NovaCopper: Value Created By Market Structure Deficiencies

| About: Trilogy Metals (TMQ)


NovaCopper is an exploration phase copper mining company.

Its price is depressed due to spinoff dynamics, ETF reweighting, and tax selling.

A near-term catalyst could appear within the next month with its capital raise.

NovaCopper (NCQ), a spin-off from NovaGold (NYSEMKT:NG), is a copper mining company in the pre-mining stages. CEO Rick Van Neiuwenhuyse, former founder, president and CEO of NovaGold, left to manage NovaCopper in April 2012.

NCQ will begin drilling at the Ambler Project, which will be the highest-grade Cu-dominant polymetallic project in the world, with more than triple the grade of fourth highest grade mine, in 2017. Using solely the Preliminary Economic Assessment by a third party (Tetratech), we can value the rights to the Artic Project at $537.2 after tax. A summary can be found here, and the full assessment here. After all dilution from options and warrants, which gets the shares up to 71.8mm, this gives us a value of $7.54, far over today's current price of $1.12.

This PEA is a great way to gauge the potential for value, and some of its assumptions are extremely conservative. For example, it holds copper prices at $2.90/lb throughout the life of the mine. Today's price of copper is around $3.07. If copper continued on its 20-year CAGR of 7.1%, then by commissioning in 2021, copper prices would be $4.96. If copper continues on its 10-year CAGR, prices would be $7.54. Moreover, production would likely be greater under higher copper prices as the company would reach for lower grade.

Where the model is lax is in its discount rate of 8%, and its assumptions of costs for the road to the Ambler district. Yet the company presents a sensitivity analysis on pages 22-5, and a 10% discount rate puts the pre-tax NPV from $927.7mm to $710.1mm. With regard to the road, a doubling of the cost of the 30-year bond to a 10% cost would reduce NPV by $100mm, with a discount rate of 8% and commissioning in 2021, and it's hard to imagine much worse than that given the low interest rate environment and similar terms given to the Red Dog mine. In addition, with predicted all in costs at $1.26 per pound due to its high grade, it's hard to put this project in unprofitable circumstances should it be approved.

While recent worries about China's economy have put pressure on copper prices, ultimately NovaCopper's price exposure is not driven by near term credit dynamics of China, but by secular trends in the urbanization of China and many other developing nations. This PEA also ignores the $100mm in NOLs that NCQ currently has for conservatism. In a conference call, NCQ management also said that these were not included in Tetratech's NPV analysis. These alone are greater than its current market cap, presenting an attractive acquisition target on its own, which I will address later.

An astute reader will still believe that a huge discrepancy must exist for more reasons, which is a fair and correct assumption. First, as many readers will know, spin-offs are usually sold off by institutional shareholders and other shareholders. Reasons in this instance likely include liquidity and market cap requirements, sector requirements like gold ETFs, etc. For example, a large institutional investor may often need to hold stocks with shares over $3, or market caps over $1 billion, etc. While Novagold met these requirements, the new spin-off shares that it received in NovaCopper did not. This can be seen in the large drag after the company was spun off. The Guggenheim Spin-Off ETF (NYSEARCA:CSD) was created to take advantage of what some might call "structural alpha," and its outperformance, despite its beta of less than 1, is evidence of this.

Ironically enough, however, CSD's index was reweighted in December, and the index sold 8% of the company in a three-day period between Dec. 11 and Dec. 13. This was followed by tax selling in the remainder of December for individual investors who wanted to receive capital gains write-offs. These individual investors are likely large owners due to NovaCopper's small size, as well as management having to sell its stock awards for payroll taxes. As a result of this, as a percentage of 2013 volume, 35% of volume was in December despite no company news. In addition, this volume abruptly stopped in 2014, likely as a result of the stop on tax selling. However, liquidity has now dropped off, as the even smaller market cap makes this even less accessible to institutional investors.

Moreover, with access mostly only to hedge funds and individual investors, the stock has suffered from excessive perception of risk, as well as an overall lack of interest due to its long time frame. However, I believe the strong deviation from intrinsic value, and the possibility of a near-term joint venture or sell-side transaction will soothe individual investors who may not have time to research it and attract hedge fund managers who are measured on a quarterly basis.

With regards to NovaCopper's fundamentals, I believe the stock is far from speculative despite its high potential return. The hard assets of the extremely high grade copper deposits will always be there no matter what the management team does, providing a strong floor. But the management team is in fact one of NovaCopper's greatest resources, with Rick Van Niewenhuyse leaving the top spot at Novagold after founding the company to lead NovaCopper. His experience creating a successful mine should be an immense advantage (not to mention the signaling of him staking his future on the company). Niewenhuyse has led strong initiatives recently, including exploring the use of LNG from a nearby, soon to be built LNG plant that he estimates would have their energy costs should they switch from diesel, and the doubling of resource estimates at the Bornite project.

Many cite other failures of permitting of other mines, but in reality, risks to completion are very limited for NCQ. And beyond Pebble, there aren't other strong examples of this. One needs only look to the nearby Red Dog Mine, which had a strong benefit for its local population and minimal environmental impact. NCQ has already negotiated with both the nearby Native American population and the Alaskan State Government. The road will improve the quality of life for many in the region through a lower cost of living and is not near any large water bodies. Alaska has spent $10mm to identify an access road, $8.5mm to begin permitting, and is expected to offer the company a $150mm 30-year bond for the completion of the access road.

In addition, NovaCopper has signed a Memorandum of Understanding with the AIDEA, the Alaska Industrial Development and Export Authority. No nearby environmental factors pose any risks in creating environmentalist protests. When asked, the best that NCQ's CEO could come up with was changes in Caribou movement patterns from the road, yet this affects only those who seek sustenance nearby, not drastic environmental costs. In addition, NCQ has negotiated with the local native population to give a 15% equity stake or 15%-20% royalty upon completion of its Bornite project, and employs many locals who are shareholders as a result of this agreement in a "bulls-eye" hiring strategy.

Large shareholders include The Electrum Group, Paulson & Co. (John Paulson) and the Baupost Group (Seth Klarman), each of which is not subject to liquidity restraints, and all of whom purchased NCQ at a 80%-plus premium to today's price. These shareholders should be able to support NCQ in receiving financing, and should provide solace to those who look to follow smart money.

The catalyst for value realization will be NCQ's capital raise, which should occur in the next couple years. NCQ will need to raise around $720mm to complete the mine, and this will attract institutional shareholders, resulting in it receiving a fair valuation. Finally, I believe there is a strong near-term potential. NCQ recently postponed its equity offering for a two-month period. I believe that this is because it is looking to engage in a joint venture or sell-side transaction after strong capital performance from its peers (both of which are listed in its proxy and points out in its investor presentations), Augusta Minerals and Reservoir Minerals, after such actions.

The company had said it wanted to postpone the decision to wait for its other mine's resource estimate, which happened on April 1. The company had all of its filings already in for the equity offering, as can be seen on the SEC's EDGAR, yet has deferred the decision for another month. I believe it is currently in negotiations, and this could put financing worries to rest, boosting the stock. I have no relationship with the company beyond share ownership, so this is purely speculation, but the postponement of an equity offering can only be a good sign as it looks for better financing alternatives the market clearly has rewarded its peers for.

Target Price: $7

Potential Risks: Environmental protests leading to delay and lack of government funding/support. Moreover, the longer that this stock remains undervalued, the longer dilution will dilute the intrinsic value per share, so to the extent that it continues to remain undervalued, the issuance of shares below intrinsic value will dilute the current underlying value per share. While I cannot predict the potential timing of the market recognizing its intrinsic value, a JV or sale of the company would offset this risk. Finally, a dramatic unwinding of the Chinese economy could harm copper prices enough over the long term such that it would hurt the long-term prospects for NovaCopper, or at the least hurt its prospects for strong capital raises.

ADDITION: Some have commented about the environmental effects, and I'd like to address these via some information I've received.

First, in the Arctic PEA, $150 was assumed for the road. Recall that this road will also give access to the Bornite mine as well. The original price tag by the AIDEA was $400 million for a two lane paved road. However, they're now looking at a one-lane flat road which AIDEA has said will be much less. In addition, the road will be constructed with a few miles of each of the villages to give them the option to decide if they want to link on to it.

Second, the LNG project was said to be made for Fairbanks, when in reality, the North Slope is 90km closer than Fairbanks. Feel free to check Google maps. AIDEA has already started financing and partners for the project and expects to start construction by 2016, which means the project could easily cut their energy costs by halve.

Third, the Red Dog road and port was constructed in the late 1980s for $180 million (1987 dollars, so $363.5mm in today's dollars), which was also paid with debt backed by the AIDEA. The road and port were paid off a couple years ago through a toll roll paid by the mine (not to mention tax revenue for the state). THe AIDEA still continues to receive the toll, going directly to the people of Alaska. This marks a major success for the people of Alaska.

Fourth, regarding the villages, in one village, Bettles, the mayor was forced to resign in disgrace after misleading residents into thinking that the road would go through the town when in fact it was well north. In another village, a representative named Virginia openly opposes the road, but many are trying to remove from her post due to her nefarious activities, as can be see in the comments. While NCQ receives broad support overall, there will be people looking to exploit the project for their personal gain.

Fifth, Novacopper is not near the Kobuk river. The two rivers that go around the Artic project and feed into the Kobuk have waterfalls and rapids located 30km away, therefore there are no salmon or scheefish near the mine. In addition, at the Red Dog, which is the world's largest lead-zinc mine, the water quality has improved to the point (before the mine was built natural acid-rock drainage kept the fish out of the Red Dog area) that Teck had to install fish weirs to keep first from migrating into the pit! NCQ is also lucky that the Bornite project is hosted with carbonite rocks which naturally buffer acid generating rocks. Thus, acid mine drainage effects can be mitigated.

Sixth, remediation and closure costs of US$82 million are in the PEA that was released. US laws require that NCQ posts a reclamation bond before construction commences.

Seventh, mining absolutely contributes to the Alaska economy. In 2012, the gross minerals production from Alaska was US$3.44 billion and this was only from six mines. While there are few mines in Alaska, each mine makes a significant contribution to the local communities and state.

Finally, NCQ has made significant contributions to the community and has spent over US$84mm on the project since 2004. In 2013 alone Novacopper spent US$8.9 directly into the region and paid over US$41.1mm in wages to NANA shareholders, who are local natives, in the past three years. NANA shareholders represented over 50% of the employees at the project which is located in an area that experiences poverty and lack of employment. NCQ also has a scholarship to help the young people in the borough.

Disclosure: I am long NCQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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