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Company overview

Claude Resources (NYSEMKT:CGR) is a Canadian gold producer with three mining projects all located in Canada, including:

  • Seabee gold operation in Northern Saskatchewan is the sole producing asset and a consistent producer with total lifetime production of more than one million ounces and substantial low cost exploratory opportunities near existing infrastructure. As of 12/31/12, proven and probable reserves were 311,100 ounces at 6.14 g/t (up from 5.37 g/t), measured and indicated resources were 344,200 ounces at 7.82 g/t (from 5.35 g/t) and inferred mineral resources were 603,400 ounces at 6.35 g/t.

  • Madsen gold project in the Red Lake gold camp of Northwestern Ontario. As of 12/31/12 measured and indicated resources of 928,000 ounces at 8.93 g/t and inferred mineral resources of 297,000 ounces at 11.74 g/t. Madsen has a history of high production and significant infrastructure already in place (permitted tailings facility, 500 ton per day mill and a 1,250 meter deep shaft). An internal scoping study is expected to be completed by end of 2Q13.

  • Amisk gold project in Northeastern Saskatchewan. As of 12/31/12 measured and indicated resources of 921,000 ounces at 6.17 g/t and inferred resources of 645,000 ounces at 4.01 g/t. Amisk is a past producing mine with low exploration maturity, an extensive list of exploration targets and open pit potential. The preliminary economic assessment is expected during 2Q13.

Ticker:CGR (NYSE), CRJ (Toronto Stock Exchange)
Country:Canada
Sector:Mining
Industry:Gold mining
Price:$0.2827 (NYSE)
Shares outstanding:175.8 million
52 week high/low:$0.94/$0.27 (NYSE)
Market cap:$49.7 million (NYSE)

Source: SEC filings

All financials in article listed in CAD unless otherwise stated

Basic shares outstanding used (rather than diluted) given weighted average exercise price of outstanding options is $1.42 or ~ 5x current market price.

Industry outlook

Investor perception of the mining industry (especially precious metals) is negative for the following reasons:

  • Large and increasing capex reduced cash flow and margins.

  • Expensive acquisitions led to write offs.

  • Negative effect of high operating leverage as mining stocks fell due to rising costs rather than rose with the price of gold.

  • Concern regarding ability to fund operations (or fear of funding with dilutive financing) especially after $230 drop in the price of gold over two days last month.

  • GLD attractive alternative to miners due to simplicity (instant access to spot price less miniscule ETF fees, no need to buy/store/secure physical and pay huge premium), less complexity (no need to research best miner) and no inherent equity risk (on "risk off" days miners often are treated as an equity rather than a precious metal). Over the past five years, gold rose ~58% while GDX fell ~ 38%.

    Furthermore, if investors want exposure to a miner they simply buy an ETF such as GDX or GDXJ rather than perform fundamental research. This lack of attention to individual miners who are no longer the best way to gain gold exposure is a negative (creates downward pressure on valuations) and a positive (provides opportunity to capture alpha by buying superior assets at discount to intrinsic value).

However industrywide changes (due to recent firings of CEOs/threat of being fired) are encouraging:

  • Capex is being significantly reduced to focus on core projects leading to higher cash flow and margins.

  • Dividends are being initiated/increased to enforce spending discipline and reward shareholders. This attracts a new investor class searching for yield previously unavailable to gold investors.

  • Management is beginning to break the cycle of raising expensive capital and diluting shareholders only to spend it on projects that fail to earn even the cost of capital.

An activist investor may be required in order to extract maximum value, however, this does necessarily require a hostile approach (more on this below). The junior miners are especially suited for activist investing for the following reasons:

  • Increased ability to demand change due to smaller target size.

  • Junior miners more likely to be target than acquirer due to size.

  • Purer play on gold since many larger miners produce other metals such as copper in addition to gold.

The industry trades at favorable valuations based on a variety of metrics (relative to cash flow, price of gold, reserves, past trading ranges). However, a low valuation compared to historical norms is not a reason alone to buy. The natural gas industry is experiencing a secular decline in profitability and valuation due to shale and fracking. Miners should be valued based on a combination of present and future characteristics (reserves, cash flows, financial strength) rather than past conditions, which may have changed.

Investment thesis

Fortunes are made during times of crisis. Few investors bought when there was the proverbial "blood in the street" during the financial crisis in 2008. Those that did (Paulson, Tepper) profited enormously. A similar situation is happening now with gold miners. From the 2008 low, CGR rose in a textbook uptrend with little drawdown from $0.12 on 11/17/08 to a high of $2.91 on 3/2/11. Obviously no one can consistently get in at the bottom or get out at the top. Contrarian and asymmetric investment opportunities (including this one) do not last forever and exist solely because of excessive and unwarranted pessimism. Fearful investors will be buying CGR in a year or two (after current fears subside) from greedy investors buying now.

Risk can be significantly reduced by the following:

  • Using a relatively tight stop loss of 10% below the recent low of $0.27. The fear of being "whipsawed" is born out of greed (that you will miss out on making money) and can be eliminated with the knowledge that you can always re-enter if price recovers. The stop loss is higher in this case due to the higher volatility of gold miners as well as the recent high volatility in gold.

  • Don't buy all at once. Buy 25% of your total position now and continue to add if the stock "proves itself" by going higher.

Below are specific value drivers and highlights:

  • Large and long life mineral resources (over four million ounces) in one of the safest countries for mining.

  • Strong management with history of effectively operating at $400 an ounce. Moreover, as others have noted (Einhorn), miners can be profitable even if the price of gold stays the same.

  • Focus on core asset. Exploratory budget ($1.6 million vs. $2.7 million originally budgeted and $14.2 million last year) focused on low cost targets next to existing Seabee infrastructure with the Amisk and Madsen projects effectively suspended in terms of spending.

  • Lower cost structure. Reduced capital spend this year of $12.4 million vs. $27.9 million last year due to completed infrastructure improvements. Most of 20% cost cutting initiative already complete with an additional $6 million in cuts identified and more on the way without jeopardizing production. This amounts to well over $400 an ounce in reduced expenditures.

  • Low valuation. Discount to book value (0.26x), junior miners (1x - GDXJ), P/E (ttm, excluding depreciation and depletion) of 3.1x. As the "E" increases, so should the "P." The current valuation implies zero value for the Madsen and Amisk projects and an extremely low multiple for the Seabee operation. Reserves and resources are valued at $68.75 an ounce.
Oz
Seabee proven and probable reserves311,100
Seabee measured and indicated344,200
Madsen measured and indicated928,000
Amisk measured and indicated921,000
Total "discounted" oz1,019,690
Market cap49.7 million
Debt20.4 million
EV70.1 million
EV/Ounce68.75

No discount for Seabee proven and probable reserves.
Discounted M&I resources at Seabee by 50%. Discounted M&I resources at Madsen by 66% since project not in production.
Discounted M&I resources at Amisk by 75% since project not in production and due to relatively lower grade. Excludes inferred resources. Debt converted to USD due to market cap in USD.

  • Increased production/reserve growth of higher grade gold to drive revenue, cash flow and earnings. Every one quarter of a gram increase in recovered rate is ~ $3 million in revenue. Last year production increased by ~ 10% and management expects similar growth compounded each year for the next five years. The Santoy Gap (part of Seabee) continues to show positive exploration results with nearly half of inferred resources (281,000 ounces) upgraded into measured and indicated at a higher grade (8.8 g/t) while continuing to grow the deposit. After completion of the current mine plan estimated by 2Q13, these new measured and indicated resources can be converted into proven and probable reserves and raise total reserves at Seabee to more than 500,000 ounces at a higher grade.

  • Financial flexibility. Recent liquidity concerns partly responsible for decline in stock eliminated due to long-term debt financing with Crown Capital Partners for $25 million (used to pay the $9.8 million debenture maturing in May 2013) and expanded debt facilities of $25 million with Canadian Western Bank. The remaining facilities will be used for expansion at Seabee and general working capital. The fact that management chose debt versus equity for financing speaks to their commitment to not massively dilute shareholders. Even with this additional debt, the debt/equity ratio will still be under 25% with operating cash flow more than sufficient to cover debt payments. Management expects to reduce debt by $4 million this year, ~ $6 million next year and will look for opportunities to pay off debt early.

  • Shareholder-friendly management and board. The thesis for traditional activist investments involves nominating one or more new board members. However, in this rare instance, it would do more harm than good. There should never be change simply for the sake of change. No one is more aware of the challenging environment and low valuation than management as they have tremendous "skin in the game" including common stock, options (all underwater) and future compensation tied directly to stock performance. Shareholder friendly actions by management include significantly reducing costs, focusing on core asset (Seabee) and financing with debt vs. equity. Shareholder friendly actions by the board include annual re-election of board members (no staggered board), majority voting and annual performance reviews.

Below are specific value catalysts:

Sell Madsen and Amisk projects. CGR fell 57% in the past year due to the previously mentioned industry challenges and in no small part due to fear that these two projects would consume cash generated by Seabee rather than generate cash in a sale. Management alleviated this fear regarding Madsen by saying on the most recent conference call that there is interest in this project with a decision regarding a joint venture expected over the summer and that it does not expect to develop Amisk.

Amisk is worth at least $10 million USD (~33% discount to $14.9 million purchase price of St. Eugene Mining in February 2012) given the recent positive developments such as the identification of a number of high priority targets. Despite the relatively lower grade, it could still be sold for a higher value than currently implied by the market which is zero or even negative.

Madsen is worth at least $25 million given that it could be the next Seabee with its large high grade resources (similar to size to Seabee at higher grade), infrastructure and location in the Red Lake region.

The Red Lake gold camp is one of the highest grade gold camps in the world (Goldcorp Red Lake project). The 2008 acquisition by industry leader Goldcorp of Canadian gold miner Gold Eagle Mines for ~ $1.5 billion (whose main asset is the Bruce Channel exploration project next to Goldcorp's Red Lake project) highlights two key points. First, it reinforces management's view of the value of Madsen. Moreover, at the time of the acquisition, Bruce Channel didn't have near the infrastructure in place compared to Madsen. Second, given the low miner valuations relative to reserves, it is quicker, easier and cheaper for a larger miner to buy rather than explore. Moreover, gold traded at $918 on the date of acquisition (7/31/08) compared to $1,410 today.

These projects could be sold to the PE funds being raised to buy non-core assets sold off by larger miners or even to Aaron Regent who started a company to invest in mining assets after being fired last year as CEO of Barrick Gold.

In summary, if CGR sold the Madsen and Amisk projects, investors would own the best and improving asset (Seabee) almost for "free." The proceeds from these sales should be returned to investors via special dividend.

No more acquisitions. Management discussed the possibility of an "accretive transaction" in the most recent annual report. Financial resources should continue to be allocated to existing promising assets like Seabee rather than buying another company for the following reasons:

  • No need to issue shares (e.g. such as for St. Eugene) and can fund using cash flow/recent debt facilities.

  • Less execution risk to develop already producing/proven asset than integrate another company.

  • No chance of overpaying (if asset is attractive you would probably pay a steep premium or if asset is less attractive you should not buy it in the first place).

Sell all non-strategic equity investments in junior miners. Although the proceeds will be relatively small (~$242,000 CAD as of 3/31/13) it will send a message that management is completely committed to returning cash to shareholders and to mining rather than stock picking. These investments would not be so troubling if they did not continue to show steep declines in value (down $136,000 sequentially). Investors can buy GDXJ if they want to own a portfolio of junior gold miners.

Source: The Bullish Case For Junior Gold Miner Claude Resources