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 Beneath a miner’s glitter ::
By Russell Muldoon
30 April 2008
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| PORTFOLIO POINT: The figures sound good, but then they’re meant to. Digging a little deeper into a miner’s books reveals a different picture. |
The resource sector continues to generate a lot of investor interest. Strong demand from China and India for all things that can be “dug out of the ground” is resulting in record commodity prices and boom-time profits for some of Australia’s resource companies.
A random selection of commodity future charts (Figure 1) shows just how favourable the winds have been for companies operating in these industries. Prices for most commodities in the past four or five years have experienced remarkable levels of appreciation.
Those that stand to benefit from rising energy and industrial commodity prices fall into four sectors: gold, energy, diversified resources and other metals. Forty-one percent (or 821) of the 1985 companies listed on the ASX fall into these sectors. There are other sectors benefiting, such as mining services and engineering, but for the purpose of this article, our focus is on those which explore, dig and produce minerals that lie underground.
The sectors are home to the likes of BHP Billiton and Rio Tinto – two of Australia’s largest companies. It might therefore come as a surprise that out of the 821 companies, only 132 or 16.1% actually make taxable profits; even fewer make taxable profits on a consistent basis.
The remainder are currently unprofitable – at a time when tailwinds abound. While a small number may become profitable in the near future, the high percentage of unprofitable businesses in these sectors reflects a common attribute: the majority are in exploration, a race to find the next Olympic Dam or Broken Hill mine deposit base.
The number of exploration companies has boomed over the past few years on the back of the commodities bull market. Over 50% of all new listings on the ASX in the past two months alone have been those directly involved in exploration activity. The reason for this comes back to the very roots of capitalism. If a business is making super-normal profits, (eg, BHP or Rio) entrepreneurs will enter the market in an attempt to share in the profit pool. A more sceptical view could be that those “in the know” use rising stock prices to take advantage of those that are not.
Large sums of money supplied by both institutional and retail investors have been thrown at uranium, nickel, platinum, gold, iron oxide, copper, base metal, coal, nickel/cobalt laterite, scandium, crude oil and natural gas explorers in the hope they will strike it rich.
While it is true that some may find a commercially viable resource or “world-class” asset, the majority of exploration companies are never likely to become profitable.
And even if the company should find a viable resource, it will require millions, and sometimes billions, to develop the infrastructure required to extract the resource from the earth. How much of the resource can be extracted, how quickly and at what price it can be sold are serious considerations for an estimate of profitability?
It would therefore seem strange that small miners with a drill rig and a few white posts in the ground get so much attention. The lure of making a speculative buck seems to be an attractive proposition and the timeless popularity of mining stocks in Australia indicates we are indeed a nation of gamblers.
I regularly receive calls regarding XYZ Resources or ZYX Energy Exploration. The usual information we receive is that the company is drilling here or there. We are then asked why we haven’t valued this business? My response? To be investment grade the company in question must demonstrate sustainable profits and have excellent returns on capital employed.
Does the company make any money? Does the company have a consistent track record of doing so? Does the company have a high return on equity, etc …?
Sure, the company might find an economic asset and it might rise from a small exploration company into a low-cost producer. But this is all speculation and has nothing to do with being an investor.
I was recently asked to give an opinion on a small mineral exploration company in Western Australia called Galaxy Resources Limited (GXY). Galaxy is a diversified exploration company with interests in five targeted projects in Western Australia covering a range of commodities including lithium, tantalum, base metals (copper, zinc, nickel), gold, iron ore, rare earths and uranium.
Galaxy listed on the ASX in February 2007, an opportunistic time given the hype surrounding resources. It raised $3 million through the issue of 15 million shares at 20¢.
Mt Cattlin is the centrepiece of Galaxy’s 185 square kilometre holding within the Ravensthorpe Greenstone Belt (Figure 2), a Lithium and Tantalum deposit that appears to be the company’s principle focus of activities. Lithium is often used in heat transfer applications such as rechargeable and single-use batteries, while the major use for tantalum is in the production of electronic components (mainly capacitors and some high-power resistors).
Drilling in this region has successfully located a potential resource base, and a pre-feasibility study suggests the project is viable and capable of generating significant revenues. An open-pit mine is planned and the life of the mine based on current mineral resource estimates is 10 years.
All this sounds promising. Based on current commodity prices, forecast production levels and expenses, the company has every chance of becoming profitable. While the speculators among you would say it’s worth a punt, investors would head straight to the financial reports to get a better feel for the company’s position before even contemplating risking their capital.
As the company listed in February 2007, we only have just over one year’s financial data available: the 2007 annual report and the report for the December half. Historical data is needed to value a business accurately. (StockVal, the proprietary stock valuation method at my company, Clime Capital, requires at least three years’ historical data.)
Starting with the 2007 annual report, we head straight for the balance sheet and the profit and loss statement, the two reports that provide an indication of what has happened to the business over the course of an entire year. In this case, the period is 2006-07.
For those not familiar with these two statements, the balance sheet provides a snapshot of the company at a particular time, its assets (what it owns) and its liabilities (what it owes). The profit and loss statement, or income statement, shows what those assets and liabilities were able to produce for the businesses owners (shareholders) over the course of the period in between.
Galaxy’s income statement (Table 1) reveals a number of important qualitative facts.
1. The company is not generating any revenue other than interest from monies held in the bank account. This tells us that the company is yet to start mining and selling resources and is still in the exploration/feasibility phase.
2. The majority of expenses the company incurred over the past year relate to:
- Consulting fees, that is fees paid to geologists to locate areas worthy of further exploration and assess or quantify finds.
- Fees and benefits paid to the company’s directors for running the company.
- General office, administrative, accounting and legal expenses: the basics of every company’s ongoing expenses.
3. The company reported an accounting net loss of $374,000 for the full financial year. This loss could have been in the millions if all exploration expenditure had been written off instead of the token amount shown here.
Galaxy’s income statement gives a feel for where money is being generated and where it is being expensed. The balance sheet (Table 2), however reveals considerably more information.
1. First, the increase in contributed equity over the year totals about $3.8 million. This represents the cash the company raised from “investors” in the IPO, through a further placement of shares and the exercise of options to fund the company’s exploration program and feasibility study.
2. Cash is ultimately kept in the bank account (hence the interest income in the profit and loss account) until it is required to fund exploration – that is, drilling activities. As can be seen below, Galaxy’s bank account balance stands at $1.7 million, an increase of $1.2 million from the $500,000 balance last year. Given the company had no business revenue and only earned interest of $72,000, the bulk of this increase in cash – $1.13 million – is from the capital raising. This brings a question immediately to mind: if the company raised $3.8 million in cash over the year, lost $400,000, and has increased its bank account by $1.2 million, where has $2.2 million disappeared to?
3. Other assets under non-current assets explains the difference. Over the year the company spent $2.3 million in exploring their tenements and evaluating their potential resource base. Normal business practice dictates that if you spend money, that is classified as an expense and it goes through the profit and loss account offsetting any revenues earned, the difference being either a taxable net profit or a net loss. In the case of mining companies, however, accounting standards allow these companies to capitalise these outgoings as an asset on the balance sheet. Irrespective of the accounting standard, clearly expenses are not an asset, so in reading this balance sheet investors need to be aware that the biggest asset the company is currently showing are capitalised expenses. As already stated, had these expenses been expensed through the profit and loss account like an ordinary business, the loss for the year could have been closer to $2.7 million, a materially different outcome from the accounting loss reported in the income statement of only $400,000.
Bringing together the profit and loss account and balance sheet movements, we are now developing a clear picture. While management talks about the Mt Cattlin resource as a viable and capable project, we have deduced:
1) The business is currently not generating any revenues and is burning through cash at $183,000 a month.
2) Directors have been paid almost $200,000 in fees and benefits over the financial year.
3) The assets shown in the balance sheet are mostly capitalised expenses and are worth nothing until a commercially viable resource is found.
4) The current bank account balance of $1.7 million, while the highest quality asset around, will only support 10 months of “cash burn” at current rates. It is therefore highly likely within the year that the company will have to raise further capital if it wishes to extend its period of cash burn.
While all this paints an unimpressive picture for the first year of operation, perhaps the latest half-year report will show a different story.
Again looking at the profit and loss statement (Table 3), we can conclude the following:
1. The company is not generating any revenue other than interest from monies held in the bank account. Again, the company appears to still be in exploration/feasibility study phase.
2. Expenses are in line with those identified previously.
3. The company this time “reported” an “accounting” net loss of $140,000 for the first six months.
Again, as discussed previously, this loss is likely to be materially different after taking into account capitalised exploration and evaluation expenditure in the balance sheet: only $13,903 has been actually written off here.
So from the full-year profit and loss statement, very little has changed. Let’s take a look at the most recent balance sheet (Table 4), which covers the previous six month period.
1. There has been little movement in contributed equity. This shows that the business did not raise further funds from shareholders over the past six months.
2. Cash in the bank account has decreased by $1.3 million and now stands at $400,000, reflecting a much faster cash burn than the previous year.
3. The company has capitalised a further $800,000 of exploration and evaluation expenditure as an asset. Had these expenses gone through the income statement, the net loss for the first half would have been closer to $1 million as opposed to the $140,000 “accounting” loss reported.
4. Trade and other payables have reduced by $400,000. This shows that the company used cash to pay the majority of the bills owed to creditors.
Having looked at the financials of the business we are in a much better position to judge management’s statements and determine whether or not an investment case can be met.
Let’s consider what we have discovered. Again, bringing together our analysis of the profit and loss account and balance sheet movements over the past year and half we have discovered that:
1. The company is not generating revenues other than interest income from cash raised in the IPO, subsequent placements and the exercising of options.
2. Cash assets have almost been exhausted. The current bank account balance of $400,000 will not support existing levels of “cash burn” required for continued exploration and evaluation programs. The company will have to raise further capital if it is to survive and continue burning money through exploration and evaluation.
On the latter point, an announcement was made by the company in late February 2008 entitled Galaxy secures additional funding. A staged exercise of unlisted options totalling $1,795,000 will boost cash reserves and enable the continuation of the Mt Cattlin feasibility study and ongoing exploration program to continue for another six to 12 months. Survival hinged on the cash injection. Without fresh capital, a very short voluntary administration would have been a probable alternative. Previously the company had 44.7 million shares outstanding. The staged exercise of options will see this level rise to 59.9 million, a 34% increase in the number of shares outstanding.
3. Directors have been paid fees and benefits totalling $240,000 over a one and half year period. Not bad considering the company is yet to make a taxable dollar.
4. The largest asset shown in the balance sheet remains capitalised expenses or “other assets”. These so-called assets are still worthless. Writing off the entire $4,197,744 leaves current investors owning a mere $406,630 (about 1¢ per share). Ninety percent of their initial cash injection of $3.8 million has gone down the proverbial toilet.
Mt Cattlin may well prove to be a highly profitable venture given current commodity price levels. The company may even strike another resource base in the near future, providing shareholders with excellent returns.
That is, by definition pure speculation.
Given the financial information we have to date, and the level of wealth erosion presently occurring, it would be hard to justify allocating a portion of an investment portfolio to Galaxy, irrespective of what the share price is doing.
Given we have looked into the company’s financial statements, seen the rate at which cash is being spent, assessed the lack of quality in the assets on the balance sheet and lack of any track record of making any profits out of drilling holes at Mt Cattlin, we can argue that the shares are grossly overpriced.
When you buy shares in these companies, you are by definition not investing, you are speculating. True value investors would sooner bury their money themselves. At least they can be sure they will find something when they subsequently dig.
If you are looking to position your portfolio to gain exposure to the continued commodity boom, BHP and its ilk should be on your radar. A very substantial discount to intrinsic value should also be demanded.
If a gamble is more your cup of tea, there are 686 currently unprofitable companies falling under the gold, energy, diversified resources and other metals sectors: certainly no shortage of options to choose from.
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