Clausi rolls out his low-risk high-return pick of the year
Here’s our low-risk high-return pick of the year, with our rationale for it.
I’ve never liked the Efficient Market Hypothesis. It assumes every investor has access to the same information at the same time. Since all facts are known, goes the theory, the market quickly and perfectly reflects the perceived value of the companies in that market.
To believe in the EMH you have to also believe that everyone reads and understands the same way at the same time, which is impossible. It’s figuring out what facts mean, which are relevant and why, that separates investors from index trackers.
It’s relatively easy to analyze the large banks, insurance companies and the rest of the largest companies. Brokerage firm analysts have proven models from which they work and teams of juniors to support the same basic research methodologies, resulting in near-consensus up and down The Street. No one starts from scratch and no one person has to carry the analysis load. EMH probably loosely applies to these larger companies, within a narrow band of interpretation.
EMH doesn’t apply to smaller companies since the areas for interpretation are so broad, the perception of “risk” is different from investor to investor, and not every investor actually understands let alone reads all the information.
So far our pen has had a pretty good year beating EMH. A review of stories covered shows more up than down with a few continuing to make progress on their business plans (yes, Contagious Gaming and Anaconda Gold, we’re looking at you and we’re looking forward to your next financial statements).
Facts are easy to find. Deciding what they mean is difficult.
Against that background, here’s our low-risk high-return pick for the next twelve months. Ladies and gentlemen, we pull the curtain back on: Hornby Bay Mineral Exploration Ltd.
What? No applause? Never heard of it? Most people haven’t. It’s a tiny company with three Canadian mining assets, and it has suffered along with the rest of the junior mining market. But there’s hope based on publicly available documents that its shareholders could have a value-filled year.
To start, let’s keep this simple and ignore two of HBE’s three assets, namely, the gold project near Timmins and the projects in Nunavut. Given the market, no value gets assigned to either one of them. If they manage to contribute any value, consider it corporate gravy.
But the third asset, oh the third asset, that’s where the value is easy to find. Here are the key facts.
First: Hornby Bay has been battling Copper Mountain Mining Corp. for years over the Net Smelter Royalty that HBE says it has on the Copper Mountain Mine. HBE claims a NSR over roughly 22% of the claims on which the Copper Mountain Mine sits, at a 5 % rate. Copper Mountain has for years denied this, which has suppressed the perceived value in HBE.
Second: in June, 2015, for the first time in its history, Copper Mountain came clean and admitted that HBE was right. See the NI 43-101 report here and read the bottom of page 7.
Third: that same NI 43-101 report from Copper Mountain provided a new mine plan. Part of that plan calls for the mining of ore from the Virginia Pit (top of page 8, and also starting on page 50).
Fourth: guess who owns the NSR on the Virginia Pit? Yep, Hornby Bay.
If Copper Mountain carries through on its mine plan and starts pulling ore from the Virginia Pit, the NSR must be paid to HBE. That’s annual cash in HBE’s hands, paid off the top when CUM sells the end product, for as long as the claims are mined.
HBE’s current annual revenue is $0. That annual cash stream will represent 100% of HBE’s revenue and value for the foreseeable future.
That’s what it is. The next step is to calculate how big it could be.
Start with CUM’s latest quarterly results, released July 9, 2015. In Q2/15 CUM reported revenue of USD$55.9M for the quarter (below analyst estimates, but again, CUM has a history of missing guidance). If the ore that generated that revenue had come from claims over which HBE’s royalty applied, then HBE would have been paid USD$2.79M, in one quarter. HBE’s cost of goods would be almost zero, meaning that payment is almost 100% gross margin to HBE, or, in other words, FREE MONEY.
For a fiscal year, that would be USD eleven million dollars (CDN$14M) of FREE MONEY.
HBE has enough tax losses to shelter this income for some time (see paragraph 16 of its audited financial statements for details on the tax losses).
Copper Mountain management made claims during PDAC in March this year that the mine life could be much greater than previously disclosed in writing. The CFO during a presentation said the mine life could be in excess of 25 years and up to 40 years. To be conservative, let’s use 15 years.
15 years times USD$11M per year = USD$165,000,000.
One hundred and sixty five million dollars. At today’s exchange rate, that’s over two hundred and ten million dollars CDN. To earn that, all HBE has to do is nothing. Nothing at all. Just wait for the cheques to be delivered.
That’s theory. In reality you can’t assume all the ore will come from HBE’s claims, you can’t assume a consistent throughput from month to month, you can’t assume the Virginia Pit will be mined in its entirety, you can’t assume a consistent grade out of the Pit, and you can’t assume uninterrupted production over the life of mine.
What we do know is that HBE’s royalty applies over 22% of the mine and CUM has announced that it will start mining the Virginia Pit. The Virginia Pit ore will likely be commingled with lower grade ore from the stockpile and other parts of the mine. Let’s assume that 10% of the ore to be processed at Copper Mountain will originate from Hornby Bay’s claims.
So re-visiting our numbers above, Hornby Bay would be collecting over USD$1M a year, every year, for 15 years. If the CFO’s presentation at PDAC was accurate, that’s a minimum of USD$1M a year for 25 years.
The numbers actually should be better than that. Since the ore coming from the Virginia Pit is of a higher grade, it will generate higher revenue which means the dollar amount payable under the NSR will increase as well. And that dollar amount goes even higher if Copper Mountain begins to extract ore from some of the other claims upon which HBE also has an NSR.
So that’s the gross revenue side. How does that impact HBE?
HBE has roughly 58M shares outstanding. Our incredibly high-end best case scenario shows added multi-year value of roughly $3 a share. As great as that would be, it won’t happen, because nothing ever works out in the best case scenario. But the minimum of USD$1M a year adds roughly two cents per share of cash, against minimal expenses and overhead, and over a decade adds twenty cents per share.
The stock is currently trading in a 7 – 9 cent range. It moved up sharply when Copper Mountain finally told the truth and admitted the NSR’s existed. It has a lot of room to move when the cash starts to flow in. Imagine the market reaction on HBE’s press release, “Today HBE received its first cheque on its Copper Mountain NSR in the amount of USD$250,000…”.
Which finally brings us to why the Efficient Market Hypothesis doesn’t apply here. All of the facts above known to the market. It’s what they mean that matters.
I don’t think HBE will ever actually see a quarterly cheque from Copper Mountain. That’s because it makes far more sense for a junior miner like Hornby Bay to immediately sell that NSR to a streaming company. It’s a safe bet that HBE is already in negotiations with a few of them.
As to the sale price, my analysis shows a discounted present value of between USD$7 and USD$15M. Changes in the assumptions (price of copper, improvements in management at Copper Mountain, slightly better grades of ore, better recoveries, changes to the discount rate) can drive that $15M amount to about $25M. Let’s work with the high end of reasonably achievable, though, which is the USD$15M sale price.
That USD$15M (CDN$18.3M) spread across HBE’s 58M shares adds about CDN 31 cents per share of net value to each HBE share. Add that 31 cents to the current price of 8 cents gives a potential four hundred per cent return, with little risk to the downside.
Our prediction then, is that Hornby Bay will sell the NSR within the next 12 months for a multimillion dollar sale price, and that’s our rationale for it being our DarkHorse Winner of the Next 12 Months, based on facts that are in the public domain.
There are four major risks to this prediction. The CEO of HBE is a bit difficult (cantankerous? curmudgeonly?) and may not be able to close the sale. Copper prices fall to uneconomic levels. No ore is extracted from any of HBE’s claims due to a mine closure or a change in the mine plan. The Viriginia Pit (and the other HBE claims) fail to produce the expected grade of ore.
Do you believe in the Efficient Market Hypothesis or your own analysis? I’ve diarized to re-visit this in 6 months to see how we’ve done.
Mr. Clausi is an experienced investment banker, executive, director and shareholder activist. A graduate of Osgoode Hall Law School called to Ontario's bar in 1990, ... <Read more about Peter Clausi>