Arizona Mining: A Deep Discount to NPV
Arizona Mining (AZ.TO) has been one of the highest quality growth stories in the junior mining sector and is up over 500% since our initial investment last year. The company has made significant progress on its flagship Hermosa-Taylor project, quickly developing it into one of the largest zinc equivalent deposits in the world. Despite this, in recent months AZ's stock has been the subject of heavy selling pressure, falling from its peak of $3.49 in December to settle in the $2.20-$2.30 range. Last week, on April 4th, 2017, the company released its long-awaited PEA. Many investors believed the PEA would be closely followed by a sharp movement in the price of AZ stock, but there has been little to no reaction from the market in the days following its release, despite the positive results. In my opinion, the market's lack of response to the PEA has created a significant value opportunity for investors. In addition, I believe there is an overemphasis on project risks and a resulting undervaluation.
Preliminary Economic Assessment (PEA)
A Preliminary Economic Assessment or "PEA" is an economic analysis of a potential mineral project to determine the viability of its mineral resources. The PEA is usually one of the first steps a mining will go through in transitioning from an explorer to a mid-tier junior miner. In terms of confidence level and predictability of resources, the PEA is subordinate to a "Feasibility Study" but it is still a primary catalyst for movement in a mining company’s share price.
The Hermosa-Taylor PEA contained the following highlights ($USD):
- Substantial NPV8% of $1.26 billion
- Robust after-tax IRR of 42%
- Initial capex of $457 million
- Short 1.7 year payback
- Total operating costs of $48/ton
- 19 year mine life based on conservative 60.8 million tons of ore production
If this your first time reading PEA results, I can assure you that these are excellent numbers. A substantial NPV value, robust IRR, short payback period, and relatively low capital costs are all considered to be attractive project features in the eyes of mining developers and financiers.
Net Present Value (NPV)
Net Present Value or "NPV" is the most commonly used metric to evaluate potential mining projects. It measures the expected change in company value as a result of undertaking the project at hand. In layman's terms, if you took all the minerals in deposit, all the costs and incomes, and processed the entire thing right now, the resulting value would be the NPV. In the case of Hermosa-Taylor, this value is USD$1.26 billion or CAD$1.69 billion of additional value for the firm and its shareholders; on a per share basis, this is roughly ~$6.75 CAD. At the time of this article, the stock price of Arizona Mining is $2.22 per share, representing a 66% discount to their NPV. It is not uncommon to find junior mining companies trading at a significant discount to their NPV. This discount reflects the various risks and potential pitfalls that can arise over the life of a project. The discount may also reflect the possibility of any future shareholder dilution, as most mining companies will need to raise additional funds in the form of equity in order to advance to the production stage. As a project gets closer to production, the various risks become less relevant and the discount to NPV is gradually reduced.
Internal Rate of Return (IRR)
The Internal Rate of Return or IRR is another metric used to measure the profitability of a potential project. The IRR is a bit more difficult to understand than the NPV. As in investor, what you need to know is that a higher IRR is desired. Also the minimally acceptable levels for IRR that mining developers like to see are also important. Projects with an IRR of less than 10% are not usually advanced to the production stage. The IRR for the Hermosa-Taylor deposit is well over this threshold, at 42%.
Capital Expenditures (CAPEX)
Capital Expenditures or 'CAPEX' consists of all the costs that will need to be incurred in order to develop the deposit and extract its resources. This number is especially important for developers and financiers of a project, as they will not usually proceed if the NPV is less than or equal to CAPEX, as these projects are considered to be much riskier. The CAPEX for the Hermosa-Taylor deposit is $457 million. As with NPV, the CAPEX of a project is also an important measure but is less useful when viewed in isolation. Comparing the ratio of NPV to CAPEX provides a more useful tool for evaluation.
This ratio compares the additional value created over the project’s life to costs that will need to be incurred. This ratio is extremely important to developers and financiers of a mining project as they will not usually invest in projects with an NPV/CAPEX of less than 1. The Hermosa-Taylor deposit features an NPV/CAPEX ratio of around 2.75. In other words, the additional value that the Hermosa-Taylor will create is nearly triple to that of its costs, a very attractive feature in the eyes of mining developers.
At the moment, there are a few key issues that investors have in mind: manganese content, possible equity dilution, and the biggest issue, permitting.
Regarding the manganese content within the resource, management has already proven that there is an ongoing interest for its future concentrates from smelters and other offtake groups. A $13 per Metric Tonne penalty was also applied to the NPV calculation to account for the costs of separating the manganese from the ore.
As for equity dilution, Jim Gowans, President and CEO recently announced the company’s intent, “to fund the project with little to no equity.” He also added: “In light of the project's strong cash flow, we should be able to attract significant conventional debt ($250-$300 million), off-take financing ($75-$150 million) and a silver stream ($200-$350 million). We will minimize equity dilution wherever we can to benefit all shareholders.”
As for permitting, James Gowans, President and CEO, announced plans to, “initiate state permitting for operations on our patented land and break ground on the tailings facility by the end of 2017.” He also added that, “Our permitting efforts are underpinned by strong existing local and state support built on early and extensive engagement."
Ultimately, approval for permitting will be at the discretion of the US Government but i am confident that AZ's management team will be able to work things out with the EPA, as this is a major product and would help to boost economic growth in Arizona.
Immediately following the release of the PEA, Robert Wares, one of the directors at AZ, purchased 100’000 shares on the open market at an average price of $2.23. While insider buying can often serve as a catalyst for an upcoming switch in the market's direction, investors must be very careful about reading positive messages into every insider buy that they see. While one big insider buy or sell order might offer investors a hint of things to come, it hardly translates into a sure-fire pointer for outperforming the market. It is important to look deeper at the order size, timing, and specific insider who made the purchase.
In this case, the purchase was from an independent director and professional geologist, Mr. Robert Wares. Wares has over 35 years of experience in the mining and exploration industry and his guiding hand on exploration has led to the ultimate discovery of over 13 million ounces of gold. This is one of the industry’s most well-known veterans making a large, strategically timed open market purchase.
A Life Cycle Analysis
The chart below show the performance of AZ's stock price since last January.
A brief comparison of the Arizona Mining stock chart to the 'Life Cycle of a Mine' chart below should help you to gain a better understanding of the recent activity in the stock price.
The 'Life Cycle of a Mine' chart displays the typical life cycle that a mining company will go through starting from the discovery/speculation phase up until the production phase.
Keep in mind that the 'life cycle of a mine' chart is overly simplistic and should not be used to time entries and exits into short-term positions, nor does it consider the possibility that the project will never reach the production stage. Rather, it should provide you with a broader view of how the average mining stock performs over the long term.
If we were to plot Arizona Mining’s current status on this chart, it would fall somewhere along the development/investment analysis phase line. The company has moved on from the discovery/speculation phase but has not yet reached production.
The discovery phase for AZ occurred all throughout 2016 and saw its share price rise from $0.30, to peak at $3.49 in December 2016, primarily due to a consistent waves of outstanding drill results and discoveries.
The first three months of 2017 marked the transition period from the discovery phase into the development phase. During this time, the stock price has fallen back below the $3 mark and has since been stuck in a narrow trading range around $2.20-2.40. Those in search of an explanation should refer to the mining life cycle chart, as a decline in stock price during this transition is a natural movement in the life cycle of a mining company and comes as a result of investor speculation and profit-taking with regards to a PEA or feasibility study. It is quite clear that investors are not worried about the size and grade of the deposit anymore, rather, they are more concerned with the roadblocks that the company will need to get past on the path to reaching the production stage.
The Bottom Line
Due to a lack of available short term catalysts, I don't foresee any dramatic short-term movements in the price of AZ stock. However, what I do see is a long term convergence between the current share price [$2.22] and the project’s NPV [$6.75]. Under the assumption of no further equity dilution, the shares of Arizona Mining are trading for a ~66% discount to their true value. I believe that an overstatement of the relevant risk factors has led to an overly aggressive discount to NPV. While there are a number of issues that still remain, the AZ management team has done an excellent job to address those issues.
A second scenario that I am envisioning is a potential takeover offer from a tier-1 producer such as BHP, Rio Tinto, or Hudbay. The Hermosa-Taylor deposit exhibits very attractive metrics and will be a sought-after project for producers looking to fatten up their balance sheets. Historically, takeover bids for junior and mid-cap mining stocks typically have carried a 38%-54% premium to market, so in the case of Arizona Mining, I would expect the offer price to be between the $5-7 per share range.
The fact is that there is a large discrepancy between the intrinsic value of the Hermosa-Taylor project and the share price of Arizona Mining. Over time, as the mine edges closer to production, the various risks factors will be greatly reduced, and so will the discount to NPV. The markets lack of response to the positive PEA results is presenting value investors with a significant opportunity.
DISCLOSURE & DISCLAIMER
The author is long AZ.
The author is NOT a registered investment advisor and this article expresses their own opinions. All readers are encouraged to perform their own due diligence and consult a licensed investment advisor before making any investment decisions. The author is not receiving compensation for the article and has no business relationship with any company whose stock is mentioned. This article is provided for information purposes.
Investments appearing in this article are high-risk in nature. Because of significant volatility, large dealer spreads and very limited market liquidity, typically you will not be able to sell a low priced security immediately back to the dealer at the same price it sold the stock to you. In some cases, the stock may fall quickly in value. You should carefully consider whether trading in low priced and international securities is suitable for you in light of your circumstances and financial resources. Past performance is no guarantee of future returns.