I appreciate this opportunity to respond to the article Tanzanian Royalty Exploration Corporation: Fool’s Gold by the anonymous writer “James Emerson.” Mr. “Emerson” opines that the current valuation of the company is “ridiculous,” “the real value of the assets is closer to zero,” and the “stock will be headed to $0.” He bases these assertions exclusively upon the accounting basis of the company’s investments, without mentioning the name, let alone the characteristics or possible valuation, of a single one of the company’s assets.
A mining company’s book value, as the author himself explains, is more or less equivalent to the sum of its capitalized exploration costs. If it succeeds in creating value through such investments, the valuation of the related assets increases while the sum of their book value remains equivalent to what was invested. Valuing a mining concern’s assets based on their accounting basis is nothing short of asinine. If the same methodology were applied to any other mining concern, equally meaningless conclusions would be reached.
In fact, mining companies that failed to create value through their exploration investments (and, therefore, whose valuation and market capitalization more closely approximated their accounting basis) would appear better values when in fact they would be the duds of the industry who had achieved little returns on their capital outlays.
The author is also critical of the company’s financing strategy. While both the data and description he presents with regard to the cost and nature of the company’s equity based financing strategy are highly misleading and inaccurate, he is correct to say that the cost of equity financing to an exploration company is high. For this reason, most such companies fall into the trap and allure of debt financing. In so doing, they often forego tremendous upside by entering into mandatory hedging programs with their lenders. Forward hedging in the current environment of currency debasement and rising gold prices has proved disastrous, and many majors have abandoned such strategies resulting in tremendous destruction of shareholder value.
TRX’s management warned against such strategies as early as 2001. By levering its balance sheet, an exploration company also assumes the precarious position of a higher degree of dependence on capital markets. TRX’s balance sheet, meanwhile, is pristine. The company follows in the footsteps of the best performing mining entities of the bull markets in exploration companies during the 1930s and 1970s.
Such companies pursued a strategy of no debt and chose instead to finance larger projects by exploiting the low hanging fruit of their portfolios (in TRX’s case, economically viable, extremely low cost surface gravels at its Buckreef, Kigosi, Lunguya and Ushirombo projects that are entering production in 2011 and 2012). Finally, as the company ramps up production, it is unlikely to require additional equity financing.
That a CFA does not understand the difference between asset valuation and accounting basis (indeed, he asserts that every one of the company’s assets deserves an impairment to a near zero valuation without naming a single example, neglecting to perform even a cursory valuation of any of them, instead relying exclusively on their accounting treatment to reach such a conclusion), the considerations between equity and debt financing, or even how to access the latest securities filing (he claims the latest filing is from August 2010) is disconcerting. Even more unusual is the degree to which Mr. “Emerson” is comfortable offering very serious assertions in such a cavalier manner without any sense of responsibility regarding the facts.
Our firm believes strongly in the importance of identifying over-valued securities and the role of shorts in the marketplace. Indeed, we actively pursue short positions for our own book. Personally, I have great admiration for many professionals who have built their careers upon this strategy. Needless to say the authentic professionals who conduct such analysis, such as David Einhorn or Jim Chanos, do so thoughtfully, conscientiously and with well-supported assertions. They also contribute such analysis to the marketplace under their own names. “James Emerson” offers monumental allegations, no evidence, and no identity. I find this peculiar, to say the least.
Of course, as even fresh participants to the marketplace soon understand, when a great deal of money is at stake, such curious machinations are to be expected. Nearly every share of TRX available for borrow in the securities lending market has been borrowed, and the associated borrow rate is currently approximately 15%. In the previous nine months, one or more shorts have borrowed and sold in excess of five million shares that they are contractually required to re-purchase and return.
Despite this technical pressure, the share price has remained firm. Our analysis suggests that the average cost basis net of interest outlay for this short position is meaningfully underwater. With 5,807,600 shares publicly reported sold short between the US and Canadian exchanges, and essentially no shares left to borrow legally, the math gets ugly fast once the short squeeze begins in TRX. When lenders of the shares last feared a squeeze could occur in February 2011, the borrow rate surged to multiples past the current 15%; imagine carrying an underwater short position at 40+% interest.
Worse yet, this short position in relation to average volume is very high. If it were to be covered over a period of one month, it would nearly double average volume every one of those days; imagine the marginal price impact of a sustained doubling of demand. When the dam breaks on this, there will be nothing but atrocious options available to this short.
Meanwhile, during the same period, the company has added approximately 1,100,000 ounces of NI 43-101 documented gold resources to its books from its Buckreef gold project. Comparable M&A activity in the mining sector in early 2011, when gold was trading at $1,350/t. oz., would value this project alone at TRX’s current total market capitalization, before accounting for the $200 increase in the gold price or any other company asset. The company is also close to completing an additional NI 43-101 resource stage report on its Kigosi project. Based on the existing information disclosed by the company, we expect this latest report to document many hundreds of thousands of additional ounces.
Similar reports will continue to be released on other properties such as Lunguya and Ushirombo, many of which already have initial NI 43-101 reports documenting ore grades, depths of mineral phenomena and other relevant considerations necessary for valuation. In addition, many other properties are being advanced to production at significant investment by major industry partners as part of the company’s portfolio of royalty agreements (If Mr. “Emerson” is correct in arguing that these assets too are worth zero without naming them or discussing any considerations of their possible valuation, no fewer than five major industry partners are in vital need of his expertise). Furthermore, the surface gravel resources at Buckreef, Kigosi, Lunguya and Ushirombo, are accessible at exceptionally low costs, very often around $100/t. oz.
This low hanging fruit will provide significant cash flow, paving the way to a substantial dividend while also financing the development of Buckreef. How much additional success the company experiences at Buckreef is uncertain, however it is relevant that TRX’s Chairman and CEO James Sinclair pioneered the nearby Bulyanhulu mine (now an asset of African Barrick PLC) while leading Sutton Resources when it was less significant than Buckreef is today. Bulyanhulu now boasts more than 15,000,000 ounces. This is not indicative of what will necessarily happen at Buckreef, but good luck betting against Jim Sinclair. Any additional value creation at Buckreef is, of course, gravy; the company’s current assets alone will propel the share price significantly higher.
Despite the full disclosure of the above in the public domain, “James Emerson” makes the curious assertion that the company has not discovered gold. If an NI 43-101 assessment is insufficient for him, then he must also believe that no gold company has found gold; the NI 43-101 standard is the standard, and there is no other. While the author’s other arguments are misleading and demonstrate a profound misunderstanding of both mining companies and valuation methodologies generally, this assertion is as shameless as it is libelous.
The author’s skeptical posture, however, is appropriate in that selecting exploration companies is like traversing a minefield. To succeed, one must be highly knowledgeable, methodical, patient and disciplined. One does not cross a minefield, however, without a purpose; ours is to succeed spectacularly as we have since inception.
Disclosure: I am long TRX.
Additional disclosure: Geier International Strategies Fund LLC controls 10.3% of Tanzanian Royalty Exploration Corporation (NYSE-AMEX: TRX, TSX: TNX).