Copper: Updating Last Year’s Dark Horse Pick
Copper has been making small upward moves lately, like a squirrel occasionally sticking its nose out of the den to check for predators. In the past three months copper has had a choppy 11% increase, from roughly $1.95 on January 15 to today’s quote of about $2.20.
Last July, we offered our low-risk high-return pick for the year going forward, with our rationale for it. That rationale centered upon third party copper production and the fallacies of the Efficient Market Hypothesis. It’s time to revisit that pick.
As was pointed out last July, the Efficient Market Hypothesis assumes that every investor has access to the same information at the same time. Since all facts are known, the market should quickly and perfectly reflect the perceived value of the companies in that market.
There are obvious problems with this theory. To me the largest is that it assumes everyone is equally educated to understand the data, and reads and digests it the same way at the same time, and that just isn’t so.
This has real-world implications in many areas (such as damages calculations in secondary market class action litigation), but for today’s purposes consider how the fallacy of EMH distorts junior companies. 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 publicly available information. An investor who takes the time to read and think, has a distinct advantage over the “momentum” investor.
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Against that background we presented our low-risk high-return pick, which was Hornby Bay Mineral Exploration Ltd. (TSXV: HBE).
HBE has three Canadian mining assets (gold, uranium, copper). It’s suffered along with the rest of the junior mining market. For this article let’s assign no value to the uranium project in Nunavut. The gold project near Timmins has some value, especially with all the M&A activity happening all along the Porcupine-Destor Fault. We expect the northern Ontario corporate and property consolidation to continue, so the Timmins gold asset is a bit of a risk mitigator for HBE.
But it is the copper asset that compelled us to pick HBE. In last July’s article we set out the facts behind the copper:
First: Hornby Bay had been battling Copper Mountain Mining Corp. for years over the Net Smelter Royalty that HBE claimed to have on the Copper Mountain Mine. HBE claimed a NSR over roughly 22% of the claims on which the Copper Mountain Mine sits, at a 5% rate. Copper Mountain for years denied this, which suppressed HBE’s market value.
Second: in June, 2015, for the first time in its history, Copper Mountain finally 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 provided a new mine plan, part of which called for higher-grade Virginia Pit to be mined (top of page 8, again starting on page 50).
Fourth: Hornby Bay owns the NSR on the Virginia Pit.
Since then, Copper Mountain has announced that it has begun taking ore from the Virginia Pit. See the April 13, 2016 press release where CUM states, “Mining activities continued from both the Pit 2 and Virginia Pit areas.”
This means HBE will soon begin receiving a steady stream of quarterly cheques from Copper Mountain on the NSR. HBE will be in revenue! That’s quite an achievement for a junior mining company. It means HBE will be able to strengthen its wobbly balance sheet, pay its bills, and survive, without any highly dilutional equity financing. HBE should survive the coming cull.
The tricky part is in projecting what that revenue will be. CUM has a history of missing guidance – we look at its projections with a skeptical eye and would rather rely upon historical data.
Our math is this: HBE’s royalty applies over 22% of the mine and CUM has started mining the Virginia Pit. The higher-grade Virginia Pit ore will be commingled with lower grade ore from the stockpile and other parts of the mine. Let’s assume that 5% of the ore to be processed at Copper Mountain will originate from Hornby Bay’s claims.
Copper Mountain’s gross revenue number for the year ended Dec 31/15 was $242M. 79.8 million pounds of copper were sold, at a realized price on copper sales for 2015 of $2.49 per pound. That will be roughly 20% lower throughout 2016, likely somewhere between $2 and $2.20.
Assuming the same production level, and 5% of the ore to come from HBE’s claims, the end result is (79.8 million pounds of copper, as was produced in 2015) x ($2 a pound) x (5% of the ore to come from HBE claims) x (a 5% NSR on those claims) = $399,000 per year. Over the 10 year mine life that totals roughly $4M, given the assumptions above. We’re not calculating any value for gold or silver.
If 10% of the ore comes from HBE claims, that annual cheque doubles to $800,000, and over the mine life would be $8,000,000.
To a junior company with roughly 58M shares outstanding, that’s a fortune.
That’s almost free money in HBE’s hands. There are minimal costs involved in obtaining that revenue, and some tax shelter is available to HBE (see note 16 to its audited financials).
The greatest variables in those assumptions are the price of copper (beyond everyone’s control) and the percentage of milled ore coming from HBE’s claims (subject to CUM’s control).
Hornby Bay engaged an advisory firm in June of 2015 to test the waters for the sale of the NSR. Copper’s slide and CUM’s debt load scuppered that effort. As copper comes back into favor, and as CUM’s delicate financial situation becomes less unstable, more value can be attributed to the NSR by a potential buyer.
Finally, if copper sees any material price increase, HBE has massive upwards leverage without having to expend any capital. That’s a huge potential return for minimal risk.
So we still see Hornby Bay being a DarkHorse Winner, based on facts are in the public domain. Whether HBE gains value by cashing quarterly cheques or by the sale of the NSR, HBE’s shareholders can look forward to a better 2016. Anything that happens with the Timmins gold asset is a bonus.
There are major risks to this call. Copper prices retrench. CUM’s debtload becomes overwhelming and a corporate re-org becomes necessary, reducing production from the mine. CUM’s and HBE’s management teams have some animosity between them, which could impede a normal business relationship. 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) fails to produce the expected grade of ore.
By July, 2016, HBE should have received its first cheque and an accounting of how the NSR was calculated. That will give us and the market better clarity on HBE’s value.
Mr. Clausi is an experienced investment banker, executive and director. A graduate of Osgoode Hall Law School called to Ontario's bar in 1990, Mr. Clausi ... <Read more about Peter Clausi>