely suspended mining operations at New Elk in order to reduce costs.  This suspension was intended to be temporary at the time, with the mine put on care-and-maintenance, in anticipation of an eventual recovery in met coal prices.

The New Elk coal mine originally opened in 1951 and was operated by a number of owners until 1989, after which it lay dormant until acquisition by Cline. The mine has all necessary permits to mine and produce coal and to transport to nearby rail-loading facilities, as well as all environmental permits. This is important, as this is not a greenfield project, with development and execution risk. This mine has been operating for decades and has developed infrastructure nearby. Furthermore, Cline invested a significant amount of capital into the mine to bring it back to operating status, only to have met coal prices drop just as the mine made its first deliveries.

In December 2014, Cline filed for CCAA protection (the Canadian equivalent of Chapter 11). At the time, the Marret group of funds were owed over $110 million in principal and accrued interest. All court materials can be found here: http://cfcanada.fticonsulting.com/cline/

In the Application Record, it was disclosed that Moelis & Co. was hired to run a sales process for Cline in April 2014, which was unsuccessful.  The reasons given for the failure of the process was the low met coal price, negative outlook on steel at the time, and glut of met coal assets for sale including Cliffs Natural Resources, Patriot Coal, SunCoke Energy, Mechel OAO, Walter Energy, and James River Coal.

Sparks to fly at Marret Shareholder meeting: “I will be there screaming”

Despite the distress that Cline Mining faced, Marret Asset Management refused to take significant mark downs on the value of the debt that they held. In Q4 of 2014, after Cline had filed for CCAA protection, MAR, MHY, and MMF took just a ~25% write-down on the value of the Cline bonds it held.

As a result of these aggressive manager marks, the street began to significantly doubt the NAV of MAR/MHY/MMF, taking down the trading prices of each of these entities, as shown below:

MHY traded at the biggest discount to NAV, given that 81% of its portfolio consisted of Cline Mining, and the remaining 19% consisted of Mobilicity bonds, a wireless new entrant that also filed for CCAA protection (and interestingly enough ended up with a full recovery upon a sale of the business to Telus).

Heading into 2015 Annual General Meeting, shareholders of MAR were not happy:

“What puzzles holders is that Cline has been delisted from the TSX for about 18 months, and is now in the process of going through a complicated restructuring. Determining fair value is a challenge. In a recent update, Marret said Cline “has sufficient liquidity to continue for at least two more years and Cline is looking at various avenues, including surplus equipment sales, to extend this period.

But given the uncertainty, ‘the entire NAV of Cline should be written off,’ noted one holder, who also wants other changes, including a substantial issuer bid.”

Excerpted from an article written in the Financial Post about this annual general meeting, anticipating screaming shareholders:  http://business.financialpost.com/news/fp-street/sparks-to-fly-at-marret-shareholder-meeting-i-will-be-there-screaming/wcm/ca55bbe9-7bc1-4414-9a1d-38699f31618a

Outcome

In April 2015, the Board of MAR announced that it was reviewing various alternatives to deal with the significant trading price discount to NAV and provide liquidity to shareholders. In June 2015, the Company proposed a plan to return capital to shareholders on two redemption dates. The first redemption date in July 2015 received $45mm of redemptions (approx. 51% of the shares outstanding).

MAR underwent a second redemption event in October 2015 received another $18mm of redemptions. Over time, MAR, MHY, and MMF became orphaned stocks, with dwindling Net Asset Values and little to no interest.

In July 2015, Cline Mining completed a CCAA plan of compromise and arrangement with a debt-for-equity swap. As a result, MAR, MHY, and MMI ended up owning 100% of the equity of Cline, with a significantly de-levered balance sheet.

My estimate of the ownership interest in Cline Mining is as follows (based on their pre-petition ownership of the secured bonds):

MMF: 5%

MAR: 22%

MHY: 73%

Opportunity Today

Today, MAR’s NAV is C$0.912/shr and it trades for C$0.395. MAR slowly transformed into a micro-cap stock, with very little liquidity and attracting no new investors.  There are plenty of reasons not to pay MAR any attention:

1. Lack of liquidity – the entire market cap of MAR is under C$7mm.

2. Boring – the share price has done nothing for years.

3. Negative stigma – MAR was tainted as an investment holding company with questions swirling around the manager’s mark on Cline. There was no compelling reason to get involved and take any accounting risk.

(Note: the investment thesis is similar for MHY, which has a NAV of C$0.725/shr and trades for C$0.11, but is even less liquid with a total market cap of ~$2mm)

This lack of investor attention and negative stigma, has created a very interesting investment opportunity with one of the most asymmetric return profiles I have ever seen.

The lack of investor attention on MAR/MHY is particularly interesting in the context of current met coal prices. Unlike many futures traded commodities, met coal is priced off of contract settlements, mainly into China which is the world’s largest steel producer. These are hard to track unless you have access to Bloomberg data, but one can look at Teck Resource’s May 2017 investor presentation for a chart of historical met coal prices http://www.teck.com/media/20170516_BofAML-Conference.pdf

If you look at page 54 of the Teck Resources slide deck, you will see that met coal prices have staged a significant comeback starting in the second half of 2016. In fact, benchmark prices were US$285/ton in Q1 2017.  This was due to many factors including Cyclone Debbie which heavily impacted coal production and shipment in the Queensland state of Australia in March 2017.  In fact, Chinese purchasers of coal turned to the US and other coal producing regions to fill the shortfall in supply in the aftermath of the cyclone (http://www.cnbc.com/2017/04/04/after-cyclone-debbie-china-replaces-australian-coal-with-us-cargoes.html).

Met coal prices have retraced from March 2017 levels, but spot prices are still above US$160/ton.

NPV Analysis of New Elk Mine

The New Elk Mine had a NI 43-101 feasibility study released in 2012, where the coal product was described as low-sulphur, medium-to-high fluidity, high vol B coking coal and deemed suitable for export. The only downside of the mine is that it is landlocked in Colorado, and thus receives a lower net price per ton after adjusting for trucking, rail, and ocean freight costs to reach end customers (typically in Asia). However, the DCF analysis within the NI 43-101 takes all of this into consideration.

New Elk’s cost structure on a run-rate basis is as follows:

1. On-site costs (mining, prep & loading, truck+rail) of US$40/ton

2. Off-site costs (royalties, taxes, sales commission) of US$15/ton

3. Ocean-freight differential of US$30/ton

This gives a total operating cost of approximately US$85/ton, after which you should add on another US$10/ton for capex, taking breakeven benchmark met coal price to $US$100/ton (before cost of capital + time value of money considerations).

Here’s where the math gets interesting:

1. At a benchmark price of US$160/ton – New Elk has a NPV10 of C$0.  

2. At a benchmark price of US$165/ton – New Elk has a NPV10 of C$142mm.

3. At a benchmark price of US$170/ton – New Elk has an NPV10 of C$288mm.

4. At a benchmark price of US$200/ton – New Elk has an NPV10 of C$1.16 billion!

See the below table for the corresponding share prices of MAR and MHY depending on the benchmark met coal price you pick:

Note that MAR has a floor price of C$0.46/shr, even if Cline Mining is worth zero because it holds C$0.32/shr in cash and C$0.14/shr in other liquid, publicly traded, high yield bonds.

MHY on the other hand, owns significantly more of Cline Mining (estimated 73%), but holds practically nothing else of value which means that your downside is a loss of all capital.

Here is the return profile from their current share prices:

Investors should note that MAR current trades (albeit very thinly) at C$0.395/shr, which is less than the value of the cash + liquid securities (excluding Cline) that it holds on hand. In other words, you are paying less than nothing for a met coal mine that is fully permitted, fully developed, was recently producing, and could be worth over a billion dollars!

Marret is Actively Pursing Strategic Alternatives for Cline

Here is an excerpt from MAR’s latest quarterly report:

Cline Mining Update

Metallurgical coal prices have been stable above $150/tonne and spiked again, well above $200, as Cyclone Debbie disrupted production in Australia for several weeks. There have been a couple of IPO’s of restructured coal companies, which indicates the sector can now attract equity capital. The Manager continues to explore the best long term solution for the Cline assets as the quality of the proposals are improving. There is concern about weak iron ore and steel prices in China, but so far met coal prices are solid. The Manager sees this resurgence in coal prices as a window of opportunity, and is actively pursuing solutions.

Marret Asset Management would love more than anything to fetch a “good” price for Cline resulting in a “par recovery” for their initial bond investment, thus saving them face and allowing them to stand tall behind their dubious manager mark over the years. This single asset is preventing the liquidation of MAR and MHY. In the case of MAR, Marret Asset Management has stopped receiving fees on the remaining assets due to the issues around the marked value of Cline, so there is no incentive for them to hold on to this asset.

Conclusion

MAR and MHY are two stocks with the most interesting and asymmetric risk/reward profiles I have ever seen. The traded price of MAR is below net cash + liquidation value, and you get Cline Mining and the New Elk Mine for free. Based on current met coal prices, Cline could be worth over C$140mm. If the strength in met coal prices continues and it heads towards US$200/ton, Cline could be worth upwards of a billion dollars. The Marret investment vehicles are heading for wind up and are looking to sell their last illiquid investment. A large strategic can purchase Cline for a fraction of its NPV value and significantly add to their reserves/production without much cost. If this were to happen, an investor in Cline could receive many multiples of their invested capital

Recently, new evidence of the resurgence of the met coal industry can be seen in an interesting article here: http://canAadafreepress.com/article/for-the-first-time-in-six-years-a-new-american-coal-mine-has-opened

A new met coal mine has opened in the US, the first time in the last six years. Why develop a greenfield project, with all of the execution and development risk, when you can get New Elk Mine for free?

Catalyst

1. MAR trades below net asset value of cash + liquid securities, plus you get a free option on the New Elk Mine.
2. MAR's latest quarterly report states that there is "a window of opportunity" in pursuing strategic alternatives for the New Elk Mine.
3. Realization of the NAV discount (excluding New Elk) gives a 17% return. Realization of any value for the New Elk Mine could result in multiples of your capital.