Value Investors Club / COBALT 27 CAPITAL CORP (KBLT.)

Description

I will try to keep this simple. I wrote this stock up in 2017 and am writing it up again because the story

has significantly changed and has become very compelling. It is a small cap name in the mining space

that trades in Canada. I estimate it trades at a discount to NAV of at least 20%. Based on that

description, it sounds like a great short the way things have been going lately. I am going to try to

convince you otherwise.

What was KBLT then: at the time of my original writeup KBLT was for all intents and purposes a

company whose only real asset was physical holdings of cobalt, (similar to Uranium Participation in the

uranium space, or NICK LN, the nickel ETF written up last year by Virtualodin). The original writeup thesis

was that cobalt prices would go up due to its use as a cathode material in lithium ion batteries primarily

because of the increased battery need due to the start of mainstream production of electric vehicles.

Additionally, as it was the only effective way to play cobalt absent buying and storing physical material, I

had hoped it would trade at a premium to its NAV due to scarcity value. At the time of the writeup, the

spot market for physical cobalt was around $29 per pound. It subsequently went to the mid $40’s. KBLT

did two stock offerings, one to buy some more physical cobalt (which was admittedly accretive), and

one to buy a stream of cobalt and nickel from a Papua New Guinea mine named Ramu by way of buying

a stream from one of its minority shareholders, Highlands Pacific Ltd. Then things started to unravel.

First, they issued a huge number of shares to buy a stream from a mine called Voisey’s Bay owned by

Vale, which isn’t scheduled to be in production until 2021 (cost $300 million, with no near-term cash

flow). The market could not absorb this amount of stock, and in fact the underwriters took a bath on

the offering. Second, the price of cobalt fell from the mid 40’s to a low of 13 and change (possible

reasons: a Chinese purchaser reneging on its purchase obligation involving thousands of tons of

material, a massive supply response from artisanal miners in the DRC, and a lack of serious interest from

car companies in purchasing cobalt at anything close to current market prices).

What is KBLT now: it is a company that owns three major assets (and a bunch of minor streams and

royalties which I have chosen to value at $0) : 1) its original stockpile of physical cobalt (all of which is

insured by the way, and in fact there was a robbery of a small amount of its cobalt, for which KBLT

recovered full value from its insurance company, so I take some comfort in that); 2) a direct minority

interest in a mine called Ramu in Papua New Guinea which is currently producing cobalt and nickel.

They acquired this by buying out a minority owner name Highlands Pacific Ltd. (“HIG”) (deal closed

Friday); 3) a cobalt steam from a mine in Labrador Canada called Voisey’s Bay owned and operated by

Vale.

Ok, so what? Why is this of any interest? Three reasons: 1) a very conservative valuation gets you to an

NAV of C$5.10, leaving the stock trading at a slightly over a 20% discount); 2) I believe strongly that

cobalt has bottomed and will move higher, perhaps appreciatively higher, increasing NAV (no view on

nickel, but seventy percent of near term cash flow is coming from nickel, so if you do have a view of

where the price is going, that should give you more information on where NAV is likely to go to); 3)

Management has promised, and I believe them given how insistent they have been on this point and

how angry the shareholder base is, that they will use the cash flow from Ramu and later from Voisey’s

Bay to return cash to shareholders by way of a dividend or a share buyback, either way actively

attempting to reduce the discount to NAV.

What do I think the assets are worth?

I believe at the current price of $17.5 per pound of cobalt (this is the current spot price), the stockpile of

cobalt is worth C$ 146 or $1.72 per share (6,405,964 pounds at $17.5 per pound*1.30 Canadian spot

exchange). You could argue that this should be discounted for time since they are not selling it for cash

immediately. That said, although management is committed to return free cash flow to shareholders,

they are not above using the physical cobalt itself to purchase a productive asset (they had a deal to buy

a lithium stream in return for 200,000 pounds of cobalt (this deal never closed, and frankly I have no

idea why the lithium miner wanted cobalt instead of cash).

The Ramu transaction was restructured from a stream from HIG to an outright purchase because of the

move lower in cobalt and nickel since the time of the stream negotiation. The transaction closed on

Friday. KBLT currently owns an 8.56% interest in Ramu, for which it paid $65 million for all the shares of

HIG, plus a contingent payment of $6 million if nickel trades at or above $13,220/ton for 5 consecutive

days prior to December 31, 2019. I assume they pay the CVR. There is also an obligation at the HIG level

of $115 million for mine expansion costs. KBLT can pay this either out of cash flow from Ramu, or by

drawing down its LOC. Once this is done, they bring their interest in Ramu from 8.56% to 11.3%. I

assume for purposes of my model, that they pay this out from the LOC very quickly. The composition

breakout of the free cash flow coming from Ramu is 70% nickle and 30% cobalt. I use a mine life of 21

years with 3300 Mt of cobalt and 36000 MT of nickel (using $17.50 per pound of cobalt and $5 per

pound of nickel). I assume that after smelter and other fees, Ramu collects $324 million in nickel

revenue and $99 million in cobalt revenue. Total revenue attributable to KBLT is about $48 million,

minus about $26 million in opex and another $7 million due to outstanding royalties at the Ramu level,

bringing their share to $13.5 million in FCF. Using no terminal value and a discount rate of 9% (I bumped

this number up a bit since the operating partner is a Chinese company named Metallurgical Corporation

of China (nothing particularly wrong with them, just general risk of doing business with China), I get an

NAV of this asset of approximately $125 million. At a currency exchange rate of 1.3, that gets me to

C$162.5, or C$1.90 per share. I use a 30% tax rate kicking in at 2025, reducing NAV by about C$.37 to

C$1.53.

The Voisey’s Bay stream will not begin production until 2021. It is located in Canada. It is expected to

have a mine life until 2034. It will produce 5.88 million pounds of Cobalt, of which 1.9 million pounds is

attributable to KBLT’s stream. The stream requires KBLT to pay an average price of 20% of cobalt at the

time of delivery. I calculate the stream is worth $24 million (I estimate no taxes since the $300 million

they paid will be amortized.) Using a 5% discount rate, 12 year mine life, and no terminal value, I get

$212 (C$275 or C$3.22 per share). I have a few sanity checks on this asset: First, when they paid $300

million for their stream (admittedly based on much higher cobalt prices), Wheaton Precious Metals also

came in and bought a stream for $390 million, based on the same valuation (someone else with a

decent track record blessed the valuation). Second, Vale has guaranteed the $300 million investment,

agreeing to return it if they fail to produce a mine up to specs.

Total NAV =C $1.72+C$1.53+C$3.22 = C$6.37

What about expenses: Management pays itself, they have insurance costs, they hire advisers, attend

conference etc. I think all in they spend somewhere in the neighborhood of $5 million. If I assume,

they will spend this much every year in perpetuity, and I discount it at a 6% rate, I get a reduction of

C$1.27 per share, which gets me to a C$5.1 NAV, which is how I calculate a 20%+ discount to current

NAV.

I have discussed management returning money to shareholders. I have no view of nickel prices. The

remaining reason to buy is based on my view that cobalt has bottomed.

For the first time in over a year, spot cobalt prices have risen (it was flat or down, mostly down, every

single week). The spot market is now $17.5, up over the last few weeks from $13 and change.

Additionally, my understanding is there are almost no spot sellers. While spot may be quoted at $17.5,

future delivery, which was trading at a discount to spot prices, is now trading at a significant premium

($20+). Moreover, my understanding is that the car companies have finally become serious about their

cobalt supply (they did not participate in the previous run up. In hindsight, I attribute that to

speculation). There is no DRC artisanal supply at these prices, nor several dollars higher. My

understanding is that the artisanal supply dried up when cobalt spot reached $20, indicating that all the

low hanging fruit in the DRC has been picked (it wasn’t worth it for villagers to mine the tougher stuff

given that they were being paid a fraction of fair market value). For the entire time that cobalt dropped,

there was a constant positive narrative of how the car companies would need to establish supply, of

there was a major mine closed in the DRC due to uranium contamination, and other lesser bullish

points. None of it mattered. The market was in over supply so the price dropped. Recently it has

spiked $4/lb., I have been told mid-teens prices are now about the marginal cost of production, and the

artisanal miners (villagers that would dig holes), have been out of the picture for months. I believe this

is real, so I believe the price has bottomed.

If you read analyst reports on KBLT, they all have much higher NAVs, some of which are due to less

conservative discount rates on the mining properties, but most of which assume higher prices of cobalt

going forward. As long as you assume there will be significant auto demand, I don’t see how prices

don’t go higher. I originally thought it was a buy at $29, and was right for a while until I became dead

wrong, so I am uncomfortable with prices targets. I just feel prices will go up, and combined with a very

conservative NAV calculation and the fact that the company will be returning cash flow to shareholders,

I don’t see a realistic possibility of a significant permanent capital loss.

Risks: 1) My model missed something big. Don’t know what it could be, but I suppose that is always a

risk. 2) My discount numbers are too low. 3) No one cares that it has cash flow or is paying a dividend

or is buying back stock. It gets treated just like Uranium Participation did when it was out of favor and

consistently trades at a discount to NAV, or it simply trades like a typical junior Canadian mining

company. 4) Cobalt prices fall or at least fail to rise. The main reason that happens at this point is that

EV’s fail to take off. I am not really too worried about chemistry advances requiring less cobalt in lithium

ion batteries (I actually think this might be something working in the stock’s favor. I think the fear of this

is already in the market, but from what I have gathered, it isn’t going to happen anytime soon (battery

manufacturers are more pessimistic about advances in chemistry then they were previously). Also,

exposure to nickel mitigates this risk. 5) Management does something really stupid (I am not too

worried about this one because I think they learned their lesson). Voisey’s Bay was a trophy asset and

they paid up for it even though no immediate cash flow. I don’t see that happening again given the

terrible stock price reaction and that fact that they are committed to returning money shareholders, not

paying it out. I do think the members of management that negotiate the streaming deals are highly

competent, so I am not worried that if they wanted to liquidate some of their cobalt stockpile and do a

small deal, that it would be bad for shareholders.

What could go right that I haven’t covered: 1) KBLT could start to be lumped in with other streaming

companies and trade at a premium to NAV. I think if this happens it wouldn’t be rational. My view is

that the typical streaming company that executes well deserves a premium because they have a target

rich environment and are able to allocate capital at attractive rates of return. At this point in its life

cycle, KBLT doesn’t have significant capital to allocate, and has a poor target environment since there

are less opportunities to stream metals involved in “green energy”, which they have self-limited to, then

precious or other metal targets that streaming companies are looking at. 2) around 60% of cobalt

comes out of the DRC. If there is a supply disruption (it is one of the world’s least stable countries)

cobalt could soar. Also, it is notorious for “blood cobaltl” (artisanal miners in the DRC are local villagers

digging holes and getting cancer). Many cobalt end users have said they don’t use “blood cobalt”, but it

is tough to track your supply chain, since it all ends up in China for processing, and I am not impressed

with efforts to date. That was why Voisey’s Bay was seen as a crown jewel. If major end users became

serious about not using “blood cobalt”, our physical supply (none sourced from DRC) and our two non-

DRC mines could command a premium, either as saleable material or if someone wanted to solve their

supply chain issue and simply acquire KBLT. I assume neither of these things happen for purposes of this

writeup.

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise do not hold a material investment in the issuer's securities.

I hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Return of capital. Higher cobalt prices.

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			2019	2020
Price:	4.00	EPS	NA (see below)	NA
Shares Out. (in M):	85	P/E	NA	NA
Market Cap (in $M):	264	P/FCF	NA	NA
Net Debt (in $M):	115	EBIT	0	0
TEV (in $M):	0	TEV/EBIT	NA	NA