Crystallex's Speculative Shine Begins to Tarnish

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 |  About: Crystallex International Corp. (CRYFQ)
by: J.L Bane

Since my last article covering Crystallex (KRY), the share price has surged by over 20% but has slowly begun drifting down again. For most investors, and in consideration of all of the promotion surrounding Crystallex and the perpetually imminent granting of a long awaited environmental permit from the Venezuelan Government’s Ministry of the Environment (Ministerio del Ambiente) MINAMB, the increase is understandable despite being illogical.

This kind of blindness to plain common sense and this type of investment fervor has occurred many times over the years, more recently during the era of the Dot.com stocks that were afforded share prices that could never be justified. Recently, however, there have been signs that Crystallex’s appeal has reached a plateau and is slowly but surely descending. This is not to say that further promotion and a higher share price is not in the cards, but more and more it seems investors are looking beyond the hype and to the facts. This cannot be welcome news for either Crystallex’s executives or its investors.

On May 14th, Crystallex released its unaudited first quarter financial report for 2007. For most companies the report itself would have been damaging to the share price but it was more or less ignored as the short term infatuation with Las Cristinas and some overly optimistic comments from CEO Gordon Thompson were more than enough to offset that. The report itself is bleak and paints a picture of a company caught in the tug of the quicksand of failed corporate management. The only thing keeping it afloat being a contract to mine Las Cristinas which could itself eventually prove to be of less worth than the paper it was printed on.

During the first quarter of 2007, Crystallex recorded a net loss of 8.2 million. Losses are commonplace for Crystallex and have come to be expected as the company has never been able to show an operating profit. While there was a period in time when Crystallex was trumpeting profitable operating figures, that all ended when faced with a TSX and OSC investigation as a restatement of the annual financial numbers showed that the profits for those years were actually misstated and Crystallex had in fact been losing money. Further inspection and reading of the current results do provide a peephole into the future of the company.

As anyone might expect, the first question that arises is why Crystallex continues to lose money on operations even as gold prices realized were 18% higher in 2007 than during the first three months of 2007. Gold sales revenue for the quarter was $6.4 million or $0.7 million less than the previous year. Crystallex produced 13% less gold than in the first quarter of 2006 and sold approximately 25% less gold that it did during the same time last year. Incredibly, the total cash cost per ounce sold was an astronomical $669.00, a 73% increase over the previous year while the realized price for the gold sold averaged $651.00.

The picture gets bleaker when it is realized that total cash cost of sales include mining, processing, mine administration, royalties and production taxes but do not include corporate, general and administrative expenses, depreciation and depletion, financing costs capital costs and reclamation accruals. According to the report, the lower production at the Revemin Mill was attributable, in part , to open pit mining interruptions including low equipment availability, delays in receiving explosives permits and water at the Fosforito pit on the Tomi concession.

In addition, despite mining and milling fewer tonnes in the first quarter of 2007 as compared with the first quarter of 2006, total costs increased as a result of general increase in most operating areas , particularly explosives, mill consumables and labor. A look at the source of the gold produced by Crystallex also shows an increased reliance on refractory ore at the La Victoria property. The report clearly indicates that there are no NI 43-101 compliant mineral reserves to report for the Tomi operations. Open pit operations are projected to cease in 2008 although new resource estimates from an underground drill program are expected in 2007. A check of the Resources and Reserves section of their website suggests it is time for an update as the company is still using 18 month old data to entice investors.

In essence, Crystallex’s projects have virtually run out of ore that can be mined profitably and the company is literally skimming the bottom of the barrel to continue production. As unpleasant as it may be, most of the information provided in the report is standard. It is only as one digs deeper and extrapolates from the information to formulate a forward looking picture of Crystallex that one realizes how truly hideous it is. Crystallex’s entire existence is based upon its contract with the CORPORACIÓN VENEZOLANA DE GUAYANA [CVG] to mine the Las Cristinas deposit. It’s current market capitalization is based upon speculation o! f the successful acquisition of the environmental permit from the MINAMB to initiate construction of the mine and milling facilities. Of the two major issues confronting Crystallex at the moment, the acquisition of the aforementioned permit from MINAMB is secondary to any changes the new mining law may bring.

AsI reported in my last article, in a recent interview with Reuters, the chief main directorate of Planning and Arrangement at the MINAMB, Sergio Rodriguez, said that Crystallex has not acted responsibly in planning their project and that the plans had to be changed to minimize or eliminate environmental objections and that Crystallex consider plans to take advantage of processing the copper deposits at Las Cristinas. This would present a significant problem for Crystallex as their MOA does not include the rights to mine copper and all of their plans are designed to process the gold only. Any forced changes could take more ! than a year to complete. If we assume that Crystallex is grant! ed the p ermit shortly, there is another consideration. While acquiring it would be a milestone , the relative worth of that permit may be extremely limited to investors in the company’s stock. There is a widespread belief, fostered by none other than Crystallex itself, as well as its promoters that this is the “final” permit required from the Venezuelan government.

With Crystallex’s reputation of deliberately avoiding full disclosure by using carefully worded statements, it may be worth a closer look. It has been regularly reported that both Crystallex and their geological neighbor Gold Reserve Inc. (GRZ) had been waiting for the same permit, the Permisso de Afectac´ýon de Recursos (Permit to Impact the Environment), based upon the approval of their respective ESIAs by the MINAMB. Crystallex is still stuck in limbo waiting as they have been for years but Gold Reserve’s wait recently ended when their permit was granted in late March. The questi! on that arises is whether or not this is truly the last permit required to mine the gold The confusion arises from Crystallex’s wording in regulatory documents . In regulatory documents, Crystallex consistently states that “acquiring the environmental permit (is) necessary to allow commencement of construction of the mine.”

The operative word is “commencement.” In some cases they juxtapose a similar statement with assurances that upon receipt, and a few other qualifications, production should commence within approximately 24 months but choose not to discuss the potential for further bureaucratic delays. Reading Gold Reserve’s disclosure provides a different picture. Gold Reserve had been waiting for the Permit to Affect from the MARN and while it has referred to the permit as the “permit to Affect for Construction and Exploitation", comments in its recently filed prospectus clarify that it has only received the permit to construct the mine.

While the issuance of the Authorization for the Affectation of Natural Resources for the Construction of Infrastructure and Services Phase of Brisas does not permit us to exploit the gold and copper mineralization at Brisas at this time, this permit allows us to commence certain infrastructure work detailed below, including various construction activities at or near the mine Site.

Gold Reserve goes on to say that:

We are currently working with the MINAMB on an environmental and social evaluation related to the collective environmental impact of Brisas and surrounding mining and infrastructure projects. During this assessment period and upon the completion of the evaluation, we expect to receive additional permits or authorizations from the MINAMB that relate to additional infrastructure approval and the approval of the exploitation phase. We also continue to pursue additional permits and authorizations from various local, state and federal agencies.

Crystallex does comment, in the RISK FACTORS section of its regulatory filings, that “the Corporation is required to have a wide variety of permits from governmental and regulatory authorities to carry out its activities. These permits relate to virtually every aspect of the Corporation’s exploration and exploitation activities” but the comment is obviously lacking. Venezuela requires a myriad of permits for mining activity from all levels of government but even though most are minor, they can still cause delays and greater expenses as Crystallex experienced with the explosive permit at the Tomi mine. The Permit to Affect is the forebearer of future permits from MINAMB even if it does not guarantee that they will be issued.

It behooves Crystallex to clarify this matter for its investors both current and potential. If the permit is divided into two parts and Crystallex will have to wait for the Permit to exploit, or if it is determined that future financings to complete the construction of the mine may not be available under acceptable terms or at all until the permit to exploit is granted, the reaction generated by investors could be adverse to the share price if they come to feel that they have been intentionally misled. If this permit provides no assurances of further permits, the avoiding of further delays in the production of gold and does not provide Crystallex with any autonomy by providing a cleared path through Venezuela’s all encompassing bureaucracy, what then is the intrinsic value of the permit from MINAMB other than allowing Crystallex to begin financing and building the mine through further possibly dilutive or expensive offerings?.

Conversely, clearing up this disparity may well provide greater confidence to market participants who may have doubts about Crystallex’s progress based upon the Gold Reserve experience. The “Permit” is currently the focus of many investors and , at least in the public eye, that of Crystallex. The issue with the greater adverse potential for the company is the enactment of the n! ew mining law. A new mining law calls for a mixed company regime in which Venezuela would control at least 51% of all mining projects.

In an April 17, 2007 interview with Dow Jones, Vice Minister of Mining Ivan Hernandez said of the Mine Operating Agreement [MOA] that Crystallex‘s operating contract has some clauses that need to be revised and that “It will move from being a contract to a mixed company (jointly owned by the Venezuelan government.)“ In a later interview with Reuters, Mining Minister Jose Kahn contradicted the statements made by Hernandez by claiming that no decision had yet been made. It should be noted that Vice Minister Hernandez and not Minister Kahn has the greater responsibility over mining in Venezuela. Minister Kahn has also let Crystallex down. Instead of confirming the status of Crystallex’s MOA, he only said that no decision had been made. In a May 28th article by Dow Jones Newwire, Minister Khan once again confirmed that no decision had yet been made even though the mining law would be submitted to the President for approval in two weeks. That statement alone suggests that Crystallex’s MOA could be redefined.

President Chavez has already demonstrated a willingness to cancel operating contracts, albeit primarily in the oil mining sector thus far, unless the companies engaged renegotiated the terms and gave up majority control of their projects. Compensation for those companies has not been determined but comments by Chavez suggest that Venezuela would only be willing to pay what the respective companies paid to build the project. He has also recently forced steel company Sidor to make concessions to its operations to avoid nationalization. Losing control of more than 50% of reserves and anticipated production profits is bad enough however Crystallex has another outstanding problem. They have a 100 million unsecured debt outstanding and a reading of the prospectus for that debt shows that there is a clause in that lending agreement that could cause Crystall! ex to cave in upon itself.

The clause reads: Project Change of Control If:

(a) a Project Change of Control occurs and (b) the Corporation (if entitled to do so) does not elect to redeem the Notes, the Corporation will be required, at the request of a holder of Notes, to purchase all or part of the holder’s Notes for cash in U.S. dollars at a price equal to 102% of the principal amount of the Notes plus accrued interest.

Project change of control, as defined in the prospectus reads :

Project Change of Control’’ means the occurrence of any transaction as a result of which the Corporation ceases to beneficially own, directly or indirectly, at least a majority interest in the Las Cristinas Project.

Evidently this means that if Venezuela forces Crystallex into a joint venture proposal and takes more than 50% control of the project, Crystallex is exposed to a potential redemption payment of up to 102 million dollars plus accrued interest. It can be assumed that with a loss of over 50% of the Las! Cristin as project, the share price would drop precipitously which would suggest that coming up with 102 million to pay back debt holders would mean significant share dilution to existing investors.

In accordance with the above information, it is easy to see that Crystallex shares could be worth significantly less than recent valuations literally overnight depending on the whims of the Venezuelan government and decisions by debt holders. Finally, there is consideration of a valuation for the worth of share ownership of Crystallex based upon the best case scenario that changes in the Venezuelan Mining Laws will not affect the company or its contract. On an operational basis, Crystallex is worth much less than its current valuation. After two years of construction, the company plans to produce only an average of about 300 000 ounces per year. As of the last report, since the inception of the Engineering and Procurement Report [EPCM] which costs the development of Las Cristinas at 293 million, Crystallex has spent 181 million on the project but only $115 million is related to the costs governed by the EPCM which means that at least 180 million must be raised to build the mine. The estimated costs are based upon a two year old assessment. Since then costs have risen. As Crystallex disclosed about its Tomi operations, there are general increases in most operational areas “ particularly explosives, mill consumables and labor.” This carries with it the suggestion that costs for Las Cristinas, which Crystallex will not update until after they are granted the permit, have also increased materially which undoubtedly means further dilution.

In addition, as noted, Crystallex’s other operations could soon cease and so, assuming permit granting “sooner rather than later“, during at least 2 years of construction, Crystallex be will require to raise capital to not only build the mine but also to fund everyday operations, pay current and any additional interest on other debt they acquire, final reclamation costs for expired concessions and other costs associated with the company.

Currently, according to Crystallex , as of April 25th 2007, they have 260 million shares outstanding, 291 million shares fully diluted. Using approximate cash cost figures from the yet to be updated study, the earnings per share [EPS] are negligible. Unless the gold price skyrockets, EPS will decrease significantly when dilution for updated costs, administrative expenses, debt payments and other expenses are added in. Making matters worse, no proper valuation multiple can be allocated to can be calculated to estimate a target share price. Crystallex has an operating contract for 20 years with two ten year renewable terms; seven of those years will have expired by the time production at Las Cristinas begins assuming the granting of a permit this fiscal quarter and there is no guarantee of terms of the MOA under renewal terms.

Crystallex’s main appeal therefore is as a takeover target based upon the control it has over the reserves at Las Cristinas. The problem is that not all gold ounces are equal and it is virtually impossible to imagine any other company willing to risk a billion dollars or more to buy Crystallex without concrete assurances that they will get what they pay for and be unrestricted by the Venezuelan government. Unfortunately, as has already been proven, under President Hugo Chavez’s administration, no such guarantees are available.

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