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Spec Value Hunter Comment - May 30, 2012: Recommendation Strategy for Northcliff Resources Ltd
 Northcliff Resources Ltd is a new Good Absolute Spec Value Buy at $0.52 with a $0.75 short term accumulation limit and a 12 month target in the $1.50-$2.00 range based the expectation that this Hunter-Dickinson junior will deliver a positive feasibility study for the tungsten-molybdenum Sisson project in Q3 of 2012 along the lines I have modeled, complete the acquisition of 100% of the Sisson project by the end of Q2, and file an Environmental Impact Statement that promises rapid approval by the New Brunswick regulators so that project financing can be achieved by mid 2013, with production startup in 2015. The stock is illiquid at the current price and thus difficult to buy, but there is an opportunity to buy Northcliff indirectly in anticipation of the pro rata distribution by Geodex Minerals Ltd of the 16,003,700 Northcliff shares it will receive if its shareholders approve the sale of its 30% Sisson interest at the upcoming June 18 special meeting. The Geodex board has decided to issue 0.145 Northcliff shares for each Geodex share. At the $0.75 buy limit for my Northcliff recommendation the equivalent price would be $0.11 for Geodex, assuming that the junior has zero enterprise value after distributing the Northcliff shares. Geodex will have 119 million shares fully diluted, about $1.5 million working capital, a portfolio of grassroots projects in New Brunswick, a burnt out management team, and a despondent shareholder base that will likely shift its hopes to Northcliff (as a long time Geodex shareholder I belong in that category). So post distribution we can expect Geodex to join the other large fleet of TSXV rollback candidates trading below $0.05. I do, however, believe, that Northcliff over the next couple years will deliver substantial gains from current levels, and possibly spectacular gains if certain geopolitical scenarios unfold, largely because Sisson is a fairly unique tungsten story located in New Brunswick, a beleaguered Atlantic Canada province with a mining history that is eager to revive its economy.
 Sisson is a large tonnage, low grade tungsten-molybdenum deposit that was the subject of a preliminary economic assessment (PEA) produced by Geodex in September 2009. The Sisson system was explored by TexasGulf in 1978-82 but was dormant due to low tungsten prices until 2004 when Geodex optioned the project from a private company and spent nearly $13 million through 2009 delineating a sizeable orebody, working out the metallurgy, and advancing the project through the PEA stage. However, by the time Geodex published its PEA the price of tungsten had dropped below $200/mtu APT in the wake of the 2008 Crash, well below the base case $300/mtu price that supported a 27% internal rate of return and an after-tax net present value of $388 million at a 10% discount rate. The after-tax NPV sensitivity chart below shows what Northcliff's 100% ownership would look like using the assumptions behind the PEA's mining scenario of a 20,000 tpd open-pit mine producing separate tungsten (60% WO3) and molybdenite (53% MoS2) concentrates sold respectively at a 23% discount to APT processors and an 8% discount to a moly roaster. Annual output assuming recoveries of 73.9% and 70% for tungsten and molybdenum would have been 491,000 mtu APT (1 mtu = 10 kg) and 3.4 million lbs molybdic oxide. The PEA assumed CapEx of $341 million and OpEx of $7/t with a life-of-mine 0.64 strip ratio for a measured plus indicated resource of 176,600,000 tonnes of 0.095% WO3 and 0.031% Mo which supported a 26 year mine life. At $300/mtu APT the after tax NPV was $387 million, jumping to $610 million at $400/mtu. Based on 119 million shares issued and 100%, this would have translated into a $3-$5 price range for Geodex if confirmed by a feasibility study (the chart reflects Northcliff owning 100% with 80.4 million shares fully diluted). Alas, the cost of the feasibility study and bad timing clobbered Geodex.
With nearly 100 million shares issued, a stock price below a dime, and a demoralized management team that had made a number of avoidable mistakes during the 2005-2008 period when I covered it as a bottom-fish recommendation, Geodex accepted a stiff option agreement in October 2010 whereby HDI would spend $17 million towards a feasibility study to earn 70%. Hunter-Dickinson Inc transferred the option into a 5:1 rolled back capital pool that commenced trading on June 8, 2011 after completing a $28 million private placement at $1. Before Northcliff started trading Geodex traded as high as $0.30, because the assumption was that once Northcliff had spent $17 million the market would have a robust feasibility study implying a valuation something in the order of $400 million that would support a $4 stock price for Northcliff, which in turn would issue $120 million worth of stock to acquire Geodex and its 30% Sisson interest, offering an exit at about $1 for Geodex shareholders without management having had to do the heavy lifting associated with a feasibility study, permitting and social license negotiations. Unfortunately Geodex management was naive in thinking that $17 million would be more than enough to deliver a feasibility study. Furthermore, although tungsten prices ascended sharply after the deal was struck, trading at $450/mtu until the recent decline to the $400/mtu level in the face of the global economic slowdown, Northcliff's listing caught the 2011 market downtrend created by the eurozone crisis and the debt ceiling debacle in Washington, with the result that the stock opened with a whimper and drifted down to its current level of $0.45-$0.55 where it trades little volume..
The HDI controlled private company which merged with the capital raised $28 million through a private placement at $1 apparently spread among several dozen large shareholders who have been longtime supporters of the Hunter-Dickinson group and who bought with the mine development story in mind. During Q1 of 2012 Northcliff let Geodex know that it will have spent $17 million by May 31, 2012, with another $11 million required to bring the project to a construction start in mid 2013, assuming mine permits were received by then. Northcliff had sufficient funds left to complete this task, but Geodex would have to start paying its 30% share. Given that Northcliff was trading at $0.50, implying a project value of only $46 million based on a 70% net interest and 64.4 million fully diluted for Northcliff, the equivalent price for Geodex with 119 million fully diluted and a 30% net interest was about $0.12 per share. Faced with diluting its stock at $0.10 or lower to fund 30% of ongoing Sisson expenses in a market that clearly thought the Hunter-Dickinson powerhouse had either mutated into a band of dwarves trapped inside a wet paper bag, or hung itself with a real stinker of a project, Geodex management capitulated by agreeing to swap the 30% Sisson stake for an amount of stock that was equivalent to 20% of Northcliff's resulting fully diluted capitalization. In reality HDI has taken a deep breath and let itself be submerged by the rising flood knowing, or at least hoping, that the flood waters will have subsided by the time their air runs out. Such is life in the junior sector when your timing is off and you underestimate the cost of getting things done.
According to Northcliff's CEO Chris Zahovskis, it is HDI's goal to build Northcliff into a flagship tungsten producer that could become the aggregator of other tungsten projects. The feasibility study is being geared toward a 30,000 tpd operation that includes an APT (ammonium-paratungstate) plant with an annual capacity of 800,000 mtu that represents 11% of global tungsten output. The parameters I use in my speculative discounted cash flow model imply annual output of 667,000 mtu APT and 4.7 million lbs molybdic oxide, which is a sizeable amount for tungsten demand to grow by 2015, though in the case of molybdenum the output is less than 1% of global supply. Northcliff itself is targeting output of 500,000 mtu, which implies that the APT plant at Sisson will have 300,000 mtu of excess capacity that can handle additional concentrates from third party producers or smaller tungsten producers Northcliff acquires through mergers or acquisitions. Northcliff thinks it will be able to secure project financing for a capital cost in the $400-$500 million range on a 25% equity basis, with the equity portion coming from a strategic investor in exchange for partial off-take rights.
With the help of discussions with Northcliff management and other sources I have created a modified mining scenario in which I assume that the CapEx of a 30,000 tpd open pit milling and flotation mine with an associated processing plant with an 800,000 mtu APT output capacity will be about $450 million, while OpEx that includes the APT processing cost will jump from the PEA $7/t to $12/t ore. On May 17, 2012 Northcliff published an updated 43-101 resource estimate which has grown the resource but at some expense to grade. Although Northcliff has highlighted a $9.00 NSR cutoff as its base case, which generates a measured plus indicated resource of 383 million tonnes of 0.067% WO3 and 0.021% Mo, I have adopted the $15 NSR cutoff which generates a M+I resource of 229 million tonnes of 0.086% WO3 and 0.025% Mo. At 30,000 tpd this resource supports a 22 year mine life.
My DCF model suggests an after-tax NPV range of $4.81 to $9.50 per share at a 10% discount rate and 80.4 million shares fully diluted, corresponding to an APT range of $300-$400/mtu (the current price is about $400 after peaking at $489 in April 2011). At these APT prices the internal rate of return is 24% and 36%. Given that most of the Northcliff stock is concentrated in the hands of long-time HDI backers, if the feasibility study turns out as robust as my assumptions, it would not be too difficult to see the stock climb to the $1.50-$2.00 level where a $100 million financing at $2 is done with a strategic partner, boosting fully diluted to 130 million shares, which reduces the after-tax NPV share target range to $3-$6 as production approaches.
Aside from assumptions about project fundamentals, Spec Value Hunters must also make the assumption that $300/mtu is the new base for APT tungsten. Northcliff is an indirect speculation on the future of tungsten prices, which will be determined by Chinese mining and export policies, as well as the unlikelihood that large tungsten deposits such as Northern Dancer and Mactung in the Yukon will make it into production. Tungsten prices have been very strong until recently, but are now sliding in the face of a slowing Chinese economy. The market views tungsten with a skepticism similar to that it shows the rare earth sector. Because China glutted the market with low cost production during the eighties and nineties so that most non-Chinese tungsten mines were forced to shut down, similar to what happened in the rare earth sector, with the result that China now dominates global tungsten supply - 82% of the 72,100 tonnes estimated for 2011, and because China has put tungsten on its restricted list with export quotas, the fear is that the strong prices during the past couple years will soon enough vanish once China opens the supply spigot again, just as many fear will happen with the rare earth sector.
But there is evidence that the era of low cost Chinese production is coming to an end. The USGS estimate for 2011 indicates that despite record tungsten supply a persistently high tungsten price bestowed a record value exceeding $3.5 billion on a market that during the eighties and nineties was worth less than $500 million annually. The easy deposits have been depleted and China is cracking down on pollution from mines and processors, especially the numerous small operations that characterized China's tungsten output. A surge in supply from these types of mines to serve the rising global demand is unlikely. Western end users are also increasingly unhappy about the quality of APT exports from China. There is also the emerging problem that the Frank-Dodd provision relating to "conflict minerals" will create demand for tungsten that is "morally" clean, not just clean of impurities. German researchers are establishing concentrate fingerprints for tungsten just as they have done for tantalum and niobium; this will not stop China from importing tungsten concentrates from conflict regions such as the troubled Kivu area of eastern DRC, because once the concentrate has been processed into APT the fingerprint is gone. But western corporations may be required to demonstrate that their tungsten inputs come from sources certified as conflict free, which no Chinese source will be able to do. This situation could attract a premium price for large, reliable suppliers such as Sisson whose APT will have the added benefit of meeting purity standards. Finally, tungsten demand could rise if the development of shale oil and gas further boosts demand for cutting tools, and if the next president of the United States decides to escalate the mutual distrust between China and the United States by declaring China a currency manipulator. If the American military "Pivot to Asia" provokes China into doing something silly about its territorial claims in the South China Sea, we could see a two-tiered price market evolve for tungsten just as we have experienced with rare earths since 2010.
Conclusion: Because I think Hunter-Dickinson's timing for a move into the tungsten sector is shrewd, because the scale of the project is monumental for tungsten supply but well within the group's in-house technical capacity and thus worthy of institutional size market attention, and because the stock is suffering from a low valuation due to general market conditions which would become irrelevant if geopolitical developments inject a sense of strategic urgency into the question of tungsten supply, I am including these considerations in my assessment of what appear to be strong economic project fundamentals, to recommend Northcliff Resources Ltd as a Good Absolute Spec Value Buy at $0.52 with a $0.75 limit prior to delivery of a feasibility study that allows me to recrunch my discounted cash flow model, and confirm that the $1.50-$2.00 target is on track.
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