Breakwater Resources’ Warrant: Too Good To Be True?

I was about to sing the praises of Breakwater Resources’ new warrant (BWR.wt.A) that was listed on the TSX this past April 9^th, 2009 and then I looked at the company’s prospectus - and now I am not so sure. Breakwater mines zinc (65%), copper (11%) and equal parts gold, silver and lead from mines in North, Central and South America. I’d be curious to know what you think after you digest the pros and cons of their warrant offering outlined below.

Warrants, as you may well know, give the holder the right, but not the obligation, to purchase the common shares of the company at a specific price within a specific time period after which, if not exercised, they expire worthless.

What caught my eye when I first became aware of Breakwater Resources’ warrant was that it would not expire until April 9th, 2014 (i.e. a 5-year term) and that it was offered (and was still trading as of April 17^th, ‘09) at only 41.7% of the exercise price. Now that was most impressive!

Impressive? Absolutely, especially when you realize that only 4% of the 100 or so natural resource companies with warrants have a term of 5 years or more (only 10% have an expiry date that is longer than 4 years). It is imperative, given the current fiscal and economic environment, that a considerable amount of time be available for a company to benefit from an improved credit environment, a higher stock market, an increase in the price of zinc, copper, gold bullion, silver and lead and renewed strength in the Canadian dollar to ensure that a company has a good chance of a profitable future and, as such, a much higher stock and warrant price. Such is the case with the Breakwater Resource warrant.

Secondly, it is very important that a warrant is priced such that it has a high probability of achieving its exercise price. An analysis of the 10 warrants with a minimum of 4 years duration reveals that the average warrant must appreciate by 1004% (the ten range from 313% to 4067%) within the 4+ year period before the holder of the warrant can exercise the right to purchase the stock of the company. That compares to just a 71.4% appreciation requirement for the Breakwater Resources warrant. That’s 71.4% vs. 1004%!! Now that is impressive - very impressive! To be fair, however, I must acknowledge that a 1004% increase in the price of a penny warrant is not that exceptional, even in a matter of months, when all the factors are going in its favor. (All of the above information was sourced from an extensive and detailed natural resource warrant data base that I subscribe to at www.preciousmetalswarrants.com.)

On the surface everything I examined appeared to indicate that investing in Breakwater Resources’ warrant was going to be a ‘grand slam’ if ever there was one. However, when something seems almost too good to be true it deserves a closer look and I did just that. The web site mentioned above provided the web site of the company in question which I examined thoroughly and provided a link to www.sedar.com where I accessed the company’s prospectus for the warrant offering. There, clearly spelled out under ‘Risk Factors’, were the reasons why this warrant had been priced so enticingly (and I quote):

“The acquisition of the Units involves a high degree of risk and should be considered speculative. You should carefully consider the following risk factors … before purchasing any of the Units. If any event arising from these risks occurs, our business, prospects, financial condition, results of operations or cash flows could be adversely affected, the trading price of our Common Shares and Warrants could decline and all or part of any investment may be lost. Additional risks and uncertainties not currently known to us, or that are currently deemed immaterial, may also materially and adversely affect our business operations.”

The specific risk factors (15) related to a) Breakwater Resources’ financial condition, b) its’ ability to renew existing concentrate contracts or secure new contracts, c) its’ counter-party credit risk in its’ concentrate sales contracts, d) the fluctuation in the price of the metals it mines, e) the impact the current global economic conditions might have on its’ financial condition, results of operations, working capital, ability to borrow, and share price, f) its’ potential need to raise more capital thereby diluting share value, g) the possible need to write down the carrying value of its’ properties and fixed assets if commodity prices do not improve, h) the funding of any defined benefit pension plan shortfalls that might occur, i) its’ ability to retain key personnel and management for the success of its’ operations and activities, j) the extent of obstacles, if any, to its’ mining operations via legal action or worker/populace disruption, k) the degree of volatility in the price of the shares/warrants, l) the extent of liquidity of the warrants on the TSX, m) the extent to which the underwriters might exercise their right to purchase additional warrants until May 9^th, 2009 which would dilute the ownership interest of other shareholders by as much as 15.3%, n) the possibility of unexpected expenses to comply with unforeseen regulatory expenses by the countries in which Breakwater Resources operates and o) the extent of liabilities associated with pollution to the environment and the disposal of waste products occurring as a result of mineral exploration and production.

Of all the risk factors mentioned above the one that concerns me the most is the role that the underwriters might have on such an investment. If they don’t exercise their option to purchase the warrants to the maximum quantity allowed it would indicate, in my opinion, that despite the favorable pricing of the warrants, that the long-term prospects of the company were not likely to be sufficiently favorable to make such an investment. On the other hand, if the underwriters were to buy up their maximum allowable allotment it would depreciate the value of the warrants by 15%. As such, I have decided to wait for a month to see how things unfold. If the underwriters pass on maximizing the purchase of their allotment of warrants I will too. If they do I will consider buying a sizable quantity at the resultant depreciated price.

Perhaps I’m crazy not to take advantage now of the Breakwater warrant’s very attractive price relative to the exercise price and its long-term duration but to do so might prove to be a ‘bunt’ as opposed to the ‘grand slam’ I was looking for. I’ll get back to you later with a report as to what unfolded and give you further insights into the “wonderful world of warrants”.

By the way, what would you do? I’d like to hear your comments. (For the record I own no Breakwater Resource securities nor have a financial interest in preciousmetalswarrants.com.)

Subscribe by RSS Subscribe by Email

Comment by spharaon

2009-04-23 23:09:31

Thank you for your review and analysis. I believe that despite all the factors mentioned, this would still be a great investment. I would like to list the reasons behind my conclusion:

1. Signs of an improving global economy.
2. Increase of demand on zinc, copper, and other minerals.
3. The recent IPO will provide Breakwater Resources with the cash it needs during these difficult times to avoid bankruptcy.

If we take all the above factors into consideration, expectations are that the financial reports for the second quarter will be very good and will drive the stock and warrants price higher. On a long term investment, I see this as a great opportunity especially if you buy at the current low prices, which will hopefully start going up with the markets and once financial situation has improved.

Reply to this comment