2011 has been a year to forget for investors in Thompson Creek Metals (TC). Despite stable prices for the company's main product, molybdenum, the stock has slid almost without interruption. It closed Tuesday at $5.96, 63% off its 52-week high, and over 20% below the level at which I recommended the stock back in September.
The biggest trouble with the stock has come from the company's failure to digest its acquisition of Terrane Metals in 2010. The crown jewel of the purchase was Terrane's Mt. Milligan property, a construction-ready project with 2.1 billion pounds of copper and 6 million ounces of gold. In conjunction with the acquisition, Thompson Creek sold 25% of the mine's gold production (net of $400/ounce cash cost) to Royal Gold (RGLD) for $311 million.
The acquisition was meant to diversify the company away from its reliance on molybdenum, which had seen massive swings between 2003 and 2009, running from $5 to $45 before crashing back to $8 during the depths of the financial crisis. The market cheered initially, and the stock rose throughout the second half of 2010 as the prices of the company's newly acquired reserves rose.
But in 2011, the stock started to stumble, and the company followed soon after. In May, the company raised the capital expenditure budget for the Mt. Milligan project by C$350 million, citing higher labor and materials costs. The company noted that funding for the project -- and an expansion at the legacy Endako moly mine -- was now reliant on "various funding facilities", and included funds from dilutive warrants issued in conjunction with a previous debt offering as a potential source of financing. In August, delays at the Endako mine meant the company had again exceeded its budget, this time by roughly C$80 million. The company added, "Thompson Creek is in discussions with such joint venture partner regarding the portion of the previously announced revised estimate of C$550 million that will be borne by such joint venture partner." Soon after, the company's stock fell below the C$9 exercise price of the warrants, eliminating a funding mechanism representing some C$200MM. (They expired worthless last month.) Then, earlier this month, in conjunction with third quarter earnings, the company announced that Sojitz Moly, its partner in the Endako mine, was balking at paying its 25% share of the overrun in Endako.
The fear now seems to be that the funding gap for the Mount Milligan project will continue to grow, should further cost inflation drive up budgets for the project and the Endako expansion. The company itself addressed the issue in its Q3 presentation [click to enlarge]:
slide from TC Q3 earnings presentation
According to the company, the funding gap as of September 30 was C$83.3 million, roughly $80 million U.S. (C$20 million would ostensibly be the obligation of Sojitz Moly, but is not necessarily clear that they will be able or willing to put up the additional cash.)
Given the importance of molybdenum prices to the company's current operations, a downturn in the moly market could move the shortfall to the higher end of that range, as operating cash flow comes in below current expectations. In addition, planned sequencing in the Thompson Creek mine means production has fallen significantly in the second half of the year, and operating cash should slow in the fourth quarter. Given that third quarter price per pound of moly was $15.64, down almost 10% sequentially, it seems likely that fourth quarter operating cash flow will be below not only the $60 million averaged for the year, but the $51 million generated in the third quarter.
But the company has acknowledged this. CEO Kevin Loughrey estimated on the conference call (no longer available online) that the company needs to raise an additional $200 million. Analysts agree; RBC Capital Markets' Fraser Phillips put the gap between $100MM and $300MM USD. The most likely source of the capital? Another gold stream transaction, as Loughrey mentioned on the conference call. This does not seem like a difficult task. From Mining Weekly:
Loughrey pointed out that [the Royal Gold] deal was concluded when bullion was selling for $1 200/oz, and Mt. Milligan was not fully permitted – which it now is – leading him to believe Thompson Creek could get more money for a smaller gold stream, seeing as though the metal now trades at just under $1 800/oz.
He added that the market was “imaginative” when it came to potential gold-linked funding deals, and the TSX-listed miner was in talks with various financial institutions regarding this.
“We’re negotiating pretty hard with them, trying to get what we think is the best deal... lots of people want to do this,” Loughrey commented.
In short, the funding gap is a real issue, but with a very clear solution. The most effective way for the company to raise capital right now would be through an additional sale of a piece of the gold stream. This would avoid entering a corporate credit market that has tightened in the wake of European troubles, and prevent the equity dilution that has hurt the company as of late. (Shares outstanding have risen from 56 million to 168 million in the last few years, mostly due to the Terrane acquisition. In addition, two secondary offerings were priced at C$21 and C$14.50 in 2008 and 2009, respectively, meaning the private placement market may not be that receptive a third time around.) And even at the high end of capital needs -- Fraser's top-end estimate of $300 million -- Thompson Creek would likely still control at least 55% of the gold revenue stream at Mt. Milligan, with its partner(s) covering the cash costs for the balance.
Given the company's struggles, and the fears about the funding gap, a drop in the stock price seems reasonable. But the funding shortfall is easily fixed, and the magnitude of the haircut given to TC equity holders simply overdone. Market capitalization has dropped by $1.25 billion in less than a year, nearly equal to the entire capex budget for Mt. Milligan and the Endako overrun. If the company announced plans to finish building the Mt. Milligan project and then set it on fire, such a fall might be understandable.
But, of course, Mt. Milligan, when completed, should be an extremely valuable asset, and the sum-of-the-parts analysis I completed back in September still applies. With our new information, we will assume that TC sells off another 25% of its gold stream (net of cash costs) for $300 million. This is an extremely conservative assumption -- the worst-case scenario for TC shareholders, where the company makes a bad deal based on lowered gold prices.
The remaining 50% gold stream still owned by Thompson Creek is worth, by that standard, $600 million (again, present value net of future mining costs.) At the figures used in the Q3 earnings presentation, the net annual profit from the copper stream will be almost identical to that from the 75% ownership of the gold stream. (89 million pounds Cu at $2.67 net of cash costs, versus 196,500 ounces of Au at $1,218 net of cash costs, each equaling about $240 million annually. Note again the prices for both minerals have risen since the prices quoted.) We can then value the copper stream at $900 million (3 times the value of the 25% gold stream sold for $300 million). Again, these figures are based on a ridiculously conservative assumption -- a worst-case scenario analysis.
As such, TC's remaining ownership of the income streams -- net of cash costs for mining, though not SG&A --for the mineral reserves in the Mount Milligan property are worth, based on a reasonable estimate, $1.5 billion right now. TC has a market capitalization of only $1 billion. It has cash on hand of $365 million, with $85 million more due from Royal Gold from the original gold financing, for a total of $450 million. $300 million more will come in from our hypothetical secondary financing, bringing total cash to $750 million. Total liabilities -- current and otherwise -- are $1.12 billion, with $430 million more from a credit revolver and equipment financing likely to be utilized before the completion of Mount Milligan. That leaves $1.55 billion in liabilities, and an enterprise value of $1.8 billion under our hypothetical scenario. ($1B market cap - $750M cash + $1.55B liabilities.)
Therefore, under the most conservative outlook possible, where the company negotiates a bad funding deal based on copper and gold prices below where they trade today, the market is valuing Thompson Creek's assets outside of Mount Milligan at $300 million. That includes the two moly mines upon which the company has long been based, plus the Berg and Davidson projects in British Columbia, and the company's smelting operation in Pennsylvania. It includes $93 million in accounts receivable, and $96 million in inventory, and the remaining portion of some $2 billion in property, plant and equipment. The market is valuing the stock as if it expects the company to royally botch its funding efforts, while still assigning a negligible value to its existing assets. Yet those legacy assets have driven a profitable company for years, with the Endako and Thompson Creek molybdenum mines still possessing 18 and 15 years of life remaining, respectively.
In short, he market has vastly overreacted to the struggles concerning the Mount Milligan project. The funding gap is real, but it is easily fixed. Investors should be aware that the company expects that deal to close in the fourth quarter, and such an announcement would likely be a catalyst for the stock. When the concern over the funding gap finally disappears, what will remain is a vastly undervalued company.