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Wednesday, September 17, 2008


Panic Creates Opportunity

This has been a brutal market, not only for housing and financial stocks, but for mining stocks as well. In May, we thought the bottom may have been put in for the junior mining sector selloff. However, that bottom lasted only a couple of months, as the sector broke to new lows and headed much lower during the summer amid the financial sector collapse. The selling accelerated in recent weeks, resulting in panic liquidation of junior miners at prices that would have been unthinkable just a few months ago. Panic and fear among investors has forced many to capitulate and sell whatever they could to raise cash as stocks seemed to endlessly move lower and lower. Though a number of marginal mining juniors won't make it because of high costs, insufficient ore, low grades, onerous debt, or political risk, the selloff has been driven primarily by the lack of liquidity, not by fundamentals (other than for high-cost producers that are losing lots of money while depleting their reserves).

Last week, the selling of mining stocks hit a crescendo, as the XAU and HUI mining indices dropped nearly in half from their highs less than 2 months earlier. Junior miners have been hit even harder than the larger cap indices, with many losing as much as 90%+ of their value since last year. However, since last week's panic lows, the XAU and HUI mining indices have rebounded 20% and 24%, respectively, even as the overall stock market had selloffs of over 500 Dow points on Monday and around 450 points today. Our favorite mining junior, Metalline Mining, has rebounded 30% since last week's low, closing higher on both big market selloff days. However, even after these rebounds, the junior mining sector is still much, much lower than it was a few months ago.

Metals have begun to decouple from the stock market, showing relative strength. Zinc has actually moved higher since it hit a low on August 12, even as the stock market has dropped over 1200 Dow points to new 3-year lows, and other commodities have been selling hard, with oil dropping from near $150/barrel to $91/barrel yesterday. With the oldest U.S. money-market fund failing to maintain the trusted $1.00 par value today, and with 3-month T-bills dropping to the lowest rate since 1954, spot gold surged $85 higher, the biggest one-day gain ever, and silver jumped even more -- 15% higher, for the biggest one-day gain since 1979. With the safety of paper dollars in question, even at the bank, gold and silver represent the safest stores of value. The flow of money that has been leaving commodities and commodity stocks in recent months is starting to flow back.

If money continues to flow back into the sector and the bottom is indeed in for the junior mining sector this time, there are some incredible investment opportunities for long-term investors, including our favorite, Metalline Mining. When we first wrote about Metalline Mining (MMG) here, it was under $1.00. It was coming out of a mining bear market selloff to under $.80 and proceeded to rally to over $5.00 within 6 months as zinc and other metals rallied. Many investors looked back and wished they'd loaded up on MMG when it was under $1.00. Now, MMG's back below $.80 again and we believe it will again make a move much higher. We're not sure about the timing, as we've been wrong about short-term price action before, but we're confident that investors will again look back and wish they'd loaded up on MMG under $1.00. Insider buying shows that MMG management recognizes this buying opportunity.

Since the beginning of summer, MMG has lost over half its market value from what we believe was already a deeply undervalued level, even as the fundamentals have improved dramatically. In late July, the company announced a new resource model more than doubled the amount of zinc present in the oxide zinc deposit covered by the ongoing feasibility study, with preliminary analysis indicating open pit mining on the much larger resource would be much more profitable than the previous plan for underground mining. The stock rallied sharply, but quickly fell back amid the sector weakness. In late August, a president's letter to shareholders provided more details on the new expanded plans, which would include both the more than doubled oxide zinc deposit as well as the adjacent Silver Polymetallic deposit, which previously was a separate project planned for later on. The stock again rallied, but again fell back to new lows as the financial crisis on Wall Street worsened.

In a healthier market, we believe MMG would have had sustained rallies from this great news. With what will likely be one of the biggest and lowest-cost zinc (plus silver, copper, lead, cobalt) mines in the world in a politically safe location with a huge amount of infrastructure in place, the stock should be at least several times the current price. With less than 40 million basic shares outstanding (and most of the outstanding warrants and options well out of the money), the current market cap is a small fraction of 1% of the metal value covered by the new feasibility study, not even counting any of the Silver Polymetallic mineralization, which could end up being even more valuable than the oxide zinc deposit. Of course there will be significant costs to build the mine and extract the metal, but, especially once the feasibility study's done, MMG should be worth many times the current price. Even the much smaller, much higher cost, remote Yukon Zinc project got bought out earlier this year (even after failing to get financing for 2 years during zinc's rally to record highs) for several times MMG's current valuation, and the Skorpion oxide zinc project got bought out for far more than that at the trough of the metals bear market when zinc was much lower than it is today. MMG's expanded project should be worth far more than those 2 were in their post-feasibility buyouts, and with the dearth of large zinc or silver projects scheduled for production the next few years, MMG's huge zinc/silver/polymetallic project should be even far more valuable as zinc and silver prices recover. We believe multiple bidders for the project will ensure that value will be realized after the new expanded feasibility study's completed.

As for the new path forward in these lean times, with the more than doubling of the oxide zinc resource and the drilling up of more and more silver, zinc, lead, and copper in the north side Silver Polymetallic deposit, combined with the current condition of the financing and metals markets, it made sense to combine the two sides into one much more efficient, huge, open pit project. The previous plan was to extract the oxide zinc via underground mining methods and address the north side Silver Polymetallic deposit in a separate project/feasibility study later. The new approach means they won't need to raise cash for the previously planned underground test mining and can put the feasibility study contractors on hold while they focus on drilling up the much larger resource, thereby significantly decreasing the cash burn rate. Metalline has a huge advantage over other juniors, as their drilling with their own local Mexican employees and their own drills costs a small fraction of what other miners have to pay, so they can make a lot of progress increasing their resources in lean times while preserving capital.

When the market conditions are better and the two huge deposits are drilled up enough for an expanded feasibility study, Metalline can raise the relatively small amount of money needed to complete the feasibility work (which can be financed a number of different ways). The end result will be one enormous, proven feasible, high-grade, high-volume, open pit oxide zinc/silver/polymetallic project, rather than 2 separate underground projects with much lower production rates. The timing of financing should be much better than under the old plan, which would have required financing much earlier, and the much higher production rate and economies of scale should mean far better economics.

Capex costs will be higher for the much bigger project, but operating costs will be much lower. Open pit means MMG won't be limited on the production rate like they would have been with underground mining, and could have a production rate at least 5 times higher, and maybe much more depending on how much they prove up on the north side Silver Polymetallic deposit.

Time to production won't change much under the new approach, as there's a lot more prep work that would have been needed for an underground mine vs. open pit -- plus, production will now likely be much earlier for the north side Silver Polymetallic deposit. However, the oxide zinc feasibility study, which would have been done around year-end on the smaller underground oxide zinc-only project, will now likely be done at least a year later; Instead of doing two separate feasibility studies for the two mineral systems, the expanded feasibility study will include both the (more than doubled) south side oxide zinc and the north side silver/zinc/lead/copper/cobalt. The focus now is on drilling up the resources to have them ready to include in the expanded feasibility study.

We believe the new timing will be much better for a likely post-feasibility buyout, as both the financial markets and the metals markets should be in much better shape at that time, especially with all the big zinc mines starting to shut down by then. Even bearish analysts project large zinc supply deficits starting by 2010 because of the large mines running out of ore and the dearth of large new mines to replace them. The much bigger size of MMG's expanded project, with much improved economics, makes us more confident than ever that MMG will get bought out after feasibility at a much higher price.

Although junior miners have been beaten down badly in recent months, we agree with BMO's Don Coxe, who asserts that “the next phase of history's greatest commodity boom will have some new characteristics that should make commodity stocks even greater out-performers once the world emerges from the current economic downturn.” While it has brought their stock prices down, the current sector washout and resultant mine/project shutdowns should turn out to be a positive for the survivors longer term, as it will mean far less metal supply than projected for coming years. It's been a very tough period to be a junior mining stock investor, but we still believe that the quality juniors will reward long-term investors handsomely for their patience.


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