How to fish for profits in takeover targets

Two years of being ravaged by a vicious bear market for junior mining stocks has left many of these companies with decimated share prices and empty treasuries. It may be time for long-suffering investors to make changes to their portfolios to reposition themselves and recoup some of their losses. Many juniors that have expelled much of their energy on developing their deposits are like hopeful salmon swimming upstream to spawn. For larger companies with strong balance sheets, there is a temptation to behave like grizzlies and gorge on these vulnerable spawning salmon. Investors who can spot these juicy salmon first have an opportunity to make quick and fat profits.

One of the greatest feelings an investor can experience is the winner’s rush from having a high takeover bid materialize soon after buying a stock. This is particularly satisfying if the stock was bought as a result of intelligent reasoning.
Recently, takeover bids for junior and mid-cap mining stocks typically have carried a 38–54%
premium to market.
Given current low market valuations, it is not unreasonable to expect these premiums to continue. However, spotting potential targets requires some careful due diligence into understanding the target company, as well as its potential acquirer.

There are two main categories of junior mining companies that are takeover targets: those that have operating mines, and those that are not yet in production but have made a material discovery. Both categories require that investors first calculate the value the takeover could add to the operations of a potential acquirer. Economically feasible projects are scarce, and the list of potential acquirers will be short. This implies that the number of ideal matches will be relatively low, which makes it more simple to find suitable matching parties.

The current environment is challenging for both small and large mining companies, as access to investment capital is limited. Since capital constraints are the primary barrier to acquisition programs, acquirers will focus on targets that will return positive cash flow immediately. Smaller companies that are already generating cash flow from production will be preferred over companies with earlier-stage projects. However, exceptional deposits may still be targeted, even during the worst of times, and, in the event of a takeover, will generally command higher premiums than producing mines. To maximize profits, investors should consider both producers and non-producers when searching for potential takeover targets.

After determining the category of mining company, as well as a short list of potential acquirers, investors should apply some “rule of thumb” evaluation techniques to determine if a takeover is a probability. This is a science of matchmaking, and investors should be looking for two parties that will be compatible. 

A disciplined approach should be followed when matching potential takeover targets and acquirers. The use of a 10-point checklist can help investors ensure that the following criteria are met.

1. Credibility

Bidders for mining companies tend to buy those that have completed enough work on a deposit to afford a clear understanding of its size and viability. They are not interested in assuming unnecessary risk. Simply put, the greater the certainty, the greater the price.

The size of a mineral deposit is difficult to calculate without completing a National Instrument
43-101 technical report. In the case of gold and silver companies, minimum resources of 2 million oz. gold or 50 million oz. silver are desirable. A preliminary economic assessment, prefeasibility or feasibility study will clarify the viability of a deposit. Investors can access these reports from company websites or SEDAR. Measured and indicated resources are more certain than inferred. 

Simply put, the greater the certainty, the greater the price.

2. Potential

After determining the deposit’s size, investors should consider the potential of adding resources and reserves through further exploration. Some companies will say that their deposit is “open at depth” — meaning that the orebody has been defined to a certain level, but there could be more resources deeper down. Investors should investigate how much of the property has been explored and the potential for discovering additional resources in those unexplored portions. This holds true for both operating and non-operating companies.

3. Geography

Bidders do not want to incur the huge capital costs or time delays associated with building milling facilities. Investors should look for non-producing targets that have deposits close to an operating mine belonging to a potential acquirer. Ideally, a target company’s deposit should be located close enough to enable the acquirer to facilitate the economic transfer of ore to its existing operating mill. Key infrastructure such as power lines, water, roads or rail should be nearby in order to reduce the acquirer’s costs.

Transportation by road should be accessible year-round and, as a rule of thumb, a distance of no more than 150 miles (240 km) is usually ideal. Rail distances may be greater, but the deposit must be large enough to satisfy volume and scheduling requirements of the railroad. Mining companies prefer to focus on continuing operations in areas where they are already established, and will pay a premium for that privilege.

4. Politics

Companies in mining-friendly jurisdictions generally command a premium over those in politically unstable environments. 

Investors should look for targets in countries where the risk of government appropriation is low. Targets should also have all mining agreements with locals and natives already in place. Government royalties and taxes must be considered in addition to restrictions on foreign ownership. Look for labour issues or outstanding litigation and a low permitting risk of obtaining both exploration and exploitation permitting. A stable political climate is one of the reasons why deposits in areas such as Canada, Australia, Brazil, Mexico and Nevada usually command higher valuations than deposits in political hot spots such as Indonesia or the Democratic Republic of the Congo.

5. Geology

If a non-producing target and a local acquirer have similar mineralization, the acquirer’s equipment, expertise and metallurgical techniques can likely be applied to mining the target to save costs. News releases and corporate presentations on the websites of both companies should have information on the composition and grade of their deposits.

Further, if the target has higher-grade ore, combining the enriched material with the acquirer’s lower-grade ore may improve mill efficiency. In this case, the target is even more attractive to the acquirer. If production costs are available on the target’s website, investors should look for companies whose cash cost of production is 40%, or less than the current metal price.

6. Management

In the case of a non-producing target, one of the most important considerations should be if management is grooming the company for sale rather than trying to move towards production. Most often, management who are project generators — skilled and experienced in exploration — may prefer to sell the company soon after outlining the deposit and then move on to start another project. They may be hesitant to take on the risks associated with development, as the incremental benefit may be small. This is particularly true if management owns 5% or more of the outstanding shares and would
benefit materially by an immediate sale, and has the flexibility to do so.

In many cases, a target’s existing management is phased out following a takeover. Sometimes, a target with weak management may be attractive to an acquirer because existing management can be replaced and profitability may improve as a result. However, investors should avoid targets whose management is entitled to receive onerous “golden handshakes” in the event of a takeover.

7. Acquirer

Resource companies buy others for the purpose of growth or to replace dwindling reserves. Larger resource companies may appoint senior management who are experienced in buying other companies to oversee this expansion. Investors can look for management bios on the website as well as on press releases when these new appointees are announced.

The financial condition of a potential acquirer should be carefully evaluated. Large companies with cash reserves or high cash flow may be able to fund a cash purchase. Acquirers with less access to cash may use their stock as a currency by proposing a share swap. This may be particularly true if their stock valuation is relatively high. Investors should also evaluate whether the size of the target is too large or too small for the potential acquirer. As a rule of thumb, large companies tend to buy targets that are 10% of their size and smaller companies tend to acquire targets that are 28% of their size.

8. Rarity

The uniqueness of certain resource deposits may be of interest to a buyer who is not another resource company. Chemical companies have been known to acquire rare-earth deposits in order to secure a future source of raw material. Determining a short list of potential buyers for these targets can be challenging for investors, as they may be private companies located in another country. These acquirers are more likely to seek targets that are already in production, as they may lack the in-house expertise to develop the resource on their own.

9. Shareholders

Occasionally, large shareholders of a target company encounter difficult financial circumstances and decide that selling their stock holdings is appropriate. Flow-through funds, natural resource mutual funds and resource capital pools are all potential candidates. If their holdings are significant, they may approach a potential acquirer and agree to offer the acquirer their block of stock. If the acquirer is able to secure enough shares at an attractive price, they may buy the remainder. This can be challenging for investors to detect until after the acquirer has already announced its intent. 

Instead, it is better to keep in mind that sometimes bidders become significant minority shareholders in a target company well in advance of buying it entirely. Investors should look for targets whose potential acquirer has invested and now owns slightly less than 10% of the outstanding stock. Later, the acquirer may make a bid for the remainder of the shares it does not already own. This is known as a “creeping takeover.”

10. Valuation

The last criteria investors should use is the valuation of the company. By comparing three different valuation numbers, the enterprise value (EV) of a target, the reserve value and the discounted cash flow (DCF) for producers or net present value (NPV) for advanced projects, with the company’s stock price, undervalued targets can be identified. (See next week’s follow-up commentary: “How much should you pay for that junior,” for details on how to calculate these metrics.)

By comparing the reserve value and DCF/NPV to the EV, investors can determine if there is enough upside from the current stock price in the event of a takeover. Investors should buy the target stock at a low enough price to allow for the 38–54% average takeover premium to market. 

It is critical that investors adhere to the discipline of using checklists when selecting takeover targets. This requires a disciplined approach that should never be varied from in order to improve the probability of success. This first table on page 2 illustrates the checklist that should be followed when selecting takeover targets.

Applying the 10 criteria to the vast number of publicly listed mining stocks provides a long list of potential targets. Despite this low price environment, investors should realize that only a small percent of the companies that make ideal targets will actually be taken over. The second table on page 2 is a list of 12 possible targets out of the many that exist today.

In today’s challenging markets there are many mining companies whose stock price has tanked. This has opened the doors for strong companies to go out and hunt plentiful game. Yet the conditions which have created the environment in which to hunt have also created barriers. Today, the dilemma is how to pay for an acquisition. Money is tight for mining companies of all sizes. The share prices of large caps are so low that issuing stock for an acquisition may be too dilutive. So only a few hunters are strong enough to participate in the hunt. Investors must consider this when speculating in potential takeover targets.

Almost anyone can learn to evaluate the takeover potential of junior mining stocks. But in order to determine if the risks are appropriate, it is always prudent to consult a professional financial advisor who is experienced with spotting these types of investments. Through careful due diligence, intelligent investors can reduce their risk and harvest enormous profits in the most exciting arena in the mining sector.

— Peter Besler is an investment advisor with MGI Securities in Toronto. He can be reached at (416) 594-2257, or pbesler@mgisecurities.com. See his new two-part interview with Mining Markets editor Alisha Hiyate at www.miningmarkets.ca.