Gold and Silver miners (Jr and Exploration)

[Edge83]

Deep Value At Hecla Mining

Mar. 20, 2018 3:13 PM ET|

Quad 7 Capital

Summary
We have been somewhat sour on Hecla Mining for nearly a year but we now see significant value in Hecla Mining after another massive selloff.

We believe the acquisition of Klondex, although pricey, will add some of the highest class mining assets on the globe to Hecla's portfolio.

Risk remains from an ongoing strike at Lucky Friday, and there are concerns over cash burn.

While a profitable trade can likely be made, we are going long on this one for deep value.

This idea was originally discussed in more depth with members of our soon to be launching private investing community, BAD BEAT Investing.

As we explained yesterday in the soon to be launched BAD BEAT Investing forum, shares of Hecla Mining (HL) have been under long-term pressure from an ongoing strike at Lucky Friday, one of the miner's premier locations. This has weighed on production and earnings, while subsequently weighing on the stock, resulting in a 40% drop in the last year. Today, shares are taking an absolutely beating, following what we see as GOOD news for the company. Hecla Mining is buying Klondex Mining (NYSEMKT:KLDX).

The terms
Hecla will acquire all the outstanding shares of Klondex in a part cash, part equity deal. Klondex's Fire Creek, Midas and Hollister mines, will be absorbed through a plan of arrangement, while its Canadian assets will be spun out to its existing shareholders.

One reason investors may be selling the news is because of the price tag. Hecla will acquire Klondex $462 million with a mix of cash and shares of Hecla common stock and the newly formed company. At its most basic level, Hecla is paying a 59% premium, or $2.47 per share in cash and shares of Hecla to acquire the assets.

A BEAD BEAT investment
Quad7Capital purchased shares today at $3.38.



Source: Yahoo Finance, Quad 7 Capital graphics overlay

The trade play:
We are in this for long-term value, based on our discussion below. HOWEVER, those seeking possible rapid returns for a trade only, we have the following recommendations based on what we have seen in the stock thus far, and from where metal price are now versus a year ago.

Entry point $3.33-$3.39

Stop loss: $3.13

Exit target: $3.75

While this may set up for a BAD BEAT trade, we like the longer-term story here.

Why Klondex is significant
While this 59% premium is certainly a sticker shock for existing Hecla shareholders, especially after ongoing strikes which we will discuss more shortly, the opportunity to pick up this significant package of land in the very safe and mining friendly jurisdiction of Nevada is hard to pass up.

What is even more appealing here is that this acquisition and the land packages that come with it happen to have among the highest grade mines in the U.S.

What Klondex brings to the table
There are three key properties to be aware of here. There is the Midas mines, Hollister properties, and Fire Creek.

Source: Investor presentation

Midas

The Midas mines are across nearly 30,000 acres. There is a lot to like here, but this acreage includes owned fee lands and unpatented mining claims in addition to seven lease agreements in Nevada (Elko County).

Most prominently, Midas' acreage includes the underground mine and the 1,200 tons per day Merrill Crowe processing facility. The mill and most of the Midas infrastructure are located on private lands. It is also the largest known gold/silver epithermal deposit along the Northern Nevada Rift. The reserves and resources are impressive:



Source: Klondex mining

Hollister

The Hollister mine is also located in Elko County, Nevada. Hollister is still young (comparatively) but we do know that the mine's drilling to-date has led to high grade veins that have produced 450,000 ounces of gold and over 2.5 million ounces of silver with decent grades (34 grams per ton of gold, 200 grams per ton of silver). Reserves and resources are respectable:




Source: Klondex mining

As you can see, the total resource and reserves are far beneath that of Midas, though the grades are a strong plus.

Fire Creek

We are very pleased with what we see at Fire Creek. Fire Creek is in Lander County, Nevada. The land has 15,420 acres of unpatented federal lode mining claims, 1,110 acres of private fee land and 230 acres of mineral leases which brings the total land package to approximately 17,000 acres. Further, the reserves and resources are strong:




Source: Klondex mining

What we like here is the potential. While the feasibility study from 2015 shows these potential resources, there could be much more. Why? Well the authors of the feasibility study noted that additional potential exists to extend reserves along strike in both directions as underground access is developed. So, what this means is that as the footprint of the mine grows and the number of available mining areas grows with it, the mining rate can be increased, and cost reductions realized through economies of scale.

What is more, this project is capital friendly. More mine development is what will make up the bulk of future capital costs. As more of the mine is developed, the ability to access multiple veins from common development should lead to significant cost reductions the unit cost per ounce, much like we would see with more developed mining operations. Take a look at the pit at its location in Lander County, showing the underdeveloped potential:


Source: Technical report

As you can see, there is a lot of potential here to reach new areas that have been largely untouched. What is more, there could be highly profitable assets here.

In reading the operational report from Klondex mines we noted the following from the authors of the pre-feasibility report:

"the high grade reserves in the mine plan provide a high return and will sustain profitable operations with up to 40% adverse variations in metal prices, operating or capital costs. The total cost per ounce, including capital expenditures and net of byproduct sales, is less than $500 per ounce."

That screams value. What a pickup for Hecla in our opinion. These are truly some of some of the highest-grade gold mines in the world. However, there are still short-term concerns for the name which may have accelerated the selling.

The deal will burn cash
While the deal is structured to minimize shareholder dilution, such dilution is unavoidable. In addition, it will burn some of Hecla's cash position, which was relatively fragile prior to the deal. At closing existing Hecla and Klondex shareholders will own approximately 83.8% and 16.2% of Hecla's outstanding common stock, respectively. There is a maximum cash consideration of $157.4 million and a maximum number of Hecla shares issued of 77.4 million. Assuming we end up pro-rating for this selloff, we will target $150 million in cash. This is a loose approximation. That is a hefty impact.

After reporting earnings last month, Hecla had cash, cash equivalents and short-term investments of approximately $220 million at year end, an increase of about $21 million. Cash and equivalents were $186 million. Here is the risk to the long-term play here, and to the deep value situation. Long-term debt is still $502 million. This is vital to watch, and is why the ongoing Lucky Friday Strike is weighing.

The strike continues, weighing on total production
On the one hand, the strike at Lucky Friday lowers expenses, and could lead to leaner operations once back online. However, the revenue generation (which is profitable) is sorely missed. It also does not look like there will be a resolution too soon, as the miners union recently rejected arbitration of the contract proceedings. That said, let us discuss production.

At the Lucky Friday mine, 838,657 ounces of silver were produced for the year. This is a whopping 77% decline in production compared to 2016 due to the ongoing strike by unionized employees. As you can see, this strike is weighing heavily, but while this headline grabs the attention of many, it overshadows other operations of the company of the company.

While we are bullish overall, there were declines at Greens Creek mine. Last quarter, 8.4 million ounces of silver and 50,855 ounces of gold were produced. These are 10% and 6% lower than last year. Lower output was due to lower grades at the mine.

At the Casa Berardi mine, 156,653 ounces of gold were produced, including 37,922 ounces from the East Mine Crown Pillar pit, where expansion is underway. This production represented a solid increase of nearly 11,000 ounces compared to 2016, a very positive piece of news for production.

Finally, at San Sebastian mine, 3.3 million ounces of silver and 25,177 ounces of gold were produced. What is interesting to note here is that this is a decline of 24% and 26% respectively. While these declines are palpable, the results were above expectations.

So, while production was weak, there were a few positives (and negatives) on the fiscal side.

Financials
The declining production has led to selling pressure on the stock for nearly a year straight, mostly because of the impact to financials. We won't go into immense detail here, but want to illustrate the impact of Lucky Friday's absence.

Sales for the fourth quarter and full year were 3% and 11% lower, respectively, than the same periods in 2016, mainly due to lower silver, zinc and lead production due to the ongoing strike at Lucky Friday. It would have been much worse if it was not for favorable pricing. The declines here were offset greatly by higher realized silver, gold, zinc and lead prices in 2017.

The net loss to Hecla was $27.7 million for the fourth quarter and $23.5 million for the full year of 2017, compared to net income of $20.3 million for the fourth quarter and $69.5 million for the full year of 2016. Much of this loss was due in part to lower revenues, but also charges associated with tax reform. As such, we like to look at adjusted EBITDA. Here there was good news for the quarter. Adjusted EBITDA was $72.0 million for quarter compared to $65.9 million last year, and $235.0 million for all of 2017 compared to $265.1 million in 2016.

When Lucky Friday comes back online (fully), we expect the impact to sales to be double-digit positive over 2017 (assuming the strike ended this year). Moreover, we anticipate that profitability will remain a focus, while labor costs will undoubtedly rise thanks to better contracts for workers. That said, the strike has eroded shareholder value over the last year, while impacting the financials. This long-term BAD BEAT, in conjunction with today's massive selloff following good news, will be leveraged for our advantage.

Looking Ahead
The addition of Klondex's assets in Nevada is a massive development for Hecla mining. Shares are being punished over the price tag for the development as well as ongoing fears over the Lucky Friday strike.

While shares are well ahead of their decade lows seen at the bottom for metal prices several years ago, the fact is that shares are 60% off their recent highs. At the present levels, with Hecla's bold moves to acquire some of the best resources in the worlds, we see value here. The purchase of Klondex is a perfect addition to Hecla's portfolio and long-term value creation approach of owning large prospective land packages with strong mining fundamentals. The question remains whether the company can take Klondex and improve costs, grow reserves and expand production. We are confident that it can, and also believe an upcoming catalyst for the stock will be the eventual end of the Luck Friday strike.

Disclosure: I am/we are long HL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This idea was originally discussed 3/19/18 in BAD BEAT Investing, a soon to be launched private forum in the Seeking Alpha Marketplace.

https://seekingalpha.com/article/4157867-deep-value-hecla-mining