FROM COLD WAR TO GOLD WAR: TMAC RESOURCES AND THE CHINESE

When the West and China get in a fight, it’s usually over things like technology transfer, corporate espionage or political prisoners.

That’s a Cold War. I’m talking to you today about a Gold War—but from an investor point of view. There is potentially a lot of money to be made here!

In fact, there’s an argument this is one of the surest investor bets in North American precious metal stocks today.

You see, a Chinese company has made a take-over play for TMAC Resources (TMR-TSX), which owns a struggling gold mine in Canada’s Arctic. But officials as senior as the ex-head of Canada’s national security agency, one Richard Fadden, suggests this is not such a good idea.

As a result, the stock is trading at 50% of the buyout price, and a US white knight investor is saying he can raise $700 million to make the mine a cash cow for investors if the buyout fails. Either way investors win big! (I am not long at this moment)

Here’s the story:

In a gold market that feels a bit frothy, TMAC Resources (TMR – TSX) presents itself as an interesting arb and value play all rolled into one.

I learned of TMAC from a RealVision interview with James Rasteh. Rasteh is the CIO of Coast Capital LLC. 

While Rasteh is not a gold bug, he is neck deep in gold miners– specifically the higher risk small and mid caps.

Rasteh observes–as I have–that there is a disconnect between the valuation of the majors and smaller names. He is taking advantage of that disconnect by going after smaller operations that are often trading at 2-3x cash flow.

Rasteh has had success in the past. His first move was Detour Gold in 2018. He joined another hedge fund manager, John Paulson, in calling for the sale of Detour. Eventually their pressure tactics worked, and Detour was acquired by Kirkland Lake Gold.

Three weeks ago, Rasteh tipped his hand on TMAC.

In an article published in Toronto’s Globe and Mail newspaper, Rasteh “urged” the Canadian government to reject the acquisition of TMAC by a Chinese state-owned gold company – Shandong Gold Mining Co.

Shandong had offered to acquire TMAC for C$1.75 of cash on May 8th.

Rasteh is not making a counteroffer. Instead, he says he will raise $700 million – not small potatoes – to turn around the operation and keep it in Canadian hands (Rasteh has Canadian roots himself, though he now lives in New York City). 

Coast Capital holds a 1% position in TMAC at last disclosure.

 

TMAC and Canadian National Interest

(isn’t gold a widespread global industry?)

 

On the surface, the acquisition of TMAC by Shandong would appear to be a done deal. It has been approved by shareholders by the Ontario court and by the Commissioner of Competition.

But there is a rub.  It comes down to where TMAC’s mine is located and who is buying it.

TMAC operates a single mine, called Hope Bay. Hope Bay is in Canada’s far North, in Nunavut, over 600 km northwest of Yellowknife. 

Source: TMAC March NI 43-101 Technical Report

As Toronto’s Globe and Mail newspaper says, Hope Bay is a “strategically sensitive area”. It is near the Northwest Passage tidewater along shipping routes.

I guess somebody thinks they will be sneaky and put in a super secret surveillance system? I can’t believe it’s because gold is sensitive, as Fadden says. That smells of a red herring.

Does Canada really want the Chinese state buying up real estate in the Arctic? And mining Canadian gold? 

Given the acrimonious relationship between Canada and China right now, I’m not so sure. The Canadian public isn’t either. A Hill+Knowlton Strategies poll in May found that 15% of Canadians support

With bi-lateral relations at a low point right now, Chinese companies buying large stakes in Canadian companies may have a difficult time.

The decision will come from Liberal Innovation Minister Navdeep Bains. Bains will determine whether the transaction qualifies as strategic under the Investment Canada Act.

If it does, the project will require a full government review.

A recent twist comes from new legislation introduced this summer. It gives the government more time to decide (6 months instead of 45 days). Ottawa is now not expected to rule on a full review until mid-October.

If the ruling comes down against the transaction, the deal will be in jeopardy. 

The arrangement agreement between TMAC and Shandong ends February 8th, 2021. There is no way that a full-blown strategic review gets done in 3 months. 

I read through the arrangement agreement, and while it is your typical legalese and difficult to pin down for a mere layman like me, it sure sounds to me like if the deal is not done by Feb 8th, that either party can back out.

If I am right about that, it sets up an interesting situation.

 

Not Your Typical “Arb” Play

 

When Shandong announced the acquisition of TMAC, gold mining investors took their money and ran. They were replaced by the usual suspects – “arb” players.

Arb is short for risk arbitrage. It is a strategy of profiting from the gap between the stock price and the acquisition price of a takeover.

With TMAC, because of the uncertainty around a Chinese acquisition, the arb has been steep. While the stock traded briefly at the $1.70 level after the announcement it has mostly hovered between $1.40-$1.50. A tidy profit for the arb trader if the deal goes through.

But this week, perhaps because of the review extension, perhaps because of Coast Capital, TMAC’s stock price fell out of bed.

Source: Stockcharts.com

I think the selling was likely the arbs fleeing the ship. At Friday’s close of $1.16, the price represents a 50% discount to Shandong’s offer. 

That is a decent upside if the deal goes through. But where it gets interesting is what the upside might be if it does not.

 

TMAC as a Going Concern

 

Hope Bay has never lived up to expectations since entering commercial production in June 2017. 

The 2015 prefeasibility study on Hope Bay forecast production of over 200,000 ounces in 2018 and 175,000 ounces in both 2019 and 2020. AISC (All-In-Sustaining-Costs) for the mine life was expected to average $785 per ounce.

Instead production came in well below that – at 110,000 ounces in 2018 and 139,000 ounces in 2019. Costs have never come close to expectations – AISC has exceeded $1,000 per ounce every quarter since commercial production.

 

Source: TMAC Resources MD&A’s

The problems have been many. First the mine struggled with recoveries.  Then it was instability at some of the underground mine workings. 

The biggest mistake that TMAC made was when they decided to start small. Rather than develop Hope Bay’s 5 underground deposits at the same time, they took the cheaper route and developed one at a time.

While starting small sounds like prudent capital management, the reality of mining is that flexibility is key – having multiple ore bodies to choose from means that if something happens to one (ie. rock instability) you shift focus to the others until the problem is sorted out. 

Without flexibility, hiccups drop directly to the bottom line.

That is what has happened here. 

But apart from problems of scale, Hope Bay has its positives. 

There is a lot of high-grade ore. Proven and probable reserves are 3.5 million ounces and at a relatively high grade of 6.5 g/t. Measured and indicated resource are 5 million ounces and inferred is another 2 million ounces.

Exploration has been successful. Regional exploration has shown success with indications of new zones. Drilling below the existing resource showed further extensions at the Boston Depost. And in August, TMAC announced promising near surface results – at Doris Valley assays showed intercepts of 9.0 g/t over 8.5 metres and 5.3 g/t of gold over 4.8 metres – and these were just 15 metres from surface. These results suggest that a high-grade open pit may be possible.

 

The Need for Capital

 

TMAC recognized that they needed scale.  They completed a preliminary feasibility study in March of this year that looked at a Hope Bay expansion.

The NI 43-101 essentially says there is nothing wrong with the deposits. The risk of geology is “low”, and there is “upside” to the resource through lower dilution than what has been modeled.

The problem is instead one of capital. The report estimates $683 million is required for an expansion.

Source: NI 43-101 TECHNICAL REPORT ON THE HOPE BAY PROPERTY

So it is no coincidence that Rasteh says he can raise $700 million if he is given the chance.

The capital expenditure would turn Hope Bay into a world class mine. A second processing plant would be built, and tonnage would more than double. All 5 underground deposits would be mined concurrently. Annual gold production would rise to over 250,000 ounces per year and production would extend 15 years.

 

Reason to Hope

 

The other piece of the puzzle is the price of gold. 

When TMAC was struggling with profitability gold was $1,400 per ounce or less. Today it is over $500/oz higher –a lot more margin than a few months ago.

Hope Bay could become a world-class mine one day. Today it is not. But at today’s gold price, Hope Bay is also not a money-pit.

If you take away the fourth quarter results (which were extremely poor with AISC of over $1,700/oz), all-in-costs at Hope Bay have averaged a little over $1,123/oz for the last 7 quarters.

That is nothing to write home about, but at $1,900 gold it is also over $775/oz of free cash margin.  At even a reduced production level of 100,000 ounces annually you are looking at ~$75 million of free cash generation from the mine and ~$40-45 million at the corporate level.

TMAC has a market capitalization of $142 million. They have debt – about $169 million of it, and $45 million of cash.

If my back-of-the-envelope free cash flow calculation is anywhere close to accurate the stock is trading at 3-3.5x free cash.

Add to that the potential for a capital raise and a mine expansion 4 years down the road and the situation starts to look like reasonably priced growth story even if the Shandong bid is rejected.

If Shandong is approved, then you just take your 40-50% gain and move on.

TMAC has only once before traded this low – and that was when gold stocks were being massacred at the end of March.  

In fact, TMAC was a $3.50 stock as recently as January. Even after the company announced extremely poor fourth quarter results, the stock remained over $2.

There are explorers with a few good holes trading at $100 million capitalizations right now. TMAC is at double that and they have 5 million ounces and a mine. 

It is a complicated story. Multiple outcomes are possible. There are likely to be fireworks. 

But even if the bid from Shandong is rejected, the current price seems unduly cheap. 

Consider that most gold stocks are up 50% to 100% (if not more!) from their pre-pandemic levels. TMAC is trading well below where they did before the pandemic (which was between $2-$3). 

This even after TMAC put up decent first and second quarter numbers (Q1 cash costs and AISC of $906/oz and $1,317/oz, Q2 cash costs and AISC of $865/oz and $990/oz respectively).  This even after Rasteh has stepped in and offered an alternative source of capital if the Shandong bid is squashed. 

I look around the gold universe and I do not see very many 100,000+ ounce producers with the kind of reserves and exploration potential that TMAC has trading at $260 million all-in.

I suspect the selling here is supply and demand. The arbs want out and every one else is gun-shy. The stocks in no mans land. It could stay there for a while. But when the dust clears, this is a war where a savvy shareholder could win big.