Probe Gold Inc. (PROBF)

[investor15]

Takeover Target Could Offer 35.7% Upside Very Soon: Probe Mines Limited

Sep 17 2013,
The Critical Investor

1.Introduction

The TSX Venture is near a 4 year low, gold is barely recovering from a 3 year low, and only one large and undervalued gold deposit is left in Ontario after some consolidations, making the controlling junior mining company which owns it a very interesting takeover target: Probe Mines Limited (PROBF.K, or on the TSX Venture where it is much more liquid: PRB.V).


As of September 16, 2013 Probe Mines has a share price of $2.07 and a market cap of $156.49M, with 75.6M shares outstanding (fully diluted 88.5M), and made a big run in the last four months already as is shown on this chart:

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Share price over 1 year period

Nevertheless I will try to explain why this stock could go up even considerably higher. Another respected SA author already showed some of the potential of Probe Mines by describing it as a long term investment. My intention is to show in-depth how much potential this could be, and highlight Probe Mines more as a takeover target and explain why this could be the case in my opinion.

2.Executive summary

Probe Mines (PROBF.PK) is a junior mining company which fully owns two very interesting projects, namely their flagship 4.3M oz @ 1.03g/t Au Borden Lake gold project, and the 3.82M t Black Creek chromite project, both located in mining friendly Ontario.

The Borden Lake project is the last multi-million ounce gold project in Ontario which isn't already owned by a mid-tier or senior producer. This project also has additional upside exploration potential and proximity to existing infrastructure. Probe Mines has plenty of working capital (about $40M) to complete an extensive drill program and a PEA. It could even release a Feasibility Study on Borden Lake as well without further equity dilution.

The Black Creek chromite project is one of very few large chromite projects located in the Western hemisphere. It has an average grade of 37,5% so the ore can be shipped directly as the limit for this is 37%. This saves a lot of processing costs (for example milling and upgrading). It is located in between two chromite projects of the mining giant Cliffs Natural Resources (CLF).

There are several catalysts for the Probe Mines share price, I will describe them in a time-sequential order. The first but negative catalyst is about Agnico-Eagle Mines (AEM), which already purchased a 9.94% stake in this company on May 28, 2013, clearly seeing value in Probe Mines' Borden Lake gold project. The holding period for shares and warrants ends at September 29, 2013.

Next and positive catalyst for Probe Mines will be an updated NI43-101 resource estimate, to be released by the end of this year. If Probe Mines can surprise the mining community with more ounces and a higher average grade compared to the current estimate, chances are this will create a serious uptick in the share price.

The final and most important positive catalyst as far as I am concerned is the upcoming PEA, planned for Q1 in 2014. A positive PEA indicates Borden Lake directly as a premier takeover target for producers.

Another positive catalyst came very recently, by Larry Summers pulling out of the race for the FED presidency. He was rather critical regarding the very loose monetary politics (QE and low interest rates). Accelerated tapering would have caused serious downside pressure on the price of gold, therefore having a negative impact on the business case of Probe Mines. The development of a physical gold market could be supportive as well, providing a possible foundation of solid demand, to a certain extent neutralizing volatility caused by the trading in gold related securities like GLD (GLD).

As always, risks often mirror the catalysts, and for Probe the biggest risks are a lower than expected resource estimate, and especially a negative PEA. The resource estimate doesn't seem to be a great risk because of recent, very encouraging drill results. Another risk preventing a takeover is the gold price. When it does decrease (which I highly doubt) below $1000 levels as several analysts forecast notwithstanding FED continuing its loose monetary politics, it is very likely this project will not be very profitable anymore, and therefore Probe Mines will lose most of its current attraction as takeover target.

To determine the value of the company, calculations were performed on three different ratio's. These ratio's were market capitalization to net present value for Borden Lake, take over price to resources, comparing this project with other relevant takeovers, and the enterprise value to resources compared to peers, on a base case scenario with a close to current gold price of $1300/oz. Taking into account a current share price of $2.07 (9/16/2013), based on 88.5M shares fully diluted (at $2.00 or higher all options and warrants are in the money) we get a target share price of $2.81, for a profit of 35.7%.


3. Company

Probe Mines is a junior mining company which fully owns two very interesting projects, namely its flagship 4.3M oz @ 1.03g/t Au Borden Lake gold project, and the 10M t Black Creek chromite project, both located in mining friendly Ontario.

Probe Mines' Borden Lake project is the last 4M+ oz gold deposit in Ontario which isn't already owned or about to be bought by a mid-tier or senior producer. This project also has additional upside exploration potential and its main advantage is its proximity to existing infrastructure.

The company is currently completing a large drill program in order to release an updated resource estimate in Q4 and a PEA in Q1 2014. There is sufficient working capital (about $40M estimated after the last cap raise of $14.5M at May 28,2013) available to achieve these milestones without further dilution.

Agnico Eagle Mines was the senior producer which bought all of the shares in this capital raise, resulting in Agnico holding a 9.94% interest in the company. This obviously implies Agnico is very interested in Probe Mines, but there are more big parties, looking around these days for relatively cheap assets in mining friendly districts, especially solid deposits near good infrastructure.

4. Projects

A. The Borden Lake Gold Project

The Borden Lake Gold Project is located near the town of Chapleau, about 1km away from existing infrastructure, and in between two large, recently acquired gold deposits (Magino and Cote Lake, more on this later on):

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Location of Borden Lake

Resource estimate

Probe Mines released a NI43-compliant resource estimate on the Borden Lake project in January, outlining an in-pit resource estimate of 4.3M oz @ 1.03 g/t gold in the indicated and inferred resource categories. The company is continuing exploration efforts on the property to upgrade the current indicated category towards measured resources and maybe even proven and probable reserves. Another target of the company is to expand the high grade part of the resources as much as possible. The last drill results bode well for this, as shown by recent results like 51m @ 10.3g/t found in the South East section of the property:

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Because the company also continues to find near surface high-grade intercepts such as 44 meters at 4g/t gold and 41 meters at 5.1g/t gold in its infill drill program, there's a good chance Probe Mines will be able to start its mining operations at the high-grade zone to achieve a faster payback of the initial capex.

(click to enlarge)

Resource estimate, January 2013

According to this estimate Probe has a resource estimate of 2.34M oz Au @ 1.7g/t (average grade) M&I using a different cutoff-grade of 1 g/t. As the gold grade is much higher, the project seems to be more robust when compared to the 4.3M oz @ 1.03 g/t (average grade) M&I resource. Higher average grade deposits require a smaller capex to be brought into production.

At this moment, the company has completed almost 150,000 meters of drilling in almost 500 drill holes. The mineralization is still open along strike and although it continues under the lake, there's a good chance these resources could be recovered as well through an underground operation.

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Map of drill hole locations at Borden Lake

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High grade intercepts at the left, open along strike

Probe Mines recently expanded its land holdings to the northeast of the Borden Gold Project. The company now controls the majority of the eastern extent of the Borden Gold Belt with the acquisition of the East Limb Property's contiguous claim group. Now totaling 2.157 claim units, the project is over 41 kilometers long and covers over 350 square kilometers. These claims are believed to cover the same horizons that host the Borden Gold deposit.

Historical grab samples from outcrops on the East Limb Property have yielded of up to 3 g/t Au and hold high potential for new discoveries:

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East Limb Property

B. The Black Creek Chromite Project

Probe Mines also owns the Black Creek Chromite project, which is strategically located in the McFauld's Lake area of the James Bay Lowlands in Ontario, otherwise known as the "Ring of Fire", in between Cliffs Natural Resources' Big Daddy and Black Thor deposits:



Big red star locating Probe Mines' Black Creek project

The project currently has a resource estimate of 10.2 million tonnes at a relatively low average grade of 37.5% Cr, but which would just make it suitable for direct shipping ore (which usually has a content of in excess of 37% Cr) without any milling required. This would obviously reduce the capex and enhance the economics of this project.



Resource Estimate Black Creek project. Source: Company documents



Black Creek block model

Chromite is one of the most important and strategic minerals there is, as it has unique characteristics and almost no substitutes. It is mainly used in the production of stainless steel, but the US Department of Defense has a strategic stockpile of chromite as well.

Three countries (South Africa, India and Kazachstan) produce about 80% of global output, and these countries can't really be interpreted as reliable and stable long-term export partners, as they aren't ranked very high on the Frasers' List (ranking the mining policies of most countries). As production in Western countries is limited, I consider every economically viable chromite deposit in the Western hemisphere to be of strategic importance for Western hemisphere companies and governments. For example the nearby large Ring of Fire chromite projects owned by mining giant Cliffs Natural Resources could play an important role when Cliffs' manages to overcome current setbacks.

As Probe Mines is now completely focusing on the Borden Lake gold project, I think it's very likely it would like to sell the Black Creek project to raise cash to fund a part of the initial Borden Lake capex when the company doesn't get bought out.

5. Valuation

As Probe Mines owns two different, large projects with one of them approaching PEA status, it is appropriate to estimate the value of the company based on several ratios. The ratios I am going to calculate are:

A. market cap vs. NPV

B. EV/oz vs. peers

C. in situ value/oz vs. peer takeovers

Based on these ratios I will estimate a target share price composed out of a weighted average, combined with other assumptions.

A. Market cap vs. NPV

In order to calculate the Border Lake gold project I use my own regularly updated database which contains most TSX- and TSX-V mining companies, in order to derive certain ratios. I found this more reliable than ratios used by mainstream sell side analysts. I always have had a more conservative approach than analysts because their modus operandi just doesn't work out most of the time, probably caused by doing their job as a sell side analyst of course.

For this project I would like to calculate 2 different scenarios, one with the 4.3M oz gold @ 1.03g/t deposit and the other with the 2.34M oz gold @ 1.7g/t scenario. The 2.34M scenario (#2) is a relatively more underground operation than the 4.3M scenario (#1) because it has a smaller open pittable part, so therefore the initial capex is relatively more expensive, as is sustaining capital. I used a slightly better recovery grade for scenario #2 as it has higher average grade.

I am introducing my own ratio to determine the capex, based on data of most juniors having released an economic study, which parameters are all entered in my database. Therefore I can generate a lot of averages, which I can use to estimate certain ratio's. The capex ratio is based on the ratio between capex and daily mill throughput, and I have it calculated for two types of mine: underground and open pit. For a combination of these two types like the Border Lake project I had to average the two capex ratios, assuming a certain part is underground and another open pit.

Part one of the calculation of capex and cash cost:

Sce nario

Res. MM oz

Mine able MM oz

Av grade g/t

Minetype

LOM y

oz pa

Rec.

Product. T pa

Tpd

1

4.3

3.6

1.03

OP/UND

18

200000

90%

6911111

19746

2

2.34

1.9

1.7

OP/UND

18

105556

93%

3529869

10085

Part two of the calculation of capex and cash cost:

Scenario

Capex ratio $M/tpd

Capex $MM

Sustaining $MM

G&A etc $MM

Cash cost $/oz

Cash cost all in sustaining $/oz

1

35

564

250

50

650

733

2

25

403

200

30

500

621

After I have estimated the capex and all in sustaining cash cost, I continue by calculating the NPV in different scenarios for the gold price.

I assume for corporate taxes in Ontario 31%, it is always a bit confusing with this mixture of local and federal taxes in Canada to get to the right percentage. As mining companies can deduct expenses like exploration, environmental assessments, permits etc, I estimate this accumulated deficit for Probe at about $70M, based for the largest part on exploration costs, resulting for scenario #1 in a tax free first three years, for #2 in a tax free first four years. Discount for NPV is 5%.

My base case scenario's have a gold price of $1300/oz:




As a bigger capex is no problem for a large company and the smaller scenario #2 isn't much more profitable relatively speaking, I assume in case of a take over a valuation based on scenario #1: NPV@5% of $406M @ gold $1300/oz.

In case Probe doesn't get bought out soon, it is more likely it continues as a stand alone company with scenario #2, as it requires less initial capex and sustaining capital.

Nowadays, for an advanced explorer like Probe, located in a very miningfriendly and M&A active region with very good infrastructure, an NPV is conservatively multiplied with 0.6 in order to derive a hypothetical market cap. This generates a potential market cap just based on Borden Lake of $406 x 0.6 = $243.6M, or a fully diluted target share price of $2.75.

Chromite

As the Black Creek chromite project isn't going into production anytime soon as mentioned, it doesn't make any sense to calculate future cash flows for this project. Instead I would like to make an estimation of the project based on an in-situ valuation with different chromite prices and different percentages of the in-situ value.

B. EV/oz vs. peers

The enterprise value (EV) of Probe Mines, just based on the Borden Lake is calculated as followed:

EV = market cap - cash + debt (estimated liabilities without project debt)

EV = $143.65M - $40M + $5M

EV = $103.65M

As the Borden Lake deposit has 4.3M oz Au, the corresponding ratio EV/oz is:

EV/oz = 24.1

The Black Creek chromite project is by far a secondary object in a takeover, but still represents a certain value. This deposit is 10M t chromite and using a price of $220/t, resulting in a gross metal value of $2.2B. The gross metal value of the Borden Lake gold deposit is 4.3M x $1315 = $5.65B, so globally three times larger, generating a hypothetical AuEq resource of 6.0M oz. Because of ongoing issues on nearby chromite projects, I value the Black Creek project at just 0.2M oz gold-equivalent, combining both projects to a hypothetical AuEq resource of 4.5M oz.

The ratio EV/oz results in: $103.65 / 4.5 = 23.0

As the EV/oz ratio according to my database is on average 21 for gold exploration companies in the same stage as Probe, it could be concluded on this ratio this company is slightly overvalued compared to his peers. When the EV/oz ratio for Probes' Borden Lake would be 21, the corresponding share price would be: $129.5 / 75.6 = $1.71.

However, the recently acquired claims adjacent to Borden Lake called the East Limb property, are very promising according to management, and offer considerable upside exploration potential. Maybe some kind of expectation has already been priced in by the markets as well.

C. In situ value/oz vs. peer takeovers

In order to estimate a takeover indication for Probe based on the Borden Lake gold project, I compared three cases in Ontario: Rainy River, Prodigy Gold and Trelawney Mining.

1. Acquisition of Rainy River by New Gold

New Gold is paying $364.3M for Rainy River. Its Rainy River flagship project holds a mostly M&I defined resource of 8.85M oz AuEq @1.21g/t. This results in an average value for this deposit of $41.16/oz. The Rainy River project is designed as a combination of underground and open pit, just like the Borden Lake project. Just 3.65M oz Au was a pit constrained resource, Probes resources however are mostly pit constrained, so I consider them relatively more valuable, and would estimate a comparable average value of $55/oz just for the pit constrained resource of Rainy River.

Gold price at the time of acquisition (8/9/2013): $1314/oz

2. Acquisition of Prodigy Gold by Argonaut Gold

Argonaut paid $341M for Prodigy. Its flagship project Magino contains 6.25M oz Au @ 1.06g/t, of which half was in the M&I categories. This results in an average value for this deposit of $55/oz. Just 2.75M oz Au was a pit constrained resource, and would estimate a comparable average value of $75/oz just for the pit constrained resource of Magino.

Gold price at the time of acquisition (10/15/2012): $1754/oz

3. Acquisition of Trelawney Mining by IAMGOLD

IAMGOLD paid $505M for Trelawney. Its flagship project Cote Lake holds a mostly inferred resource of 6.9M oz Au@ 0.89g/t. This results in an average value for this deposit of $73/oz. An economic study for Cote Lake was never released. Therefore I value Probe's resource more valuable as this is an M&I and pit constrained resource. I would like to estimate a comparable average value of $100/oz for Cote Lake.

Gold price at the time of acquisition (6/21/2012): $1594/oz



Cote Lake project

Considering the average value of these three recently acquired deposits, and considering the current gold price at $1325/oz, I would like to assume an average in situ value of $60/oz for the Borden Lake project.

This would mean a takeover price for Probe Mines based on Borden Lake of 4.3M oz x $60/oz = $258M, which generates a corresponding share price of:

$258 / 88.5M shares F/D = $2.92.

Chromite

As the Black Creek chromite project isn't going into production anytime soon, it doesn't make much sense to calculate future cash flows for this project. There are also no peer take over projects to compare. Instead of this I would like to make an estimation of the project based on an in-situ valuation with different chromite prices and different percentages of the in-situ value. Most of the resource is measured and indicated (M&I), 8,65M tonnes, and 1,6M tonnes is inferred. Frequently applied in-situ valuation methods use 1% in situ value for inferred resources, 2% for M&I resources and 3-5% for proven and probable (P&P)resources.

The Black Creek project consists out of relatively low average grade lumpy chromite (FeCr) direct shippable ore (DSO) at 37,5% chrome. Prices for comparable 40% FeCr DSO are:

(click to enlarge)

Calculations in situ value (ISV) for chromite prices between $200-240/t:



I would like to apply the current chromite price of $220/t, and like to add a small discount for the slightly lower average grade, resulting in an in situ value of $40M.

This would mean a value of $40M / 88.5M shares F/D = $0.45 per share.

Update as of September 15, 2013: Cliffs' Ring of Fire chromite projects have to endure considerable setbacks lately. The only way out for Cliffs' seems to buy out KWG (KWGBF.PK), a much smaller rival miner, which seems to have a better but far more expensive transportation proposal in the same area for the same purpose, unfortunately not without problems either. However, Cliffs is facing headwinds in the iron ore business with cost of production rising in face of low prices, and its balance sheet is stretched. Therefore, an acquisition may be the last thing on the management's mind at the moment. Besides this, an increase in the initial capex of the Ring of Fire chromite project is very likely because of the more expensive transportation proposal. Last but certainly not least there are Cliffs' ongoing long term problems with the environment assessment process, land surface rights, and negotiations with the Province of Ontario.

(click to enlarge)

Cliffs' Black Thor project

As I consider Cliffs the most important candidate to buy Black Creek as it is the primary chromite player in the region, but having all kinds of trouble now related to this very same region, chances are other competitors are not very keen on intertwining in these kind of problems either as Black Creek most likely will face some of the same issues as well when developed towards production. Therefore I prefer to value the Black Creek considerably lower at $10M, or $0.11 per share fully diluted.

This results in an estimated total valuation for both projects based on resources of:

$2.92 + $0.11 = $3.03.

Valuating the company

Three ratio's have been calculated, now it's time to compose a combined target share price based on these ratio's. The more a ratio tells about the company, the more valuable it is and therefore the more weight it deserves.

A. market cap vs. NPV: A NPV is a good way to value a project as it takes into account most parameters. As Probe isn't very close to production, the discount on the NPV is considerable with 40% (near term producers get 0-10% discount on NPV), and could be subject to many changes over the years as well. The businesscase and NPV could change a lot in 3-4 years time, therefore I would like to weight the estimated NPV based share price by 30%

B. EV/oz vs. peers: EV/oz is a very limited valuation, and doesn't tell much about the future cash flow potential of the deposit. Therefore it is more of an indicator of share price sentiment for the moment. Because of this I would like to weight this ratio by 10%.

C. in situ value/oz vs. peer takeovers: This is the most important ratio as it shows how much the company could actually be worth as takeover target, compared to several peers who recently got acquired. Especially the Rainy River take over presents very accurate information as it is located in Ontario, has the same underground/open pit mine plan and most of its resources are M&I just like Borden Lake. Therefore I would like to weight this ratio by 60%.

This results in the following components of the target share price:

A: market cap vs. NPV: $2.75 x 30% = $0.82

B: Ev/oz vs peers: $1.71 x 10% = $0.17

C: In situ value/oz vs. peer takeovers: $3.03 x 60% = $1.82

Adding these three components results in a conservative target share price of $2.81. Taking into account a current share price of $2.07 (9/16/2013), this means a profit of 35.7%.

6. Catalysts & Risks

There are several catalysts for the Probe Mines share price, I will describe them in a time-sequential order. The first catalyst is about Agnico-Eagle Mines , which already purchased a 9.94% stake in this company on May 28, 2013, clearly seeing value in Probe Mines' Borden Lake gold project. The holding period for shares and warrants ends at September 29, 2013. As AEM is holding a considerable amount of warrants at $2.00, exercising them could cause downside pressure on the share price directly after this date. Usually big parties wait until the expiry date, so I don't expect serious price action.

Next catalyst for Probe Mines will be an updated NI43-101 resource estimate, to be released by the end of this year. If Probe Mines can surprise the mining community with more ounces and a higher average grade compared to the current estimate, chances are this will create a serious uptick in the share price.

The final and most important catalyst as far as I am concerned is the upcoming PEA, planned for Q1 in 2014. A positive PEA indicates Borden Lake directly as a premier takeover target for producers. If precise modeling results in a NPV exceeding $400M, my guess is the investing community will be pleasantly surprised, sending my NPV/market cap component of the target share price even higher.

Another positive catalyst came very recently, by Larry Summers pulling out of the race for the FED presidency. He was rather critical regarding the very loose monetary politics (QE and low interest rates). Accelerated tapering would have caused serious downside pressure on the price of gold, therefore having a negative impact on the business case of Probe Mines. With Summers out, Janet Yellen became the top candidate, who is one of the architects of the loose monetary politics, and very supportive of it. This could very well create some kind of foundation underneath the price of gold, preventing it to go lower than $1200-1300/oz for quite some time.

Besides this, another positive development which could be supportive for the price of gold is the development of a large physical gold market as I wrote about in another article, preventing the price of gold to decrease to $1000/oz levels because of current massive demand for physical gold. This may not send the price of gold much higher in the near future, but it could to a certain extent neutralize possible selling pressure caused by gold related securities like GLD.

As always, risks often mirror the catalysts, and for Probe the biggest risks are a lower than expected resource estimate, and especially a negative PEA. The resource estimate doesn't seem to be a great risk because of recent, very encouraging drill results, therefore I don't expect a lot of risks for the PEA either, especially since Summers pulled out, which caused support for the gold price. When it does decrease below $1000 levels as several analysts forecast, it is of course very likely this project will not be very profitable anymore, and therefore Probe Mines will lose most of its current attraction as takeover target.

Another thing that could prevent a fast buy out at high prices are, as already mentioned, the setbacks Cliffs' Natural Resources goes through at the moment on their own nearby chromite projects. Cliffs' is the only big chromite player in this region, and most likely the only party interested in the Black Creek deposit. As an asset almost impossible to sell, Black Creek could shed some shadows on Probe as a whole, therefore lowering expectations on a takeover target share price. However I dismissed Black Creeks' value almost entirely in my valuation, so I don't expect much downside risk on this subject.

7. Conclusion

Probe Mines is the last junior company with a resource estimate over 4M oz Au in a region which saw considerable M&A over the past year and a half, as other nearby gold explorers Trelawney, Prodigy Gold and Rainy River were acquired by producers.

The company is working towards an updated resource estimate and the release of a PEA soon after, which will in my opinion very likely prove the value of Borden Lake. Although the market already recognizes the potential of Probe Mines, I consider this company for several reasons as an attractive takeover target which still has an upside potential of at least 35.7% for a conservative target share price of $2.81, and it might be up to Agnico-Eagle Mines or perhaps Barrick (ABX) or Osisko (OSKFF.PK) to prove my thesis soon.

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