I wrote about RXE in early 2011.  The company is now in a vastly better position, but due to a series of confusing or seemingly negative developments, as well as the general underperformance of smaller gold miners, the stock is down considerably.  I was going to post an update under the previous thread, but I think the upside potential here is so big I decided to turn it into a new write-up.

Please read the previous report (filed under the US symbol RXEXF) for more details about the interesting history of the company’s main asset, the underground Drumlummon Mine in Marysville, Montana.  This was one of the richest precious metals mines in US history, active mainly between 1880 and 1900, when it produced roughly $2 billion worth of gold and silver (at today’s prices.) This was done despite a geology characterized by narrow but very rich veins, which because of the primitive technology of those times were hard to find and expensive to mine.  Complex legal battles over claims prevented much of the area from ever being explored properly.  There is good reason to think that there may be a massive amount of gold and silver still there.  And even if the old timers did get all the highest grade veins, they left behind as uneconomic a lot of ore with grades that today should be quite lucrative.

Since last July RXE has been under an entirely new management drawn from important positions at major firms such as Barrick and Kinross.  It is in production now (although for accounting reasons this is called “test mining”), with enough success already to make the company cash flow positive and self-financing, starting with the June 2012 quarter.  Its exploration drilling program has an excellent chance to considerably expand its resource base over the next two years.  

Nevertheless, there has been a series of confusing and seemingly negative events in the last year that has had a bad effect on the stock price.  These include: 

1. A nasty proxy battle
2. A recent spin-off of RXE shares from an early corporate investor
3. A misunderstood 43-101 report
4. A misunderstood “Deficiency Report” from the state of Montana
5. Unusual accounting required for mines not yet considered commercial.

A year from now all these factors will be ancient history.  I believe by then the company will be reporting strong cash flow and earnings, with drilling results promising enough that investors will feel confident that the mine has many lucrative years ahead of it.  Those two changes should bring a substantially higher valuation for the company, provided precious metals prices do anything at all other than completely collapse.

Some more detail about the factors that are hiding the value here:

Proxy Battle:  RXE was founded five years ago by some entrepreneurial mining finance people, who acquired the old Drumlummon mine and claims in Marysville, MT, about 25 miles northwest of Helena.  Last spring, after a series of disputes, the founding management launched a proxy battle to oust the board.  The board responded by proposing a blue chip new management, led by Darren Blasutti, formerly one of the top people at Barrick Gold, and Bob Taylor, who was VP of North American operations at Kinross.  The board, supported by 7.4% owner Sprott Asset Management, won the proxy battle and the founders were ousted.  The new management purchased C$2.3 million worth of stock directly from the company at market price of C$0.456, and since then have bought a good bit more in the market.  The ousted founders, however, had significant bills to pay for the lost proxy battle, and I believe that they and their followers have been heavy sellers since then.

Spin-Off: In 2008 Spruce Ridge Resources, a small Canadian miner, participated in some transactions with RXE that gave it 7.5 million shares.  Two months ago, perhaps to mollify its shareholders for lack of significant progress on projects under its own control, it announced it was spinning off to its shareholders 7.16 million of them.  As is usually the case when shareholders are given a spin-off, my guess is that quite a few million of these shares have been dumped in the last two months.

Misunderstood 43-101 Report:  The ousted management of RXE last put out a 43-101 report (independent report on a company’s mineral resources, required by Canadian law) in 2009.  Its efforts since then were focused on mining what had already been found, and building a wide ramp down to the workings to allow modern vehicles to come down to pick up the ore, which it completed not long before the proxy battle.  It hadn’t put a lot of money into exploration drilling, although what drilling it did do had very promising results.

New management, which came on board in July, started a drilling program for the remainder of the year, and the 43-101 covering that program was announced in February.  It appears many investors incorrectly assumed that new management was going to drill in the most promising areas somewhat further from the existing mine activity.  Rather, its focus was to optimize the mining plan for 2012 rather than find new ore that it wouldn’t be in position to mine until 2013 or beyond.  So the company’s total resources didn’t increase very much from what was shown in the 2009 report, but most of the total did get moved from “inferred” to “measured and indicated”, and the results are guiding the company’s mining plan for 2012.  It will be this year’s $5 million drilling program that is out to find rich veins in the nearby but previously unexplored “Contested Ground”, now called “Drumlummon South”, and if they are indeed there, as the company’s geologists believe, the 43-101 out in early 2013 will cover that.  The drilling results will be announced each quarter, with possible interim releases, so one won’t have to wait until next February to find out.

Let me mention a geology issue in layman’s terms, which is all I can do because that is what I am.  There are some differences in how gold and silver get distributed in an area that have a big effect on the resources reported by different mining companies, and make them not as comparable one might think.

In some cases, often described as porphyry deposits, the ground is soft and there is a very little bit of gold and silver almost everywhere.  One can look at such a property of so many acres, of whatever its depth is, and multiply almost the entire cubic volume times one or two grams per ton of ore to produce a very large total of gold and silver. A mine on such a property would most likely be open pit, and one would need to mine a lot of ore to get each little bit of gold, but it isn’t hard to find the stuff - it is everywhere.

Drumlummon is the opposite kind of geology, called “epithermal” in this case, with narrow but very rich veins twisting and turning their way through channels in very hard rock.  Any random cubic yard underground probably has no gold whatsoever, but the veins themselves, when one can find them, are incredibly lucrative per ton of ore.  It is very hard for this kind of mine to show large totals of gold and silver resources, since it isn’t easy to be sure which way the vein will go next, or how wide it might be 50 feet in either direction; an exploratory drill hole could come very close to a fabulous vein and hardly be aware of it.  Once found, miners following the vein will dig up the ore before the geologists ever have a chance to measure, indicate, or infer its existence.

So it is unlikely that the Drumlummon will ever show resources of millions of ounces of gold, the way many porphyry type deposits often do, but if it can keep finding ore such as it has been mining lately with 8 grams per ton of ore, and a few of the 30+ grams/ton veins like they used to go after in the old days, it will do exceedingly well for a long time.

Misunderstood Deficiency Report: Currently RXE is allowed to mine up to 500 tons of ore per day, contingent upon it not disturbing more than 5 acres of surface land (not a problem for an underground mine) and maintaining water discharge standards (also not a problem given its water treatment plant.)  At some point in the future, if the exploration effort is successful, the company might want to expand production beyond 500 tons a day and build its own mill nearby, which would save the expense of trucking ore 114 miles to the mill it currently uses. 

To be allowed to do so, it would need a full operating permit from the state of Montana.  RXE submitted an application at the end of December 2011, and in March the state examiner responded with a 40 page “Deficiency Report” which went over all the changes it would like in the application and numerous other studies it wants RXE to provide to insure that the mine can be expanded beyond the current limit in a way that is acceptable for the environment and the needs of local residents.

I think investors were shocked by the extent of the state’s requirements for lengthy and complex studies to achieve approval, and that hurt the stock.  It is a moot point at the moment.  As I will show below, RXE is capable of impressive positive cash flow at production levels below its current limit.  The new MT mining law, under which RXE is the first to apply, requires the state to comment on every possible issue on the initial deficiency report, or it loses its right to bring the matter up later.  RXE has plenty of time to provide the information the state requires, and if it turns out that some particular required studies are cost prohibitive, the state will have to balance out its desire for the information with its desire for the increased employment that a higher level of operations would provide.

Unusual accounting:  This is not particular to RXE, but as I understand it, to every Canadian mining company that is not yet commercial.  RXE mines ore, sends it through the mill, and then sells the concentrate to outside parties that pay for the gold and silver content.  Instead of recording the sales as revenue, it records the revenue as an offset against operating and exploration expenses.  Moreover, it is only permitted to record the offset when the cash comes in; if the buyer doesn’t pay for 30 days, then the asset stays as inventory until then, rather than, as in a commercial mine, counting as top line revenues when sold with an associated account receivable.

It appears highly likely that cash from the sale of gold and silver will exceed all operating and exploration costs in the June quarter, at which point the mine will be considered commercial, and operate with normal accounting thereafter.  Meanwhile, an investor screening gold mining stocks and seeing no revenues would have no way of distinguishing RXE from the hundreds of outfits that are years and big capital investment away from any mining whatsoever.

All of the above issues have hurt the stock price in the last year, but are now disappearing or losing any further negative potency.  From here on, some significant positives are coming to the fore:

Bullish Case #1: near term cash flow:  A 500 ton/day limit doesn’t seem like a lot of ore, but when it is rich enough, a mine can make a lot of money on that amount.  RXE’s goal by later in the year is to produce about 400 tons of ore/day to ship to the mill, with the other 100 tons/day consisting of waste rock that needs to be moved first to allow the miners access to the good stuff.

First, a note on arithmetic: when veins consist of a mix of gold and silver, mines report sales in terms of “gold equivalent” ounces, that take into account the difference in prices.  In the March 2012 quarter for example, RXE reported production coming from the mill of 8615 gold equivalent ounces, consisting of 6625 actual ounces of gold, and 117,635 ounces of silver, the latter being equivalent in value to 1990 additional ounces of gold.

There is good reason to expect the grade of the ore for the rest of 2012 and beyond to be at least as good as what was mined in the March quarter, because of better planning based upon the results of the late 2011 drilling program, and better training of the miners to focus on the quality of the ore rather than sheer tonnage. 

Assuming no improvement in grade, and an improvement of tonnage from the 285/day in the March quarter to eventually 400/day later in the year, that should generate about 12,900 gold equivalent ounces per quarter (400/285 X 8615).  That would provide revenues of over $18 million per quarter at $1500/oz., which is below the current price.  With about $12MM/Q in operating expenses, another $2MM/Q for exploration expense and corporate overhead, and negligible interest expense, that would produce untaxed profits  of $4MM/Q, or about $0.021/diluted share/quarter, putting the stock at 4.8 times untaxed earnings.  

Gold prices staying stable from todays approximately $1650 would add an extra penny per quarter to earnings.  Improved grades of ore, a reasonable expectation over time given the area’s mining history and how little of it was explored by modern technology, would have a big positive impact, dwarfing the above numbers.  For example, if RXE could do a quarter averaging 0.4oz/ton (less than half of historical grades) compared to 0.28 in the March quarter, and work at 400 tons/day, at $1500/ounce that would produce revenues in the quarter of over $25MM and pretax profits of $0.062/Q, put the stock at a run rate of 1.5 times untaxed earnings.

Without taking into account anything about available resources, I did a Bloomberg screen looking for gold mining companies with revenues in the range of $40-$120 million and operating in the black, to see how the market currently values small but profitable gold miners.  Of the 28 stocks that met those criteria, the median and average market caps were $180MM and $284MM, versus RXE’s $70MM fully diluted.  Of course most of those companies are more seasoned and known, and perhaps have other characteristics that make them more attractive.  My point is that once the company develops a record of revenues and profits, and people see enough success in drilling results to indicate that the mine can operate profitably for many years, it should move to a higher category within the speculative gold mining field and be valued accordingly.

Bullish Case #2: possible exploration success: When this mining area was in its heyday of the late 1800s, miners were digging out veins with an ounce or more of gold per ton of ore.  Given the low prices of precious metals then, and the unautomated mining, milling, and refining methods of the time, it didn't make sense to even bother mining ore with much lower grades than that.

The legal battles concerning competing claims were such that certain parts of the district were barely explored and not mined before a combinations of economics and lawsuits shut down mining in the early 1900s.  One particular area, known then as The Disputed Ground and now renamed Drumlummon South by RXE, is contiguous with some of the richest parts of that mine.  The geology is such that it is plausible that these ounce plus veins continue right through that section. 

Over the next few weeks RXE will start a drilling program to test that proposition in the Disputed Ground and over time in other areas similarly promising.  If it turns out there is nothing much there, no big deal, the company doesn’t need that for the story to work out.  But if it runs into veins anything like what they mined in the 1880s, the impact would be significant.  It would allow earnings many times higher than I posited above, all within the current production limitations.

Possibly Bullish, or not:  The background of the current management is impressive enough that it is being shown other gold mining opportunities that could be acquired in a non-dilutive fashion to help build a much bigger company.  As we know, that can go both ways.  The fact that management has not just options, but purchased a lot of stock directly from the company upon being hired when the board won the proxy battle last summer, and more stock subsequently in the market, suggests that it won’t engage in profitless empire building.  One never knows, though.

Risks: The usual suspects:  Prices of gold and silver could go way down while labor and energy costs go way up.  Technical difficulties at the mine or the mill could reduce production or the grade.  Despite compelling reasons to think that there is a lot of gold that was never found in the old days, exploration may show that it just plain isn’t there, and the mine shuts down in a few years after it exhausts what has already been found.

One slightly mitigating factor in the (IMO unlikely) event of a severe drop in gold and silver prices is that this is a high grade mine.  There are a lot of companies mining ore with a gram or two of gold per ton that will have to shut down if gold prices dropped while energy costs rose.  Not that that scenario would help RXE, but rich ore provides some safety.  The company is not allowed to comment on its projected cost per ounce until the new independent technical report (covering the business’s economics, not its mineral resources) comes out at the end of this quarter, but I suspect it will be quite low.