A major objective of many investors active in the natural resources sector is to diversify away from the fiat-based world of finance and credit-dominated sectors such as banking, insurance and retail. These investors want exposure to hard assets, not soft ones. Today, they desperately hope that commodity prices will soon recover given the large losses just about every natural resource portfolio has incurred over the past few months, the last two in particular.
The fall in commodity prices has created an environment that has made it very challenging for natural resource companies—mining equities in particular—to obtain financing for exploration and project development. It seems cash, not metal in the ground, is king. How ironic that the one asset natural resource investors are trying to diversify away from—the U.S. dollar and its troubled competitors—is the very asset that mining equities need the most right now. It turns out that drilling contractors, engineers, geologists and miners all still prefer to be paid in paper money.
Due to the simultaneous reduction in market liquidity and commodity prices, metal exploration and mining companies that need to raise funds to finance their activities are facing the prospect of substantial share dilution or the possibility of losing their property interests if they cannot meet contractual spending commitments. We believe there has to be a very compelling reason to own cash-strapped companies in this market.
Conversely, companies that are not in need of financing have an important margin of safety in the current environment. Should metal and commodity prices stay weak for a long period of time—something that is not impossible during a bull market as the historical example of the mid-1970s demonstrates— such a margin of safety could turn into a major advantage.
Indeed, if the markets were efficient and logical, we should expect that mining equities with lots of cash and other liquid assets would trade at significant premiums to their cash-strapped peers. But that doesn’t appear to be the case at the moment.
In early August of this year, things didn’t look quite as bad, but nevertheless we had already started to notice that the market capitalizations of several mining equities were approaching their cash positions. This situation piqued our curiosity so we placed these companies on our radar. To our surprise, their prices continued to fall so that now in many cases they are trading at a steep discount to their breakup value (the estimated amount of cash that could be distributed to shareholders if all assets and liabilities are liquidated and the company is broken up). Compellingly, many of these companies have attractive property holdings—some joint ventured with majors—that are currently being assigned a zero value by the market.
Thus was born the idea for our inaugural research report on Mining Equities, the title of which—“Cash is King?”—reflects the strange contradiction that the one asset in greatest need, cash, seems to actually be more of a burden (an asset to be deeply discounted) than an advantage for some mining equities.
One example of a company that deserves closer examination is U.S. Energy Corp. (USEG). The company has a market capitalization of about $54 million while holding $70 million in cash, short-term investments, and marketable securities. With debt of $14 million, this means the company itself is being valued by the market at negative $20 million despite the fact that it holds an interest in several prospective projects and other potential royalty streams. Specifically, the market is giving less than zero value for
- the company’s Lucky Jack molybdenum project where Thompson Creek Metals Company Inc. (TC) will have the ability to earn up to a 75% interest by spending up to $400 million,
- various oil and gas interests,
- a 4% Net Profits Royalty on the Green Mountain uranium property in Wyoming owned and operated by Rio Tinto (RTP),
- up to $40 million in payments from Uranium One starting in 2010, and
- a real-estate project which could conservatively net $15 million to the company during 2008.
Short of being a very profitable producer (which the market doesn’t seem to like either), what else can a mining equity offer?
Many similar examples abound in this strange resource sector of 2008. In fact, our research has uncovered more than 30 companies like U.S. Energy (excluding oil and gas). Yet ultimately our research did not answer the underlying question: Cash is King? Only time will do that. We believe, however, there is a reasonable basis to conclude that many companies trading today below their cash value are positioned to benefit, relative to other mining equities, regardless of where the markets head next: up, down, or sideways.
Disclosure: No positions in any of the companies mentioned in this piece.