Description

Tanzanian Royalty

I believe the information herein to be accurate but it may not be. There are also opinions and subjective statement made. I would advise readers to conduct their own research and draw their own conclusions.

Tanzanian Royalty Exploration Corporation (US: TRE, Canada: TNX), has a market cap of CAD$500 million ($410 million USD). All figures to follow will be in Canadian dollars. The company's name suggests that the company receives royalties from ownership interests of one or more assets that generate cash flows, in Tanzania. The company confirms this interpretation with the following statement on the corporate website: http://www.tanzanianroyaltyexploration.com/s/Home.asp

"Our vision is to become a highly profitable royalty company that produces above-average returns to shareholders based on royalty income from long-life precious metals, base metals and diamond mining operations situated within the East African nation of Tanzania."

The only part of this statement that I can verify is that Tanzania is in East Africa. First of all, this royalty company has a long way to go before becoming "highly profitable". There are no resource estimates compliant with regulatory standards on any of its projects so the company is unlikely to generate revenue for many years, much less profits. As far as "above-average returns", the company has spent less than $3 million per year in direct exploration expenditures on its properties and less than $13 million cumulatively since Fiscal Year 2003. To justify its market cap the returns on this modest level of investment need to be extraordinary.

So far, the returns cannot be effectively measured, in my opinion, as there are no 43-101 compliant resource estimates on any of their properties. I'm not sure how one makes the claim of having "long-life assets" without having at least a resource estimate if not a full bankable feasibility study. This is from the November 30, 2008 quarterly report:

"The Company is in the process of exploring its mineral properties and has not yet determined whether these properties contain mineral deposits that are economically recoverable."

It generally takes several years for companies to progress from preliminary resource estimates to the feasibility stage and years further to finance, construct and commission a mine. This is akin to a biotechnology company with compounds that are being studied in the lab but have yet to be subjected to clinical trials calling itself a pharmaceutical company. The Company seems to agree (from Nature of Operations in the Annual Report):

"The recoverability of the amounts shown for mineral properties and related deferred exploration costs are ultimately dependent upon the existence of economically recoverable reserves, securing and maintaining title and beneficial interest in the properties, obtaining necessary financing to explore and develop the properties, entering into agreements with others to explore and develop the mineral properties, and upon future profitable production or proceeds from disposition of the mineral properties."

Financing Strategy

One possible explanation for the modest size of the company's annual expenditures is the unique financing strategy it employs, which it refers to as "self-financing":

"While many exploration companies have been negatively impacted by the downturn in commodity markets, the self-financing nature of your company has enabled it to conduct exploration activities at a record pace. In fact, I am unaware of any other company in our peer group that has actually increased exploration expenditures as we have year-over-year."

The "self-financing nature" effectively means that the Chairman and CEO regular executes private placements of stock. According to a press release dated January 14, 2009, Chairman and CEO James E. Sinclair's total placements to date aggregate $20.7mm. This leads to the obvious question of how much stock Mr. Sinclair owns.

In the current proxy, his holdings as of January 14, 2009 are listed as 2,877,202 shares, which is about 3.2% of the 88.864 million shares outstanding and is worth approximately $14mm at the recent share price. However, in the prior year proxy his holdings as of January 7, 2008 are listed as 2,951,576 shares which is a decrease of 74,374 shares. By my count, there have been five press releases over the course of the year about share placements done by Mr. Sinclair. On May 1, 2008 he bought 332,434 shares at $5.189 per share for a total of $1,725,000. On October 14 he bought 327,225 shares at $3.056 per share for a total of $1,000,000. Then the most recent press release, on the same January date where his holdings were reported as 2,877,202, the press release says the following:

"Mr. Sinclair's total share placements to date aggregate $20,689,000."

The holdings from one proxy period to the next declined despite a series of private placements. This would appear to only make sense if he were to be selling stock that the company had issued to him back into the market. I see no press releases on Bloomberg or in the News Releases section of the company's website, only news of his purchases. Fortunately, SEDI http://www.sedi.org/html/splash/index.asp has all of that information and it just about reconciles to the net decrease in stock in 2008. To repeat, the company papers the market with press releases about all of the CEO's placements of stock and how this creates company's "self-financing". At the same time, he has been actively selling stock and was a net seller of stock in 2007 and 2008. He sold stock over 50 times in 2008 in 9 different months. I would encourage readers to go back and make this calculation themselves, but from our research, we estimate that the net purchase of stock by Mr. Sinclair since the company went public is not $20,689,000 as stated on January 14, 2009, it is less than half of that.

Also, to hearken back to the "self-financing" press release for a moment, I am aware of many exploration stage mining companies that have increased exploration expenditures year-over-year. Perhaps the company is defining its peer group only as Tanzanian royalty companies with no royalties. Furthermore, this claim rings somewhat hollow upon reviewing the annual report, which shows that the "Mineral Properties and Exploration Expenditures" of $2.93 million in the fiscal year ended August 2008 was only $314,000 greater than the prior year figure. During the year, it wrote off $672,000 of its mineral properties and deferred exploration costs. That leads us to the financial statements. However, before there, it would be prudent to review the following cautionary statement from page 16 of the annual report:

"The Company has limited accounting personnel with expertise in generally accepted accounting principles to enable effective segregation of duties over transaction processes with respect to financial reporting matters and internal control over financial reporting. Specifically, certain personnel with financial transaction initiation and reporting responsibilities had incompatible duties that allowed for the creation, review and recording of journal entries, note disclosures and certain account reconciliations without adequate independent review and authorization. This material weakness is pervasive."

Financial Statements

The November 30, 2008 balance sheet shows cash of $1.55mm and net working capital was a similar amount. During the last three fiscal years, the net losses were around $4mm. This understates the cash burn as the company capitalizes its exploration expenses, which is the norm for exploration-stage mining companies. The $407K decrease in cash on the balance sheet from August 2008, plus $4.8mm raised through share placements suggests that the real cash burn was $5.2mm for the year (see "Implied Burn" in the table below). So the "self-financing nature" of the company needs to kick in again at some point in the near future. Again, readers should confirm this analysis with their own work.

As I mentioned, less than $3mm has been put into the ground each year since coming public (see Mineral Properties and Exploration Expenditures in the table below). It is worthwhile to compare this to what the company spends above ground. The table below separates out of the long list in the income statement of expenses that I found to be the most telling as far as the company's priorities. The 2008 directors' fees of $438K is a notable example. The ones that are more typical overhead items such as office and administration, office rentals, transfer agent and listing, etc. are aggregated into "Other Misc. Items".

The last and I believe most dramatic bit of information in the financials is the "Write-off of Mineral Properties and Deferred Exploration Costs". The company has had to write off $3.6mm over the last three years, which is 43% of its exploration expenditures and $6.3mm over the last six years, which is 50% of the exploration CAPEX over that period. The applicable accounting convention for the write-offs is reviewed on page 23 of the annual report, an excerpt from which is below:

"Mineral properties and deferred exploration costs are tested for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. An impairment loss is recognized if, at the date it is tested for recoverability, the carrying amount of the mineral property exceeds the sum of the undiscounted cash flows expected to result from its production and/or eventual disposition. The impairment loss is measured as the amount by which the carrying amount of the mineral property exceeds its fair value."

Finally, the press release on the "self-financing nature of your company" said that the company conducted exploration activities at a record pace. This was in fact a record for the company, but the increase year-over-year was $314,000 and the total write-off in 2008 was $672,000.

Business Update Press Releases

So there are no regulatory compliant resource estimates, only write-offs of half of the company's exploration expenditures over the last six years. The only publicly available information comes from the company's flood of press releases. One would expect that these press releases would be of good quality since the average cost over the last three years for press releases, printing & mailing, and promotions & shareholder relations is $132K.

My favorite of the recent press releases is the one issued on January 29, 2009. I provide some excerpts below but readers should look at the whole release and draw their own conclusions. From what I can tell, a company called Kazakh Africa Mining Ltd. has signed a royalty agreement for diamond licenses that the company holds. The only description of this company is as follows:

"Two of Kazakh Africa's directors hold prominent positions with the Almatyenergoservice Ltd., a Kazakhstan-based energy company. Kazakhstan is the largest of the former Soviet republics after Russia and it possesses enormous fossil fuel reserves. Its industrial sector relies heavily on the extraction and processing of natural resource."

A few paragraphs down it continues:

"We are especially interested in doing business with emerging economies whose leaders think longer term and where industrialization programs have been put into place that are unencumbered by high risk, short term, politically expedient policies that are so pervasive in the West. In my opinion, these type alliances will be the gold standard by which players in our market segment will be measured in the years ahead."

I did find the information on Kazakhstan interesting. I would point out, however, that companies like Barrick Gold, the largest gold producer in Tanzania, would be excluded by the criteria set forth in this statement. The press release continues with some information on the asset that is the subject of this key alliance:

"The world famous Williamson diamond mine, which hosts the Mwadui kimberlite, the largest, economic diamondiferous kimberlite ever discovered, is centrally located within the Mwadui Project Area."

A few paragraphs down it continues:

"The Mwadui licenses are known to host alluvial gravels whose economic potential will be evaluated by Kazakh Africa Mining in future work programs. Alluvial diamonds accumulate in gravels because of their inert chemical nature, their hardness, and their relatively high specific gravity. The type of diamond deposits that dominate the Mwadui area fall into the alluvial variety. Geologists believe these deposits were likely concentrated by the weathering and erosion of the Mwadui and its satellite kimberlite pipes."

Nowhere in this release is there a resource estimate, any information on what has been done with the project to date, or what, if anything, this new partner plans to do with this property. Typical deals like this require a certain amount of money to be spent in a certain period of time or the asset reverts back to the seller. As far as the economics of this so called Royalty Agreement, the following vague comment is made at the end:

"Kazakh Africa Mining can acquire a 100% interest on the licenses by fulfilling various Option payments whereby Tanzanian Royalty will then receive a GORR (Gross Overriding Royalty) of 1.5% on all diamonds sold."

Another release came out a day after this one, on January 30, 2009. Again, there is no resource estimate and there is no comment about when one might be forthcoming. I am not a geologist and readers should form their own opinion, but my opinion is that the vast majority of the intercepts are fairly small. All else equal, it would require a significantly higher grade to be an economic deposit. Lastly, like the Kazakh press release, this one relies on vague analogies that serve to titillate a reader looking only at the upside.

"The depth extensions we have confirmed to date are consistent with deposits found in some of the world's largest gold mining camps. One of our priorities will be to increase the drill hole density in these deeper sections given the extreme range of gold values that can occur in geological environments such as this."

In January of 2008, the SEC took an interest in the company's use of these kinds of comparisons, which is sometimes referred to in the industry as "close-ology", stating:

"We note your web site contains disclosure about adjacent or other properties on which your company has no right to explore or mine..."

Based upon the quote below, from a press release a year after the SEC dialogue, it would not appear to me that the company has given up on this type of promotion. This is obviously subjective and my own interpretation.

"The world famous Williamson diamond mine, which hosts the Mwadui kimberlite, the largest, economic diamondiferous kimberlite ever discovered, is centrally located within the Mwadui Project Area."

The links below are the documents related to this dialogue between the SEC and the company.

http://idea.sec.gov/Archives/edgar/data/1173643/000000000008038465/filename1.pdf
http://idea.sec.gov/Archives/edgar/data/1173643/000113717108000449/filename1.htm

My favorite promotional tactic employed by the company is the map at the bottom of the front page of their website that lists the number of confidentiality agreements that are in place at its various projects. Mining companies show lots of maps but this is the first of this kind that I have come across. There are likely others that I'm just not aware of. The comment explaining what this map is all about is as follows:

"The execution of a Confidentiality Agreement (CA) with an interested party will allow that party to review technical data on a specific property (or properties as the case may be) within our large portfolio of high quality mineral projects in the Lake Victoria Greenstone Belt of Tanzania. Presented below is a map of our land position in Tanzania showing the CA's we currently have in place for our various holdings."

I have been investigating the nature of the company's ownership of these properties and its requirements to continue to carry out its modest annual development plans, which to date have yielded write-offs but no resource estimates. The following two comments from the Annual Report (Note 2(e) on page 24 and Note 3 on page 28) provide some sense of how it works in Tanzania, but I have yet to figure out the specific implications for Tanzanian Royalty.

"As The Company holds various positions in mineral property interests, including prospecting licences, reconnaissance licences, and options to acquire mining licences or leases. All of these positions are classified as mineral properties for financial statement purposes."

"For each concession granted in Tanzania under a prospecting or a reconnaissance licence, the Company is required to carry out a minimum amount of exploration work before a mining licence can be granted for further development. Commencing with the new mining act issued in Tanzania in 1998, a prospecting licence is issued for a period of up to three years and renewable two times for a period up to two years each. At each renewal at least 50% of the remaining area is relinquished."

Let's put things in some sort of context. I have sifted through the rubble of the huge declines in the Canadian-listed, exploration-stage mining sector, and there are many that possess the following attributes:

1) Two to three years of cash burn on the balance sheet,
2) Modest operating overhead with most available cash going towards exploration and development,
3) Projects with 43-101 compliant resource estimates if not feasibility studies,
4) Market capitalizations as low as CAD$50mm.

Valuation

So why does this company, which has none of the foregoing attributes command a market cap over CAD$410mm? As best as I can tell, it is the cult following that surrounds the Chairman and CEO, James E. Sinclair. He has a daily blog called MineSet http://www.jsmineset.com/ which contains a lot of information for those interested. In the FAQ section of the website, Mr. Sinclair himself makes a good case for why the valuation for a company with no resource estimate and very little cash is far too high. Regarding the valuation vis-à-vis the properties:

Q: What are the criteria for selection in the junior exploration and development fields?
A (#5): The cap value of the company should not exceed a modest multiple of the already capitalized exploration costs. This will change at various stages of the general market environment. However if all other criteria are equal you should buy the share at a cost that is not extremely above what the company has already put into retained properties

As of November 30, 2008, the carrying value of the properties was $25.4mm. At a market cap of over CAD$500mm, the Sinclair fans are paying over 19 times the capitalized exploration costs, which runs contrary to his advice of paying a share cost that is not extremely above $0.28 per share. I believe that this would be an aggressive valuation since the company has written off half of the amount it has spent on its projects over the last six years, so there are no indications that the November book value figure is secure. Another answer to this same question in the FAQ section is equally insightful:

Q: What are the criteria for selection in the junior exploration and development fields?
A (#7): The company should have enough funds in place in the treasury to be able to finance their operation for at least two years from the time of your purchase. They should also have some means of income that is in place other than simply draining the treasury by which they can meet ongoing corporate expenses.

Tanzanian Royalty had $1.55mm of cash as of November 30, 2008. In fiscal year 2008, the company spent this amount just in salaries and benefits, Directors' fees, stock compensation and its annual general meeting. So this bit of advice would not lead one to purchase the stock of the company either. As far as its "self-financing" business model, as I described above, this means that the CEO does frequent placements of stock which is well publicized, though he also sells loads of stock, which is not.

As far as comparable company valuations, I can choose from among over one hundred junior mining companies trading at miniscule market caps despite well developed projects with 43-101 compliant resource estimates. One example makes the case for the dramatic over valuation of Tanzanian Royalty far better than the others. MDN Inc (Ticker: MDN CN) has a real 30% economic interest in Barrick Gold's producing Tulakawa Mine in Tanzania. At current gold price the company should have net income of about $5mm per quarter, which is the amount it booked in the third quarter of 2008. Cash at MDN is approximately $14mm and there is no debt, which gives the company plenty of room to execute its exploration program on its different projects. The market cap is $55mm. Tanzanian Royalty has no royalties, no resource estimates, no economic interests in producing mines and cash of $1.6mm, yet its market cap is over $400mm.

Summary and Disclaimer

Let me close with a final cautionary note. The company is very concerned about short sellers to the point of making the following comment towards the bottom of the front page of its website:

Dear Shareholders:

I have just been informed about new rules that have been adopted in the U.S regarding the Direct Registration System (DRS) for shares. These rules only apply to the United States at the present time. The new rules allow shareholders who request share certificates from their brokers to have their shares registered by book entry. Once registered by book entry, the shareholder becomes a client of Computershare. Then it will be up to the shareholder to request a physical certificate directly from Computershare who of course will issue certificates as requested. If you have not yet certificated your Tanzanian Royalty shares and wish to, the door is wide open to do so with a modest "two step" process as described above. We will always press the envelope to protect your right to decide rather than be told what you may do according to a broker's preference.

Sincerely,

Jim Sinclair

To be clear, I am not suggesting any wrongdoing at the company. Rather, I think that management has done a phenomenal job promoting the company as a royalty business despite the fact that it has yet to delineate an economically viable project under the standards of 43-101. I would appreciate a dialogue with anyone as far as the bull case for the stock at its current level, providing that they are fundamental, research-oriented investors.

As far as using it as a vehicle for gold exposure, there are dozens of better ways to gain exposure to gold including owning gold, owning companies that produce gold or owning exploration companies that have compliant resource estimate or even feasibilities studies.

Catalyst

None, other than investment community recognition of the points mentioned above.