Spec Value Hunter Comment - May 7, 2012: First Point pesters Cliffs for copy of independent consultant's report about Decar
First Point Minerals Corp announced on May 7, 2012 that it has served a notice of arbitration on Cliffs Natural Resources Inc over a refusal to make available information generated by Cliffs' consultants for the Decar project. Given that the relationship between Cliffs and First Point has until recently been very positive, which Peter Bradshaw confirmed to me today with the statement "everything Cliffs has done has been first class", this development suggests a chilling of the relationship and has fostered speculation that Cliffs may have developed reservations about the viability of mining the low grade nickel-iron alloy mineralization at Decar. My interpretation is that neither of these views is true, and that First Point has simply taken a legalistic step to protect its rights under the agreement, while Cliffs is acting to protect its interests in a manner that would please me if I were a Cliffs shareholder. My analysis does not have the benefit of a return call and comment from Cliffs, but that does not surprise me because First Point's arbitration notice is just another nuisance in their daily course of business. In this comment I explain why this development is simply the result of all parties acting rationally to maximize their strategic advantages, and that at this stage there is no reason to think that Cliffs has lost interest in the Decar project, nor that there is a negative report which Cliffs is withholding from First Point. The outcome of this arbitration is unlikely to be known before Q4 of 2012 when it is too late to help First Point decide whether or not to scale up the summer drilling program at Klow or Wale in order to be in a position to deliver a resource estimate by Q1 of 2013 and a PEA on a 100% owned project before the expiry of the Cliffs' standstill agreement at the end of 2013. The most important near term milestone will be confirmation that Cliffs is proceeding this summer with the Decar infill drilling program recommended by Caracle Creek which is not needed by Cliffs to meet its PEA delivery deadline in March 2013. The recommended program is required for a prefeasibility study, and if Cliffs decides to go ahead with this work in 2012, it pretty much tells us that the information in the withheld report is positive about Decar rather than negative. While it is always possible Cliffs may defer the PFS related work until 2013 for reasons unrelated to the merits of Decar, my view is that Cliffs has learned nothing new from what it has known about Decar for the past year, and with the resource estimate coming in as expected, has no Decar related reason to defer the program recommended by Caracle Creek. I confirm that my Good Absolute Spec Value Buy recommendation for First Point remains intact at the current price of $0.58.
The obvious question raised by First Point's arbitration news release is what is the subject of this report by Tetra-Tech which would move First Point management to risk annoying the operator of the Decar project through legal action. First Point's Peter Bradshaw told me that confidentiality prevents him from disclosing the nature of the report, but that its existence was not a secret kept from First Point management, and that while Cliffs has indirectly acknowledged its existence, it has declared no obligation to make the report available to First Point for internal use. My speculation is that the report is effectively a draft of the preliminary economic assessment (PEA) that Cliffs is required to file by the end of March 2013. On April 16, 2012 Cliffs published an initial 43-101 resource estimate for Decar which exceeded back-of-the-napkin estimates. The supporting technical report must be filed on SEDAR within 45 days, so it is unlikely that the withheld report has anything to do with the resource estimate. It is possible that the report is on the metallurgical studies Cliffs has conducted on the Decar mineralization, in effect a detailed flow-sheet for recovering the nickel-iron alloy and producing a concentrate that can be shipped directly to steelmakers. Not only might this report contain flow-sheet details Cliffs could consider proprietary because of its experience with the bulk processing of materials using gravity and magnetic separation techniques, but it might also include specifications relevant from a marketing perspective. In addition, the report might include the costs associated with the flow-sheet, in effect providing everything needed for First Point to understand what the PEA will look like when it is published in March 2013.
Understandably First Point management would like to have such information sooner than later even though it has no right to disclose such information to its shareholders. However, First Point is gearing up for first time drilling of the 100% owned Klow and Wale projects which have mineralization and tonnage footprints similar to Decar. In my Spec Value Hunter Comment - April 16, 2012 I presented a speculative discounted cash flow analysis using parameters from the feasibility study for the Mt Milligan copper-gold porphyry project whose mining plan would have a scale similar to that Cliffs is likely to propose for Decar. Based on my scenario I came up with a potential $1.50-$2.00 buyout range based on First Point's 25% net interest in Decar alone, if my speculative DCF parameters prove close to the mark. But a target valuation in the $5-$10 becomes possible if First Point ends up having 100% of projects very similar to Decar.
Given how predictably the Decar drill intersections converted into an inferred resource estimate, similar intersections for Klow or Wale during summer 2012 drilling would prompt the market to assume a similar resource outcome in 2013. But because no such low grade nickel deposit has ever been commercially exploited, the market would be reluctant to assign any economic value to these future resource estimates, especially in the current gloomy "glass half empty" climate. In fact, in the absence of a PEA the market is reluctant to assign much economic value to the Decar resource estimate, which is why there has been such a muted response to the initial resource estimate. First Point management may have its own ideas as to what the economics of mining Decar might be, but its confidence and strategic planning would benefit from knowing what Cliffs' consultants have concluded about the economics. When dealing with resource sector management that has credibility and integrity, duct taped mouths are a given, which is why we judge them by their actions rather than their words. First Point has not provided details of its summer drilling program, whose scale would depend on the confidence management has about what the PEA will say next March about the value of Decar.
First Point has budgeted $3 million for 2012 spread among exploratory drilling of Klow and Wale as well as surface sampling on other prospects. The density of drilling proposed for Klow and Wale is currently insufficient to facilitate an initial inferred resource estimate, which means that as things now stand, First Point cannot have resource estimates for its 100% owned projects any earlier than Q1 of 2014 after the Cliffs standstill has expired. The 2012 budget also does not provide for the collection of a metallurgical sample for metallurgical studies that would be needed to support a PEA. However, First Point's understanding of these awaruite systems is now so sophisticated that it would be in a position to recognize "game on" very early in the 2012 drill season, and make a decision to mobilize additional drilling to achieve the density needed for a resource estimate, and collect material for metallurgical studies that can be carried out during the 2012-2013 winter season. It could thus be in a position to publish a PEA for a 100% owned project during 2013 before the end of the standstill agreement, thus giving the market a basis for valuing First Point on its 100% owned projects. To do this, however, First Point will need to have the confidence to promote the stock during the summer and raise additional financing, something that in the current overall market outlook will not be easy for a junior unless it has a very strong story.
If I were in the shoes of Cliffs management and looking at a report which indicates that Decar is potentially very economic even at prices sinking towards $5/lb nickel, and the junior from whom I optioned the project, and which has a proprietary edge over me in sleuthing similar deposits elsewhere in the world, asked me for a copy, why would I immediately oblige? The less the junior knows about the potential economic value of the Decar project, the less likely it will be in a position to boast similar 100% owned projects by the time I have to provide the PEA in March 2013, and by the time the standstill agreement ends in December 2013. I would much rather have First Point continue to sleuth out similar prospects and secure title than have the junior advance any of these rapidly to a PEA level where instead of paying a buyout price based on a 100% project, I pay a price based only on a 25% interest in a project I already control and get for free the other early stage projects I know I can develop into Decar clones. By the time the arbitration ruling is delivered, which will take at least 90 days, it will be too late for First Point to accelerate exploration activity, which will keep the eventual buyout price at levels reflecting mainly the value of Decar and not additional 100% owned deposits.
Given that it makes strategic sense for Cliffs to rebuff First Point's requests for the "arbitration report", and that compliance under an arbitration order would be too late to be of strategic benefit to First Point, why has First Point risked unnerving the market and chilling the relationship between it and Cliffs? Although the joint venture agreement makes it very clear that First Point is entitled to reports relating to Decar generated by independent consultants, it is not clear about what happens if Cliffs refuses to accommodate the request and First Point fails to exercise its right to submit the request to arbitration within 30 days of the refusal. There may be a risk that if First Point fails to exercise its rights, it has waived its right to further requests not just for this report, but possibly other reports. In this regard First Point is doing the legally appropriate thing.
In addition, although a favorable arbitration decision may be too late to help management accelerate the 2012 exploration program, its eventual arrival could help the company deal with a scenario where Cliffs decides not to do any work on Decar during the 2012 field season. The exploration contractor Caracle Creek has recommended a major follow-up program infill drilling program consisting of 49 core holes totaling 16,500 metres whose objective is to upgrade the inferred resource to an indicated category and provide geotechnical data. This level of work is required for a prefeasibility study, not the PEA Cliffs must deliver by March 2013. Field work at Decar begins in mid to late June, and until Cliffs has given First Point formal notice of its plans for 2012 and mobilized the program, there is a risk that in light of the global economic outlook Cliffs may postpone the PFS calibre work until 2013 after it has published a positive PEA. Bradshaw has told me that Cliffs plans to inform First Point officially of its plans after the technical report for the resource estimate has been filed, which is not due until the end of May. News that Cliffs has decided to defer further work until 2013, news which might help out with negotiations for social license agreements with first nations, would lead the market to believe that Cliffs has concluded that mining the low grade nickel Decar deposit is not as potentially profitable as it might initially have thought. Such a perception would hurt the market's enthusiasm for the First Point story, and leave management in the dark as to why Cliffs has postponed the work recommended by Caracle Creek, and in a difficult position to reassure its shareholders that the story is still on track. Cliffs could defer further work for reasons completely unrelated to the economics implied by the material in the requested Tetra Tech report. From a strategic perspective First Point management absolutely had to serve the arbitration notice so that it has at least a 50% chance of internally knowing by Q4 of 2012 what is likely to be in the PEA when Cliffs publishes it in late Q1 of 2013. Cliffs really has nothing to lose through its refusal to provide First Point with a copy of the report, and because this action serves the interests of its shareholders, I cannot complain about this decision.
As a final note I wish to address a concern brought up by some subscribers about First Point selling done by some insiders earlier this year. I have investigated the insider activity and concluded that its nature is not indicative of waning insider enthusiasm for the outlook of First Point's nickel-iron alloy story. My interpretation is that the selling is related to exercise of options and compliance with Canadian tax with-holding rules, which Peter Bradshaw has confirmed was the case. Insiders who exercise options must not only put up the exercise price, but since last year they must also put up the capital gains tax deemed at their projected marginal income tax rate. When incentive stock options are exercised, the difference between the exercise price and the market price on the day of exercise is deemed to be a capital gain for the exercising individual whether or not the stock was actually sold. That market price becomes the cost base for the future sale of the stock, so if the stock subsequently gets sold at a lower price, the individual can claim a capital loss. The difference upon exercise used to be claimed as income, which meant the entire amount got taxed at the individual's marginal tax rate. In Canada a capital loss can only be matched against a capital gain, only 50% of which is taxable at the marginal rate. In earlier times when the gain was deemed as pure income, this quirk has bankrupted quite a few enthusiastic insiders who exercised cheap options while the market price was high and held on because they believed in the company's outlook. Revenue Canada wanted its 44% of the difference whether or not the taxpayer received any value. Now the situation has eased somewhat because Revenue Canada treats the difference as a capital gain, only half of which gets taxed at the marginal rate, but the new complication is that the implicit capital gains tax must be paid in advance. The public company is responsible for collecting and remitting this advance capital gains tax, which is accomplished by not issuing the stock until the insider has produced both the exercise price and the implied tax. The result is that insiders are now selling enough stock to provide the exercise price and the withholding tax, which looks bad during the insider selling, but which enables the insider afterwards to hold the resulting net position without worrying that he or she will be bankrupted by the tax authorities a year later if the stock's price has suffered a sharp decline. The insider selling activity in First Point corresponds to this scenario and in my view has no negative implications for insider perceptions about the company's prospects.
*JK owns shares in First Point Minerals Corp