Liquidity and Capital Resources
At December 31, 2008, Northgate had working capital of $21,947,000 compared with working capital of $235,739,000 at December 31, 2007. The decrease in working capital was primarily the result of the acquisition of Perseverance. Northgate purchased all of the outstanding ordinary shares, warrants, options and convertible securities of Perseverance for cash. Cash and cash equivalents at December 31, 2008 amounted to $62,419,000 compared with $266,045,000 at December 31, 2007.
Northgate's investment management policy permits short-term excess cash to be invested in R1/P1/A1 rated investments including money market funds, direct obligation commercial paper, bankers' acceptances and other highly rated short-term investment instruments, which are presented as cash and cash equivalents. In view of the current worldwide financial crisis, all cash and cash equivalents are currently being held in cash with chartered banks in Canada and major banks in Australia.
In 2008, Northgate generated cash flow from operations of $64,988,000 compared to $125,285,000 in 2007. Cash flow from operations was negatively impacted by lower gold production at the Kemess and Fosterville mines and the dramatic decline in copper prices. Based on forecasted gold and copper prices and foreign exchange rates used in the current production forecasts, Northgate believes that its working capital at December 31, 2008, together with future cash flow from operations, is sufficient to meet Northgate's normal operating requirements for the next year. There are no material restrictions on the ability of the Corporation's subsidiaries to transfer funds to the Corporation.
On June 6, 2008, Northgate filed a short form universal base shelf prospectus (the "Prospectus") with the Securities Commissions in each of the provinces and territories of Canada and a corresponding registration statement was filed with the SEC. The Prospectus will facilitate offerings of Northgate's debt securities, common shares, warrants, share purchase contracts and share purchase or equity units or any combination thereof up to an aggregate offering size of Cdn$250,000,000 over a 25-month period.
Financial Instruments: Northgate has exposure to credit risk, liquidity risk and market risk from its use of financial instruments.
Credit Risk – Credit risk is the risk of potential loss to Northgate if a customer or counterparty to a financial instrument fails to meet its contractual obligations. Northgate is exposed to credit risk from its receivables and investment securities. This risk may also arise on the copper forward contracts to which Northgate is a party. In general, Northgate manages its credit exposure with respect to operational matters by transacting only with reputable, highly-rated counterparties. Northgate monitors the financial condition of its customers and counterparties to contracts.
Gold doré produced in Australia is sold exclusively to AGR Matthey, a reputable precious metal refiner. Northgate believes there are other buyers in the marketplace that would buy such production under approximately the same financial terms. Concentrate produced at Kemess is sold under a long-term contract to Xstrata, a wholly-owned subsidiary of the publicly traded international mining company, Xstrata plc. Kemess gold-copper concentrate is of a quality that is readily saleable to a number of smelters under current market conditions. In the event that Xstrata is unable to purchase the Kemess concentrate, it could be sold to other smelters once appropriate logistical arrangements are put in place.
Northgate may also be exposed to credit risk on its copper forward contracts to the extent that the counterparty, Mitsui Bussan Commodities Ltd. ("Mitsui"), a reputable international commodities trading group, fails to meet its contractual obligations. Northgate has mitigated this risk by obtaining a parental guarantee from Mitsui's parent company, Mitsui and Co., Ltd. of Japan. At December 31, 2008, there is credit risk as the forward contracts have an unrealized gain, which has been recognized as an asset.
Northgate limits its exposure to credit risk on investments by investing only in securities rated R1/P1/A1 for shortterm investments and AAA for longer-term securities by credit rating agencies such as S&P and Moody's. Management continuously monitors the fair value of its investments, including ARS (refer to ARS discussion below) to determine potential credit exposures. Any credit risk exposure on cash and cash equivalents is considered negligible as Northgate places deposits only with major established banks in Canada and Australia.
The carrying amount of financial assets represents the maximum credit exposure. As at December 31, 2008, Northgate's gross credit exposure is as follows:
Liquidity Risk – Liquidity risk is the risk that Northgate will not be able to meet its financial obligations as they fall due. Northgate manages this risk such that it will have the ability to discharge its liabilities when due, both under normal and stressed conditions, without incurring significant losses or risking damage to Northgate's reputation. Northgate uses detailed cash forecasts to ensure cash is available to discharge its obligations when they come due. Cash needed for this purpose is invested in highly liquid investments.
Market Risk – Market risk is the risk that changes in market prices, including: i) commodity prices; ii) foreign exchange rates; and, iii) interest rates, which will affect Northgate's income or the value of its financial instruments. Northgate manages this risk such that it controls this exposure within acceptable parameters while optimizing the return on risk. Northgate's Board of Directors has established a Hedging Committee, which assists management in the identification and analysis of price risks and potential strategies to mitigate these risks.
Commodity Price Risk – Northgate is exposed to commodity price risk through the price of gold and copper and also through various input prices such as fuel, steel and electricity.
Northgate reviews major input prices on a regular basis and may enter into long-term contracts to mitigate price volatility. Northgate also monitors the price of the commodities it produces and considers the risk exposure to fluctuating prices. In managing that risk, Northgate is cognizant that investors generally seek exposure to the underlying commodities, particularly gold, through their investment. The value of Northgate's copper forward sales contracts are exposed to the movement in the copper price. A change of $0.05 per pound in the forward price of copper would have changed the fair value of the outstanding contracts as at December 31, 2008, and consequently earnings before income taxes, by $1,703,000.
All of Northgate's future gold production is unhedged and is fully exposed to future price movements. Gold and copper sales agreements include provisions where final prices are determined by quoted market prices in a period subsequent to the date of sale. Revenue and the related receivables are based on forward prices for the expected date of final settlement. These financial assets are therefore exposed to movements in the commodity price. A change of $0.05 per pound in the price of copper would have changed the related payable as at December 31, 2008 and earnings before income taxes by $485,000 for the year ended December 31, 2008. A $10 per ounce change in the price of gold would have changed the related payable as at December 31, 2008 and earnings before income taxes by $268,000 for the year ended December 31, 2008.
Foreign Exchange Rate Risk – Northgate is exposed to foreign exchange risk on its financial assets and liabilities denominated in Canadian dollars. Movements in the Canadian dollar relative to the US dollar may have a significant effect on future earnings. A 10% change of the US dollar against the Canadian dollar as at December 31, 2008 would have changed earnings before income taxes by $2,684,000 for the year ended December 31, 2008. This analysis assumes that all other variables, in particular interest rates, remain constant.
Northgate is also exposed to the effect of movements in Australian dollar relative to the US dollar, which may also have a significant effect on Northgate's net investment in its Australian operations.
Interest Rate Risk – Northgate is exposed to interest rate risk on its Short-Term Loan (refer to the discussion on Short-Term Loan under "Investments" below) and its capital leases. The Short-Term Loan bears interest at LIBOR plus 100 basis points. The capital leases bear interest at a fixed rate. A change of 50 basis points in the LIBOR rate for the year ended December 31, 2008 would have changed earnings before income taxes by $226,000 for the year ended December 31, 2008. This assumes all other variables, in particular foreign currency rates, remain constant.
Capital Lease Financing: Northgate invested significantly in plant and equipment at the Fosterville and Stawell mines during 2008. Total capital lease financing at Fosterville and Stawell for the year ended December 31, 2008 was $14,983,000 with terms ranging from two to three years. At December 31, 2008, total remaining capital lease obligations were $10,744,000, of which $4,533,000 will be paid in the upcoming year.
Investments: Northgate continues to hold certain ARS investments. The par value of the ARS investments is $72,600,000. All of the ARS currently held by Northgate were rated "AAA" at the time of purchase.
ARS are floating rate securities marketed by financial institutions with auction reset dates at 7, 28, or 35 day intervals to provide short-term liquidity. Beginning in August 2007, auctions at which these securities were to be re-sold began to fail, and as of the date hereof, attempts to conduct auctions have generally ceased. Currently, these securities cannot be readily converted to cash for use by Northgate to make capital investments or for other business purposes, although the underlying payment and other obligations of the original issuers of these securities remain intact, and these issuers or their guarantors continue to make regular interest payments to Northgate. All ARS currently held by Northgate were purchased on its behalf by Lehman Brothers Inc. ("Lehman"), acting in its capacity as broker agent of Northgate using the discretion conferred on it. Based on representations from Lehman, Northgate had believed that the securities conformed to Northgate's internal investment management policy. Subsequent to the ARS investments of Northgate becoming illiquid, management of the Corporation received from Lehman a loan collateralized by the ARS held in Northgate's investment account managed by Lehman, pursuant to a Client Agreement between Lehman and Northgate dated October 18, 2007 (the "Short-Term Loan").
Based on investigation conducted after the securities in question became illiquid, Northgate concluded that a number of representations from Lehman had been incorrect, and that Lehman had mishandled Northgate's account. On July 3, 2008, Northgate filed a Statement of Claim (the "FINRA Claim") with the Financial Industry Regulatory Authority ("FINRA") in New York, a self-regulatory organization with jurisdiction over customer-broker disputes, regarding alleged mishandling of Northgate's investment account (including the unauthorized purchase of ARS) by Lehman and several of its employees. Northgate has alleged that Lehman's inappropriate conduct constituted, among other things, breach of contract, breach of fiduciary duty, fraudulent misrepresentation and abuse of discretionary authority. Among the relief sought by Northgate in the FINRA Claim is a ruling of FINRA relieving Northgate of its obligation to repay the Short-Term Loan as partial compensation for losses suffered as a result of the misconduct of Lehman, effectively ‘setting-off' the debt owing by Northgate to Lehman against the damages claimed by Northgate from Lehman and its employees.
On September 15, 2008, Lehman Brothers Holdings Inc. ("Lehman Holdings"), the parent corporation of Lehman, filed for Chapter 11 bankruptcy protection in the United States, and shortly thereafter Lehman commenced liquidation proceedings. On September 17, 2008, Barclays Capital ("Barclays") announced plans to buy certain assets from Lehman Holdings and its subsidiaries pursuant to an Asset Purchase Agreement with Lehman Holdings, Lehman and other Lehman affiliates (the "Purchase Agreement"). While Barclays has assumed from Lehman the management of the account in which the ARS of Northgate are held, based on available information, Northgate believes that Barclays did not assume the Short-Term Loan in the manner prescribed by the courtapproved Purchase Agreement.
From a legal perspective, the FINRA Claim survives the bankruptcy of Lehman such that Northgate now may claim against the bankrupt Lehman estate. In order to preserve its right to claim against the Lehman estate at the appropriate stage of the bankruptcy administrative process, Northgate has arranged for the filing of the necessary proof of claim in bankruptcy with the appropriate authorities. Northgate continues to work with its US legal counsel to collect and analyze additional information regarding Lehman, including with respect to the residual value in the Lehman estate, applicable insurance coverage and the aggregate value of competing claims against the Lehman estate so as to be able to make an informed determination regarding a prudent course of action going forward.
The estimated fair value of Northgate's ARS holdings at December 31, 2008 was $39,291,000, which reflects a $30,106,000 decline from the estimated fair value of $69,397,000 at December 31, 2007. Following the bankruptcy of Lehman, Northgate retained an independent valuator (the "Valuator") to assess the fair value of its ARS investments. The Valuator considered several factors in making such assessment, including the probability of future defaults by the respective issuers, the potential impact of recent events in the global financial markets, the relative seniority of each security within the capital structure of the issuer, the credit position of financial guarantors and the value of investments and reserves held by the issuers. While Northgate continues to earn interest on all its ARS investments, the estimated fair value of those issued by derivative product companies (companies involved in the issuance of credit default swaps) has fallen significantly below par value. Accordingly, for its investments in these particular securities, Northgate has recognized an other than temporary impairment of $20,310,000 into earnings for the year ended December 31, 2008. The conclusion for an other than temporary impairment is based on a variety of factors, including the very substantial decline in the estimated fair value of individual investments over an extended period, recent downgrades in issuer credit ratings and continuing adversity in the credit and capital markets.
Based on information currently available, Northgate believes that the decline in estimated fair value for the remainder of its ARS investments (issued by Regulation XXX Insurance companies) is temporary. In determining that the loss in value is temporary, management considered the fact that these particular securities have a lower probability of future default, continue to make interest payments at present, are insured by monoline insurance companies and continue to maintain a credit rating above investment grade. Management also considered the senior rank of its holdings in the capital structures of the respective issuers and the fiduciary obligation of the major insurance companies who own the Regulation XXX entities as factors that improve the likelihood that these investments might eventually return to par value. While the foregoing valuation judgments are based on current information available and are intended to conform to applicable accounting principles, it is possible that the actual damage to Northgate would be considered to be equal to the par value of the securities under applicable US laws.
Short-Term Loan: Northgate received from Lehman the Short-Term Loan collateralized by Northgate's ARS investments subsequent to such ARS investments becoming illiquid (refer to previous discussion on the Short- Term Loan under "Investments", above).
As of December 31, 2008, the principal outstanding on the Short-Term Loan was $43,096,000. Northgate continues to treat the Short-Term Loan as an obligation and has continued to classify it as a current liability based on its original maturity date.
Taxes: In March 2005, Northgate received correspondence from the Canada Revenue Agency ("CRA") indicating that the CRA's initial estimate of Northgate's 95% royalty interest on the Kemess property (which had been converted to an equity interest in December 2000) was significantly lower than Northgate's initial valuation. The Corporation filed its response with the CRA in June 2005. The CRA remained silent on the matter until July 2007. Northgate continued discussions with the CRA and its independent advisor, Natural Resources Canada, and provided them with an independent valuation, which supported Northgate's position. In early 2009, Northgate received notice from the CRA indicating that it had accepted Northgate's initial valuation and that the matter was closed.
Acquisition of Perseverance: On February 18, 2008, Northgate completed its acquisition of Perseverance with a total of A$230,552,000 ($210,831,000) being paid to Perseverance securityholders. The financial results of Perseverance have been included in Northgate's consolidated financial statements from February 19, 2008. In connection with the acquisition of Perseverance, Northgate was required to pledge a cash amount of A$109,400,000 in the form of a stand-by letter of credit ("SBLC") in favour of a major Australian financial institution.
A portion of the SBLC was released upon Northgate satisfying a portion of the debt obligations it assumed in connection with the Perseverance acquisition. The funds remaining in the SBLC at December 31, 2007 were used to settle Perseverance's gold forward contracts for A$49,317,000 ($45,550,000) and to pledge certain performance guarantees in Australia for A$8,020,000 ($7,434,000). The SBLC was fully extinguished in the second quarter of 2008.