Griffin – an unusual company but a potential value play

Griffin is certainly an unusual company. Even after digging through the recesses of the Main Market and AIM, you would struggle to find many companies whose share price soared 65% since the beginning of this year despite a sharp decrease in net income! How to explain this apparent paradox? Well, it’s of course true that the company didn’t make any sales in H109 but there’s more to this statement than meets the eye….

The Business

Griffin Mining Limited is a mining and investment company. Its principal asset is the first new foreign owned and operated mine and processing plant in China at Caijiaying, which mined 433,000 tonnes of ore in 2008, producing c. 24,000 tonnes of zinc concentrate (together with smaller amounts of gold, silver and lead). Through China Zinc Limited, one of its subsidiaries in Hong Kong SAR of China, GFM indirectly holds 60% of the interests in Hebei Hua’Ao, the company registered for exploration and production of the Caijiaying zinc-gold mine. The Caijiaying zinc-gold mine enjoys great benefits from transportation as it’s closely located to the northeast of Beijing, in Hebei province. Hebei Hua’Ao also enjoys a preferential tax rate in China because of its status as a foreign investment enterprise [ref] According to the New Tax Law in China, the tax rate is currently 12.5%, and will gradually increase to 25% in the next several years. http://www.deloitte.com/view/en_CN/cn/press/cn-pressreleases-en/press-release/0a4d7b442e502210VgnVCM100000ba42f00aRCRD.htm [/ref] .

Griffin’s prospects are highly correlated with the price of zinc. Its main income is from the revenue of Hebei Hua’Ao, which in turn relies on the sales of zinc extracted from the ground. Griffin’s profitability was severely impacted by the fall in the price of zinc, which has decreased 46% in 2007, and further 50% in 2008 to $1,100 per tonne. Since the economies and financial markets around the world started to recover from economy pit in March 2009, the price of zinc has fortunately started to pick up from its three-year bottom.

Although Hebei Hua’Ao’s income mainly came from zinc ore which were traditionally in Zone II and Zone III, Griffin significantly increased the production of gold and silver in 2008, diversifying its income streams. Coming out of the economic downturn, Griffin’s enhanced throughput should position it well.

Griffin enjoys extremely low cost of production since its main site is in one of the poorest villages in China, not to mention that China is a country well known for its low labour cost. We can easily see the effect on the financial statements where the cost of sales is at a much lower level than we would expect based on common sense, leading to high gross profit margin of over 40%. This helped the company to make a profit of $7 million even in 2008 when zinc price fell by 50%. It’s worth noting that Griffin is taking the opportunity of being in a recession to renegotiate terms with local contractors. However, this is not to suggest that Griffin is mistreating its labor force. Indeed, workers at Caijiaying seem to enjoy both the facilities and the employment opportunities provided by Hebei Hua’Ao. And productivity levels are high so this has decreased labor and administrative costs expected to be high because of the corporate structure of the JV.

Griffin enjoys a generous cash position: $65 million at the end of July, and no debt at all. Cash generation is extremely high due to the low cost of production. This provides a useful cushion in difficult times and scope for acquisitions but, on the negative side, it is not the best way to manage working capital to hold cash at such a high level for the past two years, generating only interest income. It also makes it a potential M&A target and, interestingly, the company’s management have a golden parachute. The options Griffin issued to directors and other key personnel during 2008 were designed to vest in three tranches but they can vest immediately upon a takeover offer being made or a change in substantial control of Griffin taking place prior to the expiration of the options.

Griffin’s own M&A track record has been a mixed bag. Back in 2008, it tried and failed to buy into Yukon Zinc, the high grade advanced zinc-silver-copper-gold-lead Wolverine Project located in Yukon Canada. In November last year, Griffin bought into loss-making Spitfire for about £2.5 million but it’s only a 39.2% stake. Spitfire’s principal asset is the Salmon Gums Lignite deposits in Western Australia. The Company bid in March 2009 [ref] Company website. March 24, 2009. http://www.griffinmining.com/gm_news.asp?date=20090324 [/ref] for Invernia, a Toronto Stock Exchange-listed miner, hoping to bring back Ivernia’s Magellan lead mine in Western Australia, shut following an environmental incident, back into production. However, this was blocked by corporate actions taken by Invernia’s Board [ref] Company website. April 3, 2009. http://www.griffinmining.com/gm_news.asp?date=20090403 [/ref] .

So what happened operationally then in the first half of 2009? In light of the low market prices for base metals in 2008, Griffin took the seemingly bold move of suspending production from January to May “to undertake development, maintenance and construction effectively and efficiently without incurring the large economic cost of a shutdown of operations in a high commodity price environment” [ref] Company website. December 19, 2008. http://www.griffinmining.com/gm_news.asp?date=20081219 [/ref] . In particular, it wanted to develop the next mining levels without interruption from blasting and haulage traffic. During the shutdown, a review of costs and procedures was also undertaken to see what scope there was to reduce the operating costs at Caijiaying.  This announcement must have got a fair few private investors biting their fingernails (coupled with the fact that the mine suspension took 5 months, rather than the originally planned 3 months [ref] Reuters website. March 27, 2009. http://uk.reuters.com/article/idUKBNG46068420090327 [/ref] ). It also raised questions about Caijiaying because the shutdown could be interpreted as meaning that the mine was only marginally profitable.

However, it does seem that, during this period, the Company made good progress with ore-body re-modelling and maintenance of current equipments and facilities. The majority of the increase in the stock price happened in April and May, from 21p to 42p. That’s when Griffin was releasing its preliminary and final audited financial results for the year 2008. Here, the market seems to have had confidence in the reopening and in the calibre of the company’s 2008 result, which were impressive in spit of the weak zinc price and the economic recession. The recent interims stated that “since the recommencement of operations, zinc and silver metal in concentrate production has been ahead of expectations with record gold production in July” (although no numbers were provided to back this up, unfortunately). Now that Griffin has entered normal sales mode instead of suspension, its cash position should strengthen further.

One key area concerning some investors concern is the permit for mining below the 1300 level at Caijiaying which should increase production of higher grades of zinc and especially gold. According to the Interims, all further documentation required to permit mining has now been submitted to the Chinese authorities, but the process seems to be dragging out.

Certainly, the external environment has now improved. China is expecting a growth rate of 9% this year and, with the revival of the Chinese economy, the demand for zinc and other metals are expected to increase as well. Right now, the Zinc price is back above $2,000 per tonne again. With the increase in commodity prices accompanied by economic recovery, the price of zinc can be expected to be at a much higher level in the near future than over the past year.

The maximum price during 2008 was about $2,200, so we can get a sense for Griffin’s future performance by noting its sound performance in 2008. This comparison doesn’t take into account the capacity increase due to the maintenance and construction work in the first half of 2009, which should also have a positive impact on its growth. Capital expenditure on construction work was also undertaken with an aim to increase the processing rates to 750,000 tonnes of ore per annum.

Conclusion

Griffin is a difficult stock to get to the bottom of. Prudent investors are unlikely to be satisfied by the thin amounts available on the website or recent public announcements. The financial statements are rather skimpy, operational updates seem to be few and far between and private investors are crying out for a detailed trading update giving a sense for total ore mined in Q3 and the mix of metals.

Sceptics interpret the recent shutdown negatively and see Hebei Hua’Ao as a marginal mine offering little more than a leveraged play on zinc. However, on closer inspection, the market seems to rightly perceive than there’s more to the stock than this. And that’s not just the fact that its current share price of 37p (£67.2m mkt cap) is backed by almost 22p of cash. Some more visibility on current trading post the shutdown would certainly be welcome. However, given confirmation of the positive trend, investing in Griffin for the medium term looks like an interesting value play given the potential growth driven by underlying Chinese commodity demand.