Dear Reader,

The Valuation of Mining Companies - Newsletter #4 of 6

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.

*    *    *    *    *

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, #2 and #3 of the Series were e-mailed on June 3, June 16 and July 2.  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, all eventually filed under the aforementioned 'SRP Newsletter Archive' Button.

Newsletter Index and Release Dates

Mining Company Risk Assessment - Part #3 - Topics Discussed in this Newsletter
 
Mining Company Risk Assessment - Overview
Development Stage of Project
Feasibility Studies
Mineralization & Mining Technique(s)
Mining & Process Infrastructure
Mining & Processing Costs
Mine Life
Environmental Issues
Other Matters of Interest
 
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 6 Part 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.
 
Development Stage of Project
 
It is important to know what exploration or mine development stage the Company's project currently is at.  Project 'stages' can be summarized as:
 
1. The 'seed money' stage, where one or more exploration properties have either been identified as acquisition targets, or have been either recently acquired or targeted.  Investment at this stage obviously is highly risky, as any investment made at this point is to a very large degree a 'bet on the Board and Management' both being able to find and negotiate acquisition on commercially sensible terms if they have not already accomplished that.
 
It is important for anyone investing in a private placement at this stage in the company's evolution to be satisfied with the terms of the private placement offering (including the number of warrants offered in conjunction with shares, the escrow period, the promote (if any), including options (if any) granted to the Board and Management concurrent with the financing.  It also is important to reflect on whether the size of the private placement will be sufficient to ensure completion of the initial project exploration and resource and reserve determination without the likelihood of the company having to dilute shareholders pursuant to subsequent financings.  Investors who purchase the company's shares in the open market should assess these same things in a risk context.  While highly subjective, in order to invest in a mining exploration company at this stage an investor ought not to invest unless he/she believes the near-term return on investment potential has a real potential of being very significantly higher than returns expected:

• by corporate acquirers when they acquire conventional businesses with established products, customer bases, and after-tax free cash flow - this is discussed in the last Post in this Post Series; and,

• from investments in normal sized trading lots of 'Mid and Large Cap' public companies.

2. Partway through its exploration program without proven success.
 
This is arguably the riskiest investment stage where an exploration program has been partially completed and has yet to find what it expects to be find.  Any investment made at this point continues largely to be a 'bet on the Board and Management', in circumstances where the Board and Management to date has not realized success.  Again, investors ought not to invest unless they believe the near-term return on investment potential has a real potential of being significant higher than returns expected by corporate acquirers when they acquire conventional businesses, and from investments in normal sized trading lots of 'Mid and Large Cap' public companies.
 
3. Partway through its exploration program with some demonstrated success.
 
4. At the stage of having NI 43-101 measured, indicated and inferred resources.
 
5. At the stage of having NI 43-101 proven and probable reserves.
 
6. At the pre-feasibility study stage.
 
7. At the feasibility study stage.
 
8. At the permitting stage.
 
9. At the mine and processing facilities funding stage.
 
10. Successfully completed the mine and processing facilities funding stage.
 
11. Partially completed the mine and processing facilities construction.
 
It is particularly important at this stage to monitor both cost overruns against forecasted costs and the actual time of construction measured against the planned construction timelines.
 
12. Completed mine and processing facilities construction and in production.
 
Arguably risk diminishes as the project proceeds through each stage in its evolution from demonstrated exploration success to production.  Once in production risk can be assessed on a day-to-day basis based on conventional rate of return expectations.
 
Importantly, during the mine and mill construction phase the risks of cost overruns, equipment shortages, timing delays, unanticipated problems with infrastructure tie-in, and so on are always present, and need to be carefully monitored.
 
Feasibility Studies
 
1. Pre-feasibility and Feasibility Studies are comprehensive study of the viability of a mineral project that has advanced to a stage where the mining method in the case of underground mining, or the pit configuration in the case of an open pit, has been established and an effective method of mineral processing has been determined.  These studies include financial analysis based on reasonable assumptions of technical, engineering, legal, operating, economic, social, and environmental factors that enable:

• a Qualified Person (as defined in Canadian NI 43-101 to determine if all or part of the Mineral Resource may be classified as a Mineral Reserve;

• the Board and Management to determine if in their respective views a project is commercially viable; and,

• ultimately for lenders, investors, and perhaps in the end corporate acquirers to determine if in their respective views a project is commercially viable.

Things that must be considered when determining whether a project is commercially viability include:
 
1. The existing resource and reserve base at any given point in time in the contexts of geographic location, average grade, existing proven and probable NI 43-101 resources and reserves, and the perceived potential to expand the mineable deposit and timing of such expansion.
 
2. The project's physical location and comparative geo-political risk.
 
3.  The geology of the deposit in the contexts of extraction method (open pit versus underground), quantity, grade and metallurgy.
 
4. Whether company determined mineral cut-off grades are commercially viable over commodity pricing cycles expected over the life of the project.
 
5. What infrastructure (roads, rail lines, water access, utilities access, ore processing facilities), trained labour, weather conditions (enabling year-round exploration and drilling), and access to assaying laboratories is available to the property.
 
6. The economics of the project in the context of forecasted metal prices, mining, milling and processing costs, recovery of secondary metals, and project financing.
 
7. Specifically with respect to financing, it is important to understand the company's (read Board of Director's and Management's) philosophy and strategy of financing through debt, equity or a combination of the two. The company's resultant debt:equity ratio is an important measure of project and company risk - and speaks directly to investor-specific risk tolerance.
 
Where a company has completed a pre-feasibility study or a feasibility study it is important to review it or them in detail to gain an understanding of the assumptions that have been made with respect to both revenues and costs, and the resultant internal rate(s) of return imputed in those studies.
 
Mineralization & Mining Technique(s)
 
1. It is important to understand the targeted mineralization and expected mining technique, including consideration of historic mine workings and proximity to existing commercial deposits.
 
Generally, but in particular with respect to an early stage exploration company, the anticipated grades and potential quantities of targeted mineralization need to be carefully considered both in and of themselves and in the context of the physical characteristics of the prospective ore body.  Essentially there are two distinctly different mining techniques, being 'open pit' mining, and 'underground mining'.  The former typically enjoys lower operating costs per unit of production, and faces less risk on many fronts than the latter.  Accordingly, one typically would expect low grade ore bodies to be commercial only if they were found in reasonably consistent quality and large quantity near the surface such that they can be 'quarried' pursuant to an 'open pit' mining process.
 
Mine & Processing Infrastructure
 
1. It is important to understand the project's mine and processing infrastructure in at least the following contexts:

• If the mine and processing infrastructure is of a 'greenfield' nature, what is the likelihood of it being permitted on a timely basis, and of it being built on time and within budget?

• If the mine and processing infrastructure is completed and mineralization is being mined and processed, how well maintained is that infrastructure in the contexts of annual repairs and maintenance expenses being incurred?

• If the mine and processing infrastructure is completed and mineralization is being mined and processed, how well maintained is that infrastructure in the context of annual sustaining capital expenditures being incurred?

Mining & Processing Costs
 
1. With respect to 'producer' operations, it is important to understand and assess the company's historic and (more importantly) prospective processing and refining costs per unit of output, cash operating costs per ounce produced and metal credits, and its annual EBITDA (earnings before interest, taxes and depreciation), EBIT (earnings before interest and taxes), after-tax income, annual sustaining capital reinvestment, prospective free cash flows, and what might be ultimate mine closure and environmental remediation costs?
 
2. With respect to the company's labour force, what Labour Laws exist in the country where the company conducts its operations with respect to severance and safety, is trained labour readily available, are there labour productivity enhancement opportunities, and is the labour force unionized and what are the contract terms?
 
Mine Life
 
For a producer at least the following questions need to be addressed with respect to resources, reserves, capital assets, production capacity and efficiency:
 
1. What is the company's estimated mine life at any given point in time having regard to where in the commodity cycle metal prices then are?
 
2. What is company's 'capitalization v. expense policy' with respect to capital equipment and spare parts?
 
3. What is their technological state and state of repair and what is the dollar amount of forecasted capital expenditures over next three fiscal years?
 
4. Are required new equipment and spare parts readily available?
 
5. Importantly, what % of Capex is of a 'sustaining' versus a 'growth' nature, where 'sustaining capital reinvestment means 'the capital outlay required each year to maintain operations at existing levels'?
 
6. What is mine output capacity, mine efficiency, processing plant capacity, processing plant efficiency, and so on?
 
7. Does the mine experience, or is it at risk of experiencing, water flood issues?
 
8. Are power, water, and other utilities readily available to the company's exploration and mining sites?
 
9. Does the company have long-term supply contracts for power, water, and other utilities and if so on what terms?
 
10. Does the company prospectively face possible significant escalated utilities and water costs?
 
Environmental Issues
 
For both explorers and producers at least the following questions need to be addressed with respect to environmental issues:
 
1. Is there both a Board approved environmental policy and system of internal ongoing environmental surveys, prevention policies, and environmental liability audit procedures in place?
 
2. Are there known environmental liabilities, or have there been third-party environmental complaints, inspections, or examinations?  If so, how have these liabilities been quantified and accounted for?
 
3. Has the company commissioned Phase I or Phase II environmental studies with respect to its properties?
 
4. Is there adequate environmental liability insurance to cover any existing or possible liabilities?
 
5. What were the prior uses of the company's properties, and have appropriate steps been taken to ensure the company has not assumed environmental liabilities created by prior owners or lessees - including ensuring that prior owners and lessees are contractually committed with respect to environmental liabilities that existed when the company took the properties over?
 
6. Does the company have environmental liabilities related to properties it previously owned?
 
Other Matters of interest
 
For both explorers and producers at least the following additional questions need to be addressed:
 
1. What liability insurance, operations insurance, and property insurance does the Company have in place?
 
2. Are, or in the past have, the company or any of its Directors and Officers been subject to penalties or sanctions related to bankruptcy, income tax, breach of securities law, or been found guilty of criminal or fraudulent activities?
 
3. Is the company or its operations subject to unusual Government Approvals or Regulations?
 
4. Does the company have any outstanding disputes with tax authorities, including unresolved income tax assessments or reassessments?
 
5. Does the company have any known unresolved regulatory compliance issues?
 
6. Is the company a litigant or potential litigant in threatened or ongoing litigation?
 
7. Does the company have any contractual obligations outside it normal course of business, or any material contingent liabilities?

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.

Copyright 2009, Stock Research DD Inc.  All rights reserved.  This Newsletter is protected by copyright and other intellectual property laws and may not be reproduced, rewritten, distributed, re-disseminated, transmitted, displayed, published or broadcast, directly or indirectly in any medium without the prior written permission of Stock Research DD Inc.