The Globe and Mail

  Hot commodity or value trap?


Tuesday, September 25, 2012

Separating the scintillating value opportunities from the sneaky value traps is always a challenge for the contrarian investor. One that Ben has been painstakingly puzzling over for the past year is Thompson Creek Metals. Following it has been a classic case of the cheap getting cheaper. However, since hitting a 52-week low of $2.23 on August 13, the stock has had a sprightly 50 percent rebound. Has the turn finally been made?

Thompson gained fame during the great molybdenum boom of the mid-2000s. The metal is as tricky to pronounce as it is to dig out of the ground — it is never found in its pure form, requiring the excavation of vast amounts of material and intensive processing. Yet its capacity to make strong steel alloys makes it a valuable industrial commodity.

Extraction typically occurs in conjunction with other metals, such as copper. The company's two operating mines — its namesake in Idaho and the 75 percent-owned Endako in British Columbia — are atypical, as they are exclusively molybdenum.

It was this aspect as a "molly pure play" that made it a natural candidate for Sprott's launch of the Molybdenum Participation fund in 2007. That helped push Thompson's share price to a high of $25.58 in October of that year.

Since then, it has been pretty much downhill. The commodity crash in 2008 took molybdenum prices with it, and Sprott's mollymobile was ignominiously junked in 2009. Molybdenum prices have made little progress during the weak economic recovery, currently at about $11 a pound, down from $18 in early 2011 and a far cry from the high of $46 in 2005.

During the bonanza years, Thompson had a fine balance sheet with low debt and a nest egg of over half a billion in cash was accumulated. Management decided being a pure molly play was no longer such a great idea, and looked to diversify into other metals to emulate its giant competitors.

The ticket was the acquisition of the Mount Milligan copper-gold project in north-central B.C. in 2010 for $650 million. Reserves at the site are 2.1 billion pounds of copper and 6 million ounces of gold. A feasibility study concluded the mine could produce 81 million pounds of copper and 194,000 ounces of gold per year.

In May 2011 the project gained momentum with the issue of $350 million in debt at a rate of 7.4 percent, due 2018. But construction costs in the remote area escalated sharply, from an early estimate of about $1 billion to $1.5 billion. With the molybdenum mines contributing much less cash flow than anticipated, Thompson has been forced into a series of increasingly painful financing options.

Last December, Royal Gold increased its stake in the mine by another 15 percent for $270 million. In May a further $412 million was raised in a complex deal. Of that amount, $200 million was in the form of notes payable in 2019 at a steep interest rate of 12.5 percent. The remainder was in tangible equity units, a debt/equity hybrid dreamed up by the big brains at JP Morgan. These units have an effective interest rate of 11.7 percent and will be converted to equity in 2015.

The degree of dilution will depend on the stock price at that time, likely in the neighbourhood of 25 percent. Moody's cut the rating on Thompson's debt from B3 to a lowly Caa1.

Operational problems forced one more trip to the well, and last month a further 12.25 percent interest was sold to Royal Gold for $200 million. With a bit of luck, that should finally be sufficient to see the project start operations in the fourth quarter of 2013.

A highly productive mine spinning off plenty of cash flow in 2014 is a plausible scenario that has enticed fund managers such as George Soros and David Dreman. Insiders have also shown their confidence with purchases. But there is a nagging doubt here that CEO Kevin Loughrey is chasing his big dream. Sure, it requires skill to efficiently run a mine, but building one from scratch is a far more noteworthy challenge. In his drive to succeed, has he given up too much?

One problem is that the agreement with Royal Gold is not to split the profits, but for Thompson to sell 52.25 percent of gold production to Royal at $435 an ounce. If the expenses are well above that — which could easily happen — then Thompson will be losing money on over half of its gold production. And if molybdenum or copper prices soften, Loughrey will be negotiating a thicket of debt covenants.

If the U.S. Federal Reserve's latest round of monetary stimulus works as advertised, a rally in commodity prices can be expected and Thompson Creek could prove to be a wise gamble.

For now, Ben is thinking about Hemingway's story The Old Man and the Sea. Loughrey may bring his marlin home, but after the sharks have had their share, it is questionable how much meat will be left on the skeleton.