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The Valuation of Mining Companies - Newsletter #3 of 4

Today's Newsletter is authored by Ian R. Campbell FCA FCBV.

Ian R. Campbell is a graduate of the University of Western Ontario School of Business Administration, a Fellow of the Canadian Institute of Chartered Accountants, and a Fellow and founding member of the Canadian Association of Canadian Business Valuators.  He is the author of the widely used business valuation texts The Principles and Practice of Business Valuation (1975), The Valuation and Pricing of Privately Held Business Interests (1990), and The Valuation of Business Interests (2001); he also is an Editor of Canada Valuation Service.  He worked actively in the founding of The Canadian Institute of Chartered Business Valuators, and was a director of the Institute from its inception to 1976.  In 1976 he founded Campbell Valuation Partners Limited, where he continues to play an active role.  He has given evidence in Business Valuation matters before most Canadian and Provincial Courts in many of the leading Canadian business valuation related cases. The Canadian Institute of Chartered Business Valuators annually awards the Ian R. Campbell Research Grant in the amount of $10,000 to one or more applicants who provide Business Valuation research topics for consideration.  This Grant was established in 2007 and first awarded in 2008.

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Background

I concluded in mid-2005 the U.S.$ was going to fall against other world currencies, and focused on the mining and oil & gas industries.  Much to my surprise, I found little written on 'How to Value Mining Company Shares'.  Having written Business Valuation tests used by many Canadian professionals, I decided to write an 'Electronic Book' dealing with what I think ought to be considered when valuing Mining Companies - which I initially converted into a 4 Part Newsletter Series.  Newsletters #1 and #2 of the Series were e-mailed on June 2 and June 16.  They can be found filed under 'SRP Newsletter Archive' Button on the Home Page of http://StockResearchPortal.com.  Due to length, I have elected to split what was going to be Newsletters #3 and #4 each into two Newsletters to be e-mailed in accord with the following schedule.  Hence the entire series will be comprised of 6 Newsletters, not 4, all eventually filed under the aforementioned 'SRP Newsletter Archive' Button.

Newsletter Index and Release Dates

Topics Discussed in this Newsletter

Mining Company Risk Assessment - Overview
Macro-Economic Conditions
Geography of Principal Operations
Balance Sheet & Access to Capital
Financing Requirements
Hedging Contracts
External Infrastructure
Internal Infrastructure

Mining Company Risk Assessment - Overview

The following assumes a 'single project' company.  If a company has more than one project the considerations discussed that are 'project specific' need to be considered separately with respect to each project.  From an investor perspective important timing issues, risk assessment, company information, and an appropriate 'risk related rate of return' ought to be include a large number of common factors. Newsletters #2 - #4 of this Newsletter Series discuss many of these factors - in some cases followed by discussion shown in smaller print.  On a cautionary note, 'Risk Factors' are fact and circumstance specific, and no list or broad discussion of 'Risk Factors' should or can be considered all-encompassing.

Macro-Economic Conditions

1. Macro-economic prospects, both near-term and long term, for the principal commodities the company is exploring for, or planning to mine, need to be continuously monitored.

The price of minerals historically has been, and is likely to continue to be, cyclical.  This cyclicality is critical to risk measurement when assessing mining projects.  Comparatively poorer mining projects (measured by Measured, Indicated, and Inferred resources and Proven and Probable reserves, capital cost requirements, mining and other operating costs, etc.) can be economic at times of high prices for the minerals produced or planned to be produced, while comparatively excellent mining projects can be uneconomic in periods of poor mineral prices and escalated capital and operating costs.  Thus it is important to have an understanding of the macro-economic climate at any given point in time and its possible effects on both prospective relevant mineral prices and capital and operating costs. Examples of issues that need to be considered when investing in shares of mining companies, be they explorers or producers include:

• Prospective forecasts for continued shifting of production to low labour rate countries and the near-term and long term prospects for those emerging market countries.

• Prospective comparative country specific GDP, inflation rates, and household savings rates.

• The prospective direction of the U.S. $ exchange rate measured against other currencies.

• The ability of the U.S. consumer to continue to spend at recent historic levels given U.S. housing prices and the U.S. consumer debt levels at any given point in time, thereby supporting emerging market manufacturing infrastructures.

• The willingness of the U.S.'s trading partners prospectively to hold U.S. $ generated through trade deficits.

• Prospective metal demand/supply issues.

• Prospective capital cost escalations where mine and ore processing infrastructure has yet to be built, or has been built and needs to be maintained.

• Prospective operating costs.  This is particularly relevant in an escalating energy and general operating cost environment.

Geography of Principal Operations

1. The geographic location of the Company's project(s) is of significant importance.

Many mining explorers have one or a small number of geographically scattered projects.  On one hand it can be argued that this mitigates risk through diversification.  On the other hand it can make a company's prospects more difficult to assess, and leads to questions related to whether company management is capable of maximizing opportunity as a result of time and effort dilution.

Of particular importance, current and prospective government stability, political risks, and political attitudes with respect to labour and safety laws, the environment, mining, mine permitting, mine infrastructure, and income tax law and rates all bear on project risk.  Hence all are things that require careful consideration by investors in their respective risk assessments.

Balance Sheet & Access to Capital

1. It is important to assess how much net cash on hand (i.e. cash and equivalents less interest bearing debt) a company has when compared with its exploration and mine development capital spending programs.  It is important to analyze this carefully in at least the following contexts:

• Where the company does have net cash on hand, in what money market or other instruments is it invested, and at what risk are those investments?

The U.S. sub-prime mortgage problems that came to market attention in August, 2007 highlighted this as an important consideration;

• Does the company have enough net cash on hand to fund those programs without raising additional capital?

• In prevailing lending and capital markets does the company have an ability to curtail exploration or capital spending, 'mothball' its projects, and wait out a 'down-cycle'?

• What is the likelihood of a requirement of near-term and longer term prospective dilutive primary share offerings on reasonable terms?

• In prevailing lending and capital market conditions will it be necessary for the company to raise new financing on what fairly might be considered as 'unreasonable' terms, or in extreme circumstances, will the company be able to raise new financing at all.

Assessment of lending and capital markets at any given point in time is very important.  For example, this began attracting increasing importance in the summer of 2008 as lending and capital markets tightened.  In September, 2008 (as this is being written) many Small Cap Mining Companies are having difficulty raising capital at anything other than on highly dilutive terms, or simply finding it impossible to raise new capital.  

2. As a general rule exploration companies fund their exploration activities though private placements and other primary share offerings (i.e. a sale of treasury - newly issued - shares that results in dilution to existing shareholders).  In private placements warrants typically are offered as incentives to cause investors to participate. In these circumstances the following things need to be carefully considered:

• where an accredited investor (as that term is used in Canadian Securities Law) is considering investing in a private placement the term of escrow (typically four months in the case of a Canadian company) and more importantly the terms and conditions of the warrant offering that typically forms part of a private placement 'unit'; and,

• whether there is any provision in the private placement documents with respect to director and management options that may be issued in the near term following the closing of the private placement.  Where this is the case, or in particular where such options are granted shortly after the closing of the private placement without disclosure in the private placement documents, this can be a clear sign of director and officer 'option featherbedding' and may speak directly to a circumstance where directors and officers place their own self-interest ahead of that of their company's shareholders.

Financing Requirements

1. What are the company's current and prospective financing requirements, including whether the company is in compliance with outstanding loan covenants?

2. If an exploration company, does the company have debt on its balance sheet, or off balance sheet obligations?

It is unusual for a Mining Explorer to finance exploration activities with debt or off-balance sheet financing.  Where debt or off-balance sheet financing exists the reasons should be clearly understood having regard to incremental risk that likely results vis a vis mining exploration companies who finance exploration solely with equity.

Hedging Contracts

1. Does the company have a history of hedging or a stated hedging policy?

2. Does the company have any hedge contracts outstanding?

If so, the impact of those contracts on prospective operating results need to be analyzed.

External Infrastructure

1. It is important to understand the proximity of a company's mineral deposits and possible deposits to available transportation infrastructure, utilities, water, trained labour, existing ore processing infrastructure, and to understand whether exploration is seasonal due to weather conditions.

Consideration of these things is fundamental, as without transportation infrastructure, utilities, water and available of trained labour the economics of any new deposit will be very different than if those things are readily accessible and in close physical proximity to such a deposit.  Further, if exploration is weather dependent and hence exploration is seasonal, value enhancement if exploration is successful typically will take longer than it otherwise would.

Internal Infrastructure

1. It is important to understand whether mine and ore processing infrastructure already exists (even if it is somewhat rudimentary), or whether if a commercial deposit is found or is planned to be expanded a Greenfield mine plan and ore processing infrastructure would have to be built.

This is important because deposit economics (and hence commercial viability) can be far different if:

• a mine infrastructure and ore processing plant exists on or in proximity to the company's property that can be acquired, or

• if there is an existing ore processing infrastructure with excess capacity that can be contracted with,

than if a Greenfield mine and ore processing infrastructure must be built.  This is particularly true in periods of economic growth and periods of high and escalating energy and capital costs.

For a comprehensive discussion of Share and Business Valuation see 'The Valuation of Business Interests', Ian R. Campbell and Howard E. Johnson, The Canadian Institute of Chartered Accountants, 2001, available through the websites of either Campbell Valuation Partners Limited www.cvpl.com, or The Canadian Institute of Chartered Accountants www.cica.ca.

The views expressed in this Newsletter are those of the author. The value of shares of a given company is time and fact specific.  The valuation theories, principles, methodologies, observations, comments and data inputs discussed in this Newsletter are of a general nature, and are provided for information and general guidance only.  They should not be taken to include all 'value or price relevant factors'.  Nothing in this Newsletter is intended to, nor should be taken to, constitute economic or investment advice.

The author(s) of this Newsletter or the owners of Stock Research DD Inc. (the owner of StockResearchPortal.com and StockResearchPortalBlog.com) or their families, entities in which they have ownership interests, and officers, directors, employees, agents, partners, affiliates and partners of Stock Research DD Inc. may beneficially own securities and participate in Private Placements of companies references in this Newsletter.  The fact that a company is referenced or discussed in this Newsletter should not be construed as an investment recommendation with respect to that company or its securities.

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