Cornerstone Capital Resources (CGP.V) – Merger Arb and Company Sale – Upside TBD

Current Price: C$3.30

Offer Price: C$3.66

Current Spread: 11%

Expiration Date: Q4 2022

 

A merger of two junior miners, which comes as a consolidation of interest in one of the largest and high-potential copper-gold projects. Unusually for such small cap transaction, multiple global mining/royalty giants such as BHP Group and Newcrest Mining and Franco Nevada are involved. There are two ways to play this situation. First, a straightforward merger arbitrage with 11% spread that’s very likely to close in a few months. The second more speculative, yet also much more lucrative, bet is that the combined company will get acquired by BHP in short term, i.e. CGP.V is a cheaper way to create a position in SOLG.L before the latter gets acquired. I am positioned for the second option, unhedged long in CGP.

Cascabel is the only available Tier 1 copper-gold project that is not yet in the hands of any major global mining giant. The asset is located in Ecuador and is currently about to enter a definitive feasibility stage. Cascabel is owned by two junior miners – SolGold (listed in LSE and TSX) and Cornerstone Capital Resources (listed on TSXV), which including cross-ownership have around 79% and 21% interest in the mine. After 5 years of unsuccessful attempts, both parties have finally agreed to consolidate their ownership in Cascabel – SolGold will acquire CGP with an exchange ratio of 15 SOLG shares per each CGP. At current prices, 11% spread remains with plenty of cheap borrow for hedging. CGP shareholder meeting is expected in Q4 and the merger should close soon after that. Proxy will be released in Q4 as well. Shareholder approval should pass easily – all CGP directors (own 44%) have entered into support agreements while the remaining CGP shareholders are also finally getting a fair deal.

The whole ownership consolidation saga has been ongoing since 2017, which probably explains part of the spread. This is the 5th time SOLG is trying to takeover CGP. All previous offers were lowballed and would have diluted CGP’s total interest in Cascabel – e.g. the exchange ratio of the previous offer (2019) would’ve lowered CGP’s interest in the project from 23% to 18%. All the previous offers were rejected immediately and CGP raised impossible conditions for further negotiations, such as requesting half of the board seats of the combined company, etc. In 2020 SOLG even tried to go hostile, but the offer expired without any acceptance. More background on the previous takeover attempt can be found here. Finally, both companies have reached mutually acceptable terms and the current offer comes with no dilution to CGP’s 21% interest in Cascabel and proportional allocation of 2 out of 10 board seats. I expect that CGP shareholders will have no issue in transferring their interest into the combined company at these fair terms.

The risk of SolGold walking away from this transaction is very low. The strategic rationale is straightforward – SOLG will consolidate the interest and become a sole owner of an attractive Tier 1 copper project. This ownership consolidation is likely preparation for the sale of the combined company (more thoughts on this below). NPV of Cascabel is in multiple times higher compared to EV of the combined company. Together with the merger, SOLG has also announced the appointment of Citigroup and Maxit Capital (which interestingly is also the largest shareholder of CGP) to explore value-creating alternatives for the combined group including a spin-off of the remaining exploration assets, other than Cascabel, to shareholders of the combined group. Both companies have several such projects, but they are at very early stages.

SOLG’s share price is now at absolute lows since 2016 when Cascabel excavation started. The 40% YTD selloff in SOLG shares might have been partially driven by artificially created financing uncertainty creating an opportunity for BHP to scoop it up opportunistically. Assuming the merger closes, then CGP is a cheaper way to bet on SOLG eventual sale.

BHP Group (US$179bn market cap) and Newcrest Mining (US$10bn) have shown substantial interest in Cascabel and currently own around 27% of SOLG. BHP has amassed a large influence on SOLG management and has long been rumored to eventually acquire SOLG (more on this below). Royalty giant Franco-Nevada (US$22bn) is also involved as a major debtholder of SOLG.

Major shareholders of CGP (presentation):

Major shareholders of SOLG:

 

Cascabel project and its valuation

Cascabel is directly owned by Exploraciones Novomining (ENSA), 85% of which is controlled by SOLG and 15% by CGP. Additionally, there’s some cross-ownership between the two companies with CGP holding 6.85% in SOLG, while SOLG has a 5.6% stake in CGP.

Until feasibility studies are completed SOLG will finance the project alone, which CGP will have to cover by paying 90% of its cashflows (from 15% interest) once production starts. As of June, the amount owed by CGP to SOLG was US$48m.

Cascabel is a large Tier 1 copper-gold project, which is expected to become one of the top 20 largest mines in South America. Pre-feasibility study has been completed this April showing measured and indicated resources of 12.6Mt of copper, 26.7Moz of gold and 92.2Moz of silver. At peak production, the mine is expected to produce 391kt CuEq, 210kt copper, 82kt gold and. 1.4Moz silver annually. The mine also has 26-year mine life and is expected to have very low production cost with an average copper AISC of US$0.06/lb. A definitive feasibility study is expected to start in Q4 this year and finish in 2026. Production start is estimated in 2029.

My experience with pre-production mine valuations is limited, however, at a quick glance it seems that Cascabel is rather inexpensive right now, especially considering its top-tier status and backing by top names in the industry. At a base case of $3.6/share copper and $1700 gold prices (in-line with current spot prices) and 8% discount rate, Cacabel’s after-tax NPV is stands at US$2.9bn – see tables below (presentation). In comparison, the combined EV of CGP and SOLG is just US$600m. A very big discount, part of which accounts for various uncertainties related to many years remaining until the start of production as well as substantial CAPEX requirements to put the mine online – US$2.7bn pre-production and US$2.1bn additional post-production.

Pre-feasibility financial data:

NPV sensitivity:

Expected timeline:

 

SOLG management also highlighted company undervaluation in the recent merger presentation:

 

Interest in Cascabel from the mining giants

Since 2016 both BHP and Newcrest have been going over each other’s heads in order to acquire a larger stake in Cascabel:

•  In 2016 both mining giants competed to fund SOLG. BHP has even offered to acquire 85% of SOLG’s interest in Cascabel for US$275m in 2016, but got rejected and Newcrest’s proposal to take 10% stake was chosen instead.
• In Sep’18 BHP acquired a 6.1% stake and increased the stake to 11.2% at a premium to market price. Newcrest also increased its ownership in 2018 at premium prices.
• BHP then subscribed for even more shares in 2019 amassing a 13.6% catching up to Newcrest’s 13.5% stake (adjusted for current share count). Both mining giants then entered into lock-up agreements, which prevented them from further increasing their stake SOLG and even acquiring shares in CGP. Newcrest’s lock-up agreement expired in 2019 and BHP’s – in October 2020.

Given the large ownership, speculations around a full Cascabel takeover by its major shareholders have been circulating in the media for years (for example). Even CGP management used the potential takeover argument while defending from the previous lowball offer from SOLG:

There may be a number of other companies interested in Cascabel, such as BHP Billiton and Newcrest Mining, both of whom have acquired substantial shareholdings in SolGold.

At the end of 2020, both BHP and Newcrest were looking toward increasing their stakes through another equity raise in SOLG, however, for some reason, the previous management of SolGold has decided to go for very expensive debt issuance with a royalty giant Franco Nevada (US$22bn market cap) instead. This angered shareholders and resulted in prompt CEO resignation a few months later. Subsequently, in 2021 almost all of SOLG’s board has been reshuffled. It seems that BHP might’ve had a hand in this as in Nov’21 SOLG’s non-exec chairman wrote a letter to shareholders saying he received information that BHP was in some way meddling in the reappointment of SOLG’s board members. Instead of working behind the scenes, the chair invited BHP to put forward a takeover offer.

‘It has come to my attention in recent weeks that one of SolGold’s significant shareholders, BHP Group Ltd., has been actively canvassing certain shareholders and members of the board’. ‘‘if a party wants control or to significantly influence the development of your Company, the party should put forward an offer that results in all Shareholders benefitting from a premium’.

Just a few days after this letter, SOLG announced a new CEO/managing director – not surprisingly, a veteran from BHP, who previously worked as a senior executive in BHP’s Australian copper and gold project. Aside from the CEO/managing director, there is also another BHP-alumni on SOLG’s board. BHP seems to have amassed a very strong influence on SOLG management.

 

The sale of the combined company might be in the cards

The timing and situation of the current CGP takeover are definitely strange and suggest that something is happening on behind the scenes. SOLG is likely getting dressed up as a pure play on Cascabel with an endgame being an opportunistic sale to BHP at depressed prices (but still at a premium where the company is currently trading).

• SOLG is short on cash – as of the latest report (June) it had US$21m, which will run out by the end of this year. SOLG had been looking at the financing options already for a few months. In July, rumours appeared that the company has unsuccessfully tested equity markets and the attempt to raise equity failed. This seemed just outright weird, as how could Cascabel fail to find interested parties, when it’s backed by BHP and Newcrest, and both major shareholders previously indicated willingness to provide euity financing themselves? Apparently, BHP might’ve had a hand in this again. Shortly after the failed funding rumors, an activist/minority shareholder Berry Street Capital published a letter saying that SOLG’s major shareholders might’ve intentionally interrupted the equity raise and again urged a full company sale:

‘We believe the Board should represent the entire shareholder base and not only a select group who might be exercising control. Hence, we urge the Board to act fully independently and begin a strategic review imminently to initiate a sale process of the Company.’

• Several key SOLG executives have resigned recently – in May CFO and head of exploration left the company. In August, another director and the new CFO (which had been working for 6 weeks only) resigned as well.
• Without any response or announcement from SOLG, the financing issue has been dragged uncomfortably close to the year-end, when the company is due to run out of cash. As a result of this uncertainty, the SOLG share price has tumbled by 40% YTD.
• Then suddenly a few weeks ago, SOLG announced the merger with CGP saying it will also explore spin-off of all non-Cascabel assets after the merger.

As suggested by AFR below, the current setup comes down to only two remaining scenarios – either major shareholders will provide financing themselves or buyout SOLG/combined company:

There’s bound to be a time in the next few months when its two big Australian shareholders will have to decide how much they want Cascabel. If it’s a bit, then the two shareholders will have to tip into an equity raising and try to maintain the status quo. But if it is a lot, like some analysts suspect, then we could see a pair of Australian heavyweights in a ding-dong battle.

The way the situation has been handled so far suggests that the latter scenario is more likely. There was plenty of time to do an equity raise earlier, especially when the latest merger presentation highlighted that ‘Strong interest in SolGold assets remains despite challenging short-term market dynamics’. Instead, the financing question was getting postponed till SOLG is almost out of cash. Consolidation of Cascabel’s ownership by merging the two companies is a hint that the sale is coming.

A few more bits and pieces pointing towards the likely sale of SOLG/combined company:

• BHP is now transforming itself into green-energy metals-focused miner and has been on the hunt for copper assets. BHP recently tried to acquire Australian copper miner OZ Minerals for A$8.4bn but got rejected. Although Cascabel still has many years until full-scale production comes online, the project would clearly fit as a long-term strategic asset. Newcrest seems less likely as a potential acquirer here – its hands are full with the recently completed US$2.8bn takeover of gold miner Pretium Resources.
• Warren Irwin of Rosseau Asset Management (PE fund which owns 8.1% in CGP) has been vocal about SOLG/CGP merger on Twitter. One of the commentators suggested that BHP is now in control and will buy out SOLG cheaply. Warren rebuked his argument saying, ‘Don’t worry, you will be proven wrong. We will not be rolling over to BHP’. This might imply that Rosseau Asset Management wants a cash exit at a material premium.
• Ecuador is the most underexplored region in the Andean copper belt, which accounts for 40% of global copper production. Till recently, the country wasn’t a particularly friendly mining location. However, several years ago the government changed its tone, made multiple law reforms and began inviting mining investors to scale-up mining production in the country. As a result, many global names entered the country and total exploration spending jumped up 4x since 2016-2017. Nonetheless, this month the government has temporarily suspended new mining licenses for 1 year due to pressure from local groups until a new consultation law is adopted. Arguably this has increased the value of current, already ongoing projects for those willing to enter this mining destination.