The Thesis

We believe that PolyMet is developing a very attractive tier 1 base metal project with the greatest risk being environmental opposition preventing permitting.

The project economics are enticing.

The company's strong partnership with Glencore reduces execution and financing risk and generally adds to the attraction of this particular project.

We see no urgency for retail investors to get involved at this stage since permitting is ongoing and will probably continue to play out for a while to come.

Reference

Some time ago fellow author Ben Kramer-Miller published an "analysis" on PolyMet Mining Corp (PLM). This article contained errors, meritless assumptions and some wild guesses. We believe this company deserves better. In the present article we would like to correct some of these errors and add our own analysis and conclusions.

The Project

PolyMet is developing the NorthMet deposit close to the Canadian border in Minnesota. This deposit forms part of north eastern Minnesota's Duluth Complex which contains large quantities of copper, nickel, cobalt, platinum, palladium and gold. PolyMet's orebody is similar to the Twin Metals project developed by Duluth Metals (DULMF.PK) in JV with Antofagasta (ANFGF.PK), except that the NorthMet project is amenable to open pit mining.

Polymet also owns the Erie Plant, a former taconite processing facility with extensive milling capacity and associated supporting infrastructure located at a six miles (or 10km) distance from NorthMet.

PolyMet has filed a Definitive Feasibility Study, or DFS, in 2008 and has released an update in 2012. This DFS is a substantial piece of work spanning 1000+ pages of very detailed information. Most of our analysis summarized in this article will be based on results documented in this study. It can be downloaded in its entirety from SEDAR. The DFS describes a bulk mining project processing 32000 tons per day on a 24/7/365 basis over a mine life of 20 years based on current reserves. There are substantial additional resources and near mine exploration targets.

The main reason for the 2012 update of the DFS was a decision to develop the processing facility in two phases. Phase I will produce concentrates containing copper, nickel, cobalt and precious metals; Phase II will process the nickel concentrate through a single autoclave, resulting in production and sale of high grade copper concentrate, value added nickel-cobalt hydroxide, and precious metals precipitate. This staged approach will limit the initial capital expenditure prior to first production. Cash flow from Phase I concentrate sales will fund Phase II development.

PolyMet has forged a strong partnership with Glencore Xstrata (GLCNF.PK). Glencore owns 34% of Polymet's stock on a fully diluted basis. Moreover, PolyMet has an offtake agreement with Glencore covering all metals and concentrates produced at NorthMet at market conditions.

(click to enlarge)

(Erie plant. Photo taken from company website)

Valuation…?

The referenced article values the project on a price to cash flow ratio, whereby annual future cash flow is related to the present market capitalization of the company. This "method" is flawed, in our humble opinion. It neglects development capital expenditures, cost and risk of project financing, and does not consider any discount for future cash flow. What makes things even worse, the computed cash flow in the referenced article is based on incorrect numbers. Here is an incomplete list of in-accuracies:

• Northmet will produce 72M lbs of copper during the first five years, not 65M lbs; Northmet will produce 157M lbs of copper-equivalent during the first five years, not 130M lbs.
• The author claims that the copper co-product cash costs of $1.05/lb "include some variability" and therefore incorporates "an error of $0.25". May we remind our readers that the cash cost is taken from an exceedingly conservative DFS. Insinuating that cash costs are erroneous by 23.8% without giving a reason is major head-shaking material.
• The author then adds another $0.45 to these inflated cash costs, allegedly accounting for "administrative expenses, mine repairs, interest payments, and other expenses". Most of these items are either already included in the cash cost of $1.05, or (like interest payments) should not be considered as part of production costs.
• In consequence, the so-called "cash-flow" analysis in said article is performed with assumed production costs of $1.75/lb. A number that is not reconcilable with the company's DFS in any way.

To prove the point, consider the case of copper price at $2.00/lb. According to the referenced article, cash flow should be negative at a whopping $32.5M per year at this price level. Interpolating between two DFS scenarios ($1.50/lb and $2.25/lb) leads to an NPV (7.5%) of $450.9M and an IRR of 22.3% for the very same case of $2/lb copper equivalent.

In short: while the referenced article concludes that this project is not viable at $2.00/lb the DFS shows very robust economics for this copper price scenario.

Valuation - It's All In the DFS.

Let us now use the data contained in the DFS for a meaningful valuation.

The DFS evaluates a host of different scenarios and gives all the tools to value the NorthMet project for many different price and cost inputs. And there is no need for accounting acrobatics either; we can take the following table straight out of this study to gain an overview of post-tax NPV (7.5%) and IRR for three different price scenarios. The right-most column shows the metal prices at the time of finalizing the DFS.

This table clearly shows an exceedingly robust project that remains profitable even at $1.50/lb of copper. Basic assumptions chosen for reserve calculation, pit shell design, metallurgy and capital expenditure are very conservative. We felt comfortable using DFS results after digesting much of the presented information.

(click to enlarge)

Shares of the company trade at the NYSE for $0.78 at the time of writing. Accordingly, the market capitalization computes to $143M. The company has just raised $60.5M in a rights offering that increased the outstanding share count to 274.9M (332.4M fully diluted). Glencore owns 34% of the company and insiders hold 6% on a fully diluted basis.

After repaying a bridge loan PolyMet had $51M in cash at the beginning of July and is therefore financed through permitting plus it can order long lead items in anticipation of mine construction. The company carries $31M in convertible debt. We will assume that this debt will eventually be converted into shares adding to Glencore's holdings. Note, that we have already given shareholdings on a fully diluted basis for this very reason.

Assuming an enterprise value of $92M (accounting for cash, but not for the debt) we conclude that the NPV is a multiple of the present company value. Considering the "Market Case" in the table above we note that the company is valued at just over 15% of the project net value. Did we call economics enticing in our introduction? We did indeed, and we would like to repeat it here based on these numbers.

Financing…?

According to the 2012 DFS update initial capital expenditure will be in the order of $312.1M to get Phase I into production. Capital expenditure for Phase II will come from cash flow.

The referenced article states:

"Assuming the company simply dilutes shareholders at the current valuation of $0.752 per share (it has other options that I discuss below), it will have a fully diluted market capitalization of roughly $550 million."

Hey, that's great. Simply dilute shareholders and the market cap goes up. Why stop at $300M, why not turn the company into a multi-billion dollar enterprise by issuing stock. Life is so easy!

Unfortunately, as most seasoned investors know, it works the other way round: a company issues stock, and consequently the share price adjust downwards to account for dilution. Need proof? Just study the chart below showing PolyMet's market capitalization and share price around the time of the last capital raise. Upon announcement of the capital raise on June 11 the share price dropped to reflect dilution. The rights offering closed on July 5, the new shares were issued and the market capitalization recovered to just above pre-raise levels.

PLM data by YCharts

Issuing stock in excess of twice the current market capitalization, as the author of the referenced article suggests, is… well, let us call it a folly.

The other financing options that this author proposes in his article are equally beside the point. So let's not bother at this point and turn to a much more realistic scenario with regards to raising the funds to develop the NorthMet mine.

Financing: History Might Repeat.

Glencore is a strong partner in this project and has already assisted with financing the exploration and the development of this project in the past. In fact, Glencore maintains partnerships with a number of junior exploration companies on promising base-metal projects world-wide. Glencore's support for Trevali Mining (TREVF.OB) for development of the Santander Mine is an example for this strategy.

These partnerships may serve as a template of what kind of scenario will most likely unfold when the time comes to raise capital and build the NorthMet mine.

Take YTC Resources (ASX:YTC) as another example. This company is building a precious and base metal mine in the Australian Cobar Basin and has forged a partnership with Glencore to finance construction. Glencore supplied a $150M funding package for an $80M market cap company covering the full extent of capital expenditure needed to bring this mine into operation. The package consisted of a mixture of debt and convertible notes. The mixture was tailored to ensure partial repayment of the debt from future cash flows, but will also lead to a growing stake in the company for Glencore. The rules agreed in this particular case also included Glencore's participation in mine development on a technical level. This particular deal received the "Small Cap Deal of The Year" award in Australia.

Considering that Glencore has already provided funding for PolyMet in the past, and considering that Glencore already owns a substantial stake in this company we would suggest that a similar deal will be struck when the time comes to fund construction of the NorthMet mine.

Glencore pulling out of this project, or leaving a door open for other parties to participate would set off alarm bells with your humble scribe.

Environmental Issues

NorthMet is partially a brownfield development in a historical iron ore mining district. However, despite several iron ore mines operating in the state PolyMet has been given a very hard time permitting their project which would be the first non-ferrous mine in the state to the best of you humble scribe's knowledge.

A large portion of the mine site is located on federal public land within the Superior National Forest, and the proposed mine also affects wet lands. The company has proposed a land exchange with the US Forest Service that would ensure ownership of these landholdings and also eliminate certain environmental legislation.

A draft Environmental Impact Statement, or EIS, was submitted by PolyMet in 2009. Comments and recommendations were received and for the last 3.5 years the company has been preparing the supplemental draft Environmental Impact Statement. This document will finally be available for public review in November. Release of the supplemental draft EIS will begin a public review period. Various government agencies will then review and respond to comments. Eventually a final EIS will be published that may or may not contain modifications to the present draft. Provided this EIS adequately evaluates the project and its likely environmental impacts an "Adequacy Decision" and federal "Record of Decision" will be issued forming the basis for issuance of permits.

In this year's Survey of Mining Companies by the reputable Canadian Fraser Institute Minnesota receives a rating of 58.1 out of 100 in the policy potential index which is a summary index of various sub-categories. This puts Minnesota towards the bottom of North-American legislations. "Uncertainty concerning the administration, interpretation, and enforcement of existing regulations", "Uncertainty concerning environmental regulations", "Uncertainty concerning environmental regulations" are listed as the strongest deterrents to mining investments in Minnesota in this report. Add fierce opposition by environmental organizations to this mix and estimating the timing for achieving a final permit becomes a guessing game.

Conclusion

The NorthMet project is an exceptional investment opportunity. The economics of the project are compelling and the partnership with Glencore de-risks the project considerably. The NorthMet project appears profitable at metal prices significantly below today's level.

The main risk at the present time is permitting and overcoming environmental concerns. The risk of falling metal prices is partly alleviated by the mixture of metals in this deposit and can be further reduced by hedging.

We expect construction to be funded in partnership with Glencore. We also expect the final funding deal to lead to some shareholder dilution.

Permitting will most likely drag on for quite a while and interested potential investor should pick their entry points with patience.