July 13, 2010
Escape From Finance Thinking
August 1, 2010


There are only two times when you can make large multiples on your money in mining (three if you want to roll the dice on exploration). The first of these is a situation where there was a failed production start-up and the company now trades for a good deal less than was spent to build it. The other time you can make large multiples on your money is when you have a world class asset that is about to go into production. Mining companies like to confuse investors with the notion that big is the same as world class. It isn’t. Big just means big—low grade is still low grade and return on capital is all that really matters in the end. A world class asset is one that has high returns on capital, a cap-ex payback of less than two years and a cost per ounce in the bottom quarter of all mines. Finally, it needs to be in a politically safe place that supports mining.

The problem with most junior mining companies is that they’re frequently about stock promotion. Insiders get their shares for pennies and then try to use public funds to go out and drill holes. They never really have any intention of building a mine. They just want to get the shares up and blow out of them. These companies are mostly run by slick finance guys or incompetent geologists. The best way to make an asset seem important is to keep poking it with holes so you have more press releases and a bigger resource. In reality, this is stupid. You only need a big enough resource to get the banks to fund it—nothing more. If you keep spending money you don’t have—you create endless dilution. Getting bank funding is important as it significantly less dilutive than other financing methods—it is also much more difficult to achieve—which is why you rarely ever see it.

Andean American Mining (AAG: Canada) is a $53 million market cap junior that doesn’t play by the normal rules and is therefore virtually unknown. Andean is run by John Huguet, a man who’s been responsible for building dozens of mines as part of Atkinson Commonwealth Construction. He knows his way around engineering, he knows how to build something on the cheap and he knows how to think on the fly to avoid delays that are the main reason for cost overruns. Huguet put millions of his own money into this company and is not about to suffer endless dilution just to drill holes and wow the market. He thinks like an owner and that’s why I like him.

Portal to the 3400 level discovery

Andean’s key asset is the Invicta deposit in Peru. Peru is politically safe and friendly to mining. There is good infrastructure near the mine and the local community is supportive.  The reason I’m so excited about Andean is the asset. As it currently stands, the resource is 7.8 million tonnes with an average grade of 2.14g/t Au, 16.08 g/t Ag, 0.43% Cu, 0.32% Pb and 0.30% Zn. Using base case $USD metal prices of Au 900/oz, Ag 12.50/oz, Cu 2.50/lb, Pb 0.70/lb and ZN 0.75/lb, the mine should produce $66 million of cash flow in year one which should ramp up to $91 million by year three when the mine is at full capacity. The anticipated cap-ex is $65 million, which means that you are looking at less than a one year payback using the base case scenario. There are very few assets in the world with the potential to yield a 100% return on capital. Clearly, this is a phenomenal mine.

The best way to think of a mine is to look at the dollar value of an average tonne of rock, subtract the cost of mining that rock, adjust for recoveries and get a total profit per tonne processed. Then, you multiply that number by the expected tonnage for the year and you can get to a cash flow number. Based on the base case pricing scenario, a tonne of rock at Invicta is worth about $100. Mine costs are expected to be $31 a tonne the first year and then drop to $24 a tonne by year three. This leaves you with a lot of gross margin per tonne. Calculated net of byproduct credits (deducting revenues from other metals), the mine produces an average of 97,000 ounces of gold a year at a negative cash cost of $126 an ounce. Clearly this is a very low cost mine as well.

Invicta Core Shack

Invicta is the classic definition of a world class asset—high returns on capital, quick project payback and low operating cost. Then there is the part that REALLY gets me excited. While building an adit in order to create drill stations to further define the ore body, Andean made a phenomenal discovery. The main ore body is an epithermal system. As they drove the adit, they unexpectedly came upon a mesothermal system at the 3400 level. I’m not a geologist, but I know that mesothermal is good. They have now advanced the adit nearly a kilometer into this vein and it is open along strike in both directions. It averages 23 meters wide and at today’s metal prices, the rock is very lucrative to mine. Upon making a discovery like this, most juniors would have diluted shareholders, raised $10 million and drilled this. John Huguet does not run Andean like most juniors. After realizing he had something amazing, he did the unthinkable—he stopped advancing the adit to conserve cash. He didn’t want to spend a dollar more than needed. He will explore it using cash flow from the mine. So it’s time for blatant speculation. How big is this ore body?

There’s no way to know how long this vein is and very limited testing has been done to see how deep it goes. There are a few cross-cuts so they know that it averages about 23 meters of mineralization. Besides some chip samples, they do not even know the average grade. As I walked along this adit, I would call out a meter mark and the Andean geologist would read off the grades to me. It’s entertaining, but clearly not scientifically valid. Sections range from $100 a tonne to over $1,000 a tonne. By eyeballing it, I’m guessing it averages $200 to $300 a tonne. I have no idea if I’m actually close. However, the highest grade section was right where they stopped the adit. My fund paid for a trusted geologist to visit the site. Based on the current dimensions, and his extensive knowledge of mining, his guess is that the vein they found contains 4 to 7 million ounces of gold equivalent. Is he right? Who knows? Fortunately, I don’t have to base my investment upon his estimate. The only sure thing is that there’s at least a few months of ore that’s worth more than twice the average grade of the main deposit. I’ve been to a fair number of deposits. I’ve never seen anything as mineralized as this adit. My own experience would tell me that there is more to this vein than just what I saw. How much more? Who knows, but it certainly adds a lot of upside to the story if this vein is big. Based on the strength of the mineralization, it’s unlikely to be a small vein.

Massive Invicta Veins. These Are Highly Mineralized

Geologic history would indicate that when you find a vein that is this highly mineralized, there are likely to be others like it nearby. The company has done very limited regional geology. They’ve found a few pretty surface rocks, taken samples of them and the grades have been off the charts. Does it mean anything definitive? No. Is it good news? Absolutely. Given the size and grade of the new vein, there are likely to be multiple veins on the property. It may take some time and money to find them, but there’s a very good chance that they’re there. All of a sudden, this changes things. No longer is this one 7.8 million tonne deposit with additional inferred resources. This is a district play that seems to have a lot of upside exploration potential. The mine life is no longer capped at five years with another seven years of inferred resources. There’s a very good chance that once the company spends money on exploration, they will be able to find enough ore to feed the mill for a very long time—potentially at a much higher grade. This has all the makings of a significant discovery.

Often when investing in mining, you mostly know what you have. The orebody has been extensively drilled and they’ve mined the highest grade portions first. That means that over time, you’re liable to only be disappointed—it’s unlikely that the average grade will increase. The upside is limited. At Invicta, more testing will very likely increase the average grade. Upside surprises can be quite lucrative in mining.

That’s valuable rock!

The company has roughly 95 million shares outstanding. Based on that share count, the company should produce between 69 and 96 cents a share of cash flow a year according to the base case scenario. At a current share price of 56 cents, you’re paying less than one times expected cash flow, however; the share count will increase modestly as the company issues some additional shares to fund operations until they can access the bank financing. Bank financing has been a work in progress which they started in 2008. The collapse of the banking system forced them to put things on hold and wait for a more favorable environment. They’re now pretty far along in the process and they hope to finalize and draw on bank debt sometime in the fourth quarter. Following that, they will begin to build the mine and production should start about a year later.

Comparable companies at a similar stage of development would likely trade for a few dollars a share. Yesterday, Andean closed at 56 cents. Why is this so cheap? For starters, no one knows it exists. There are a few thousand junior mining companies and a few of them slip through the cracks in the investment world. In particular, people tend to ignore you if you haven’t paid investment banking fees in years, have no analyst coverage, put no effort into investor relations, rarely put out press releases and are generally oblivious to the way that a normally promotional junior mining company is supposed to operate. The company is run by people who build mines—they are not stock promoters. It’s hard to blame them for not wasting money on telling the story. Andean slipped through the cracks. This is changing now.

Last month, Andean hired a new CFO, Bruce Ramsden, to expedite the banking due diligence and a new president, David Rae, to help negotiate the financing and finally tell the market that Andean exists.

There’s metal in these hills. The company just hasn’t spent the money to figure out where.

Let’s talk risks. This is mining. Absolutely anything imaginable can go wrong and usually does. The economics of this mine are so robust that it is somewhat immune, but things always go wrong. To quickly go over my biggest fears in mining at Invicta you have the following:

Community Relations—You need to work hard not to alienate those living nearby. Most mining companies do a decent job of this. However, little incidents can become serious misunderstandings. If you lose the support of your local community, your mine is as good as finished. This is always a risk—it is a big risk.

Roads—The deposit is near a main road, but that doesn’t always mean it’s easily accessible. When I visited, we went up a dirt road. It was 2,000 meters straight down if we slipped and was not wide enough to ride a mule up. Naturally we rode pickup trucks. The company plans to build a low gradient road to the site. This will be an engineering feat. I have confidence that they can achieve it, but the risk is that it costs a lot more than they expect it to.

Capital Cost—The cap-ex is stated at $65 million including a $7 million contingency. There is an added contingency as the company will gradually get back the IGV of $9 million. This means that they’re budgeting $65 million for a mine that they expect will cost $49 million to build. I went over all the sizable items. I think the company has been very conservative. John Huguet has built a lot of mines. He knows how to keep costs down. Then again, this is mining. Small delays can rapidly escalate into very expensive problems. There’s a fat cushion here on the cap-ex. I hope it’s sufficient.

Recoveries—The company intends to use Knelson concentrators. Gravity is one of the cheapest processing methods. On small tests, this seems to work well. That’s not always what happens when you do it on a much larger scale. Lower recoveries could seriously harm the mine economics.

Financing—This really is my worry. The economics of this mine are just so good that even if they’re off by a bit on their numbers—and they probably are—it won’t really be a mine killer. Funding is a process. The company is slowly moving along that process. So far nothing is critically wrong—which is a good thing—but it takes time and there’s no way to know if the world financial system will remain stable until then. Financing is a real risk here.

If they cannot get bank financing, there are quite a few other ways to fund the mine. In order of least to greatest dilution; they can monetize their interest in Sinchao Metals Corp (SMZ: Canada), they can sell a royalty stream to an entity like Royal Gold (RGLD: Nasdaq), they can use convertible debt, they can partner with a larger mining company, they can finance with equity or they can do a combination of the above. Invicta is unique because the banks are even willing to consider financing it. Most juniors do not have a chance to do anything but an all equity financing. John Huguet could have built this mine a while ago if he was willing to accept that sort of dilution to get funding. He’s been patient for this long because the bank debt will entail significantly less dilution. If he is forced to go another route, I am pretty confident that he will be creative and minimize share issuances. The fortunate thing about having an amazing asset is that lots of people are willing to partner with you.

Site Enterance

So what’s this all worth? Based on a few comparables, at this stage of development, the shares should trade for a dollar or two. If they can build and commission the mine roughly in line with estimates and do it with minimal dilution the shares are likely worth something in the mid single digits. Finally, if the high grade zone turns out to be extensive, this could potentially be a double digits share price. Clearly, this is mining and there’s a whole lot of speculation in here. Nothing ever goes as planned—we shouldn’t expect it to. I think there’s a lot of safety in the mine economics. They just need to get funded. Given their assets, I think the downside is somewhat shielded. If they cannot get funding, they could likely sell the deposit for at least twice today’s quote—even in a fire sale. A proper auction would likely yield even better results.

A deposit without financing is just a hole in the ground. It’s a pure speculation. I have hesitated to write about Andean until I got to meet the new management hires. I really wanted to wait until the bank financing was almost assured. However, a few friends have now met with the new management team and been quite impressed. On the financing side, things are advancing—but so are the shares. I had wanted to wait until this was more of a sure thing, but I have instead posted this now as the shares have started to pop. The company has finally started to tell the story and as they get more active, the shares will likely continue to increase. I will be meeting with the new management hires in two weeks and will report on anything new I learn..

Disclosure: My partnership owns shares of Andean American. We may buy or sell shares without further notice.

Categories: Current Investments
Positions Mentioned: AAG.v

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