Tuesday, 29 January 2013

AIM Stocks – what to watch out for....

My own professional expertise covers one particular area of minerals and metals processing.  Note, however, that I'm not a financial adviser.... do your own research.
The Alternative Investment Market (AIM) is a UK market for shares in smaller, more risky companies.

You've spotted a start-up company that's reporting great things – they've recently floated on AIM to raise £100m and the financial press is full of its potential – and so you've also bought into the marketing spiel and you now own a fraction of this company – they either have a new production process that's going to revolutionise an industry sector or else they've specific oil, gas or mineral rights to a particular piece of land or sea and therefore everything looks rosy, yes ?  

Wrong ! 

Why ?  Read on....

So, this fantastic new company has, say, the oil or mineral rights to a particular piece of land or sea.  What does this mean ?

Well, it means exactly what it says.  The company has probably agreed to acquire the sole and exclusive rights to extract whatever mineral they specified from under this piece of land or sea, but usually only for a finite length of time to commence, i.e. some government or other has given them maybe five years to build a full-scale production operation, or at the very least to commence 'meaningful works' – if your company fails to meet this deadline, then this (very expensive) option lapses and is up for grabs again and anyone else can then bid for the future rights.

So, your AIM company with a market capitalisation of £100 million wants to develop, say, a mineral minesite. 

Dead easy, yes ? 

Wrong again !

Have you any idea of the sort of financial and regulatory frameworks with which it's required to comply, even in so-called third-world countries ? 

Firstly, there's the initial cost of acquiring the option, let's say a lowly £20m, then they may need to confirm that the resource is exactly as rich as it's claimed to be, maybe £2m in further testing etc, then there's a series of feasibility studies required, eventually up to a level that would be acceptable to future equity partners or lenders.  Let's say £1m in total as a ball-park figure.  Then there's an Environmental, Social and Impact Assessment study (ESIA) into the proposed development, let's say £500k and which may well be on the low side.  Then there's survey & planning fees, consultation with local residents, possible relocations, public relations etc, let's say another £1m just for starters, if you're very lucky.  

In some areas, perhaps even more money to be set aside for kickbacks to the local political elite.  It happens, although they're not perhaps described as such - rather the company may suddenly and unexpectedly be required to fund some local infrastructure or community projects which would then ease the passage of the necessary permitting and approvals processes.

The company principals will also want to get the rest of their start-up costs back from the IPO, i.e. everything the company's already spent before and during the IPO in terms of salaries, premises, travel, up-front commitments, lawyers and financial advisers etc.

So, after the first year or so your £100m backed company has now spent around £30m, more than a quarter of its capital, before it can even begin to think about developing the site, and at this stage it's an awfully long way from making any sort of return on your investment.   And all this time, the founder / CEO plus perhaps a couple of dozen or so others are all drawing a very decent salary from your investment funds, and could continue to do so for several years.

Then of course there's the huge cost of project implementation, to actually produce something from the resource and bring it to the market.  To exploit a half-decent resource, then maybe £1 billion or even very much more is the order of the game.  The feasibility studies and EISA may also have thrown up unforeseen problems that require much more cash to overcome. 

Notice something ?  Your £100m capitalised company is more than 10 times short of the mark in available cash required to bring the project to fruition and start to generate returns.

So what can it do ?  Well, the company has no track record and can't possibly borrow the money from the markets at any sort of reasonable interest rates, if it could even borrow at all, which is highly unlikely given the lack of collateral and the huge sums involved for such a small company. 

It therefore has a few choices – to sell the rights it's acquired (or even the company) to someone much bigger (by far the preferred option for the initial investors, at least you may see a profit on the deal) or, more likely, to seek more funds from the existing shareholders, i.e. you, or, even more likely, from other wealthier investors who are now very interested in the game because your initial cash has done all the spadework, but they're smart businessmen and so they want a preferential deal.

So, a series of rights issues could follow (raising more market capital from existing shareholders) or, much more worrying, from private placements.  At least with a rights issue you can always choose to increase your stake to maintain a proportionate share in the future prospects.  

In reality, and at this stage now armed with a much more realistic business plan and all the supporting documentation that your money has actually funded, the company could well approach a third-party with deeper pockets to become an equity partner.  So they could issue new shares not generally available to the existing shareholders and obtain the additional funding in this way.   A private placement is commonly a back-door deal that shafts the initial investors, but in extreme cases it may be the only way to save the company from extinction and to salvage anything at all from your original investment.

However, at this point, you're totally screwed – if they've raised further cash in this way then your original shareholding may have been diluted many-fold.  Remember, that although nothing at all on this scale could possibly have been achieved without your initial investment, you're now left out in the cold with a much smaller chunk of any future profits.  You can't even reasonably complain about this, unless it was specifically stated in the prospectus that the capital raised from the IPO was thought to be sufficient to bring the product to market.  Even if it was, things always cost more than initial approval budgets and can also take many years longer to implement than originally planned - remember, all this time your company is racking up further project, salary and benefits costs without any revenue stream to support them.   If there are severe delays, then the company may need to shell out more cash to extend their option, or in the worst case even to re-bid for the rights after the option expires.

So the moral is, leave the speculation in new mine and oilfield developments etc to the very biggest boys in the industry, who better understand exactly what's required to get the stuff out of the ground and can either fund the development off their own balance sheets or otherwise get the best loan terms to finance it.  

If you want to invest in oil or mineral developments, then do it through the big Footsie players  Beware though that even the biggest players can screw up occasionally - just take at look at the write-downs in their annual accounts for huge amounts previously spent on capital projects and / or acquisitions that failed to live up to expectations.

However, if you do still want to chase the fairly remote possibilities of huge returns from AIM-listed miners and oil companies etc, then be sure to examine their prospectuses and annual accounts in great detail :- 

  • beware of any company that doesn't look as if it will be able to extract a meaningful amount of product, and to sustain extraction operations, without the requirement for further external cash injections, i.e. is obviously undercapitalised.
  • examine the specific product / commodity prices on which their future revenue predictions are based, and compare them to current and historic levels.   
  • be very sceptical of any claims that the resource in question is likely to become scarce or that demand is set to surge - it rarely turns out to be the case, and many commodities are cheaper in real terms now than they've ever been.

Exactly the same can apply to those AIM companies who have developed new industrial or chemical processes, especially if they're using your money to fund a 'pilot plant'.  There's a world (...and many millions of pounds...) of difference between a pilot plant operation and full-scale commercial implementation....

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