Spec Value Hunter Comment - September 15, 2014: Understanding the importance of First Point's 1% NSR in Decar
The new management of Cliffs Natural Resources Inc has made it official that its direct interest in the Decar nickel project is for sale, which presumably also means that its 13.6% equity stake in First Point Minerals Corp is also for sale. This outcome was anticipated in SVH Comment July 30, 2014 which outlined several scenarios for First Point over the next 18 months. As it now stands, the outlook for First Point in the short term appears to be bleak because the destiny of Decar is stuck in limbo until Cliffs' new management comes up with a realistic monetization strategy and the overhang of 14,353,190 shares owned by Cliffs is resolved. The dismal performance of Cliffs stock in the wake of the proxy battle victory by the company's self-proclaimed saviors does not exactly bolster optimism, but it may also put pressure on the Casablanca number crunchers to demonstrate acumen beyond the textbook mindlessness that has characterized its discourse so far. Given that the new Cliffs management's solution to its falling share price is to borrow $200 million and liquidate assets for cash in order to support a share buyback, First Point management and its shareholders will have to dig in until a new activist group ousts the sack of hammers now in charge of Cliffs. In my view the best win-win solution would be for Cliffs to swap its 60% Decar stake for the 1% Decar NSR owned by First Point and for enough stock to boost its 13.6% First Point equity stake to 19.9%, and put its trust in First Point's management to turn Decar into a valuable asset that provides Cliffs with a profitable exit strategy. The sooner Cliffs does this, the better, for nickel prices are weakening despite talk that the Philippines will join Indonesia in banning the export of raw laterite ore and First Point will need to raise capital to conduct a PFS or find a suitable partner. On the assumption that Cliffs will find its way to this solution sooner than later, or that First Point's modest drill program now underway on the 100% owned Mich project confirms that this awaruite deposit in southern Yukon is a clone of Decar, I am confirming my Good Absolute Spec Value Buy Recommendation at $0.085. Spec Value Hunters need to be aware that the stock has a 14.3 million share overhang that could drive the stock into the pennies as shareholders give up waiting for the new Casablanca backed management to come to its senses; passive rather than aggressive accumulation during the rest of 2014 is the best way to soak up a position in a junior that will emerge as more than a survivor.
Cliffs has invested $22 million in Decar to earn a 60% interest by completing a PEA and has until August 31, 2015 to complete a PFS to earn 65% and keep alive its option to earn as much as 75%. However, since very little work was done by Cliffs on Decar during 2014 as management unsuccessfully fought off a proxy battle launched by a hedge fund called Casablanca, it is physically impossible for Cliffs to meet the PFS deadline. Decar is thus owned 60% by Cliffs and 40% by First Point though Cliffs remains responsible for holding costs until it has formally defaulted on its 65% earn-in. First Point does not have a right of first refusal on Cliffs' 60% stake, but it is the obvious purchaser and Cliffs has indeed offered to sell its Decar stake to First Point, though apparently at a price that reveals how out of touch Casablanca is with reality. The number crunchers behind Casablanca have likely based their asking price on the market value of First Point and the not implausible assumption that after deducting First Point's $2.5 million in working capital the 40% Decar stake is the only asset that supports First Point's market capitalization. On this account, if we assume 121 million fully diluted and a stock price of $0.085 First Point's market cap is $10.3 million, which leaves $7.8 million attributable to the 40% Decar stake, implying a $19,500,000 value for Decar on a 100% basis. By this logic, Cliffs would want $11.7 million for its 60% stake, accepting a near 50% haircut on its original investment.
It is unrealistic to expect First Point to raise such an amount under current market conditions, so one must assume Cliffs will try to peddle the 60% stake to another party. Cliffs, however, is unlikely to find a buyer because the market and any potential buyer will recognize that in fact the current market cap of First Point is assigning a zero value to Decar's 40% working interest.
What Casablanca appears to have forgotten is that First Point also owns a 1.0% uncapped NSR on Decar which is currently the main basis for First Point's market value if we for the moment ignore the potential of the 100% owned Mich project to turn into a clone of Decar. First Point has initiated a small 1,000 m fall drilling program designed to test if the coarse grained awaruite mineralization seen at surface persists at depth, which, if successful, would allow First Point to focus 2015 on advancing Mich as a Decar lookalike if the destiny of Decar remains stuck in limbo. First Point is drilling two 50 degree angled holes away from each from the same setup within the southeast target where surface sampling has revealed a 2,000 m by 540-570 m wide zone grading 0.1% plus nickel (Davis Tube). The goal of the program is to determine if the grade and coarse grained nature seen at surface persist at depth within a drilled footprint representing about 200 million tonnes. The overall surface footprint of Mich suggests a target in excess of 500 million tonnes. So far Mich surface sampling has demonstrated much better grade and texture consistency at surface than was seen at the Wale project to the south in British Columbia, which turned out to suffer from erratic grain size distribution and a preponderance of barren dykes. The results of this simple two hole program of 400-500 m each have high impact potential in that they may enable First Point to shift its focus to delineating Mich during 2015 while Cliffs flops about trying to recover water that has flowed under the bridge. Until I see the Mich drill results I am discounting it in my valuation of First Point, but I am hopeful that they will allow First Point to drive its story on its own next year. We should get the Mich results by late November, and if they flash a green light, I will shift my buy recommendation from passive to active. For now we remain at the mercy of a hedge fund trending toward Wall Street laughingstock status.
Spec Value Hunters should base their accumulation strategy on the 1% NSR First Point holds under the Cliffs agreement. The NPV/share sensitivity chart above shows what the 40% net interest is worth in after-tax NPV terms using a 10% discount rate, and what the 1% NSR would be worth in pre-tax NPV terms at various nickel prices. Both calculations are generated by a DCF model based on the PEA published by Cliffs in 2013, which relied on fairly conservative assumptions First Point believes can be improved through pit optimization, metallurgical improvements, and better market targeting. Although my model follows the ore schedule presented in the PEA, it generates weaker after tax NPV and IRR results at the base case price of $9.39/lb nickel than the headline numbers published by Cliffs. This is likely due to Cliffs' inexplicable failure to provide a detailed cash flow schedule in the PEA that reveals the depreciation and capital spending schedule. The report is also woefully inadequate in explaining the revenue side and the costs associated with delivering the product to market. I am shocked that the BCSC has not taken Cliffs to task for filing such a deficient technical report.
The project after-tax NPV assumes production startup a year from now, while the NSR pre-tax NPV assumes royalties will start flowing 7 years from now, which is the timeline one would expect for completion of a feasibility study, permitting, construction and mine commissioning for the 114,000 tpd open pit mining scenario envisioned by the PEA. At the current nickel price of $8.20/lb the project NPV per share is worth negative USD $53.4 million on a 100% basis or CAD ($0.15) per share reflecting First Point's 40% stake. In contrast, the NPV of the 1% NSR is worth US $20 million or CAD $0.18 per share, though one has to keep in mind that Decar would never be developed if $8.20/lb was the long term nickel price assumption. At the base case price of $9.39/lb nickel the project NPV jumps to USD $343,500,000 (100%) or CAD $0.95 per share (40%), but the NSR NPV increases to only CAD $0.21 per share. This illustrates the leverage difference between a project equity interest and a royalty. Clearly Decar offers substantial upside to First Point on a project equity basis in the event that nickel prices increase and/or the project economics improve with further feasibility work. It is this substantial upside leverage which bestows value on the NSR even though the spot nickel price is too low to support mine development. First Point ultimately is a bet that long term supply issues will support a long term real price in excess of $9/lb, but not so high that low grade sulphide deposits such as Royal Nickel's Dumont deposit attract development funding.
Because First Point is not the operator of the project, does not have a right of first refusal, and would be subject to cash calls from a future operator, one should under the current circumstances assume that First Point's 40% equity stake will be diluted down to a 1% NSR as provided by the Cliffs agreement. In this scenario the $0.075 per share value of First Point after stripping out the $2.5 million working capital is the value the market is assigning to not just the 1% NSR First Point already owns, but to the 2% NSR it will end up with if it cannot fund further work proposed by a new operator. The chart above shows what the 1% NSR is worth in USD terms at various nickel prices on both an immediate and 7 year startup basis; just double the numbers to get what a 2% NSR is worth (ie USD $40 million with 7 year startup or CAD $0.36 per share). The CAD $0.075 per share enterprise value is thus considerably less than what the NSR would be worth if Cliffs sold the 60% stake to an aggressive new party with the means to develop Decar. This low valuation is understandable because the market sees Decar as stuck in limbo, for the project involves development of a very low grade style of nickel mineralization never before put into commercial production and thus unlikely to attract a buyer at Cliffs' asking price. The market is saying that nobody will buy the 60% Decar stake and that Casablanca does not have the smarts to monetize Cliffs' $22 million sunk cost along the lines I've proposed in a timely manner.
Cliffs' new management would have a much better chance of recovering its $22 million investment and a lot more if it simply assigned its 60% interest to First Point in exchange for sufficient stock to bring its stake to 19.9% and the 1.0% NSR currently owned by First Point. Assuming 105,804,339 issued shares and 14,353,190 shares owned by Cliffs, First Point would need to issue only 8,366,883 shares, bringing Cliffs' stake to 22,720,073 shares representing 19.9% of 114,171,222 issued or 17.5% of the resulting 129,497,807 fully diluted. Such a deal would instantly restore 100% ownership of Decar to First Point as well as operatorship, a development the market would reward by taking the after-tax NPV leverage of the project seriously. At $8.20/lb nickel Decar appears to be sub-economic, but at the base case $9.39/lb nickel price the after-tax NPV jumps from CAD $0.95 per share for the 40% interest to $2.37 per share for the 100% interest (see above chart showing the AT NPV per share for both 40% and 100% ownership; the chart below shows the AT NPV on a 100% basis). With 100% ownership First Point would be in a strong position to raise additional equity for the PFS from institutional audiences, or bring in a deep-pocketed partner who shares the vision of Cliffs' ousted management. This would allow for rapid monetization of Cliffs' interest in Decar through its First Point equity stake, and future cash flow from its royalty which it could probably sell for a good price when Decar is more advanced. This makes a lot more sense than shopping around its 60% Decar stake at ever lower prices and then trying to find a bid for the First Point equity position.
I remain convinced that Decar can be put into profitable production and that both the 1% NSR and 40% project interest owned by First Point have a substantial value far above the current market valuation and recommend Spec Value Hunters accumulate the stock while uncertainty about Casablanca's plans prevails. Either Cliffs will find a buyer for its interest who is unlikely to do so without the intention of quickly resuming feasibility study work, or it will do a deal which allows First Point to create substantially greater value over the longer term.
*JK owns shares in First Point Minerals Corp