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Waking Up with Moly Part 2

The Bag-of-Hot-Air-Shaped Recession
I’ve got to air out a pet peeve of mine before I finish swatting Mosquito. I watch CNBC’s Sqwuak Box online every morning before I go to work. It’s a great show. The hosts maintain a casual atmosphere that’s fun and the conversation and debate is often spirited and insightful. Guests include Fortune 500 CEOs, top money managers from PIMCO and Blackrock, and top economists. Never hurts to listen and learn from the best in the business … even if they are, as my friend Lane cynically puts it, “just selling me their shit.” Of course they are selling me their shit! That’s capitalism! Nothing more than people walking around, selling their shit. And if your sell or your shit, isn’t good enough, I ain’t buyin.
So on Sqwuak they focus a lot on economic data and they have a constant stream of economists, traders, and investors providing their opinions on inflation, job creation, interest rates, and … the hottest debate during the Great Recession … the shape of the recovery. And guests will bloviate endlessly about all of these things: will the jobs report show +20,000? Or +50,000? Will interest rates be increased this summer or this fall? Will the recovery be L-shaped, U-shaped, V-shaped, or the lesser known square-root shaped??? Or will it be the shape of a Chinese character? Or the shape of an astrological sign? What does it all mean for stocks over the next 12 months?
To me, these discussions, when drawn out beyond a minute or two, contribute little more to humanity than the carbon dioxide emitted from excess breathing and the corresponding acceleration of global warming. They are the equivalent of economic penis-measuring contests. Everyone trying to out-do the other with some new insightful twist that has at best a spurious impact on the valuation of any company I may invest in.
All this time wasted dissecting economic data and predicting short-term outcomes … like the shape of the recovery and the exact month in which we will experience job growth … could actually be used discussing business and investing. What a stretch for so-called business and investment professionals! We could be talking about good businesses, how they’ve obtained competitive advantages, how they’ve maintained them, what are the industry factors that allow it, the company factors, how their business model provides for sustainable growth or exceptional growth, how managers allocate free cash flow, how large their distribution networks are, how their value proposition fits within the long-term macroeconomy, whether these business are undervalued … all much more relevant information to investing than the shape of the market-wide recovery in the short-term. The market goes up, it goes down, and, then, 99.9% of the time, it goes up again! (And if it doesn’t go up again, you’ve got bigger fish to fry, my friend). Good businesses will outperform in any environment. So I try to spend my time learning and thinking about business, because I think it will make me a better businessman and a better investor.
Molytov Cocktail
So back to this business of Mosquito Consolidated Gold Mines and their gigantic moly mine CUMO. As I mentioned last week, it’d be nice to think the company was undervalued some few thousand percent, but it’s not that simple. The CUMO project has a large NPV, its true, but it requires significant investment to realize that value, some $2.8 billion in initial capital for the 150kt/day mine. Those investors will probably want a share of profits for their troubles. Actually, they will probably want a great big chunk. That’s usually how investing works.
$16 Billion!?! Ya, not so much
One thing that really irritated me about CUMO’s 43-101 is the calculation of the project NPV. You may have noticed from the last post that the NPV uses a 5% discount rate and is calculated before-tax. To me, this is pretty ridiculous. I realize the 30-year US treasury is just a touch under 5% right now and that the US government isn’t as sturdy a credit as it used to be … but there is still no way Mosquito or anyone else potentially operating CUMO is a safer credit, except for Warren Buffett apparently. And unless Hugo Chavez infiltrates the Republican party, stages a coup, and nationalizes US molybdenum production, Mosquito is probably going to have to pay taxes over the life of the mine.
Informative Aside: If you are ever really bored and want to see a cool chart, check out stockcharts.com’s Dynamic Yield Curve. It’s the “yield curve meets psychedelics”. Notice how the curve was inverted on the short-end during late 2006 and early 2007? It’s different this time, right?
To be fair to Mosquito, there seems to be no set standard for NPV calculation in a Form 43-101. I looked at 5 or 6 different reports and each one took a different approach. Mosquito’s, however, was definitely the most aggressive … and no other mines were plastering their inflated project NPV over every marketing and corporate material like a bad political campaign.
So I’ve re-calculated the NPV and IRR for two of the proposed projects for CUMO as per below.
    100 kt/day 150 kt/day
    Low* Base Low Base
Initial Capital Cost
($ mil)
2,237 2,237 2,807 2,807
           
Pre-Tax NPV 5%
($ mil)
  10,000   16,000
After-Tax NPV 8%
($ mil)
(697) 3,548 (144)  6,406
After-Tax NPV 10%
($ mil)
 (974) 2,507 (624) 4,748
           
IRR, pre-tax 9% 29% 12% 36%
IRR, after-tax Nil 22% Nil 28%
*Low and Base refer to price scenarios of $7/lb and $16/lb moly respectively.
For 150kt/day, you’ll notice a 10% discount rate and a 36% tax rate sucks some $11 billion out of the value of the project. And, of course, now neither project is profitable in the low price scenario, losing what was a good cushion. You might say, “Ya, the NPV changes when you change the discount rate, but that’s what the IRR is for!” And it’s true, the IRR for both projects remains strong on an after-tax basis. Still, I like conservative managers and the fact that Mosquito is touting this $16 billion nonsense makes me wonder what else they might be exaggerating … like the resource itself perhaps??? And I’m not a geologist. I have no way of knowing if they are.
What Am I Made of Moly!?!
So what is a share of Mosquito worth today, before existing shareholders are diluted by a measly $2.8 billion worth of further investment? A simple way to value Mosquito is to consider if the company were purchased outright in all up-front cash. There are some 100 mil fully diluted shares and warrants outstanding. The acquiring company (which could be me, if I’m really bored that day) would have to spend $2.8 billion to bring the mine into operation … but none of that cash would be used to payout existing shareholders, who will probably want some payback for all the money they’ve poured into bogus mining projects all their lives. The acquiring company will have to pay additional cash to purchase the shares of existing shareholders. This additional cash would decrease the IRR of the project for the acquirer.
How much additional cash must be paid? This depends on a few factors: how much IRR the acquirer is willing to sacrifice, whether there are competitive offers, how greedy existing shareholders get, etc. Given the size of the project (150kt/day), the acquirer could pay $500 mil or $5/share for Mosquito and still achieve a 23% IRR. Current shareholders would make a ~500% return.
As my buddy Lane was quick to point out, this is an idealized scenario. There is still a lot of risk involved in the project at this stage, risk that might not be fully compensated in a 23% return. And financing will be obtained in stages, not in one lump sum at the project’s outset. In this way, the project resembles the round financing used often in venture capital.
Moly-Go-Round Financing
Start-up ventures are generally financed via sequenced rounds of investment (also called stages or tranches): the earlier the investment, the lower the probability of success of the venture, and the greater the required internal rate of return (NYSE:IRR) of the investor (also known as the ROI, RRR, RoR, or E(NYSE:R) etc. required rate of return is like the Jay-Z of finance concepts). An investor achieves a greater IRR by obtaining a larger ownership position, which for our purposes takes the form of a common equity stake. Thus, the greater the required IRR, the more shares the investor receives. The price of the shares is simply the investment divided by the shares received (Duh!).
IMPORTANT! The IRR of a tranche is also impacted by the amount of ownership given to later tranches. Share sales to later investors will dilute the stake of earlier investors. So at any point, the share price is affected not only by the current round of financing, but also the outcome of each subsequent round of financing. Well, I’m glad this is getting easier!
In a perfectly efficient market, we would all know the exact amount of financing and the required IRR of each tranche. And I would be Brad Pitt … or Michael Buble. Hell, I’d settle for Steven Segal. And in this wonderful world where I make bad action movies, the market price of Mosquito’s existing shares should equal the NPV of the project after ownership is doled out to the remaining investors.
So, to determine whether Mosquito’s shares are fairly valued, I set-up the following model:
1)     Adjust the required IRR for each round of financing
2)     Determine % ownership of each round in final project
3)     Determine portion of project NPV attributable to existing shareholders
4)     NPV divided by diluted shares o/s = Fair Value
Then I can run a scenario analysis to determine the impact of a change in ownership on Mosquito’s value.
I used the following inputs:
Project:                                     150kt/day
Initial Capital Cost:              $2.8 bil
Financing Rounds:                7
 As noted in the 43-101, Mosquito requires $72.5 mil to complete a feasibility study spread out over the next 3 years. Subsequently, it will require $2.8 bil invested evenly over 3 years to get the mine operational. Each year of investment is considered a round of financing. Also, the existing market cap of the company is considered a round of financing (so we can determine the fair value of the existing shares … you know, since those are the ones we might buy). The 7 tranches are as follows:
($ mil) 2009 2010 2011 2012 2013 2014 2015
Existing 100            
Stage 1   25          
Stage 2     20        
Stage 3       27      
Stage 4         936    
Stage 5           936  
Stage 6             936
Now, the only stage whose IRR does not depend on subsequent financing is … drum roll, please … the last stage! So the IRR is estimated beginning with Stage 6 and each preceding stage thereafter. The only stage where the IRR is not input is the Existing Stage.
So let’s consider some possibilities:
SCENARIO 1: ROB THEM BLIND
(mil) except per share IRR Initial Own-ership Final Own-ership % of Invest-ment NPV10 Total SharesO/S FairValue
Stage 6 12% 13% 13% 32%  $82 361  
Stage 5 14% 20% 17% 32%  $235 314  
Stage 4 17% 35% 24% 32%  $504 251  
Stage 3 54% 10% 5% 1%  $192 163  
Stage 2 59% 15% 6% 1%  $270 147  
Stage 1 58% 20% 7% 1%  $340 125  
Existing 51% 100% 28% 3%  $1,226 100 $12.26
               
Late Stages* 15%   55% 95%  $821    
*I found it useful to combine Stages 4, 5, and 6 (I’ll refer to them as the “Late Stages”) for analysis purposes.
In this scenario, Stages 4, 5, and 6 (again, the “Late Stages”) require a very low IRR. I’ve set-up the IRR such that the earlier rounds have a higher IRR commensurate with the higher uncertainty of realization of the project. In this scenario, existing shareholders retain a whopping 28% stake in CUMO (compared to their contribution of 3% to the total investment), achieving an NPV of $1.2 bil. Given there are currently ~100 mil shares o/s, this puts fair value of Mosquito’s stock at $12.26.
Note that the Late Stages acquire just 55% of the project cash flows while contributing 95% of the investment. This huge mine companies don’t get huge making shit deals like that.
One item you may have noticed is that the total NPV10 for the project is $2,883 mil. Well, that can’t be right!?! That’s even below the adjusted NPV10 I proposed above for the 150kt/day project! Well, it is right. The difference is, in this scenario, I have pushed the positive cash flows 6 years into the future where as in the previous analysis they were realized in the 1st year. This cuts the NPV nearly in half again. Like my professional sports career, $16 bil is now nothing but a fantasy.
SCENARIO 2: SOUNDS FAIR
(mil) except per share IRR Initial Own-ership Final Own-ership  % of Invest-ment NPV10 Total SharesO/S FairValue
Stage 6 20% 20% 20% 32%  $410 1012  
Stage 5 23% 35% 28% 32%  $733 809  
Stage 4 24% 70% 36% 32%  $1,069 526  
Stage 3 27% 10% 2% 1%  $53 158  
Stage 2 30% 12% 2% 1%  $63 142  
Stage 1 34% 20% 2% 1%  $108 125  
Existing 32% 100% 10% 3%  $391 100 $3.91
               
Late Stages* 23%   84% 95%  $2,211    
Here the Late Stages receive slightly less ownership than their total investment, the difference being a payment to current owners for taking the risk and finding the moly. Existing shareholders maintain a 10% ownership stake and fair value is $3.75.
SCENARIO 3: ALL FOR NOT
 (mil) except per share IRR Initial Own-ership Final Own-ership  % of Invest-ment NPV10 Total SharesO/S FairValue
Stage 6 20% 20% 20% 32%  $410 3288  
Stage 5 26% 40% 32% 32%  $920 2630  
Stage 4 28% 90% 43% 32%  $1,388 1578  
Stage 3 11% 10% 0% 1%  $2 158  
Stage 2 14% 12% 1% 1%  $8 142  
Stage 1 16% 20% 1% 1%  $18 125  
Existing 16% 100% 3% 3%  $70 100 0.70
               
Late Stages* 26%   95% 95%  $2,718    
If the Late Stages contribute 95% of the investment, why shouldn’t they obtain a 95% ownership? If the earlier stages expect the mid-IRR scenario, they will purchase the same ownership as in that scenario … and their returns will be crushed. 13% return sound like fair compensation for buying a company with no earnings and no means of developing its resource on its own?
If the earlier stages smell something in the wind, however, and adjust their required IRR accordingly:
(mil) except per share IRR Initial Own-ership Final Own-ership  % of Invest-ment NPV10 Total SharesO/S FairValue
Stage 3 36% 50% 2% 1%  $       92 284  
Stage 2 8% 12% 0% 1% -$         3 142  
Stage 1 10% 20% 0% 1% -$         0 125  
Existing 11% 100% 2% 3%  $         7 100 $0.07
Ouch. Clearly, the outcomes of the later rounds of financing have a serious impact on an investment in Mosquito … If this isn’t definitive evidence in your view, you must have been a juror in the OJ trial. And because the current market cap is so small, just a tiny variation in the ownership structure can have a major impact on value. The Late Stages gain just 9% ownership between Scenario 2 and Scenario 3 and the existing shares lose 80% of their value.
($ mil) except per share Scenario 2 Scenario 3
Late Stage IRR 23% 26%
NPV – Existing 391 70
Share Price 3.91 0.70
P.S. You can see why the complexity and inherent imprecision of round financing valuation causes most VC firms to avoid it all together. They just stick to a 33% to 50% ownership rule-of-thumb and be done with it.
How do you fit all that in one Pebble?
I mentioned the Pebble project last week. Pebble is a truly gigantic resource located in southwestern Alaska. It was discovered by Northern Dynasty Minerals ((NDM). NDM actually purchased it from the predecessor of Teck Cominco for what turned out to be the bargain of the century. Oops. But don’t worry, Teck Cominco rebounded by purchasing Fording Coal right at the top of the commodity bubble and using a whole lot of leverage to do it. Oops again!
Random Aside: By the way, what’s with these mine names? Are we really going to name these areas covering square kilometers containing thousands of tons of dirt and earth … Mosquito? and Pebble? Wouldn’t The Abominable Mine be more appropriate? How bout Titanic Mine? No chance of a disaster using that name. Why not Massive Mine? Gigantor Mine? Gigantasaurus Mine? We need a writer from WWE to start coming up with some mine names for us. Could it be the mining companies wish to understate the size of the mines on purpose? I’m sure Green Peace won’t be fooled by that one.
NDM released its first pre-feasibility assessment on May 21, 2003. The report found a potential resource of 6.0 bil lbs of copper and 20 mil oz of gold. About a week later, on May 29, NDM’s share price reached a 2-month low of $0.68. As people digested the report and gained an awareness of the potential of the mine, the stock EXPLODED vertically, reaching $6.95 by Nov 6. And NDM raised only $9 mil in new equity during the period.
Further drilling and exploration massively expanded the size of the resource. NDM now reports Pebble to contain 80 bil lbs of copper, 107 mil oz of gold, and 5.6 bil lbs of moly. The resource has increased 10 fold! Yet by July 30, 2007, NDM’s share price had only appreciated to $14.82, little more than doubling. Nobody would complain about a doubling in the price of their stock, but commodity prices were reaching record highs (gold doubled in that time) and the resource grew 10 fold. The market clearly underestimated the impacts of dilution on the stock price.
Then, on July 31, 2007, NDM announced a partnership with Anglo American, one of the world’s largest mining companies. Anglo agreed to provide a $1.5 billion initial investment along with 50% of all required investment thereafter, in exchange for 50% of operating cash flow of the Pebble project. NDM reached the holy grail: an economically viable resource with the financial backing of a major player. NDM even received an investment that was greater than the cash flow it was giving up (similar to Scenario 2 above).
How were existing shareholders rewarded when the good news broke? The share price plunged from $14.82 to $9.72 in a week. Again, the market wasn’t pricing in enough dilution.
I Say That To Say This
Mosquito has had an impressive run since word first spread in May 2009 of its CUMO project, jumping from $0.32 up to $1.37 on April 16, 2010. The market is pretty efficient, even in the small cap mining world (not perfectly efficient, because I’m not Steven Segal). And it’s moved quickly to squeeze every penny of value out of Mosquito’s existing shares.
And a lot of risks remain. Rome wasn’t built in a day and neither is a world-class mine. There will be environmental issues, First Nations issues, unexpected cost issues, global trade issues and on and on and on. Plus, there is still a good deal of uncertainty around the resource. It could be bigger, it could be smaller.
And the biggest difficulty of all is financing. If I buy the stock I’m making a pretty specific bet on a future outcome that his highly unpredictable. Who knows when Mosquito will secure financing? Who knows what market factors will prevail at the time? Who really knows exactly how much ownership will be given up? I sure the hell don’t. And if I and the rest of the market is wrong on any of those points, the investment could be cut in half in short order.
I like a little more certainty and a lot less complexity. This particular Moly is much too high maintenance for me.


Disclosure: Not long MSQ.V. You may choose to be.