While the company has been, kindly put, a basket case over the past year, the report does give glimpses that recovery is on the way. It has two primary operations – Mine Waste Solutions, which reprocesses previous tailings for gold (and uranium in 2012 and beyond), and this part of the business is quite profitable – about $22.8 million in profit from this operation and likely to increase in the future. However, the other project, the Ezulwini Mine, has suffered through massive setbacks and managerial incompetence and has lost about $63 million for the year.

First Uranium spent most of the first calendar quarter of the year getting rid of its management and restructuring its board of directors with people that seem to have extensive credentials in the mining business.

Most of the solvency concerns were alleviated with the March 2013 secured debenture issue, which will be listed on the TSX sometime in August.

First Uranium at this point becomes an interesting case on whether they can turn around the Ezulwini mine operation or not. From the MD&A:

The Ezulwini Mine has yet to build up sufficient production to generate positive operating cash flow. The production build-up to date has progressed much slower than originally anticipated due to a number of factors including:
- The estimation of gold available compared to the gold accounted for was significantly below expectations, a relationship better known as the mine call factor. The planned mine call factor for the year was 87% whereas the mine achieved a factor of lower than 70% during the first nine months of the year.
- The face length creation proceeded as planned but the start-up and conversion from development to stoping was slower than anticipated. Significant improvements are expected in FY 2011.
- The face length utilization was relatively low during the year due to the newly appointed mining teams as well as inadequate face equipping. Special attention is being paid to the training of crews and equipping of panels, thus mining readiness is expected to improve in the forthcoming year.
- During the fiscal year, some seismic activity occurred in the shaft pillar which caused delays but more importantly required special attention to resolve it in a safe manner. The extra precautions and diligence paid to rock engineering issues resulted in slower than anticipated performance in FY 2010. The majority of the engineering issues are now resolved, thus improved mining performance is expected.

The new management appears to know what’s going on, and they are performing a detailed bottom-up production plan which is apparently going to be ready by the end of June 2010.

On the equity side, FIU closed Friday at $1.25/share, and has 180.8 million shares outstanding. Factoring in the senior secured debentures converting at $1.30/share, this brings shares outstanding to 315.3 million shares.

I am not sure how much cash flow they can get out of Ezulwini even if they turn around the operation. The interest “bite” is not too severe – the unsecured debentures have $155M at 4.25%, while the seniors are approximately CAD$150 at 7%. It is likely if the common shares are trading higher than $1.30 by the time June 2012 comes rolling around that it will simply be a debt-for-equity swap which will make the unsecured debenture holders whole.

The unsecured debentures have turned very illiquid and have recently traded around 66-70 cents on the dollar. Assuming a purchase of 70 cents at the ask, you are looking at a 6.1% current yield and 19.5% annualized capital gain assuming a maturity payout at par. I do own these debentures, and think they represent a fairly priced risk. I still cannot recommend the common, although it could double or triple in value if the Ezulwini project does indeed turn around from the financially disastrous fiscal 2010.

If they managed to pull off a steady-state operation of about 250,000 ounces a year (note: far above 30,000 in the last year, geologist report has 5.2 million ounces over 18 years), at current gold prices that would suggest First Uranium would clear operational profits of roughly $80-100 million. Flow this and the Mine Waste Solutions project into the bottom line and you get a justification for a much higher stock price than present, even with all the potential future dilution – my paper napkin valuation model suggests around a $4-5 share price with a conservative valuation multiple. There are a lot of “ifs” and given the track history of the company, it’s no wonder that First Uranium equity is currently in the toilet – it indeed represents a large risk.

This is a very bitter pill for the equity holders to swallow – they will be heavily diluted by virtue of the conversion privilege attached with the notes, at $1.30/share. Assuming conversion occurs, this will result in 115.4 million shares outstanding more than their existing 166.8 million. In addition, to settle the contractual arrangements with another partner, they will be issuing 14 million shares extra.

All of this means that First Uranium’s existing stockholders, assuming full conversion, will have their holdings reduced to about 56% of the company. However, a significant shareholder (Simmer and Jack with 37% of the prior equity ownership) will also have $40 million of the issue of the notes, which if fully converted, will leave them with approximately a 31% stake.

Probably the only reason why they got into this offering to begin with was to salvage their ownership in the company, which was clearly going to slip away in an upcoming and very messy bankruptcy proceeding.

Gold Wheaton, a company that has purchased a fractional interest in the gold mined from First Uranium, also will be investing $20M and receiving 14 million shares as a result of a settlement on a contract that First Uranium failed to live up to. Assuming full conversion, this will give them about 10% of the company.

The Notes are guaranteed by the subsidiaries of the Company, secured by second ranking security over all assets currently encumbered by Gold Wheaton and first security over all other current and future assets of the Company, not be redeemable until maturity.

Assuming First Uranium will remain above $1.30/share, their recapitalization should be half done.

The other medium term issue for First Uranium, other than the establishment of its mining operations (and subsequent cash flow that would be produced by such operations) is that they have a $150 million issue of unsecured debentures that are due to mature on June 30, 2012, which I so happen to be holding.

First Uranium has a few options.

One is that they should be prioritizing their operations to be cash flow positive, which will make it easier to float another equity or debt offering that the market will be receptive to, enabling them to pay the subordinated debentures.

Another option, concurrent to the above, is that they have the option of paying off the debentures in shares of common stock at 95% of market price; at current market prices of $1.45/share, it would involve issuing another 109 million shares, for a grand total of another 27% dilution of common shareholders. This option will be progressively more attractive as the common share price goes higher. Such an action would be done in 2012.

Another solution is to renegotiate directly with the debtholders and sweeten the terms of debt (i.e. increase the coupon, lower the conversion price) in exchange for an extension of maturity date. This would require ratification of 2/3rds of the debtholders.

Ultimately if the company doesn’t pay up, the unsecured debtholders can force the company into bankruptcy. While their rank in the company, by virtue of subordination to this new issue of debt, will lead to low recovery, it is unlikely the owners of the company would want to proceed with this action and thus it is more likely than not that between now and the 2.2 years to maturity that there will be a way found to make the June 2012 debtholders whole. Simmers and Jack would not want the subordinated debtholders to pursue the “nuclear bankruptcy” option and thus it is more likely than not there will be a solution.

I do not believe First Uranium equity is a good risk at present prices, while I think the June 2012 debentures have probably priced in the right amount of risk and would present themselves as a speculative high risk opportunity.

The notes are convertible at $1.30/share and this will represent a substantial amount of dilution for existing equity holders, assuming conversion – about 48% dilution.

I was informed that the notes will have a 7% coupon attached to them.

Also in the announcement is that the CEO, Gordon Miller, will depart and be replaced by another CEO, Deon van der Mescht, who is currently the CEO of Simmer and Jack.

A relevant quotation is the following:

In addition, the Company is relying upon exemptions from the minority approval and valuation requirements of Multilateral Instrument 61-101 – Protection of Minority Security Holders in Special Transactions, on the basis of financial hardship. The Company’s current payables do not, in the Company’s estimation provide comfort to wait for 21 days to begin closing the Offering. As previously announced, the Company’s financial situation has been severely compromised by the termination of discussions regarding certain financing options as a result of the decision to withdraw and subsequently reinstate the Company’s environmental authorization for the new Tailings Storage Facility designed to accommodate future tailings deposition at the Company’s Mine Waste Solutions tailings recovery project.

First Uranium, therefore, is very close to bankruptcy. If this deal falls through, then bankruptcy is guaranteed. There would be a process where creditors (including the debentureholders) will be able to make their claim on the assets in accordance with Canadian law. Simmer and Jack’s investment would have been completely destroyed in the process, which is why they had to take this very unpalatable deal in order to save their interest in the company – which by all means should be able to produce a substantial amount of revenues once the core operation commences.

If you are holding equity in First Uranium, you have virtually lost most of your value over the past couple years. This deal should probably stop most of the blood-letting, but it is at a huge cost to shareholders.

The market, seeing certainty on the horizon, bidded up First Uranium shares 13% to $1.68. This also provides a substantial conversion cushion for the private placement component of the convertible offering to succeed.

The convertible debentures also rose 12% to 77 cents on the dollar with this news. The convertible debentures are a $150M issue, with a 4.25% coupon and maturing on June 2012. I happen to own some of these and am not afraid of dilution – in fact, I prefer dilution.

If this deal succeeds, it is more likely that I will receive payback on my investment, especially since the maturity date of this new deal is later than the existing convertibles. It is not clear, without reading some sort of prospectus statement, whether the secured nature of these new notes would interfere with the payment of the unsecured debentures.

Of note in this press release is no quotations from any officers in question – probably because this deal was entirely organized without the management of First Uranium consenting to it.

Today they announced that they have it back.

This is what I was referring to the political instability risk concerning investing in companies that have major operations overseas – judging how burdensome the local government is very difficult unless if you are living there and have a “feel” for them.

First Uranium equity today jumped by 39% and closed the day at $1.81/share. This gives them a market capitalization of $300 million. Before this fiasco began, their equity was valued at about $2.50/share. I suspect their equity is under-valued, but I am not interested in the equity – I am interested in the debt. The equity still has other risks (dealing with governance, management compensation, composition of the near-majority shareholder, etc.) that I am not interested in taking. In addition, there still is the operational risk of actually being able to get the gold refining project up assuming anybody wants to finance the operation. The operation will likely be financed with some combination of equity and debt. Future dilution is something equity holders will face, but this is already baked into the relatively low share price.

The debentures are trading at bid/ask 68/71. Now with their business prospects significantly enhanced (providing that they can raise $100 million of capital that would be require to get the project going), I believe there is a material chance that these debentures ($150M par value) will be paid off at par in 2.3 years to maturity. I am guessing that once the project gets established and the revenues come in as projected (which will be substantial) that sometime in 2011 or early 2012, the cost of capital for the company will be considerably lower and I will get paid off at par. At 69.5 cents, the debt has a 23% annualized combined yield-capital gain for an acceptable risk.

Today, however, they will likely trade lower because of First Uranium’s corporate update. In it contains the following words:

The announcement of the withdrawal of the EA has not only delayed construction of the TSF, it has also disrupted certain well-advanced corporate financing opportunities, which, along with the slower than expected production buildup at the Ezulwini Mine, would, if alternative financing is not obtained, severely compromise the Company’s financial position. The Company is now reviewing strategic alternatives, and is engaged in discussions with respect to alternative financing opportunities.

My guess is that the common stock will trade down about 10% on Tuesday and the debentures will trade down another 3 cents. The company will likely have to sell more equity in future gold sales (as they have done previously), or equity in their company in a heavily dilutive offering. Management does not own too much common stock and is likely to dilute through equity to reduce the influence of Simmer and Jack.

The latest financial update from First Uranium was at September 30, 2009. The debentures are CAD$150M and they would be first in line (after a $22M facility) in the event of a default.

The valuation of First Uranium, as its operational woes continue, have to increasingly be looked with respect to what the asset value of operations would capture in the event of a bankruptcy proceeding. As long as the price of gold does not crash, there is value in the operations and debenture holders will likely be able to still make a fair recovery.

Most of the value of the debentures, assuming they are paid, will be in the form of capital gains so keeping these outside the RRSP is likely the best option – at 65 cents on the dollar, your split will be 1 part income to 3 parts capital gains, assuming they mature. Any resulting income will be taxed at around 62% of the income produced from the investment.

With the First Uranium debentures example, my execution in hindsight was horrible – they traded as low as 65 cents today. Assuming an execution at that price, it would have resulted in a current yield of 6.5% plus a capital gain of 19.7% annualized if they paid off at par. You add these two and it’s roughly 26% you are looking at annualized, again, assuming a payoff at par 2.5 years down the line.

It appears that this was some frightened investor (likely a fund) that dumped at the bid and wanted to get out of there – now the bid/ask is 68/72 cents.

Unfortunately, looking back at charts is rather useless in terms of market timing and the only question is whether the position is still worth as much as the existing market value thinks it is. I think the debentures are still the better risk, especially at 26%. There are significant operational issues, but there is so much capital locked up in the project that they’ll have to deliver for somebody – whether it’s the equity owners, or whether it’s the debt holders that may eventually take control of the firm.

The equity is down 23% as I write this; it brings their market capitalization down to $344M, which means that if shareholders wanted to capitalize the debentures, it would cost them 30% of the company instead of 25% the day before.

The debentures, however, remained within the bid-ask spread. Currently they are quoted as 75 cents bid, and 78 cents ask. I tend to trust the debt markets more than the equity markets in terms of true valuations.

It might actually be a good time to look at the equity as a more serious investment candidate if I was a little more risk-taking, but I will be continue to be happy with the debt. The foreign country operational risk is something I find very difficult to quantify and measure beyond a “gut feel” and this is the overriding factor in my decision. I believe something “political” is going on with this news release, but I have no way to judge whether it is a genuine operational aspect, or whether some politician is trying to wring a campaign donation out of the company or its management.

Continuing with my less than diversified strategy, I have placed the sum of the TFSA into the debentures of First Uranium (FIU.DB). The debentures give a 4.25% coupon, maturing in June 2012. They are convertible into equity at $16.42/share, but this is unlikely to be a factor in the valuation. The total issue was for CAD$150M. They went as low as 41 cents in the debenture crash of early 2009.

The price I received was 74.5 cents on January 11, which is a 5.7% current yield and an implied annualized capital gain of 13.0%. Assuming a 1.2% (short term interest rate) reinvestment of coupon, this is a realized return of about 16.8%, which is (barely) above my investment threshold. The previous Harvest Energy investment was above 30% at the time and price I made it, but the spring of 2009 was a very special investment climate where buying anything would give you massive returns. Today, things are much different and you really have to pull out a high powered microscope since anything with a high return has a lot of baggage you have to sift through. First Uranium is no exception.

First Uranium is a Toronto corporation, but with operations primarily in a South African mine with uranium and gold reserves. The name is misleading in that the bulk (~85%) of the company’s revenues are expected to be from gold sales. The foreign nature of their operations introduces a risk, but South African mining operations have been able to operate sustainably in other circumstances. Although I have my geopolitical concerns about South Africa in the medium term (10 years out), I have discounted such concerns in the 2.4 year timeframe of this present investment. It is also likely that coming closer to maturity that the investment may be liquidated sooner than later, or when the yield shrinks to my sell target (around 95 cents presently).

Most of the operations have been financed by equity – the last financing was done in June 1, 2009 at CAD$7/share. Today the common shares are at $2.66/share with 167M shares outstanding – a market capitalization of about $444M. Some portion of the gold reserves have been hedged off at below-market rates for up-front financing. In addition, the mining operations are still at the end of the initial capital injection phase before they can start producing sustainable positive cash flow, which is expected in the March 2010 to March 2011 fiscal year.

In terms of management and ownership risk, this is an interesting story. Simmer and Jack, another (larger than junior) South African mining company, owns 37% of the company as of September 2009. There has been a recent management and board struggle dealing with the Simmer and Jack management, who have moved over to First Uranium after they were kicked out of the Simmer and Jack board. The kicked-out CEO and Chairman, Gordon Miller, owns 1.66% of Simmer and Jack and roughly 0.1% of First Uranium. Although this struggle has an indirect impact on the value of the debentures (mainly that I am concerned about being paid off rather than owning the company), it is worthy to note that some deal must have been cut with the existing Simmer and Jack board such that he be allowed to run First Uranium since the 37% minority ownership of Simmer and Jack would likely be able to prevent him from doing so if they did so voluntarily.

There is a complex relationship here with respect to the debentures – Simmer and Jack is highly incentivized to make sure the debenture holders don’t take over the company so they can realize value of their equity stake. Gordon Miller likely wants to make a ton of money out of the deal and try to get some sort of revenge against Simmer and Jack and try to wrestle control away from the company. Either way, the debentures will have to be paid and it seems likely at this point it will be done by a simple equity swap – the current market capitalization is sufficient to pay off the debentures with about 25% dilution to existing shareholders.

On the balance sheet, First Uranium has US$60M in cash at the end of September and they have poured in about US$563M into their mining operations. Their only significant liabilities are a $22M loan from Simmer and Jack, and the CAD$150 of debentures. The income side is ugly when one looks back, but the corporation should start to generate cash through mining operations in the upcoming year and slow down capital expenditures – and perhaps even pay some common share dividends sometime in the second half of 2011 if things really go well and the refinancing of the debentures are in the bag.

The risks otherwise are typical of a mining firm – commodity pricing (gold and uranium) and realization of “proven” reserves into actual output. There is also some currency risk – they report in US dollars and their equity and debentures are denominated in Canadian dollars. Reading the technical report on the main mine and getting a feel for the operation is also essential (and rather dry) reading.

Although this investment is not the most ideal, I do believe that the company will be able to pay off the debentures, whether by refinancing, equitizing the debt or generating cash flow before the June 2012 maturity. There is enough of a margin of error to feel comfortable, but not “home free”, which is why the market value is trading significantly below at present. Assuming their story turns out, the equity side is also a compelling story, but it contains a high degree of risk that I am not willing to take – especially concerning the future of gold prices. That said, I expect these debentures will be made whole and will be a positive decision in terms of my risk-reward profile and being able to avoid income tax and capital gains tax by virtue of it being in the TFSA.

I also prefer short duration plays simply because when interest rates rise again, cash might be a more attractive option.

(Subsequent note: Operational risks include adverse news releases after hitting the “publish” button, although I do not think this one is too severe to my underlying investment thesis.)