I have made some good risk arbitrage trades most recently on Corvette and Cape Lambert and before that on Dow and Rohm & Hass. There is an opportunity now in Felix resources.

Yanzhou Coal ( YZC ) have agreed to purchase Felix Resources. The Australian Foreign Investment Review Board was a major sticking point. That is now resolved with the conditional approval provided yesterday. Felix closed at $16.75 on Friday 23rd. The YZC offer price is $17.5. That is 4.5% in 2 months or 27% annualized. Though that isn’t the exciting opportunity.

The YZC bid for Felix was barely adequate when it was announced. On the basis of coal price and market moves since the August announcement the YZC offer is too low. I estimate that there is now a much better than 50% chance of a competing bid (or an increased offer from YHZ):

• A DCF of Felix values it closer to $24-$30
• YHZ have accepted onerous conditions from the FIRB
• The market for M&A has reopened
• There is some minor discontent about the deal within FLX shareholder ranks.

I suggested in this post on sniping Felix that a competing bid would wait until November. I also identified the potential alternate bidders for Felix in another post. BHP and Vale are obvious suitors. Xstrata was a no show at that time but things have improved for them since and they have an obvious advantage with their Ulan mine next to Moolarben.

The trade and the odds

Buy FLX at 16.75;

* including dividends

The probability adjusted profit is $2.78 over a probability adjusted period of 5 months for an annualized profit of 40%.

Short Term

If your timeframe is just a risk arbitrage on this position, then deal fails case becomes;

The probability adjusted profit is $1.78 over a probability adjusted period of 2.9 months for an annualized profit of 44%.

It’s not often that you get the opportunity to make a risk adjusted profit of 40%+ where your downside is limited by the cheapness of the assets.

posted by Neil  # 10:14 PM 0 comments

Lynas Corporation (LYC) is traded on the ASX. They are building a Rare Earths (RE) mine in Western Australia and a processing plant in Malaysia.

Rare Earths have been capturing quite a lot of attention amongst early investors. A short introduction can be found at the following links:

• Rare earths are vital, and China owns them all
• China predicts rare earths shortage
• Rare earths offer unique investment opportunity

Until recently they were going to sell slightly over 50% of themselves to the Chinese in exchange for equity and guaranteed loans. The Australian Foreign Investment Review Board (FIRB) rejected the application and the Chinese deal collapsed. Instead LYC have launched a massive capital raising, made much easier by Australia’s laws which allow rights issues and institutional sales without a prospectus. Large capital raising can go ahead in only a few hours.

The capital raising consists of:

• $88M placement
• $295 rights offering
• $67M conditional placement

Based on 670M shares (inclusive of in the money options) outstanding before the offer they will add about 1bn shares.

Before tax based on:

• $9.6 US per kg of RE sold, increasing by 5% per year
• $7.45US per Kg of all in costs , increasing by 3% per year
• Long term AUD/USD of 90c
• 10,500 tonnes in year one growing to 20,000 in year 6
• Production commencing in 1 year
• Cost of equity of 13.4%

LYC would be worth about 32c after the capital raising. To get to today’s price of 60c AUD you need to assume that RE price grow by 8% per year. 8% a year may not seem like much but that is $41 per kg in year 20. Alternatively you get to today’s price by taking the $14 all time high for LYC’s basket of RE’s and growing that by 3% per year for 20 years. Again, if that happens then you break even. Remember this is all before tax.

Lynas is planning to get to production without any debt having had bad experiences with debt financing up to now. While the value of the firm should not change based on the capital structure (Modigliani and Miller equivalence and all) the returns to equity would have been much higher with a mix of debt. While this is often true it’s worth noting in this case because the dilution from this capital raising is so substantial.

Buying into Lynas is a leveraged play on Rare Earths. If you think they are going to go up over 4 times in the next 20 years then you’ll break even!

You would have to have very bullish assumptions on RE prices to buy into Lynas at these prices.

posted by Neil  # 10:13 AM 0 comments

Natural Gas Partners (NGP) proposed a series of transactions with Eagle Rock Energy Partners (EROC), as detailed in this post. NGP have just submitted a revised term sheet to EROC.

The changes mentioned in EROC’s press release are:

• $145M instead of $135M for Mineral Business
• $4M less in fees to NGP and fee can be paid in units if the equity raising is less than 105M
• Option on remaining GP units extended to 2012 from 2010

By redlining the two documents the following changes are also proposed:

• Warrants only exercisable four times a year
• If the public equity offering price is above $3.40 then EROC will issue up to $140M instead of $105M
• Sale of the Mineral Assets will be effective on January 1^st, 2010. All profits from then until closing will accrue to NGP.
• EROC can set up a data room and may market the mineral business. An alternate deal has 100 days and can be for all or part of the minerals business. It must be for more than $145M and must either close within 100 days or have no conditions.
• They clarify that the transaction fee is only payable if the approvals are obtained
• Proceeds can be used for hedge resets
• NGP could terminate the agreement between the definitive agreement and the approval if the share price dropped below $2. This has been changed to $1.50.
• EROC’s conflicts committee has a fiduciary out. That would allow them to accept another, superior, proposal if their fiduciary duty requires them to. NGP would get a $7M break fee. This out is only available until the Approval date.

All of these revised terms are more favourable to EROC though not substantially so. At best this may provide a few extra percent in value from $6.90 to $7.20 (versus $7.66 before the NGP EROC deal). The pricing of the equity offering is going to be much more important than the minutiae of the NGP EROC terms.

This revised term sheet indicates that a deal is very likely and the timeframe for realizing a good profit on EROC should be around 3 months. EROC closed at $4.57 so there is still a 58% gain if you see through the whole rights issuance (though we may not see all of that gain in 3 months).

posted by Neil  # 6:25 AM 0 comments

As discussed in late August, Bayswater is trying to purchase Pine Tree-Reno Creek and the Wyoming properties from Strathmore Minerals (STM STM.V).

Bayswater just received a positive pre-feasibility study on the Reno Creek Uranium project. This study is for less than the 10% of Strathmore that BAY is purchasing.

The NPV of the Reno Creek project is US$164M using an 8% discount rate. Assuming that this is a reasonable average NPV for each remaining 10% of STM, it would value STM at 9x164 = $1,476M USD or $20USD a share.

I don’t think 8% is the correct discount rate for STM. Using a regression Beta from Reuters you get a cost of capital (it’s all equity) closer to 20%. That would make the NPV closer to $63M for Reno Creek and a total value for STM closer to $7.60 USD per share or $8 CAD. That is slightly higher than my liquidation value for Strathmore of $4-$7 CAD. Last night STM closed at $0.56 CAD.

Why is STM worth so little as a going concern versus an orderly selloff of their properties? The answer is their cost of capital. An established mining company could bring a much lower cost of capital to the project thereby capturing value closer to $20. Over time, as STM matures, their cost of capital will decrease and they will be able to capture more of the value that is currently discounted away.

This is yet another support for a valuation of STM in the $4 - $7 (or $8) CAD range today and an eventual value of close to $20, albeit with much higher than market risk.

posted by Neil  # 8:36 PM 0 comments

Natural Gas Partners (NGP) have proposed a series of transactions with Eagle Rock Energy Partners (EROC). These transactions involve:

1. A rights offering to current holders
2. An equity offering back stopped by NGP
3. Sale of EROC’s Minerals Business to NGP with the opportunity to sell to a higher bidder if one arrives
4. Repurchase by EROC of NGP’s Subordinated units, some General Partner Units and the attached Incentive Distribution Rights (IDRs)
5. An option to repurchase all of the General Partner (GP) Units
6. New Equity Incentives for Management
7. Restructuring of certain terms and conditions in the partnership agreement

Valuation

To analyse the proposed transactions we'll use the EROC Valuation from July this year as the base case. The other starting data we need is the end case of the proposed transactions; they can be divided into:

• Changes to discount rates
• Changes to cash flows
• Changes to shares outstanding

The total debt repaid as a result of the transactions would be around 250M. That greatly improves the debt to equity ratio and reduces the 2010 discount rates from 17.5% to 11.6%. 2011 onwards discount rates move slightly from 12.2% to the revised 11.6%.

There are three impacts on cash flows:

• The loss of the minerals business
• The reduced interest expenses
• The reduced cash losses from purchasing in the money hedges to avoid violating loan covenants

The minerals business produced $2.8M in profit in the six months ending June 30th 2009. Our base case is based on 2009 cash flows so annualizing that to $6M is consistent for comparison. The minerals business earned 31.8M in 2008 and nearly zero in 2007. EROC describes the 2008 results as a phenomenon as they reflect $17M of bonus payments “as a result of the regeneration phenomenon we received an initial royalty payment for 304 new wells”.

Interest expenses in the base case are $29M per year (they are in fact running slightly less than that now). Debt will be reduced by 31% which should lead to a straight line saving of $9M.

As described in the initial valuation of EROC, they manage their loan covenants by purchasing in the money hedges. As prices exceed these in the money hedges, EROC net loses money. This was not effectively modelled in the base case but was an inefficient use of cash and not doing this in the future is a benefit even if it’s not quantified.

The cash flow and discount rate changes look promising. Unfortunately they are offset by changes in shares outstanding.

• The rights offering will add 19.6M shares
• The equity offering will add 33.9M shares
• The repurchase of half of the GP units will retire 400k shares
• The subordinated units will not become active in 2022
• Management will receive 8M shares as incentives

The net effect is about 117M shares from 56M today.

Cash flows are 49% of pre-transactions cash flows on a per share basis. With the reduced discount rate this values each unit based on a dividend discount model at $6.90 from $7.66 in the pre transactions base case.

Rights Offering

That’s not quite the end of the valuation. Current unit holders are offered the right to purchase .35 additional units for each unit they hold. They can purchase additional units for $2.50 and will receive a 2 year $6 warrant for each additional unit purchased.

Valuing the right is easy. It’s 0.35 * (post transaction value - $2.50) = $1.54

Valuing the warrant is more complicated. One model would be .35 * (post transaction value – strike price) = $0.315. Unfortunately the warrant is only good for 2 years and therefore an option pricing model is probably more appropriate. Using the option inputs provided I’d value the warrant at 41c. As you only get .35 per current unit held then the warrant is worth $0.14.

• New post transactions valuation - $6.90
• Rights - $1.54
• Warrant – $0.14
• Total value - $8.58

This assumes:

• EROC does not exercise the option for the other half of the GP units
• The equity offering is conducted at $3.10. Every 10c increase in the price of this offering offers unit holders about the same 10c in unit value
• All rights are exercised
• Other assumptions per the original base case estimate

Other considerations

There are also some intangible benefits of the proposed deal:

• If interest rates increase dramatically over the next year or two, EROC will be much better positioned to manage that
• EROC will be better positioned to renegotiate their loan in 2012
• Yield investors will be attracted back to the units
• There is a short term catalyst for the stock

There are also some disadvantages:

• EROC loses a low risk line of business with upside
• The opportunity to assume the risk and reward of the debt pay down over the next 12-18 months is removed. The analysis presented here is based on values at the end of 2009. There is an extra 60% value to be captured in 2010/2011 if EROC makes it through that time period. That risk/ reward is captured in the discount rate.
• These transactions will not be evaluated strictly on their benefit to unit holders, see conflicts of interest below.

The repurchase of the subordinated units and the IDRs for $35.5M is fair. The subordinated units will receive payouts from 2022 onwards. Discounting that back to today values the subordinated units at $40M. The IDRs appear close to worthless.

Restructuring

The transactions propose that future accruals of the minimum quarterly distribution cease. Current accruals may remain but they are a moot point once the subordinated units are redeemed.

Conflicts of interest

NGP have identified in their offer that these transactions pose a conflict of interests. The conflict will be put to the independent directors. Furthermore the most recent 10k outlines the responsibilities of those directors. While it’s well worth reading in full; you should note:

• “Neither our partnership agreement nor any other agreement requires the NGP Investors to pursue a business strategy that favors us”
• “Our partnership agreement limits our general partner’s fiduciary duties to holders of our common units and subordinated units.”
• “We may issue additional units without limited partner approval, which would dilute ownership interests.”
• “Our general partner is allowed to take into account the interests of parties other than us in resolving conflicts of interest”

Opportunity

It appears, on balance, that this is a fair transaction. It offers NGP a way to convert some long dated opportunities into shorter dated ones. It gives unit holders more short term upside while sacrificing a higher risk/ reward over the next few years. It also creates a catalyst as a result of the rights offering and the resumption of distributions. As valued today, these transactions moderately increase the value of EROC units to current holders.

posted by Neil  # 8:46 PM 0 comments

Strathmore Minerals has agreed to sell Pine Tree-Reno Creek, Wyoming properties (Sale Properties) to Bayswater for $30M USD.

$30M USD is 43c CAD per share of STM. On August 18th STM closed at 43c CAD.

The sale properties are about 10% of Strathmore’s uranium or slightly less if you adjust for the reliability of the estimates. . It’s probably reasonable to assume that this deal values STM at about $4.5 CAD in the even of an orderly liquidation. I valued Strathmore in a prior post based on the Rio Kintyre sale at about $7.50 - $12 CAD based on an orderly liquidation.  A lot has happened since July 2008 but $4 - $7 is still supported by this deal with Bayswater.

My original valuation of Strathmore as a going concern is in the teens. Again nothing has changed dramatically but that’s unlikely to be realized until they have some properties producing.

This is a sound deal for Strathmore. They are probably giving up a couple of dollars per share in the very long term for cash now. Not doing this deal could risk everything. There are some conditions that need to be met including Bayswater raising $36M. They have 4 months to close the deal. There is a small break fee of $250k which STM would have to pay if they accept a better offer or Bayswater will need to pay if they fail to close.

The problem is that Bayswater’s market cap is currently $17M CAD. It is unclear how they think they will be able to raise $36M. STM have a bit of a history of entering deals with companies that simply can’t pay. The same has happened with Great Bear & the Chord property.

The recent concerns about STM have been whether or not they have the cash to see through production.

“They continue to be able to sell equity in properties that they acquired for cash. Real properties with Real Uranium deposits, even if they can't raise equity or debt financing. “

Strathmore went through a dramatic decline from 2001 to 2003, reaching 6c. In 2005 it reached $5.18. In Strathmore Groundhog Day I outlined that STM would survive this crisis just like the last one.  In the end when you have real assets you can always generate cash.

If this goes ahead it will be great for STM. If it doesn’t, then STM will need to find another source of cash which they are very likely to do successfully.

posted by Neil  # 11:30 PM 0 comments

Anyone who has bid in an auction on ebay has learned that there are only a few winning strategies that participants use:

1. Bid low and early, in the hope that no one else will participate. You win the auction at the reserve price.

2. Bid very high immediately not in small increments. This frightens off competing bidders, especially if your bid is at or above a fair price for the item.

3. Snipe, which is waiting until the last second and making the smallest incremental bid to win the auction before the other party has time to counter.

These is a fourth strategy which generally doesn’t win:

4.  Participate in the auction. That is bidding a little bit more than the last person at any time during the auction.

It’s pretty clear that Yanzhou is using strategy 1 (bid low and early) in their bid for Felix. Given the recent financial crisis it is unlikely that any competing bidder is going to have the stomach for strategy 2 (bid very high). That leaves an incompetent bidder using strategy 4 (participate) or a smart bidder using the one remaining strategy which is to try and snipe Felix.

Why does this matter? Because anyone expecting a counter offer should not expect it soon. Based on the published timeline, a counter offer can wait until November. There is additional benefit in waiting as the counter offer will be able to consider problems that the Foreign Investment Review Board (FIRB) has with the Yanzhou offer. Anyone looking to arbitrage a Felix buyout should wait for the excitement to die down. There is a good chance that you’ll be able to buy Felix at a lower price once the market believes that a counter offer isn’t coming. In fact, readers of this blog will know that a counter offer may yet arrive from a smart bidder.

I still expect a counter offer (>50% chance). The capital position of potential bidders is not great on the whole but this is counter balanced by the high ROI available from a counter bid. I don’t expect a counter offer in the next 4-8 weeks.

posted by Neil  # 9:57 PM 0 comments