Silver Lake's integral takeover

Diggers and Dealers, the part festival part conference that engulfs the town of Kalgoorlie this time each year, kicked off with news that Silver Lake Resources would buy Integra Mining. The announcement prompted jubilation all around. For Silver Lake, it represents an excellent purchase. For Integra management, it is an honourable exit. And for the gathering crowd, it was hope amid a darkening mood.

Silver Lake will exchange one share for 6.28 Integra shares, an arrangement that values Integra at about 45 cents per share, or $426m, a 40% premium to Integra’s pre-deal share price.

The combined entity, to be called Silver Lake, will become a substantial gold producer; production will jump immediately from 85,000 to 200,000 ounces per annum and rise to 400,000 ounces in two years. Costs will remain below $700 an ounce and the balance sheet will hold no debt and over $100m in cash. Reserves climb to 1.8m ounces while resources leap to 6.6m ounces.

Silver Lake shareholders have bought assets cheaply. Integra, which was facing mounting problems with a short reserve life and withering cash, has received a reprieve. Silver Lake has paid the equivalent of $200 per resource ounce, which doesn’t appear stunningly cheap, but consider that Integra already produces 100,000 ounces per year, owns a valuable processing mill and generates about $50m in operating cashflow per annum, and it’s clear the deal is favourable to Silver Lake.

Although a hefty jump in size is a consequence of the transaction, it’s unlikely to be the sole motivation. Unlike other mergers in the industry we have been critical of – Catalpa’s merger with Conquest Mining (see 11 Jul 11 (Sell - $1.41)), for example, or Avoca’s foray into Turkey (see 14 Sep 10 (Sell - $3.11)) – this deal involves neighbouring mines consolidating. That makes all the difference.

That’s more like it

A typical takeover in the gold industry follows a predictable script. A miner that has reached production limits agrees to buy another miner somewhere in the world. St Barbara, for example, which operates mines in Western Australia, will buy Allied Gold, with mines in the Solomon Islands and Papua New Guinea.

Does consolidating different gold mines suddenly create value simply because ownership changes? Unless you’re an ambitious mining executive, it doesn’t. No, most transactions in the industry are about size; getting larger for its own sake. Ego and ambition play a larger part than shareholder value. This transaction is, thankfully, different.

Silver Lake was formed when the company’s founders – including current Managing Director Les Davis – consolidated individual tenement holders across the eastern goldfields of Western Australia, where fragmented landholdings had previously prevented structured exploration.

Consolidating tenement ownership has been vital to Silver Lake’s subsequent success. Now, Les Davis is trying to repeat the same trick.

Integra Mining owns tenements adjacent to Silver Lake along the same geology. Buying them up is not just a case of buying a gold mine somewhere in the world and claiming to have created value. There are genuine gains to be made; two processing facilities will now operate across nearby mines and handle higher volumes; different grade ores can be blended to increase output; and combining tenements will increase the odds of exploration success.

Better management, more cash

We knew Integra had fine assets – it was the reason we recommended buying the company back in Integra Mining’s trump card on 30 Apr 10 (Speculative Buy - $0.26). Increasingly, however, we were becoming wary of management, who had morphed from meek explorers into promotional producers. Problems were ignored, insignificant drilling results proclaimed as magic and cost estimates were quietly lifted. It’s the key reason we haven’t upgraded the stock despite it breaching our buy threshold.

With Integra folding into Silver Lake, shareholders get perhaps the best management team in the local industry. By all accounts, Les Davis is careful with cash and demanding with expectations. This is the kind of manager a gold miner needs. Encouragingly, no manager from Integra will be offered a board seat. If you're an Integra shareholder, you should delightedly ACCEPT THE OFFER.

An important consequence of the takeover is that exploration and development will be funded from operating cashflow. Integra was forced to undertake an aggressive exploration program because of its small reserves position. The new Silver Lake faces no such pressure and will most likely ease off on exploration spending in order to pay dividends.

Silver Lake will continue to spend $18m each year on gold exploration and a bit more on copper exploration (which, by the way, is looking hugely promising). The $25m budgeted for Integra’s exploration will probably be shelved, freeing that cash for other uses (dividends please, Les).

Corporate action in the gold mining industry is often disastrous; this is a rare exception. Despite issuing fresh equity, we’re happy to maintain our previous recommendation guide. Silver Lake’s share price has fallen 14% since 20 Jun 12 (Hold - $3.05). An upgrade looms, but not quite yet. HOLD.

Note: The Growth portfolio owns shares in Silver Lake Resources.