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Saturday, 03/17/2007 2:34:44 PM

Saturday, March 17, 2007 2:34:44 PM

Post# of 113
February 8, 2007

Imminent merger between American Gold and Chesapeake a marriage made in heaven

Synopsis: American Gold Capital Corp (AAU-V: $2.71) was recommended a medium priority bottom-fish buy in the $0.75-$1.00 range on January 5, 2006 (Tip of the Day - January 5, 2006). The basis for the recommendation was the ownership of two "out of the money" gold deposits in Mexico and Nevada called Metates and Talapoosa that Sun Valley sponsored American Gold acquired while gold was below $400 per oz. The stock jumped in March 2006 when the Chesapeake merger was announced. After analyzing the merger terms I issued a Good Relative Spec Value Buy recommendation at $2.09 (Tracker 2006-08 - March 20, 2006) on the premise that the value of the share, warrant and conversion "right" American Gold would receive upon completion of the merger would be worth much more than the prevailing price. These terms have changed somewhat to accommodate jurisdictional and tax issues, but their effect for American Gold shareholders remains largely unchanged. American Gold stock traded as high as $2.80 in May 2006 before succumbing to the double whammy of the general market sell-off and delays encountered with the details of the merger. We are now close to the merger's completion, and we have a gold price once again in an uptrend that is at the highest level since the sell-off in May 2006.

For those of you adhering to the bottom-fishing strategy American Gold remains a Spec Cycle 100% Hold because 1) I expect the 3 pieces of paper you will get during the next couple weeks will soon be worth a lot more than the $2.71 you could get today by selling American Gold, and, 2) the bottom-fishing strategy forbids adding to your position once a speculation cycle gets underway. For those of you who are Spec Value Hunters, namely sophisticated investors seeking to exploit inequities in the resource sector, I recommend not only holding the American Gold shares you bought when I recommended the stock at $2.09, but I also recommend adding to your position at the current price of $2.71 before the merger to secure a position that not only gives you a stake in Randy Reifel's ability to repeat the success he achieved with Francisco Gold through the El Sauzal and Marlin gold discoveries, but to also secure a stake in the possibility that the price of gold will soar well above $850 during the next 5-6 years. However, I qualify this recommendation in that if you are a hard money or apocalyptic gold bug (Paul van Eeden, Ian Gordon etc), you should ignore this recommendation, for if you believe gold will go up because the US dollar collapses or the global economy goes to hell in a handbasket, you will probably lose money buying American Gold because in your scenario American Gold's assets will remain out of the money regardless of the price of gold. But if you are a conspiracy gold bug (GATA, John Embry, James Turk etc) who thinks the price of gold has been artificially suppressed and will slingshot to a much higher "real" level without a corresponding rise in capital and operating costs, then buying American Gold now before the merger makes a lot of sense. And if you are a "prosperity" gold bug such as myself who believes that gold's increasingly obvious irrelevance as "money" makes it highly attractive as an asset class independent of sovereign and corporate risk in an expanding global economy whose eventual power structure 10-20 years from now strikes you as rather murky, meaning that in the interim raw gold ownership demand will outstrip incremental mine supply as everybody hedges a portion of their wealth in something that is not readily "fabricated", "printed" or otherwise bestowed with the ontological quality of "existence", then you too will (hopefully) see wisdom in owning American Gold before the merger is consummated.

The merger between American Gold and Chesapeake Gold Corp (CKG-V: $6.88) is expected to close by February 14 (a suitable day for a marriage made in heaven), at which point I will close out the American Gold bottom-fish cycle because it will become too complicated to track the value of the 0.29 Chesapeake shares, 0.145 Chesapeake warrants and 0.029 Chesapeake Series 1 Class A (possibly non-trading) shareholders will get for each American Gold share. For those of you who are math challenged or averse to complexity, or just plain skeptical that gold will rise much above $850 during the next five years, I recommend the simplicity of just buying Chesapeake Gold at $6.88. In formal terms, Chesapeake Gold is a Good Relative Spec Value Buy at $6.88 based on the $300 million implied project value of Metates based on 43 million fully diluted Chesapeake shares. This alternative of ignoring American Gold and buying Chesapeake instead is valid because the merger gives Randy Reifel's Chesapeake the critical mass needed to attract an institutional audience leery of mother nature's willingness to cough up new world class discoveries, but cognizant of the Reifel team's willingness to squeeze value out of an existing deposit. Sun Valley's strategy of accumulating "out of the money" deposits with an optimistic macro commodity outlook was essentially passive, but in merging with Chesapeake this strategy gains an active component where the Chesapeake management will look hard at making Metates and Talapoosa work at a gold price below $850. Metates has a resource of 3.4 million ounces gold and 61 million ounces silver, while Talapoosa has a resource of 1 million ounces gold and 14 million ounces silver. Randy Reifel thinks his team can make Metates and Talapoosa valuable at prices below $850 gold. Chesapeake is thus very attractive to speculators who think gold will oscillate between $500 and $1,000 during the next 5-6 years without triggering the $850 conversion privilege, and who think Randy Reifel's team has the smarts and will to extract value from Metates and Talapoosa below $850 gold. The American Gold/Chesapeake merger is an example of where the sum of the parts is worth more than the value of the parts on their own. Beyond telling KBFO members that buying American Gold at $2.71 and Chesapeake Gold at $6.88 constitutes rational speculation, Tracker 2007-01 tries to explain how these various pieces of paper American Gold shareholders will get will work.

Breaking down the value of the post merger securities

Shareholders have approved the merger between Randy Reifel's Chesapeake Gold Corp (CKG-V: $6.88) and American Gold Capital Corp (AAU-V: $2.71), with completion expected by February 14, 2007. The merger terms are straightforward for Chesapeake shareholders who keep their shares in the new company which will continue with Chesapeake's name. American Gold shareholders will receive 0.29 Chesapeake shares, 0.145 of a warrant to buy Chesapeake at $8.00 for 5 years (expected to be listed for trading), and 0.029 of a Series 1 Class A share (TSX-V still thinking about listing it for trading). At current prices for American Gold ($2.71) and Chesapeake ($6.88), the value of these three securities breaks down as follows. The 0.29 Chesapeake shares American Gold shareholders will receive are worth $2.00 at $6.88 Chesapeake. A five year warrant exercisable at $8.00 is bound to be worth at least $1.00. That, at least, is what I would be willing to pay; I have not attempted a Black and Scholes valuation because the leverage implicit in Chesapeake's price as linked to Metates suggests an off the scale volatility. On my terms the 0.145 warrant received for each American Gold share would be worth about $0.15. At $6.88 Chesapeake, if the $850 magic number was triggered, the 0.029 Class A shares would convert into 0.29 Chesapeake shares worth $2.00. This $2.00 value for the 0.029 Class A shares, however, is not realistic because of the uncertainty that their convertibility will be triggered during the next 5-6 years. They would thus have a market value lower than the converted value. For the value of American Gold now and the 3 securities issued after the merger to be a wash, the 0.029 Class A share would have to be worth $0.56 ($2.71 AAU price minus $2.00 for 0.29 CKG at $6.88 minus $0.15 for the 0.145 CKG warrant trading at $1.00). In other words, if the Class A shares were listed, they should trade at $19.31 to make the American Gold merger exchange a wash. Since the Class A share converts into 10 Chesapeake shares if gold trades at $850 average for 90 days, it would have a theoretical value of $68.80 on conversion if Chesapeake is at $6.88. The current pricing of American Gold relative to Chesapeake is assigning a 72% discount to the Class A shares.

Why make the Class A shares convertible into Chesapeake 10:1?

If the Class A share were trading, what would one expect its value to be? The Series 1 Class A share is an unprecedented instrument whose value is tied to the price of gold and the share price of Chesapeake. If the LME afternoon gold fix averages at least $850 per oz during any 90 day period, the Series 1 Class A share converts into 10 Chesapeake shares. One might ask why American Gold shareholders receive 0.029 Class A shares that convert into 0.29 Chesapeake shares rather than 0.29 Class A shares that convert 1:1. The answer is that Class A shares carry the same voting rights as common shares, which would have given American Gold shareholders nearly 50% of the votes of Chesapeake in the 1:1 scenario. In effect, this signals that control of the destiny of American Gold's "sleeper" assets shifts from Sun Valley (Peter Palmedo and Chris Falck) to Randy Reifel. Lurking in the background as a significant shareholder of the merged company will be Goldcorp, which has now swallowed the swallower (Glamis Gold) of Randy Reifel's past success stories.

The Class A share is an external event driven security

The merger was first announced on March 3, 2006, and has taken a long time to complete because of complex jurisdictional and tax issues. What started out as a merger structure viewed as brilliant by people like myself, got bogged down in consequences for American and Canadian shareholders, as well as regulatory concerns about exchange values and other arcane issues. The biggest trouble has been caused by the Class A share, a hybrid security whose value is linked both to the future price of gold and the value of Chesapeake. It is an "event driven" security, meaning that it has no intrinsic value until an event external to the security it converts into has occurred. Gold could swing between $650 and $1,000 during the next 5 years without ever producing that $850 average price over 90 days needed to make the Class A convertible into Chesapeake stock. While everybody is focused on Chesapeake's ability to demonstrate Metates economic at less than $850 gold, Chesapeake could make a world class discovery on one of its grassroots exploration plays in Mexico which takes the stock to $50. That would make the Class A portion shareholders got for their American Gold stock worth $14.50 if it became convertible. But until that trigger is achieved, the intrinsic value is zero. In this scenario the price of gold becomes unrelated to the price of Chesapeake. The market value of the Class A share would thus be based on the probability that the Class A share would become convertible into common Chesapeake stock. That probability would be exclusively linked to the gold price.

What about Chesapeake speculation that conversion will never be triggered?

The pricing of the Class A share, however, is more complicated than estimating the probability that gold will average at least $850 for 90 days during the next five years and looking up the price of Chesapeake. There is nothing special about the $850 price in terms of the economic value of the Metates deposit. At $849 gold the Metates deposit could be worth a lot to Chesapeake, especially if metallurgical breakthroughs are achieved. If the Class A shares expire in 5 years without the conversion trigger occurring, about 9 million shares of potential Chesapeake dilution will disappear. Assuming the trigger is within achievable range given the volatility of the gold price, the market would be expected to price Chesapeake on the basis of its projects' economic value divided by Cheaspeake's fully diluted capitalization. For example, suppose nearly 5 years from now the market decided Metates, Talapoosa and Chesapeake's other assets were worth $2.2 billion. At 43 million fully diluted shares that translates into about $50 per share. Suppose the Bank of England decides it is time to sell some more gold with great fanfare, knocking back the price of gold just enough so that the magic 90 day average price of $850 is not achieved. The Class A shares that would have converted into 9 million common shares evaporate, reducing the fully diluted capitalization of Chesapeake to 34 million shares. Because a 5% swing above or below $850 gold is not going to materially change the market's economic assessment of Chesapeake's gold assets, the new Chesapeake stock price should be $2.2 billion divided by 34 million, or about $65. But how much of that post-expiry jump will already be built into the Chesapeake price? At $65 Chesapeake the Class A portion received for each American Gold share would have a conversion value of about $19 rather than the $14.50 at $50 Chesapeake. The point I'm trying to make is that the pricing dynamic underlying the Class A shares becomes circular as we approach boundary conditions.

Another wrinkle: the gold price can extend the Class A expiry by 1 year

The merger terms also include a provision that if the Class A shares are listed for trading on a stock exchange, and LME gold manages to close at $850 or higher for only 1 day during the final 6 months of the 5 year expiration period, the expiry will be extended to 6 years. Here a single day's price fix could prevent the Class A share from becoming worthless, and bestow on it another year to actualize the conversion triggered underlying value. This is not a simple matter of calculating time and volatility premiums. The pricing of the Class A shares in these boundary conditions involving unrelated forces interwoven in a non-linear dynamic will keep some mathematician very busy.

Sad, but no surprise that the TSX is reluctant to list the Class A shares

That the TSX regulators are mulling the Class A shares with furrowed brows is no surprise, because this instrument is precedent setting and will be much copied, especially if an exchange accepts them for trading. It creates a way for apples and oranges to merge. For example, both Stornoway and Ashton shareholders might have been happier with a takeover bid which included a security with a time limit that converted into Stornoway stock only if a certain milestone were achieved. In the case of Ashton the milestone would not have involved linkage to a diamond price, but rather some sort of diamond resource size threshold like those which trigger back-in rights in property option agreements. The case of American Gold is different in that the resource is already known, and it is a commodity price change which would create value. Chesapeake, of course, would have no control over the price of gold. At a time when there is great uncertainty about the level of long term metal prices - witness the ongoing battle between the structural bulls and cyclical bears - at the same time there is the will and capital to consolidate assets that could be developed into mines if current metal prices prove sustainable, one would expect Class A scenarios such as pioneered by Chesapeake and American Gold to become a popular negotiating term.

The Chesapeake Class A share is a blueprint for a novel merger and acquisitions strategy

For example, consider Blue Pearl, a medium sized molybdenum producer. There are a number of juniors with molybdenum deposits that are economic at $25/lb molybdenum, but are trading well below the value of the deposit in discounted cash flow terms because the market is unwilling to plug current metal prices into cash flow models. The gap between the market value of these juniors and the project DCF at current base metal prices is often enormous. This gap could be closed by a Blue Pearl issuing Chesapeake style Class A shares with a conversion trigger linked to long term molybdenum prices when acquiring strategic molybdenum deposits.. Blue Pearl would only suffer the dilution from the conversion if molybdenum prices hold up over the long run. In such a scenario the acquired deposit would likely be worth much more than the acquisition price paid in common and convertible stock, because the negotiated value would be somewhere between the company's market value and the DCF value of the assets at prevailing metal prices. What clinches the deal is the expectation that the shareholders of the acquired junior would receive a bonus through the conversion of their "Class A" shares in the event that the rosy metal price scenario transpires. If such contingently convertible securities are allowed to trade, the initial recipients could collect a premium before the trigger is fulfilled. It would be a way for both the acquiring and acquired company to shift commodity price risk to the market. It would encourage more merger and acquisitions activity involving the juniors, which is a way of cementing the value created by a venture capital oriented stock exchange such as the TSX-V. It would also encourage larger companies to include "strategic" considerations in their decision-making, such as Inco did in 1996 when it bid 4 times more for Diamond Fields than Voisey's Bay was worth in discounted cash flow terms. (Readers may recall that Inco also used time limited securities in the bundle it issued for Diamond Fields.)

Could Class A style shares be the niche CNQ needs to put itself on the map?

It is understandable that the TSX would prefer to keep its distance from securities with complex pricing dynamics. It has been suggested that such shares get listed on the Montreal Exchange which specializes in derivatives, but the Chesapeake Class A shares are not a true derivative and the Montreal Exchange is apparently not interested in this type of security. Could it be that this is the niche which could put Canada's fledging CNQ stock exchange on the map? I don't bother to follow anything which lists on the CNQ because the universe of juniors offered by the TSX-TSXV is large enough and CNQ appears to be a destination for companies whose corporate transactions are rejected by the TSX. If CNQ can offer efficient order execution for the Chesapeake Series 1 Class A shares, and accepts listing of these securities which convert into the shares of companies listed on bigger exchanges, it would make itself relevant to a very broad audience.

If the TSXV lists the Class A shares, the convertibility changes

At the moment Chesapeake management is pessimistic that the TSXV will accept the Class A shares for trading, in which case the recipients will have to hold them or try to sell them in the grey market. If they are listed for trading, the conversion terms would change slightly, thanks to an obscure exchange requirement. Key to the conversion ratio is the price of Chesapeake on the day that the conversion trigger is deemed to have been achieved. The conversion ratio will be the Chesapeake price less $1.00 divided by the Chesapeake price and multiplied by 10. So if Chesapeake is at $8.00, one Class A share would convert into 8.75 Chesapeake shares. If Chesapeake were trading at $50, the Class A share would convert into 9.8 shares. (The higher the stock price, the closer to 1.0 will be the conversion ratio.) Of course, if Chesapeake's price has collapsed to $1.00 or lower, the conversion ratio would be zero. The formula protects Chesapeake from a dilutionary death spiral. This sliding conversion ratio applies only if the Class A shares are listed for trading within 60 days of the merger. I don't like this feature because it adds another layer of uncertainty to the value of the Class A shares, and because this provision was at the insistence of the TSX, which is backing off from letting the Class A shares trade, I would hope that Chesapeake abandons this formula if it gets the Class A shares listed on another exchange such as the CNQ.

The merger of American Gold and Chesapeake creates a strong company

The Series I Class A instrument was created because American Gold's primary asset is the Metates gold-silver deposit in Mexico whose various metallurgical, environmental and location challenges require $850 gold or better to be economic. When the merger plan was announced in March 2006 Chesapeake was cash rich and busy generating gold-silver projects in Mexico with the goal of duplicating its discovery successes, El Sauzal and Marlin. American Gold wanted to acquire additional "out-of-the-money" gold deposits, but its ability to do so on lucrative terms was hampered by the fact that higher gold prices were needed to justify a higher stock price based on Metates and Talapoosa. For both companies it was a waiting game whose outcome neither management could speed up. The merger would combine an exploration machine with a couple advanced gold-silver deposits whose value would blossom with a rising gold price. The merged company will have about $40 million working capital. It is a good example of the Plan A-Plan B-Plan C strategy which I think is perfect for that phase of the market cycle where one is uncertain that this is as good as it will ever get, or just a lull before it gets a lot better.

Randy Reifel not a fan of hard money or apocalyptic gold bug thinking

In designing the terms of the Series I Class A share Chesapeake's Randy Reifel has distanced himself from the "hard money" gold bug crowd which anticipates a much higher gold price due to the collapse of "fiat money". Unfortunately, real costs do not shrink when a fiat currency is debased, with the result that a higher gold price created by rampant inflation is accompanied by correspondingly higher cost thresholds. In accepting the terms of the Series 1 Class A shares, Reifel is gambling that the cost of developing Metates stays put while the price of gold soars above $850. If anything, he is expecting an increase in the real price of gold. For those who tie the price of gold to the fate of the US dollar, this merger has dilutionary implications for Cheasapeake, which may be forced to issue extra stock when the price of gold goes up even though Metates remains worthless thanks to a corresponding increase in costs. This group would include "hard money" gold bugs like Paul Van Eeden as well as apocalyptic gold bugs like Ian Gordon for whom the only way to benefit from a rising gold price is to own gold itself.

The new Chesapeake will appeal to conspiracy and prosperity gold bugs

The deal does, however, make sense to the conspiracy type of gold bug such as GATA and John Embry, who believe that the price of gold has been artificially suppressed. In this view the inflation has already happened and is reflected in the real cost of developing Metates. What the conspiracy gold bugs are looking for is a slingshot effect where gold jumps to a much higher level without a corresponding increase in costs. This "catchup" is similar in outcome to that expected by "prosperity" gold bugs, among whom I would count myself. But while a conspiracy gold bug thinks that the market for gold is manipulated by a cabal of masterminds trying to hide the true state of affairs, a prosperity gold bug thinks that the gold market is free in the sense that all gold owners are acting to maximize their own interest, and that a higher gold price will develop if demand for gold ownership outstrips new supply in the long run. Furthermore, such demand will not develop because the economic apocalypse has arrived, but rather because the growing prosperity of a global economy engenders new demand for an asset class that is independent of sovereign and corporate risk. In this scenario the size of the global economy vastly eclipses the current value of the 4 billion ounce above ground stock of gold, and is growing at a faster rate than the incremental new supply added to the gold stock by mine production. For the prosperity gold bug the real price of gold has to go higher precisely because gold is no longer relevant as that accounting system called "money", but has become relevant as a passive physical asset class whose value lies in the fact that it costs resources to bring more of it into existence. (To put gold's irrelevance in context, consider that all the gold in the world sitting in vaults doing nothing is worth just $2.6 trillion while $1 trillion worth of oil gets burned up annually to keep wheels turning.)

Hoping gold does not go to the moon, but not minding if it does

While it would be foolish for hard money and apocalyptic gold bugs to speculate on gold projects that are marginal at current prices, it makes perfect sense for both conspiracy and prosperity gold bugs to speculate on marginal projects such as Metates. And because Chesapeake will have both a Plan A bet on better real gold prices, and a Plan B exploration bet on new discoveries that work at current or lower gold-silver prices, the sum of the two parts will be more than the value of the parts alone. For his part, Chesapeake's Randy Reifel concedes that he is not a gold bug of the hard money or apocalyptic type, and is in fact hoping that gold averages $849 for the next six years while he tries to improve metallurgical recoveries and identify higher grade zones within Metates that make the deposit valuable below $850 gold. But he will not complain about a $1,000 or higher gold price if costs stay put, because that extra $150 per ounce all flows to the bottom line. High cost gold deposits offer extraordinary leverage to scenarios where the real price of gold increases substantially.