Tiger Resources clouded by short-term risks

Tiger Resources’ (TGS) proposed deal to buy the 40% of the Kipoi copper project that it doesn’t own from Congolese government-backed miner Gecamines is a clear positive for the copper junior, but this is probably not the time to buy a position in the stock.

The full ownership (excluding 5% which has to be ceded to the Congolese government) lifts the valuation of Tiger as the deal is priced at a sharp discount to the value of Kipoi, but the transaction materially increases the risk for investors.

Tiger had been eyeing a way to bring Kipoi fully into its den and recent financial trouble at Gecamines may well have played into management’s hands. Kipoi is a long-life 1.2 million tonne copper resource that is in the south of the Democratic Republic of Congo (DRC).

Bloomberg reported that Gecamines needs $US160 million to pay retrenchment benefits as it sacks more than half of its workforce. The Congolese mining company doesn’t have enough cash to even pay regular wages and its workers have gone on strike.

Tiger’s cash offer of $US111 million ($120 million) will go a long way to plug the funding gap and could explain the attractive price for Tiger. Based on the terms of the deal, Kipoi is worth around $300 million, or a 50% discount to my net present value calculation, and the transaction would theoretically lift my discounted cash flow (DCF) based price target by about 10 cents.

The deal still has to be approved by the DRC government and could be knocked back due to the “low” price (Gecamines’ previous chief executive was fired two months ago for selling assets too cheaply and without state approval), but I suspect it will be approved given Gecamines’ dire need for a capital injection.

But Gecamines isn’t the only one in need of cash. Tiger had to take on expensive debt and go cap in hand to shareholders (yet again) to scrounge up the dough to consummate the deal.

Weighing the risks and benefits

If there is anything I don’t like about the acquisition, it’s the debt. Tiger secured up to $US100 million in loans from private equity firm Taurus Funds Management that attracts an 11% interest rate for the first six months. The facility can be extended to a year with a monthly extension fee of 0.5% of the loan amount.

That’s expensive money and net debt to equity is forecast to rise to 39% from 22%. Gearing isn’t very high compared to the broader market, but it’s high relative to its mining peers.  

The plan is for Tiger to repay the debt in six months but refinancing such a large amount (I am assuming the facility will be fully drawn) could prove to be a choke point. The fact that Tiger is sitting on a world-class asset and the relatively positive outlook for copper gives me some comfort that it can secure more attractive refinancing terms early next year, but this is still a risk to recognise.

It also helps that Tiger can withstand some copper price volatility as it is one of the lowest cost producers with an all-in sustaining cost of around $US1.75 a pound, or $US4,079 a tonne. Copper is trading at just under $US7,000 a tonne currently.

More importantly, copper will have to be more than 15% below my 2015 and 2016 assumption of $US7,100 a tonne and $US6,650 a tonne, respectively, before the stock starts to look expensive at its current trading level of 30 cents.

Further, the copper price has to undershoot my forecasts by more than 30% before Tiger delivers a loss. The miner has been turning a profit since 2012 and its financial year is the same as the calendar year.

Another issue is dilution. Taurus is entitled to 20 million warrants as part of the funding deal that can be converted into shares at an exercise price of 40 cents a warrant over the next four years.

This will dilute the share base even further given that shareholders are expected to tip in $73.4 million to fund the deal through a new share offer. This means the number of shares on issue is set to expand by over a third if you included the warrants conversion.

On the upside, the new share offer is priced with next to no discount at 30 cents a pop. Management didn’t need to price new shares below the market price to attract strong interest from institutions, who contributed $45.6 million to the capital raising. Retail shareholders will get the chance to buy shares at the same price through a one-for-five share offer, which opened on Friday (September 5) and closes on 19 September.

Valuation

What’s more, even with the big dilution and heavy interest burden, the deal is still value accretive although I am cutting my price target to 38 cents from 50 cents a share to reflect the share dilution and for the reasons outlined below.

First, management had cut its production guidance for the current year due to lower than expected output from its soon-to-be decommissioned heavy media separation (HMS) plant. Tiger is ramping up its more advanced solvent extraction electro-winning (SXEW) plant, which is forecast to deliver 28,000 tonnes of copper cathode in 2015 and 50,000 tonnes the following year.

There is some risk that the ramp up of the SXEW plant may be slower than expected if the 2015 refinancing becomes a challenge as management will probably have to cut capital spending to expand the new plant to preserve cash.

I have not factored this potential “slippage” in my forecast, but issues with the HMS plant have led me to cut 2014 revenue by 13% to $172.3 million.

Second, I have increased the discount rate on my DCF price target (the higher the discount, the lower the price target) to reflect the increased risk profile for Tiger with its higher debt levels and the potential for a slower than expected ramp up at the SXEW plant. The discount rate is now pegged at 16% compared with my previous assumption of 14.9%.

There are two other drags on Tiger’s earnings this year: a higher depreciation & amortisation charge, and bigger interest burden.

This means shareholders should brace for a big drop in net profit for 2014 to $7.7 million from last year’s $33.2 million.

However, I believe any sustained share price weakness will only increase corporate interest in the miner now that it owns 95% of Kipoi, and there is no shortage of potential suitors given the number of global mining giants operating in the vicinity. These include the likes of Glencore Xstrata, Freeport McMoRan and a number of Chinese government owned entities like MMG.

There has long been speculation that Tiger would attract a bid given the attractiveness of the long-life Kipoi asset, but it’s thought that suitors were put off by Gecamines hold over the asset.

Conclusion and recommendation

However, a lot of things can go wrong with Tiger and only time will tell if it has bitten off more than it can chew. This is why I am downgrading my recommendation to a “hold” until the deal gets the green light from the DRC government and we have greater certainty about the refinancing.

As I’ve stressed before, Tiger is only suited for investors with a high tolerance for risk. I think existing shareholders should take up the new one-for-five share offer at the offer price of 30 cents, as long as the current share price is trading above the offer price.

My price target only values Kipoi and not its other copper prospect Luputo, which has an indicated copper resource of 134,000 tonnes.

To see my forecasts and financial summary, click here.