A Mexican Silver Takeover

| About: First Majestic (AG)
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On Sunday, December 16 2012 First Majestic Silver (NYSE:AG) announced the friendly takeover of Orko Silver (OTC:OKOFF) by way of a plan of arrangement paying a considerable premium of 69% on the prevailing share price at the time. As a result of this proposed deal ex-Orko Silver shareholders will own 13% of the merged entity and Orko's La Preciosa project will be added to the Mexican silver portfolio of First Majestic Silver. Closing of the deal is expected in late February 2013. Using today's share price as a yardstick the transaction is worth approximately $315M, or $1.19 per known ounce in the ground at La Preciosa.

First Majestic Silver is a highly successful silver mining company producing 9.1M silver equivalent ounces in 2012. The market capitalisation is $2.3B with $72.8M cash at hand (not including the $50M of the recently announced forward sale of base metal by-products). First Majestic Silver is active in Mexico only and claims to be the purest silver mining company producing 91% silver and only 9% by-products. Three mines are in full production (La Encantada, La Parrilla and San Martin), the recently acquired La Guitarra mine is undergoing a cost reduction and mine plan revision program, and the Del Torro mine commenced production on January 25 2013.

First Majestic Silver's market valuation as a producer depends on actual silver production much more than on silver resources in the ground which may be mined some time in the future. La Preciosa is a minimum of three years away from production and the proposed merger will reduce the EPS due to dilution (while increasing the NAVPS). This was clearly reflected in the share price which dropped by 10% upon the announcement of the deal and has been on the slide since then. However, it can be presumed that the rationale behind the proposed deal is long-term gain offsetting the present short-term share price pain.

Here is a brief history of the exploration of the La Preciosa deposit. Following the discovery of the Martha vein in 2007 Orko Silver embarked on an initial drill campaign in 2008. Based on these results a joint venture with Pan American Silver (NASDAQ:PAAS) was formed and a detailed drill campaign was undertaken in 2009 and 2010 leading to the release of a PEA in 2011. The joint venture came to an end on April 5 2012 when Pan American Silver relinquished their interest in the project. Orko Silver continued to explore the deposit and published an updated NI 43-101 compliant resource estimate in November 2012 suggesting strongly improved economics for the project. Just a little more than a month later, First Majestic Silver announced the friendly takeover of Orko Silver.

Orko's share price took a hard hit in April 2012 due to the termination of the PAAS joint venture. The premium offered by First Majestic Silver in the currently proposed friendly takeover more or less neutralises this hit and brings the Orko share price back to the level it traded at when the JV was still intact.

At 110M oz (indicated) and 154M oz (inferred) La Preciosa is hailed to be one of the largest undeveloped silver deposits by their current owners. Indeed, the impact on the total resource and therefore the NAV of the combined First Majestic Silver entity including Orko is significant, increasing total indicated and inferred resources by 78% and 77% respectively. Moreover, the nature of the deposit promises the possibility of low-cost mining methods.

Being long with great conviction on First Majestic Silver and having been intrigued by the La Preciosa deposit for quite some time we decided to find out a little more and contacted the two companies. Ben Whiting, chief geologist at Orko Silver was kind enough to reply on Orko's behalf, and Todd Anthony took the time for First Majestic Silver. Here is what we received as answers to our queries.

Here are Ben Whiting's answers to our questions:

Q: In your view, what where the reasons behind the termination of the Pan America Silver JV? What did First Majestic see that Pan American Silver missed in their evaluation?

BW: The reason for the termination of Pan American's involvement was not a reflection on the quality of the La Preciosa asset. In the contract, Pan American had three years to complete a full feasibility and present a mine building schedule. As they were not ready to do that by April 2012, due to internal reasons, their courses of action were to buy out Orko, or withdraw from the joint venture. A few months earlier, Pan American had taken over Minefinders for their Dolores Mine. The Pan American directors were not prepared to undergo another significant takeover so quickly on the heels of Minefinders, so they terminated the Orko joint venture.

I reiterate, Pan American did not pull out of La Preciosa because there was something wrong with the geology of the deposit. They pulled out for reasons external to the geology of the La Preciosa Project.

First Majestic is not the only company to see the value of the La Preciosa deposit. There was a competitive bidding process, with another major company. It is a truly remarkable deposit.

Q: What timeline do you anticipate for the development of the La Preciosa deposit? And what is your view on the exploration upside around the current resource?

BW: I see the mine building scenario as ongoing engineering mine design and permitting in 2013, construction start up in 2014 and full production for 2016.

As the Chief Geologist of Orko and having been with the project since the very beginning, I have submitted to First Majestic a list of exploration target areas for further testing. There is a considerable upside to the discoveries at La Preciosa. I am intrigued by both the expansion of the current deposit to the southeast and down El Orito Ridge, as well as the Esmeralda Area, a multi-vein target area 12 km to the northwest and still on the property.

The involvement of Orko Silver Corp may be ending, but the story of wealth generation and discovery at La Preciosa is far from over.

Q: Where do you see the benefits for current Orko Silver share holders in the merged entity?

BW: The Orko team are exceptionally good "explorers", but we are not structured to be "mine builders". First Majestic [Silver] is a top quality mine building team and [the] La Preciosa Project is close to their head office of operations in Durango. They are capable of building a very profitable mine on the La Presioca deposit. Orko shareholders would also benefit from having exposure to the producer valuation as a part of the silver stream coming from First Majestic's other five operations. It is a win-win situation.

Q: The 69% premium on the Orko share price offered by First Majestic seems like a very good outcome for Orko share holders at first sight. On the other hand, the offered price brings the share price back to the level it was trading at just prior to the termination of the Pan American Silver JV. This would suggest that all the development work performed since the JV termination have not been priced in. How do you explain the takeover price to your share holders?

BW: At the time of any negotiation, the team has to look at the market conditions, financing opportunities and prevailing forecasts as to what would be best for Orko shareholders. When Orko started comparing competing bids in December 2012, the share price was about $1.58 and a 69% premium on the 30-day average was a good bump upward. This is on the high-side of premiums for other takeovers in the precious metals sector.

Did the market price fully reflect the value of the work? Probably not. Some say the market is never wrong, but in reality the market is rarely right. Markets over react to perceived negative news and it takes time and effort to counteract the perception.

And here are Todd Anthony's replies:

Q: What value do you see for your share holders in the La Preciosa deposit that Pan American Silver might not have seen when they terminated the JV with Orko Silver in April 2012?

TA: While First Majestic won't speculate as to why Pan American walked away from Orko, their JV agreement to pay for 100% of the capital investment of La Preciosa and only receiving a 55% of the benefit might not have been accretive for their shareholders. Also, the timing of their decision was around their acquisition of Minefinders and the permitting issues w/ Navidad; so one could only imagine they were probably stretched very thin.

Q: La Preciosa is a few years away from production, and therefore the takeover does not add immediate value in the same way as last year's acquisition of Silvermexx with the producing La Guitarra mine. What kind of production figures are you anticipating from La Preciosa and by when do you hope to have the deposit in production?

TA: First Majestic will be publishing a Preliminary Economic Assessment (PEA) in the second half of 2013 which will describe in detail the size of the operation and capital cost projections. At the current time, First Majestic's management has stated the operation will be between 5k-8k tpd; for reference, Pan American had published a PEA in 2011 on a 5k tpd operation [...].

Q: Judging from the share price performance since the announcement of the takeover the market has not reacted too kindly. What do you think will it take to convince the market of the value of the proposed deal?

TA: The overall mining sector and the price of silver have witnessed a substantial drop in price over the past few weeks (equities have been dropping for a few months). The 9% drop on December 17th (the day of the Orko acquisition announcement) was expected as the deal is approximately 14% dilutive to current shareholders. Also, there is an arbitrage trade that is currently taking place as a result of the stock-for-stock transaction. The current pullback is very similar to the April-May 2012 timeframe when First Majestic announced the acquisition of Silvermex, which in turn proved to be a wonderful buying opportunity.

Q: The way the proposed takeover is set up will lead to significant dilution for existing First Majestic Silver share holders. Surely, other forms of payment must have been considered in the process. Can you comment on why you think the structure of the present deal is the most advantageous for shareholders of your company?

TA: The Orko transaction will mark the fourth public company First Majestic has acquired since 2006; all of which have been equity transactions. Furthermore, management has had a successful track record at leveraging our paper for strategic acquisitions over the years.

Our conclusion: First Majestic Silver has managed to score a remarkable resource for a fair and reasonable price. We expect the new asset to develop into yet another stepping stone for First Majestic Silver and view the present share price weakness as a buying opportunity.

For those wishing to follow the Orko team on their next venture keep an eye out for Orex Minerals (TSX.v:REX).

Disclosure: I am long AG. 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.