Focus Minerals (FML.AX) Valuation Part 2 - Crescent Gold (CRE.AX) Acquisition

Updated 20.06.11 - EPS adjustment (sorry for any inconvenience)


It has not been long since my first post for Focus Minerals with an initial price target of $0.14.

Big News

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Today on 20 June Focus announced the proposed acquisition of Crescent Gold offering one share for every 1.18 Crescent shares in an off-market bid. The effective acquisition market value is around $72.5 million by my figures and to achieve this Focus will be issuing 940.8 million shares. For the time being, I'll be ignoring the impact of any unlisted options, which should not have a significant impact.

Crescent is currently 1,110,217,187 shares @ 5c or $55.5m market cap

Offer is at 30.5% premium = 6.525c

1,110,217,187 shares @ 6.525c = $72,441,671 market cap

Shares issued by FML = 72,441,671/$0.077 = 940,800,927 shares

This announcement took me and the market by surprise. It was not expected. Recent speculation had been based on a resource announcement, joint-venture or some sort of partnership arrangement. This was clearly not the case and Focus came out with what appears to be a very well planned acquisition.

Details of takeover:

• Takeover requires 90% acceptance
• Offer closes 8 August 2011 (7 weeks from now)
• Deutsche Bank total ownership is 29.23% of Crescent:
• 19.9% ownership agreed now
• 9.33% remaining ownership, may be included or may be sold to third party
• Focus to obtain around 5.4% ownership from $3m secured loan (estimate) plus 18% ownership from the proposed working capital facility:

  - Focus has provided a $3m secured loan which according to plan will be converted to shares and options. I'm going to take a stab and say that the option is to adjust for the spike in the share price of Crescent post announcement and that effectively Focus will get somewhere near $3m shares at around $0.05 or 5.4% ownership*

  
  

  - Focus to provide around $10m working capital facility on the same terms as the $3m secured loan which should obtain 18% ownership (estimate)

• Combined ownership between Deutsche Bank and Focus should be around 52.63% by my estimates

* In May 2011 Focus provided a $3 million secured loan to Crescent which upon shareholder approval will turn into a convertible note.  Once approved, that convertible note will be convertible into Crescent shares at the conversion price of the lower of $0.05 and 85% of 5 day VWAP of Crescent shares, with 1 free attaching option for each two shares provided.

This means that the takeover would be well ahead from the start and has a fairly high chance of success. Focus has done its homework.

Analysis of value post take-over

I'm not a geological expert. This is a pure financial metric based valuation and scenario analysis. The scenario models are on the assumption that Focus can make the geology work for them in a cost effective manner and cheaper than current operations of Crescent Gold. Having reviewed the current projects, I believe that the acquisition can achieve good cost control. The scenarios that I have listed below are based on cost and assumes that both Laverton and Summit are in production. It is also based on calender year production figures due to the production guidance.

Scenario 1: Optimistic

The optimistic scenario, should it be accurate at all, looks fantastic. This scenario is based on the following:

- 100,000pa production from Laverton current and ongoing (figures included for 2012)

- 50,000pa production from Summit Underground starts in 2012 without significant additional costs (figures included for 2012)

- Total cost per ounce remains in line with existing costs of Focus

- Summit Underground cost per ounce target states $650-700 which is less than that of Focus

- Laverton cost per ounce for the end of 2009 based on processing by Barrick Gold was $841 per ounce with long term forecast of $850

- Other costs to double from 2011 estimate

- Assumes that current operation costs of Crescent are not due to actual cost of production and are associated with significant development costs and complexity. For example they recently built a 40 person motel.

If this scenario is remotely possible, there is clearly huge upside!

I actually think this scenario is possible, but I have no idea about what sort of probability it has. It all comes down to the cost control.

Note that the liquidity problem from the forecast has been solved by the recent capital raising.

Scenario 2: Mid-line

This scenario is the same as above, on the basis that overall cost control is there, except:

- Cost per ounce increases slightly from $875 per ounce to $900 per ounce.

- Other costs to increase significantly from 2011 estimate

Scenario 3: High cost of production

This scenario is the same as above, but cost of production blows out:

- Cost per ounce increases significantly from $875 per ounce to $1,100 per ounce for the total current and new production

- Other costs to double from 2011 estimate

Initial Conclusion

• Optimistic: forecast business value rises from $0.14 to $0.48
• Mid-line: forecast business value rises from $0.14 to $0.34
• High cost: forecast business value rises from $0.14 to $0.15

This looks like a very attractive investment decision made by Focus - as long as costs can be controlled!


Under a high cost scenario, this will likely add no value and be a risky venture.

I will only support this on the basis that they are able to control cost - I do not wish to invest in a high cost producer with cost of production any higher than already experienced by Focus.

The business models for Laverton and Summit are based on a forecast cost of production lower than Focus. As long as Focus has done it's homework and can integrate these additional production lines in to the existing business with good cost control, I believe that it will prove to be a fantastic acquisition. This will be the key factor.

Crescent Gold

I'm glad to see that capital has already been raised for the development of Summit Underground Mine ($33m initial outlay).

Laverton: 

Production: 100-140,000 ounces per year

31 Dec 2009: “The first campaign equivalent cash costs (C1 unaudited) of A$841/oz came in slightly below the long term forecast of A$850/oz.”

Summit Underground Mine: 6.64g/t $650-700 cost per ounce

Production: 50-70,000 ounces per year starting 2012

The company has been experiencing ongoing cost control issues and I hope that Focus is able to clear this up.

Information from Crescent Gold:

March Quarterly Report:

“The Company  announced  that it had  temporarily  suspended its operations on 18 February 2011  as a safety precaution and mining operations recommenced  on a limited basis  shortly afterwards following dewatering of pits and review of the haul roads. The impact of the rains is expected to reduce production for the full year to December 2011 to between 80,000 and 90,000 ounces (down from a range of 105,000 to 115,000 ounces). Gold produced during the March quarter totalled 14,918 ounces against a forecast of 27,000 ounces.”

From the half-yearly statement:

“During the period mining operations were undertaken at Admiral Hill, Craiggiemore, Mary Mac South and the higher grade Fish deposit. In addition trial mining and some pre‐stripping was completed at the West Laverton deposit”

“A commitment to purchase facilities including a 40 person motel style camp at Fish was made. This should be in place in the first half of 2011. The purchase of the camp was economically justified on the basis of improved productivity from the Fish deposit, but also has significant safety and personnel benefits and will be a major benefit in optimising the economics of the promising Lord Byron deposit, which is adjacent to Fish. It is expected that these two pits will produce approximately 60,000 oz over the next two years alone.”

“Mining operations at Admiral Hill were suspended in October as high cyanide soluble copper levels were identified by grade control drilling earlier than anticipated. The high copper levels led to minor processing delays at the Granny Smith plant due to the stringent cyanide code requirements in operation at that facility. Blending the ore has since been trialled successfully and controlled mining operations will resume during the next quarter following a complete review of the resource.”

“The Company’s cash on hand and funds on deposit as at 31 December 2010 was $30,069,000 (30 June 2010: $8,863,000). The increase in cash on hand is largely due to the raising of capital during the period, namely through a loan facility of $15 million and a rights issue raising which closed at the end of January 2011.”

“In January 2011, Crescent repaid A$5 million of its A$15 million loan facility to Indago Resources Ltd”

2010 Annual Report:

“The operational focus of Crescent during the year was on the development of the four advanced stage projects which progressed to mining status early in the reporting year; Sickle, Euro, Admiral Hill, and Castaway. Line of lode investigations were accelerated on the Craiggiemore, Mary Mac South and Mary Mac deposits, with the result being the Craiggiemore deposit coming on line before the Fish deposit. A start date for commencement of mining at Fish was held off pending results of drilling around Lord Byron. With the economics of the Lord Byron deposit influencing the planning of infrastructure on the Fish project, a scoping RC drill programme was completed at Lord Byron late in

the reporting year. Minor RC drilling on the West Laverton deposit was designed to refine the resource model and update planned pit design”

Laverton Ore Purchase Agreement with Barrick from end 2009:

What do the Aussie markets look like? ASX20 analysis

I recently conducted an analysis of the Dow Jones companies by stacking them together and considering it one big business. The purpose was to obtain an understanding of the facts and the potential impact on the markets in the event that QE3 does not occur. The risk that many people perceive is that there will be a massive withdrawal of liquidity from the markets, akin to the collapse in 2008 post-Lehman. The most common justification for this viewpoint is that the ‘markets’ are expensive and have been propped up by the liquidity injected into the systems via the US Federal Reserves ‘Quantitative Easing’ programs, which are due to end very soon and by the end of June.

The result of my analysis was that I concluded that the companies that constitute the Dow Jones Industrial Average are, in aggregate, in a solid position. They are generating a lot of cash flow, have been reducing debt and have been buying back some shares. They are definitely much stronger than in 2008/09. If earnings expectations are met, they are reasonably undervalued. Even if they are not met, the base is strong and there is no reason at this point in time to think that there would be a collapse in share prices. Ultimately markets respect real business value.

The next step is to have a look at the Australian market (ASX), which has been flat for some years now. Referring to the S&P 200 index (XJO), one can see that we are at 4485 on the index, compared to a peak of around 6,800 in 2007. The market has been flat since August 2009, which is now nearing 2 years. Will it end? Are we doomed to a stagnant market for another year or even more?

My purpose here is to conduct an analysis of the companies which are part of an ASX20 index and represents the largest companies listed on the ASX. They are generally well-known and account for a significant percentage of the total ASX market capitalisation. In this case, I’ve aggregated all the companies together and have adjusted them based on their size. Therefore, assuming the ASX20 is just one company, some components such as BHP and Rio Tinto account for a larger part of this business than others. The reason for this is that the ASX and the ASX20 are heavily impacted by financials (big four banks), BHP and Rio Tinto. Whilst it does not provide as great a generalisation, it does provide greater clarity for the impacts that these businesses are likely to have on the markets in Australia.

 

The current market capitalisation of the ASX20 is around $922 billion. It is heavily weighted towards BHP, RIO and the financials.

What does it look like?

Margin of Safety: 17%

This weighted average business has a theoretical share price of $38.54 and the forecast value is $46.51, providing a reasonable buffer. However the key here is that current price is not based on current value; it is based on expectations of future earnings over the next two years. This is fairly typical however it does mean that it is very important that the growth of earnings is achievable.

 

Without a doubt, we can see that since 2001, the value of these companies have increased substantially from $7.01 in 2001 to $25.56 in 2010. This is very strong growth and it is clear that profitability has been exceptionally strong with return on shareholder’s equity of over 20% in most years. 

Forecast earnings for 2011 and 2012 fiscal years are high compared to 2010. The consensus expectation is for a 34% increase to 2011 and 52% to 2012. These figures are high but there have been larger increases in recent years. Given the challenging economic environment it will be important to monitor the results to see if they are achieved. A very large component to this expectation is earnings from BHP, but also Newcrest Mining, Macquarie Group, Wesfarmers and Woodside Petroleum. Earnings are expected to fall for Telstra and Westfield Group.

Alternative scenario: no profitability growth

Given that earnings expectations are strong, what would happen if earnings expectations are unrealistic and are not met? For example, Woodside Petroleum just came out with news that the Pluto gas project has been delayed resulting in $900 million in additional capital costs and inevitable earnings downgrades. I’ve adjusted the figures to determine the outcome to the business value should current profitability remain at current levels. I actually think this is a more realistic outcome as there are certain segments of the market which are experiencing some difficulty, although others continue to stand on strong ground such as BHP.

Margin of Safety: 4%

Based on this scenario, the market is priced close to perfection and should not result in significant adjustment. The area to watch for downside risk would be bank profits, which have experienced a flat-line in earnings and may have some potential for increased bad and doubtful debts.

Remember, some of these statistics are skewed because there is a significant weighting towards the financials, which tend to have significantly higher debt loads, due to their business model, compared to other companies.While top-line revenue is reducing, earnings are growing which represents an increase in overall profitability.

The biggest take-out from the above information for me is that companies have very healthy cash flows. This cash is partially being used to pay down some debts and also buy back a few shares, which were raised through the financial crisis. This mirrors the US companies in the Dow Jones which were performing similar actions, although a bit more aggressively. Australian companies have been able to resume dividend growth back to trend, which is significant. This is generally preferable to Australian investors due to the benefits received from franking credits. The biggest positive above anything else seems to be the fact that cash flows from operating activities, or their usual business cash flow, is growing in a perfect trend and has not halted at all through the past few years.

Based on this information, Australian companies have very strong cash flows and are accumulating cash. I expect that they will soon either increase dividend payments and/or look for mergers and acquisitions. My prediction is that a bit of both will occur and I expect to see some evidence of this occurring in the next 12 months.

Conclusion

If everything goes to plan and earnings expectations are met, we could see double digit share price growth of around 20% over the next year which would represent 5,380 on the S&P 200 (XJO). If this transpires, it will likely result in significant increase in market confidence which is currently low due to the ongoing flat market conditions. If earnings expectations are not met and profitability remains flat, then we are looking at a continuing flat market with the S&P 200 at 4,500 to 4,700. 

Two final points: firstly, this earnings season will be very important in order to determine the overall direction of the market. I’ll aim to update my analysis after a significant amount of results have been released. Secondly, whilst the market may remain flat if earnings disappoint, there is still value to be found if you look hard enough and if you are selective, you can still generate a solid rate of return in a flat market.

Note: a significant amount of data is collected in order to put this together. The systems I am using continue to be developed, so please feel free to point out if there are any discrepencies that require attention.

Medusa Mining (MML.ax)

Medusa mining is an exceptionally well managed company and is my favourite gold producer due to its stability, first-class management and low production costs.

• Current producer (100,00 ounces)
• One of the lowest cost producers in the world ($190 per ounce)
• Significant production increases planed over the next 5 years (100,000 to 400,000 ounces p.a.)
• Expansion potential clearly defined and significant
• Production increases to be achieved organically via cash flow
• Is now paying a dividend
• Very tight control over share issuance and shareholder dilution
• High profitability (over 40% return on equity)
• Strong and consistent cash flows
• Debt free
• High institutional ownership
• Has delivered on targets

There is a board restructure in progress with the current managing director Geoff Davis stepping down and being replaced with Peter Hepburn-Brown (current Executive Director of Operations).


This is unfortunate, however it does not cause me concern at this stage because Mr Davis will be reappointed as Non-Executive Chairman and Mr Hepburn-Brown seems well suited to steer the company's ongoing expansion. This will likely be a smooth transition and should not impact on the success of this fantastic company.

Disclosure: I own MML with an original entry price of $4.46.

Ramelius Resources (RMS.AX)

Ramelius does not have any analyst coverage and this analysis is not based on consensus EPS forecasts. The EPS figures below are based on current 2011 production figures and the 2012 figure is an extrapolation based on current trend.

Based on production guidance figures provided by the company, as well as a projection based on current costs, I've come up with some rough workings in an attempt to come up with an approximate EPS figure for 2012 financial year.

Ramelius Resources is an exceptionally profitable company. In the event that they are able to sustainably expand production as planned (growing to 230,000 pa oz by 2013/14) and if they can maintain low production costs, RMS is shaping up to be a fantastic investment which a very large margin of saftey.

Disclosure: I own RMS and originally purchased at $0.82 based on the model.

Focus Minerals (FML.AX) Valuation

Valuation based on current consensus forecast earnings:

Note that this does not include the impact of the capital raising, which based on current information, seems to be unlikely to increase earnings per share over the next two years.

Potential adjustment:

Some rough estimates based on production targets and capital raising are listed below. Based on these figures, EPS forecasts come in below consensus. Note also that the production targets and these EPS figures are based on calendar year and not fiscal year.

 

Disclosure: I own FML and purchased at around $0.05 based on the model.

Will markets crash without QE3?

Much has been said about the markets needing the liquidity provided by the US Federal Reserve in order to maintain current levels. Certain forecasts such as S&P at 400 without QE3 has caused me no end of confusion as there are so many conflicting views and palpable fear that it is hard to see the forest for the trees. In some ways, this has caused me to doubt my investment strategy by thinking that there could be a massive drain of liquidity from the market and thereby impact all investments in stocks, both good and bad. I haven't changed my strategy and am still focusing on profitable gold, oil and gas producers.

I've read commentary about PE ratios and overall fundamentals not being up to scratch to current prices. I'll address this issue as I've had a good look at the market valuation. I was surprised with my conclusion and it has provided me with significant insight as to the potential market movements over the next 12 months.

My view of investing and investment valuations includes the idea that PE ratios are a terrible indicator of value and they are a rule of thumb that does not indicate anything about the actual business itself. How does the current market price for a share provide you with any idea at all about the value of the underlying business? The share price is irrelevant in this context and is a derivative of the business itself - a derivative that can wildly fluctuate at any point in time without any price sensitive information being released. The share price, divided by the company earnings, does not provide any insight on the business value or inherent risks involved.

PE ratios and similar rules of thumb are a very poor tool in determining current business value. Therefore, given the fact that the market is an aggregate of many individual businesses, the current value of the total market is poorly represented by PE ratios. This is similar to the concept that a combination of toxic collateralised debt obligations is not less risky in aggregate compared to an individual break-down.

The approach that I take is to look at the intrinsic value of the business and then compare it with the current market price. By doing this we can determine that margin of safety of investing at a certain price. The intrinsic value is driven by the profitability of a business, measured as return on shareholder’s capital and the ability to sustain a high incremental return on equity versus the payout of earnings in the form of dividends.

Based on my analysis, stocks will generally move towards their intrinsic value over a 12 to 24 month period. There can be significant short term divergence between market price and value, but this is inevitably corrected. The largest component to future company value is future earnings and the ability to either grow, sustain or the inability to sustain an adequate rate of return on reinvested profits.

So what I’ve done is to create an aggregate value of the 30 companies in the Dow Jones as if they were one company and titled it a Dow Jones Industrial Value Index. The result is a rolling intrinsic value which can be compared with the price. It is the same process that I use to analyse an individual company. I can therefore determine whether the Dow is cheap, expensive or about even. I can also have a look at the Dow as a company and determine if it is something that I’d personally invest in or alternatively if it is an ugly beast that I’d hide from.

Price versus Value

Margin of safety: 30%

The current forward value of the index is $2,265 and it is current trading at $1,579. This is based on consensus earnings forecasts and is therefore dependent upon the accuracy of such forecasts. However it is based on current expectations and adjustments can be made based on the risk of earnings failing to meet the forecasts.

We can see that companies are currently very profitable and are expected to be able to maintain it at current levels. There has been a significant improvement since 2009, but earnings don’t look stretched. In the event that companies are able to maintain current profitability, there looks to be a significant margin of safety of 30% at current prices and therefore stocks don’t look like they are about to tip over without further injections of government liquidity in to the markets.

The downside risk from here is that current profitability is, to use the cliché, ‘transitory’ and will fall back from here. In the event that this were to happen (e.g. profitability becoming slightly worse than 2009 levels), the model shows that the underlying value would fall to around $1,344 over the next 12 months or so and therefore could be as much as 15% overpriced. Even if this were true, it provides me with an understanding of the downside risks and indicates a negative scenario that really isn’t too bad. This works out to be around 2:1 upside versus downside risk. Clearly the markets can fluctuate wildly based on sentiment in the short term, but they must respect value eventually.

The Dow index includes Bank of America and JP Morgan which can skew the picture and clearly have significant issues at hand. By excluding these two companies, the overall price versus value picture is very similar with a current forward margin of safety at 28%. 

Price versus Value - ExBanks

Margin of safety: 28%

The remainder of my analysis excludes the banks as they significantly skew the picture when it comes to company debt levels and reduces clarity in determining what companies have been doing with their finances. From what I can see, Bank of America and JP Morgan together account for around 61% of the total debt load out of all the Dow.

Components (excluding BOA and JPM)

On a per share basis, companies have been able to maintain debt levels relatively stable. Of course during the financial crisis companies had a significant increase in debt levels in order to protect them against liquidity risks; however they have now been able to scale it back.

Earnings are clearly strong at present and companies are profitable. They seem to have been retaining earnings in order to better manage their financing activities. This is a good thing as it reduces the risk of further liquidity shocks in the future.

Revenue is growing, dividends are stable but not growing as fast as they used to and cash profit is relatively stable. Short term assets have increased substantially versus short term liabilities, which is reassuring.

Cash balances are increasing at a very rapid pace and are approximately double the level held in 2007.

Cash flow is positive and clearly is being directed towards financing activities. Debt loads are being substantially reduced and companies are also managing to buy back some of the shares raised in recent years. In this respect, business health seems to be returning to trend and is a very positive outcome.

What will companies do with their cash?

I’ve listened to a lot commentary about companies currently sitting on large cash hoards and speculation on what they will do with it: ranging from mergers and acquisitions to buying back shares. I’m going to take a stab at this and say that companies, in aggregate, are not going to do anything substantially different to what they are already doing. What they seem to be doing, from my perspective, is significantly reducing debt burdens, buying back shares that were raised during 2009 and 2010 and improving overall liquidity by allowing cash to build up at a much faster pace compared to short term commitments.

Many companies seem to have been caught unaware when the financial crisis hit and therefore sold expensive capital when share prices were low and are now buying it back when prices are higher. This is not necessarily the most efficient form of capital management (buy high and sell low), but at least they are taking action and the debt is being dealt with.

As mentioned above, cash holdings seem to have doubled from 2007 at around $150 billion to around $300 billion in 2011/12. I think that companies will keep on doing what they are currently doing and perhaps if cash holdings continue to rise at current rates, businesses will increase the growth of their dividends which have been slightly held back during this period.

Conclusion

Credit market and sovereign debt issues aside, businesses are currently very profitable. Based on consensus forecasts there is a very decent margin of safety between prices and value. This provides substantial shelter in the event that earnings in the near future come in below expectations. I started out being concerned about market levels and whether or not QE3 would eventuate (I think it will), what shape it might take and the timing. I have now concluded that it doesn't matter too much for the market. I think that there are serious issues that the world faces, but the DOW companies are well positioned and are unlikely to fall substantially from current levels as some claim. 

Is the aggregate of the DOW a business that I would personally invest in? Probably not, but that's mainly because I seek individual companies with greater upside potential. Is it an ugly beast that I'd hide from? Definitely not.