‘AIM for Success’ Part 3: A blog by @AIM_Chaos

In  the third and final part of @AIM_Chaos’ blog series, he brings us a case study example on AIM and TSXV listed Mkango Resources Ltd (MKA). This article was written on the 17th January 2018 prior to Mkango receiving shareholder approval for their Talaxis transaction.

Below I provide one such example of an investment that I hold that has experienced this sort of situation. To stress, given the extremely high investment risk nature of buying directly into nano-cap stocks, it should be noted that these types of investments certainly do not always flourish. In my case, the aforementioned base metals pre-producer is just one (of many!) examples of that!

The company that I will briefly write on is Mkango Resources Ltd (‘Mkango’ or ‘the Company’), in which I hold a 5.0% stake. I have chosen Mkango as the example for this particular note because the Company is at present in the sights of many investors, owing to a game changing corporate transaction that is subject to shareholder approval – which is being sought at a General Meeting tomorrow in Canada.

Mkango is primarily focussed on the exploration of rare earth elements (‘REE’) in the Republic of Malawi, south-eastern Africa. Its flagship asset is the 100% owned Songwe Hill, a REE deposit that has had a prefeasibility study (‘PFS’) completed over it. The PFS revealed a base case NPV of $345m, an IRR of 37% and total initial capex of $216m. The Company also has two other 100% owned exploration licences in Malawi:

Thambani, an early stage but very high-grade uranium-tantalum-niobium asset; and Chimimbe Hill, a nickel/cobalt asset.

For numerous reasons that compounded upon another, Mkango remained in a valuation range of £2m to £4m for its first 18 months following its AIM IPO in mid 2016. Let us put this valuation into context: I do not have up-to-date figures, but on my last round of analysis (early 2017), the mean discount to project NPV that AIM-listed miners (post completion of PFS, but pre-completion of definitive feasibility study (‘DFS’)) were trading at was circa 90%. Post-completion of DFS (but pre-production), the discount was circa 78%. Of course, the prices of REEs were suppressed throughout 2016 and into 2017, and thus one could argue that the mean discount should not be employed for Mkango. On the other hand, spot commodity prices for the vast majority of the constituents of the AIM mining sector were significantly below the prices employed in their PFSs and DFSs. As such, in Mkango’s case I believe it would be appropriate to use the 90% discount figure. That would equate to a valuation for Mkango for Songwe Hill alone of $34.5m: using the current total issued share capital of 105.04m and an USD/GBP rate of 0.72, that translates into a share price of 23.6p.

In contrast, Mkango was trading at approximately one tenth of that – or circa 1%of its PFS-stated NPV – throughout the 18-month period after listing on AIM.

The prime cause of this was, in my view, the dire prices of REEs that reached five-year lows in November 2016. However, throughout the course of 2017, prices recovered between 50% and 125% (there are 17 REEs, each with (in some cases vastly) different pricings). One would have expected that Mkango’s share price to have recovered in a correlating manner. It did not in the slightest, and this leads me onto the second key reason that Mkango persisted with a brutally suppressed valuation for so long: the REE industry is relatively small, very opaque, almost entirely monopolised by China, and finally has historically provided investors with horrific returns.

In July last year I penned an extensive note on the global REE industry, which can be found here: aimchaos.files.wordpress.com/2017/07/rare-earth-elements-time-to-invest.pdf

The thesis of the note was as follows:
“The supply / demand dynamics of the global rare earth elements (‘REE’) industry are set to become imbalanced, owing to quasi-monopolist China curbing domestic production, and to the rapidly accelerating global adoption of renewable energy technologies that utilise REEs. We are of the opinion that the approaching market imbalance will ultimately be corrected by the fast-tracking into production of ex-China REE deposits.
As such, we believe that investors should be positioning themselves for the impending recovery in the rare earth sector by investing in late stage REE projects that possess mineralisation geared towards renewable energy applications.”

One of the points of the note was to highlight to the AIM community that the REE subsector was receiving absolutely zero attention, in stark contrast to the much more in-vogue ‘green metals’ – lithium, cobalt, nickel, copper, etc – despite the fact that some REEs are crucial to the world’s surging renewable tech revolution. My belief is that the financial media has over the past two years focussed predominantly on battery technology used in electric vehicles (‘EV’), and comparatively little on traction motor technology. Lithium, cobalt and nickel are integral to EV batteries, yes. However, four of the REEs are equally integral to EV traction motors. A key moment (symbolically speaking) came in August 2017 when it was disclosed that Tesla had opted to use a REE-based permanent magnet motor for its new Model 3, rather than the copper induction motor that it had used in its previous two road models. Now, every major manufacturer of EVs worldwide is employing REE permanent magnet motors. In a study published last year, UBS estimated that were EVs to reach 100% of the global vehicle market, demand for REEs would increase by 655%.

Now to Mkango’s ongoing corporate transaction. In November last year, Mkango informed the market that it had entered into an agreement with Asian trading house, Noble Group Ltd (listed on the Singapore Exchange). The deal will see Noble and Mkango jointly develop Songwe Hill via the launch and completion of a DFS (and subsequently potentially onto mine construction/ production). Noble is to take a 49% stake in the project for a total cash injection of £12m at project level (thus not diluting existing shareholders of Mkango at PLC level). The investment values Songwe Hill at £24.49m – which translates into a share price of 23.3p – remarkably almost exactly the same as our valuation exercise on the previous page calculated.

More significantly however is the option agreement attached to the £12m investment. It stipulates that Noble can increase its stake in Songwe Hill from 49% to 75% by securing all project finance (currently estimated at $216m). If we assume a 4:1 debt to equity ratio for the project, then Noble would be required to put up a further $43m at the project level (or find a partner to assist in this), and also secure $173m in debt finance. Construction would be fully funded, and the mine would enter into production.

Mkango would not be required to inject any further capital into the Songwe Hill project, were the option exercised. Given that the DFS will be fully funded by Noble, it is thus feasible that Mkango will not actually be forced to return to the market for the foreseeable future for further cash. Let us assume Noble exercises the option (and the £12m investment is already good reason to make this assumption): Mkango would have a completely free 25% carry on a REE mine that (using the existing PFS) will be generating – on average across its 18-year mine life – EBITDA of $103m pa on revenues of $162m pa. How would one value a vehicle (namely Mkango) that it appears likely will enjoy £18.5m EBITDA pa for almost two decades, commencing say in early 2021? Crucially that valuation should be based on Mkango’s existing capital structure, save for outstanding options and warrants that are presently ‘in the money’.

Employing a lowly multiple of 6x EBITDA would imply a valuation for Mkango’s 25% free carry in Songwe Hill of £110.8m. The total diluted share capital at the current price amounts to 153.5m. Accordingly, one could argue that were the option to be exercised by Noble to increase its stake in Songwe Hill to 75%, then Mkango could be worth 72.2p per share based on Songwe’s existing economics alone.

Of course, there are many variables to consider and discounts to factor in at this stage. The most obvious variable to contemplate is whether Noble will actually exercise its option. On the other hand, there are equally variables that could substantially boost our valuation estimation. The economics of the project could be enhanced during the DFS, for example; and REE prices could continue to surge upwards.

Mkango also owns three other assets: Thambani (the uranium-tantalum-niobium deposit); Chimimbe Hill (a recently acquired licence that holds a nickel-cobalt deposit); and an 85% stake in a joint venture with a UK technology company, Metalysis Ltd, that is developing a novel process for producing REE alloy powders. The JV will be exploring the usage of these alloy powders in 3D printing – ultimately of REE permanent magnets. On that note, in tandem with its investment of £12m into Songwe Hill, Noble has also committed a further £2m investment for a 49% stake in an as yet unnamed new vehicle (‘Newco’) which will hold the 85% JV stake, leaving Mkango with 51% in Newco. That investment alone values Newco at £4.1m, or 3.9p per share.

Last month, less than a month after the initial announcement of the deal, the TSX-V (upon which Mkango is dual listed) granted conditional approval for the deal (i.e. shareholders (excluding Noble that already held a 13.9% stake in the Company) would have to vote in favour of the deal for it to be sealed). Upon receipt of approval – which will very likely be granted tomorrow at the General Meeting – Noble will be required to provide £5m of the total £12m for Songwe Hill, and £1m of the total £2m for Newco (the Metalysis JV). The balance will be due later this year, upon certain milestones being met by the respective projects.

TSX-V approval should not really be in doubt for investors: the law exists to protect the interests of minority shareholders – evidently the deal will be enormously value accretive for existing equity holders in Mkango. However, a real issue for investors has been the financial situation of Noble itself. Once one of Asia’s leading trading houses, less than a decade ago surpassing a market capitalisation of $10bn and dreaming of rivalling the Tier 1 traders such as Glencore, Noble has endured a huge fall from grace in recent years. It has a debt pile of $3.5bn and its market capitalisation has diminished to sub $300m. There has been considerable coverage in the financial media in recent months as to whether the business can survive in its present format. Accordingly, AIM investors looking at Mkango have rightly questioned whether Noble will be in a position to stump up the £14m that it has committed to two of Mkango’s assets.

Yet there are a number of factors that I believe the wider AIM community has not taken into consideration over the past month. Firstly, upon receipt of TSX-V conditional approval in December, £2m of the £5m for Songwe Hill was put into escrow. Regardless of whether Noble puts up the remaining £3m for Songwe Hill in the coming week (and the first £1m of the £2m for Newco), Mkango will receive the £2m that is sitting in escrow in exchange for 8% of Songwe Hill. Coupled with the circa £1m currently on its balance sheet, that would be sufficient for Mkango to commence the Songwe Hill DFS in the coming months.

There has also been a certain level of feeling amongst the AIM community that were Noble to default on its debt obligations, the business would simply go bust. I feel that this is in fact unlikely: the more probable outcome will be a significant debt / equity restructuring. Yes, existing Noble shareholders will be diluted horribly – but the business will likely survive and operations will continue. The fact that creditors extended an unsecured revolving credit facility in December by a further five months so that restructuring talks between management and creditors could continue could be taken as evidence of this.

Moreover, there is the fact that the Noble / Mkango transactions are being structured through a new wholly owned subsidiary of Noble, named Talaxis. Mkango has entered into the two investment agreements (for Songwe Hill and Newco) with Talaxis, not Noble. As such, even if restructuring talks were to come to nothing and Noble were forced to declare bankruptcy, Talaxis would still in all probability survive. Over the past year, Noble has sold off numerous divisions and assets. Were administrators called in, Talaxis (and its contracts with Mkango) would also be put up on the block. Now, in light of the limited number of advanced stage (post-PFS) REE projects there are globally, I would be astonished were none of the six Chinese state-owned enterprises that have all but monopolised the global REE industry not to have carried out detailed due diligence on Songwe Hill, and indeed not to have submitted bids to rival that of Noble. Following this stream of thought, one could also plausibly suggest that Noble invested £0.5m in Mkango at the PLC level back in September last year – only seven weeks before the announcement of the much larger Songwe Hill / Newco project level investments – precisely to have a foot in the door at Mkango and in doing so give itself first rights over Songwe Hill / Metalysis, whilst it fought to bring its own balance sheet and debt burden under control.

In any event, it would be entirely unsurprising – in the unlikely event that Noble did fold in the coming months – were Talaxis to be snapped up by one of the six Chinese SEOs, by another trading house or by a private equity house. The new owner of Talaxis would then simply be tied by the existing agreements with Mkango, and developments both of Songwe Hill and the JV with Metalysis could continue.

Despite all this, today on the very eve of the General Meeting, Mkango languishes at a share price of 11p (market cap £11.5m) – despite the likelihood of it having £7m net cash on its books by early next week and majority stakes in four potentially very valuable projects. Even more extraordinarily, after the initial announcement of the deal with Noble in late November and the initial spike up to 12p, the share price subsequently retreated to the 6p to 7p range, where it remained for over two weeks.

I have used Mkango as a case study as over the past eighteen months it has exemplified so many of the aforementioned points that make AIM such an inefficient market. Its valuation was suppressed so severely for so long because, amongst other factors:
– It endured incessant fears over financing;
– Its operations were misunderstood;
– The market it operated in was misunderstood;
– It suffered from a lack quality independent research that was freely available to investors;
– It lacked institutional investor support, and thus was subjected to the short term outlooks of the greater part of the retail investment community (which included the dumping of IPO stock);
– It was subjected to aggressive online trolling for an extended period owing to evident hostilities between a large shareholder and said trolls.

If one can perceive such facets in the environment that a particular nano-cap exists in, can appreciate the weightings of these facets on said nano-cap’s share price and can understand where the nano-cap’s valuation should be, were these facets to be removed – then one will hold an immeasurable advantage over the majority of investing peers focussing on this nano-cap end of the AIM market.

The most important point to always keep in mind when investing or trading on AIM is that it is a highly inefficient market. Forget efficient market hypothesis and all that. From my experience, at any given moment there are several hundred companies that would be valued significantly differently, were they listed on a different market such as the LSE’s Main Market or Australia’s ASX.

For the AIM-focussed investor / trader – therein lie the investment opportunities.

Welcome to the world of AIM.

Myles McNulty
17 January 2018

Disclosure: AIM Chaos is the research branch of a private investment vehicle named Sons of Ulster. It is responsible for generating investment ideas and subsequently monitoring held investments. The assembled information disseminated in this report is intended for internal use, and is neither a solicitation to buy nor an offer to sell securities to outside parties. All information collated and utilised in this report has been sourced from the public domain. AIM Chaos has no business relationship with any company referred to in this report, and has received no compensation from any party for writing this report. Sons of Ulster, which wholly owns AIM Chaos, does currently hold shares in Mkango Resources Ltd, a company referenced in this report. Consequently this report should not be regarded as independent research.

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