Guest Pitch: Base Resources (BSE:AX)

Merger Arbitrage – 11%-20% Upside

This pitch was shared by Povilas.

This is a definitive-agreement-stage merger arb opportunity in the mining industry with an 11%-15% spread and 3-4 months left till closing. Merger consideration is in stock and there is plenty of cheap borrow for hedging. The remaining spread seems to be explained by a combination of 1) the cross-border nature of the transaction, 2) a steep c. 60% downside, and 3) the risk of any unforeseen adverse developments in the target’s ongoing fiscal regime negotiations with Madagascar’s government. I am sharing my research notes below and would welcome any feedback from the other SSI subs.

The key asset of the Australia-listed Base Resources (A$330m market cap) is a development-stage ilmenite/zircon/rutile/monazite project, Toliara, in Madagascar. In April, the company agreed to be acquired by US-listed uranium and rare earth metal miner and processor Energy Fuels (UUUU). As part of the transaction, BSE equity holders will receive 0.026x UUUU stock plus an unfranked dividend of A$0.065 per BSE share. Factoring in a 20% tax on the dividend, the spread at today’s prices stands at 11%. However, the spread is volatile and stood at 20%+ at the beginning of the week, so the timing of position entry is important. The special dividend is expected to be paid in August, and the merger is anticipated to close shortly afterward in Q3’24.

I would expect the key closing conditions to be easily satisfied.

• Shareholder approval (75% of votes cast threshold) seems highly likely given the support from two large shareholders, Pacific Road Capital (owns 26.5%) and Sustainable Capital (24.8%). The acquisition offer comes at a massive 100%+ premium to pre-announcement levels. The transaction will also allow the better-capitalized combined entity to fund the development of BSE’s key asset, Toliara, until the expected production in 2027/2028. Toliara’s total development/construction capex has been estimated at c. $600m compared to BSE’s net cash of $79m as of Dec’23, implying significant potential shareholder dilution if BSE were to remain a standalone entity.
• The transaction will require regulatory approvals from the Australian Foreign Investment Review Board, the Competition Authority of Kenya, and the Malagasy Competition Council. The pushback from FIRB appear unlikely given the company does not operate any Australia-based assets. The two remaining antitrust approvals appear to be customary in nature.

The transaction seems to hold a strong strategic rationale for the acquirer. While UUUU has historically focused on uranium, since 2020, the company has been expanding into the production of other rare earth element products (oxides and other materials). The buyer has stated that it intends to source monazite from Toliara for processing in its White Mesa Mill facility in Utah, currently undergoing an expansion. UUUU’s commitment to increasing its exposure to monazite supply is underscored by several similar transactions over recent years, including a memorandum of understanding with Astron Corporation to develop its monazite sand deposit (2023) and the acquisition of several monazite mineral concessions in Brazil (2023).

So, why does the spread exist?

This is a cross-border merger with no overlap between the trading hours of both stocks, with the added complication of FX volatility. However, another, and probably more important, explanation might be the ongoing negotiations between BSE and the government of Madagascar regarding the fiscal terms of its currently suspended Toliara project. Some quick background details on this:

• Back in 2019, shortly before the release of Toliara’s definitive feasibility study results, the Madagascar government suspended activities at the project due to opposition from local communities and unfavorable terms for the country.
• In response, BSE stated that the suspension was required “whilst discussions on fiscal terms applying to the project are progressed.”
• Discussions between the two sides regarding mutually beneficial fiscal terms have been ongoing ever since, but no agreement has been reached so far.

Why is this important? While the the closing of the merger is not conditioned on the parties reaching a fiscal agreement, the merger agreement specifies that the material adverse change condition includes any events that would hinder BSE’s ability to lift the suspension of the Toliara project, including any public statement from the government of Madagascar. See excerpt from the merger agreement (p. 8) below:

Company Material Adverse Change means any event, occurrence or matter (whether occurring on or after the date of this Deed) which is or would (either individually or when aggregated together with any other events, matters or circumstances of a similar type or nature) reasonably expected to: […]

b) be material and adverse to the Company Group’s ownership interest in a Material Project, including any material and adverse changes to: […]

ii) the Company Group’s ability: […]

B) in the case of the Toliara Project, to lift the suspension, obtain the legal right to exploit monazite or otherwise exploit the Toliara Project (including as a result of any public statement or regulatory action by or on behalf of the Government of Madagascar or any applicable court of law).

So the market might be worried that any unfavorable turn in the discussions with the government regarding fiscal terms before the transaction closing (e.g., an indication from the government of Madagascar that it will oppose lifting the suspension) would allow the buyer to walk away, thus fully derailing the merger.

While this outcome is not out of the cards, several aspects indicate that any adverse developments are unlikely in the ongoing discussions over the next 3-4 months.

The delay in reaching an agreement over the recent years appears to be explained by uncertainty surrounding the new mining code and Madagascar’s recent presidential elections. Discussions on the new mining code among Madagascar lawmakers had been ongoing throughout 2022-2023 (see here). More recently, in late 2023, BSE noted that discussions with the government of Madagascar were limited due to “preparations for the upcoming Presidential elections.” However, with the passing of the new mining code into law in 2023 and the conclusion of the presidential election in Nov’23, both of these uncertainties now seem to be in the past. In Feb’24, BSE stated that negotiations have resumed. Importantly, management has been very upbeat about the coming to a fiscal agreement with Madagascar, highlighting that the government has “expressed support for production of a monazite product from the project” – see quotes below.

After limited engagement with the Government of Madagascar in the lead up to the Presidential elections in November 2023, discussions on fiscal terms and lifting of the Toliara Project’s suspension have recommenced. With the Government indicating that progressing the Toliara Project is a priority, the new year has seen a period of sustained engagement with positive progress made — including expressed support for production of a monazite product from the project.

In light of the progress achieved and the Government’s demonstrated level of focus and engagement, in applying the Company’s capital management policy the board has decided not to pay an interim dividend.

[…]

We were excited to deliver the results from the monazite pre-feasibility study in December, enhancing the already exceptional potential of the Toliara project. Realization of this potential is now more important than ever. With the President of Madagascar’s government now formed and a new Mining Code in place, a positive shift in dynamics and significant focus and attention from the Government on the project’s progression is evident. We are optimistic that mutually attractive fiscal terms can be secured that will support development of the Toliara Project for the benefit of our host communities, the nation of Madagascar and our shareholders.

In this context and in light of the approaching conclusion of mining at Kwale operations, we believe it is appropriate that cash now be retained for the anticipated progression of the Toliara project.

BSE’s management has highlighted that the “fiscal provisions” in the new mining code were “not materially out of step with Toliara Project DFS assumptions.” For reference, under the new mining code, royalty was increased from 2% to 5% compared to 4% assumption in Toliara’s latest DFS.

Another positive factor to consider is that in the recent press release of the merger announcement, the companies highlighted that acquisition discussions between BSE and UUUU have been ongoing for 12 months before the signing of the definitive agreement. This suggests that UUUU is likely aware of the ongoing discussions with the government and/or is confident that an agreement between the two sides will eventually be reached.

Quick background on BSE

The company’s key asset, Toliara, is a development-stage ilmenite/zircon/rutile/monazite deposit in Madagascar. Toliara’s DFS was initially completed in 2019 and updated in 2021. The project’s NPV-10 has been estimated at $1bn, with a 38-year mine life. Capital expenditures were forecasted at $520m. More recently, in Dec’23, BSE completed a pre-feasibility study on the deposit’s expansion with a monazite concentrator plant that is required to produce monazite. The project expansion’s NPV-10 has been estimated at $1bn compared to incremental capital expenditures of $71m. Management expects a Final Investment Decision for the asset’s development after around 11 months of reaching a fiscal agreement with Madagascar. This is expected to be followed by another 29 months of estimated project construction.

Aside from Toliara, BSE owns Kwale, a production-stage mineral sands deposit located in Kenya. The asset is at the late production stage, with mining operations expected to be suspended by the end of 2024 as “reserves are fully depleted”.