Klondex Mines (KLDX) – Merger Arbitrage – 5% upside

Current Price – $2.46

Merger Consideration – $2.57

Upside – 5%

Expiration Date – 12th July, 2018

Acquisition presentation

 

Couple members suggested to look into this merger arbitrage opportunity. Klondex Mines are due to be acquired by Hecla Mining (ticker HL) for 77.4m in Hecla shares and $157.4m in cash. Using current prices, this works out to approximately $2.42 per KLDX share. Additionally, Klondex’s Canadian assets will be spun out to existing shareholders – likely providing additional value of between $0.13-$0.17 per KLDX share. Thus overall consideration presents 5% spread on current Klondex share price. Transaction is subject to 2/3 KLDX shareholder approval and meeting is scheduled for the 12th of July.

The upside here clearly hinges on the valuation of the spin-off, but first let’s start with couple arguments of why the deal is likely to be approved by KLDX shareholders:

• Merger consideration presents a premium of almost 80% to unaffected KLDX share price;

• $21m termination fee;

• 25.4% of shareholders have already entered into support agreement, suggesting that 55% of the remaining shareholders need to vote for the deal.

• In the absence of acquisition KLDX would need to raise additional funds and dilute shareholders. From the proxy: “The Klondex Board, with assistance from Klondex’s legal counsel and financial co-advisors, therefore began to explore other potential alternative options, including a potential rights offering and preparing a short form base shelf prospectus to access the capital markets in the event that a transaction with Hecla did not proceed.”

 

Canadian Asset Valuation

Canadian Assets consist of True North (acquired in Jan 2016 for $31m) and Ogama-Rockland (acquired Oct 2017 for $7m). Company claims that a total of $70m has been invested in Canadian assets.

Few quotes from the annual report:

True North, located in Manitoba, Canada, is 100% owned, fully-permitted, and was acquired on January 22, 2016. True North is a past producing underground gold mining operation consisting of three underground deposits with a modern, fully-permitted mill. Under previous ownership, mining took place at True North continuously from 2007 until May 2015, when the operation was placed on care and maintenance. True North was placed into production towards the end of the third quarter of 2016 following the release of an updated mineral reserve and resource estimate.

After the Company performed an extensive review of the operational performance at True North and the 2018 objectives of the Company as a whole, management decided to place the mine under care and maintenance to review strategic options and to provide optionality at higher metal prices. This decision was largely based on the site’s inability to achieve planned operating and cash flow targets in 2017 and to refocus the Company’s resources on Nevada assets.

The costs associated with the reduction of underground operations and workforce at True North and our future plans for the True North mine could adversely affect our operating results and financial condition, and there can be no assurance that our future plans for True North will be successful.

Additionally, the recently acquired Ogama-Rockland property is approximately 30 kilometers or approximately 19 miles from True North, and we are in the process of assessing the potential of processing ore from both the True North mine and the Ogama-Rockland property through the True North mill to improve the economics for our properties in the region.

These Canadian assets appear to be the ugly duckling that Hecla did not want to take under its wing. True North was already uneconomical when KLDX acquired it, then management wasted some more capex on it, produced gold at $1,500 and sold at $,1250 and then decided to close the mine again continuing to be exposed to workforce termination and severance costs. Ogama-Rockland is non-operating and might remain so. Canadian assets generated $6.5m loss in Q1 alone. And now these non-producing assets will also carry corporate overhead of a publicly listed entity.

Hecla is injecting $7m cash for 13.5% interest in the spin-off, with existing KLDX shareholders receiving the remaining 86.5%. At this valuation the spin-off is worth $0.24 per KLDX share. However, I think this valuation is far fetched and Hecla sees $7m not as an investment in the spin-off but rather as an additional cost of acquiring Klondex Nevada assets.

I think these assets are not worth more than their acquisition costs or even 25% haircut on that assuming KLDX management overpaid – thus a value of $0.17-$0.13 per KLDX share. It is also quite likely that the real value is much closer to zero – cash burn will be high and eat through $7m injection over couple of quarters, True North mine is clearly non-economical, mill has no use without assets nearby and Oagam Rockland prospects are still uncertain. However, at least initially I would expect the spin-off to trade somewhere between management’s assigned value and my calculations.

Assuming transaction closes as expected (which IMHO is very likely), investors are paying $0.04 to gain $0.13 – $0.17 (or $0.24 at management’s implied valuation).

If the deal breaks losses of 50%+ are likely.