Cornerstone (CGP.V) – Merger Arbitrage – 27%-50% Upside

Current price: C$0.33

Expected merger consideration: C$0.42 – C$0.50

Upside: 27% – 50%

Expiration Date: Q3 2019

This idea was shared by Ilja.

 

This is an interesting potential merger situation between two junior miners that have joint interest in Ecuador copper-gold project Cascabel. Investment by large cap names BHP Billiton and Newcrest Mining at higher price levels adds quite a bit of confidence in the property itself as well as workout of this case.

Cornerstone Capital Resources (CGP.V) has received an indicative takeover offer from its bigger peer SolGold (SOLG.L and SOLG.TO) at 0.55 SOLG/share (235% premium to the last closing price). The offer has been rejected on the same day as apparently over 50% of the shareholders have expressed their dissatisfaction. Despite that, CGP has stated that they are open to continue talks with SolGold and any other potential buyers. In it’s turn SOLG stated that they will proceed with their offer anyway.

There is a nice 8% spread to the rejected offer price and I am expecting that SOLG will eventually have to increase share exchange ratio in order to receive support from Cornerstone shareholders.

For both companies the main asset is their ownership of Cascabel (15% for CGP and 85% for SOLG) – a high potential copper-gold project in Ecuador. There is also cross-shareholding between the companies, which results in Cornerstone’s 23% direct+indirect ownership in Cascabel. The remaining assets are mostly exploration licenses and their value for the purpose of analyzing this merger situation is negligible.

Since 2016 Cascabel drew the attention of the mining industry giants – Newcrest Mining (A$19bn market cap) and BHP Billiton ($187bn market cap), which currently are the largest shareholders of SOLG (15.3% and 11.2% respectively) and which have increased their stakes recently in Q4 2018. Therefore I am assuming they would be interested in CGP’s Cascabel stake as well. However, currently both large cap miners are restricted until Oct 2019 and Oct 2020 by the standstill agreements. Thus SOLG seems to be under a time pressure here to buy out CGP before other players are allowed to step in.

Three largest CGP shareholders (together own 37%) have acquired main portions of their holdings in 2017 by exchanging their SOLG shares into CGP at 0.65 ratio. This should serve as a lower limit for any successful merger negotiations between the companies. The upper limit is likely around 0.77 SOLG (40% premium to the rejected offer), which is the amount that wouldn’t dilute CGP’s current stake in Cascabel adjusted for upcoming exploration debt repayments (explained below).

If the deal fails, downside to unaffected price is considerable (60% ), however CGP has hinted a few times already that are interested buyers are present.

 

Cascabel Project

In the last 40 years Cascabel had 8 owners in total, which at most made some samplings, but did not proceed further with the project. In 2011 the project was initially purchased by Cornerstone and then in 2012 SOLG has entered into the scene by acquiring 20% and then exercising the option to increase the stake to 85% in 2014. Cascabel project is currently still in early stages and should have completed the pre-feasibility assessment by the end of 2018. The most recent exploration campaign resulted in 2x larger estimation of the total resources than the previous one – 10.9Mt Cu and 23.2 Moz Au.

According to the agreement between CPG and SOLG until the completion of the feasibility studies, the financing would come 100% from SOLG (so far has spent $117m and is expected to spend another $80m). CGP will have to repay their 15% part after the commercial production starts by giving 90% (out of their current 15%) of the cash flow to SOLG. Also, after feasibility studies further development of the property will have to be done by both companies proportionally to their holdings in Cascabel and in case either party fails, their ownership will be diluted accordingly. If CGP stake gets diluted below 10%, it will be reduced to 0.5% NSR royalty, which SOLG will be able to acquire for $3.5m.

Another thing, is that Ecuador is increasingly becoming an attractive spot for mining companies due to the recent regulatory reforms. This definitely adds to the attractiveness of the project.

 

BHP Billiton and Newcrest Mining

Apparently, both Newcrest and BHP have been going over each others head since 2016 in order to acquire larger stake of Cascabel (BHP has even offered to acquire 70% of SOLG’s interest in Cascabel for US$275m, but got rejected). At the end of last year both firms have increased their stakes in SOLG at a premium to market price – BHP has increased their stake by 5% at £0.45/share (28% premium at the time), while Newcrest by 1.5% at £0.40/share (8% premium at the time). Both of these investments also were done at a higher price levels than the current £0.375 SOLG share price.

Despite that, the limiting factor is that both of the companies are currently unable to make any moves on CGP. Newcrest is bound by the subscription agreement, which until the 17th of October 2019 won’t allow them to buy any shares of CGP. At the same time BHP is restricted by the standstill agreement, which doesn’t let them buy any shares of CGP without SOLG’s consent till the 16th of October, 2020.

Given the apparent potential of Cascabel, I think motive behind SOLG’s offer is clear –  to acquire as cheaply as possible the remaining 15%, while other interested parties haven’t started to move yet. Thus SolGold is likely under a time pressure as Newcrest will offer to acquire CPG as soon as their standstill expires.

Moreover, the possibility of other potential buyers have been mentioned by CGP a few times already and SOLG has also stated that they are aware that:

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.

 

Previous Merger Attempts

Apparently this is not the first time SOLG has tried to talk with CGP about a possible merger. Although I’ve not been able to find any original announcements, in the most recent indicative offer SOLG states that they have already tried in 2017 and 2018, but nothing moved forward because CGP’s conditions of “(i) 50% of the seats on the board of directors of the combined entity were allocated to Cornerstone, (ii) the Chief Executive Officer of SolGold was replaced, and (iii) the Chairman of the board of directors of SolGold was replaced.” were seen as unrealistic given the difference in size of the companies and their stakes in Cascabel. The current offer and the responses from CGP, however, did not mention any of the conditions above, so I think this time the outcome might be different.

 

Merger Discussions

Both companies have provided numerous arguments for and against the offer, yet I don’t think any of them stand on strong ground. Overall, the discussion doesn’t seem friendly – both parties are accusing each other of making misleading or false statements and on some points arguments simply seem silly. For example, SOLG has stated that they are paying 20% premium to Cornerstone’s 2 year high price, however apparently it is false as CGP was trading at C$0.55 (60% premium to the current offer) on the 17th of July 2017.

Nevertheless, the main argument why the offer was rejected is that with the current holdings of 15% in the Cascabel + 9% stake in SOLG, Cornerstone owns 23% in the property, while in the combined company (at 0.55 share exchange ratio) they would have only 18% stake. So in order for CGP to keep their 23% stake, share swap ratio should be 0.85. Adjusting this figure for Cornerstone’s 15% part that will have to be repaid for the feasibility stage investments results in 0.77 ratio, which is 40% premium to the rejected offer.

In the calculation above I have ignored other SOLG and CGP assets, which are mostly exploration licenses on the properties that have not been touched yet (at most only some initial samples have been collected) and which shouldn’t have a significant impact on the valuations of both companies. Merger discussions between the two companies also did not seem to refer strongly to any other properties besides Cascabel.

 

Cornerstone Shareholders

Cornerstone is an exploration company without any operations – SOLG described CGP’s management as passive. Since the time of its earliest filings (in 2009) the company hasn’t done much and its current value now is holding on just that 15% stake in Cascabel.

Cornerstone is largely held by the privately owned hedge fund sponsor Rosseau Asset Management (14%), CEO of Maxit Capital – Mr. Dmyant Bob Sangha (13%) and the company’s chairman Greg Chamandy (10%), who is also a co-founder and ex-CEO of Gildan Activewear (C$9bn). Apparently, all three of them have acquired the majority of their holdings by exchanging (here and here) part of their SOLG shares into CGP at 0.65 ratio. I haven’t been able to find any explanation on why did they swap the shares, except that it was done just before CGP wanted to spin off all of its other assets except for ownership in Cascabel (eventually the spin-off was cancelled). Likely these shareholders were expecting price convergence between SOLG and Cornerstone – which would mean 0.85 exchange ratio before adjustment for Cascabel exploration expense repayments.