In this article I introduce the reader to the business model of prospect generators, or project generators as an alternative to straight-up mining companies. In subsequent articles I will discuss individual companies.
1: What is a Prospect Generator?
Prospect generator is a term that describes companies with a couple of different business models, but in general they are companies that focus on mine exploration, and they delegate more capital intensive mining tasks to other companies. Before I delve into the specifics investors should be familiar with the basic procedural timeline of a mine, that is how it goes from being a plot of land to being a mine.
A: The Procedural Timeline of a Mine
Mining companies begin as junior explorers: that is they consist of the following elements: land, capital, and people (management and geologists). At this point the mining company's goal is to find geological configurations on the land that can become economical mines: i.e. rocks and minerals that can be extracted from the land and separated into their element components and sold on the open market at a profit. The probability of a mining company succeeding at doing this at this early stage is extremely slim, as most exploration efforts do not yield these aforementioned geological configurations.
Assuming that a company has found such a geological configuration the next step is to develop a mine (after all, it is still just a bunch of rocks in the ground). Developing a mine includes building the infrastructure necessary for extracting the valuable rocks out of the ground, developing further infrastructure for transporting the extracted rocks to a refinery so that the valuable elements can be prepared for sale on the market. In addition to infrastructure development there is a lot of regulatory compliance that needs to be done so that the mine is legal once it goes into production.
Once development is complete the mine can go into production.
B: Justifying the Prospect Generator Business Model
Exploration and development are incredibly costly, and they are also high risk entrepreneurial endeavors.
Exploration often yields nothing of value, and in order for many exploration companies to stay afloat they need to issue additional shares. Unfortunately many companies fail in the exploration stage, or they enter a cycle whereby they issue shares and each time they do so they use the new capital to explore and find nothing.
Development often takes several times more capital than development-stage companies have access to. . For example, Pretium Resources (PVG) has roughly $20 million in cash, but it estimates that its Brucejack project will cost nearly $500 million to bring to production
Companies in Pretium Resources position can raise the capital necessary to construct the mine using one of the following methods:
- They can issue debt, although given that they don't have any revenues they would have to pay a very high interest rate, and they would have to issue even more debt in order to pay the interest on the initial debt.
- They can issue shares in the company and dilute existing shareholders. This is generally a very unappealing option: e.g. if Pretium Resources were to do this an existing shareholder would lose nearly half of his or her interest in the company.
- They can sell futures contracts representing the metal that they anticipate producing. This is not an option for several companies, however, because production is often many years into the future and no such contracts exist, or if they do exist they are very illiquid.
- They can raise money through royalty or streaming companies, give mining companies an upfront payment in cash or stock in exchange for a royalty or a stream on an agreed upon mine. A royalty agreement entitles the royalty company to a predetermined portion of the resources produced by the mine in question, while the mining company operates the mine. A stream entitles the streaming company to the right to purchase a predetermined portion of the resources produced by the mining company at an agreed upon price. Given that metals prices are slumping currently along with shares of mining stocks this seems like a good alternative to raising capital by issuing stock or debt, or by selling futures contracts.
Given what I have just said about exploration and development it seems miraculous that there are as many successful producing companies as there are. In fact there are innumerable success stories that illustrate that the risks involved in early stage mining are worth taking: companies can end up with market capitalizations of several billion dollars when they had market capitalizations of under $100 million just a few years earlier.
Nevertheless, the fact remains that exploration and production are high risk and capital intensive operations, and it is for this reason that the prospect generator business model makes sense.
C: Defining the Prospect Generator Business Model
Companies that operate as prospect generators look to mitigate the cost and risk of exploration and development. More specifically, prospect generators seek funding for exploration or development from outside sources in exchange for some of the property. In essence they sacrifice a good part of the potential upside that successful mining companies enjoy in exchange for protection against share dilution, debt issuance, or forward sales of metal that management believes will be worth more in the future.
There are variations on the business model, yet there are two primary approaches:
- The company seeks funding for exploration. This way the company does not have to dilute shareholders as often as a traditional exploration company does. An example of such a company is Eurasian Minerals (EMXX). Eurasian Minerals makes deals with larger, well-financed mining companies such as Vale (VALE), whereby Eurasian Minerals receives capital and performs the actual exploration. If it finds a potential project the funding company is given an ownership stake.
- The company explores on its own, and once it finds a potential mine, rather than building it itself it finds a partner to fund the development of the mine in exchange for an ownership stake. It can also sell the mine outright to the funding company for some benefit. For example, one of the largest prospect generators by market capitalization is Virginia Mines (OTCPK:VGMNF), which sold its Eleonor discovery to Goldcorp (GG) in exchange for a royalty on the property (for a detailed discussion on royalty/streaming agreements, see my article on gold and silver royalty companies). Goldcorp has the means to develop the property, and Virginia Mines does not have to find funding to develop the property while it retains some of its upside potential.
2: What to Look for and What to Avoid when Analyzing Prospect Generators
- Prospect generators are companies that focus on exploration. Thus it makes sense to look for companies that employ people who have had success in exploring for resources. One notable takeaway from this point is that investing in prospect generators is more about betting on people and less about leveraging exposure to the prices of certain resources. For instance, Eurasian Minerals has well over 100 properties on which it can potentially find copper and gold resources that can be economical at lower prices for each metal. But if the company finds nothing on these properties its stock can decrease in value even while copper and gold prices soar.
- Prospect generators need to find partners in order to prosper. Thus it makes sense to look for companies that either have joint venture (JV) partners. The largest gold prospect generator by market capitalization--Seabridge Gold (SA)--has yet to find JV partners to develop its enormous resources, and so I would avoid them. The two prospect generators that I mention above--Eurasian Minerals and Virginia Mines--both have found JV partners. Consequently they have an advantage insofar as there are larger, well financed companies (Vale, and Goldcorp), whose interests are aligned with their smaller, prospect generator partners.
- I like prospect generators that overtly state that they are prospect generators. Given that all aspects of mining are incredibly risky and complex I value companies that know what they are doing and who take the effort to explain this to their investors. There are a lot of companies that will just hint at the idea, and it suggests to me that these companies do not have a clear idea as to how they will become successful and profitable companies. Eurasian Minerals, for instance, states directly in its corporate presentation that it is a prospect generator. In fact on page five the company justifies the business model. Compare this to Seabridge Gold, whose corporate presentation makes no mention of this. Towards the end the company claims that it is looking for JV partners to develop its properties, but otherwise there is no clarity as to the nature of the company's business model.
- Mining is a high risk and capital intensive business. It can be extremely lucrative but there is a good chance that investors will lose their capital, especially during early stages of these companies' existences. Prospect generators are companies that find JV partners to supply some of the necessary capital in order to explore or develop prospective mines.
- Prospect generators will benefit from the rise in price of the commodities that they are exploring for, but for these companies more so than with other mining companies their success or failure is largely determined by the quality of managements and exploration teams.
- Successful prospect generators will not only find potentially economical mines, but they will also find partners to build these mines, or to explore property. A promising sign to look for in choosing a prospect generator is to focus on those that have JV partners, as there is a much greater chance that prospect generators will survive if they have the financial backing of larger mining companies.
In subsequent articles I will discuss some individual prospect generators.