Description

This is an unconventional recommendation.  Ten years ago I spent a week in Kazakhstan doing investing due diligence and concluded I should never invest in a Kaz business.  Mining companies are dead-last on Buffett disciples' lists of what sectors to own; they are literally commodity businesses, huge capital hogs, and often have terrible management teams (liars standing next to a hole in the ground, shoveling in as many dollars as you'll give them).  Most of my recent recommendeations are for stocks you could buy at any time and then probably hold forever.  So of course I now offer you a time-sensitive, shorter-term recommendation to buy a uranium miner in Kazakhstan during an all-out financial and natural resources war between Kazakhstan's big brother, Russia, and the entire developed world.  You should probably do so only if you are already a uranium-head or become one, and you should buy KAP as part of a uranium basket.

KAZ reported its full-year 2021 earnings this morning, and the earnings call just ended.  This recommendation is therefore "fresh" and will work best if you buy before a successful resolution of the Russia/Ukraine crisis.

Here is the thesis summary:

• Uranium and uranium miners are probably at the start of a massive up-cycle, after a decade of industry devastation.  All these stocks could return multiples of their current prices.
• On its business fundamentals, KAP is the world's best and economically-safest uranium mining asset.
• KAP's ordinary-times frontier-market risks look acceptable given the stock price.
• KAP's Ukraine/Russia risks appear more than priced in.
• KAP's idiosynchratic risks vanish when placed in a basket of uranium stocks.  If KAP is hurt, the rest of your basket should do fabulously as a direct result of KAP's problems.

URANIUM IS AT THE START OF A MASSIVE UP-CYCLE

The uranium thesis has been well publicized over the last eight months.  For more detail, start with azia1621's September 2021 VIC write-up of the Sprott Physical Uranium Trust (ticker U.UN but usually called by its acronym SPUT).  Kuppy has been pounding the table for it on all his usual platforms.  I can probably add value not with the details, but with a more rigorous thesis structuring than I normally see:

• DEMAND: Nuclear energy, i.e. demand for uranium, is at the start of a massive 15-year renaissance.
  • It has been obvious to "some of us" for "some time" that nuclear should be used much more to meet its carbon-reduction goals.
    • Renewables cannot get the job done.  Solar and wind are intermittent, i.e. they cannot provide continuous "base load" electricity.  They also cannot be deployed at sufficient scale, sufficiently close to the demand sources.  Hydro is not a growth source.  Etc.
    • Nuclear today is much safer than generally appreciated.
      • Nuclear has probably killed less people in its entire 70-year history than coal kills every few months.
      • The Chernobyl accident required a monstrously bad reactor design paired with monstrously bad operating decisions.  (The HBO documentary's detailing of these mistakes was heartbreaking.)  The industry has worked extremely hard to make sure nothing like that could happen again.
      • Fukushima's design flaw has been rectified at every similar "Mark IV" plant.
      • Today you can literally fly a jetliner into almost any nuclear plant and it will still not leak much radiation.
      • And these are the old plants, most of them 50-year-old designs.  Every new generation of plants is safer yet.  The new modular nuclear reactor (mini-nuke) designs, such as those funded by Bill Gates, are claimed by their owners to make melt-down literally impossible.  Smaller plant size also means smaller absolute risk from any one reactor.
  • The world's acceptance of the pro-nuclear argument started growing significantly in 2021 and has accelerated massively in the last three weeks.
    • Japan decommissioned all its plants after Fukushima in 2011.  Germany and many other countries accelerated their decommissioning. As of a year ago, the default stance of most Western countries was to  decommission their remaining existing plants and never build another one.  (Meanwhile China had already announced a massive program to build new plants, and some other countries have been building as well.)
    • Last year that stance began visibly changing.  Countries began announcing that existing plants would be upgraded to extent their life and further improve their safety.  The two big examples: The EU added nuclear to an "approved list" of green energy sources.  The US put money for nuclear plant life extensions in its big infrastructure bill.
    • The Russia/Ukraine conflict  has suddenly increased the number of people thinking realistically about their remaining fossil-fuel reliance and "energy security."  The last few weeks have seen a tidal wave of country after country announcing a change in policy to extend their existing plants' lives and consider building new plants.  (A few U.S. states did so also.)  Even Japanese politicians have been stating publicly that Japan should restart its nuclear fleet.  The only remaining holdout I am aware of is Germany.  The German government's statement last week that "we looked again and still no" had very weak justifications behind it; I think it likely that Germany changes its mind in the not-too-distant future.  The German government is now directly subsidizing its coal-fired power plants to keep the lights on.  Even the German Green Party will probably change its mind now that every other country has.
• SUPPLY: The uranium ore industry is finally close to working through its massive glut of inventory caused by the post-Fukushima shutdowns.  SPUT (and Asian peer ANU) are accelerating that process.  The Russia/Ukraine conflict will further accelerate that process and increase demand.
  • Fukushima caused a sudden, sharp, semi-permanent drop in uranium demand and left a massive surplus of inventory available for use.  Miners took time to reduce production, which created more inventory. 
  • Prices fell to well below the marginal cost of production for almost the entire industry, and stayed there.  Eventually production fell significantly, to ~1/2 annual demand.  It has taken 11 years to work down that inventory.
  • Sprott saw what was coming with the cycle turn and launched SPUT last summer.  SPUT is a trust that takes in dollars, buys uranium ore, and stores it, potentially forever.  They are hoovering up large amounts of the available remaining inventory.  This action both will reward owners as prices rise and is acting as an important accelerant in soaking up the remaining inventory.  A similar fund, ANU Energy, targets Asian and Middle Eastern investors and has raised $550m so far.  KAP helped launch ANU, funded its seed round, and is the primary seller of uranium into that fund.
  • Cameco, the world's #2 uranium miner, signalled the turn last month by announcing it would restart its mothballed McArthur River/Key Lake mine, one of the Western world's premier low-cost uranium ore assets, with production beginining in 2024.  (Cameco's supply increase, and others in the industry, still won't bring total annual supply back up to total annual demand.)
  • The Russia/Ukraine conflict will boost ore demand further through an obscure mechanism.  Russia has 40% of the world's uranium enrichment capacity.  It has not yet been sanctioned, but it could be, and even if it isn't, the West will want to turn away from Russian sourcing.  It will take years to get new capacity built in the West.  But in the mean time, existing enrichers can "overfeed" their centerfuges with extra ore.  The amount of enriched uranium they produce is a function of how much ore you put in, and how long you spend enriching it.  Because the centerfuges must always keep spinning, during the recent low-demand years, enrichers have been "underfeeding" -- using less ore but keeping it in the centerfuges longer.  That has further reduced the demand for ore.  If their capacity is suddenly in higher demand, they will start overfeeding -- using more ore so that they can enrich for a shorter time per unit of output, thus increasing ore demand.
• PRICE -- Ore prices can go much higher and stay there for an extended time.
  • Spot ore was at ~$30/lb a year ago.  It reached $45 in 4Q and has now risen to $55-60 in the last week.  Much of the industry won't produce below $60.  A lot of marginal production probably requires $75.
  • Prices can go much higher than marginal costs.
    • New uranium mines are difficult to get permitted, and take a long time to open, even compared to other mines.
    • The old pre-Fukushima price peak was $140.  Inflation-adjusted, it was $190.  The current industry set-up is better than it was back then.
  • High ore prices will not cause much demand destruction.  Ore is ~20% of a nuclear plant's fuel cost.  (The rest is enrichment and conversion into fuel rods or other fuel units.)  Fuel is ~40% of operating cost.  So ore is 8% of operating cost.  And a disproportionately high amount of a nuclear plant's all-in costs are the capex, not opex.
  • Utilities' paramount concern isn't the price, it is certainty of supply.  According to the surprisingly-large group of uranium-market experts in investor-land who publicly comment, ten years of industry oversupply has made the utilities' uranium buyers very complacent and very price-focused.  But as occurred in the previous cycle 12-14 years ago, once supply starts getting tight and price starts moving up, buyer psychology changes, and they scramble to buy more of their forward requirements rather than less, which supercharges the up-cycle.

KAP OWNS THE WORLD'S BEST URANIUM MINING ASSETS

Today KAP produces 25% of the world's uranium ore.  (Other Kaz sources produce another 15%; 40% total.)  KAP's cost to do so is so much lower than Western assets that I haven't bothered to nail down the peer costs. KAP's 2021 cash cost per pound was $8.80/lb, and their all-in sustaining cost was $12.63.  Suffice it to say, KAP has been highly profitable during a period when Western producers were losing money.  During 2021, with spot ore sales prices in the $30s, KAZ printed a 42% gross margin, 34% operating margin, and 32% net income margin.  It did so despite its $32/lb averaged realized prices being 8% below spot (due to their long-term contracts struck earlier when prices were lower); its realized price should rise going forward even if spot prices stall.  The results are also despite a self-imposed production volume cut of 20% of KAP's capacity, which KAP has announced it will continue through 2023.  Obviously with prices now above $55, KAP earnings are going much higher in 2022 and beyond, unless geopolitical events restrict sales or production.  Beyond 2023, if prices rise or even maintain as expected, as demand keeps rising and inventories fall, KAP can lift production by 25% and boost profits further.  Management said this morning that the production boost would require only modest capex boosts, signficantly less than KAP's average capex per pound produced.

KAP'S ORDINARY-TIMES FRONTIER-MARKET RISKS LOOK ACCEPTABLE GIVEN THE STOCK PRICE

Kazakhstan looks like a modestly better place to invest than it did eleven years ago.  The country has been engaging in less shenanigans towards foreign investors for the past 10 years than it did in years past.  Then in this January's "civil unrest," they finally fully sidelined Nazarbayev, a world-class kleptocrat who had ruled all the way from the Soviet collapse in 1990 through 2019 and ruled behind the throne from then through January.  Russia's 2014 invasion of Crimea caused the Kazakhs to reevaluate their Russia relationship, and they took some steps to distance themselves.  They had only just moved their national capital to a newly-built city closer to the Russian border, in part to create a second major power/economic center and in part to get their national government away from the major earthquake risk around Almaty.  After 2014 they said "never mind, we'll take the earthquake risk," moved the capital back, and beefed up their own military.

More importantly, KAP specifically appears to have relatively low frontier-market risk relative to some other types of businesses.  Odds seem relatively low that the government is going to screw KAP, that KAP or the government will screw minority shareholders, or that management will screw up the business.

• KAP is a big exporter, big employer, and big contributor to the government budget.  It is in the government's good graces and is an inside player.
• Minority shareholders have been treated well so far.  (Yes, this could be like Taleb's Thanksgiving turkey.  But still, the signs look good here even if you know about the potential for Thanksgiving.)
• Management is professional.
• Audited by PwC.
• Investor relations is good.  Everything is in English, the financial/operating results disclosures are good, the web site is good, the earnings calls are good.
• The stock trades in London, is priced in US dollars, and has $8m/day average trading volume.

And then of course, the stock is cheap enough to account for the country risk, as long as you accept the overall uranium thesis.  While every other western uranium stock is trading at a negative multiple because they are losing money, KAP is trading at maybe 15x 2022 earnings assuming no massive disruptions, with strong multi-year earnings upside beyond that.  If the uranium thesis sputters and prices stop rising or even fall, KAP will probably still be highly profitable and paying you dividends.  The 2021 payout based on 2020 earnings was $353m, a 5% yield on today's market cap.

KAP'S UKRAINE/RUSSIA RISKS APPEAR OVER-FEARED AND MORE THAN PRICED IN

KAP appears to have five types of risk related to the Ukraine conflict.  These risks look acceptable, for a smaller position size (as I assume KAP would be for you if you also own other uranium stocks).  Last Friday KAP's chief commercial officer held a videoconference to discuss most of these risks, and the sell-side host helpfully posted the video on YouTube.   https://youtu.be/JuWh8NvBKis  Management covered them again on this morning's earnings call.  I will elaborate on some of those points and add others.

The highest-level theoretical risk is that Kazakhstan gets sanctioned itself as a Russia ally or even sides with Russia in some meaningful way that invites sanctions.  I have spent a lot of time over the last three weeks watching for signs of this risk emerging, and they haven't.  Russia asked Kazakhstan to send troops to Ukraine, and Kazakhstan immediately refused.  No government has even suggested sanctioning Kazakhstan.  Indeed, Kazkhstan's 40% global share of uranium supply is one of the strongest arguments against that risk; Kaz wants to keep selling, and the world wants to keep buying, especially if the West cuts off its own Russian supply.  The same is true of Kaz's oil, gas, and other resources.

The second country-level risk is that Kazkhstan's close economic ties to Russia cause Russia to drag Kaz down.  KAP is mostly immune from most of those risks.  It can probably keep mining regardless of whether the Kaz financial system gets stressed or consumer spending falls or GDP falls.  Indeed, the Tenge's (local currency) 15% fall against the US dollar is a short-term positive for KAP.  Almost all its sales are denominated in dollars, while almost all its costs are in tenge.  (The tenge-denominated costs would rise over time from price inflation.)  I would worry far more about buying, say, a Kazakhstan bank stock right now.

Third, KAP's operations could be disrupted due to supply chain issues for materials imported from Russia or through Russia.  This risk seems decently high-odds but lower-cost and temporary.

The fourth risk stems from KAP's joint ventures with Russian uranium giant Rosatom (via Uranium One), which could fall under new sanctions.  (Russian uranium entities have not been sanctioned so far; the financial sanctions carve out energy, and the U.S. energy sanctions carve out uranium.)  These JVs represent 20% of KAP's total output.  More importantly, if the West does sanction Russian uranium and it hits KAP's JVs, the profitability and value of KAP's remaining 80% assets will probably rise materially because uranium prices would jump.

The fifth and largest risk results from half of KAP's output -- everything that goes to Western and Indian customers -- getting transported by rail to St. Petersberg and then loaded onto ships for transport to those customers.  (A small amount gets sold to Russian customers; the other half is sold to China with delivery at the Chinese border.)  Bad news could definitely come here, but:

• The St. Petersburg trans-shipping falls outside the sanctions and has so far continued unimpeded.
• KAP keeps title to the trans-shipped ore all the way to the customer, which makes its shipments less vulnerable to sanctions.
• Since 2018 KAP has been establishing and occasionally using an alternative route through the Caspian, then overland through Azerbaijan and Georgia, then through the Black Sea and out into the Mediterranean.  It is unclear how much volume they could send through that route today, but they could likely beef up the route's infrastructure and send more in the future.
• China (already 50% of delivery volume) could serve as another trans-shipment point.  KAP has used this option in the past.  Obviously not ideal for serving European customers, but doable.
• Most importantly for this risk, if shipping problems arise, they seem likely to be short-term.  The Western countries are not going to allow 40% of the world's uranium ore to remain bottled up in Kaz for the long term.  They will help find a way to get it out.

As with the everyday country risk, these risks seem sufficiently priced in.  Year-to-date, KAP is -20% while its closest peer, Cameco (CCJ) is +15%.  The entire difference appears to be due to KAP's country risk and sanctions risk in light of the Ukraine/Russia conflict, as well as the desire/need for the Russia/Central-Asia/Eastern-Europe investors who own KAP to cut risk and raise cash by selling KAP regardless of fundamentals.  If this discount ends, KAP would rise 44% to catch back up to CCJ.

KAP IS A GREAT ADDITION TO A BASKET OF URANIUM STOCKS

This is a simple but powerful point: Because KAP is 25% of the ore market and Kazakstan is 40% of the market, any bad news for KAP or Kaz output is necessarily fantastic news for every other uranium producers.  If KAP is, say, 10% or even 30% of your basket, then on the imaginary day that the bad news hits, your absolute profits from the other 70-90% should dwarf your losses in KAP.  Indeed, the most likely bad news is that Russian uranium companies get sanctioned; even KAP might be up that day, thanks to the unsanctioned 80% of its output (discussed above).

On the other side, if the Ukranian conflict ends, your other uranium holdings might fall as the Russia-risk premium leaves the spot uranium market, but KAP's price should jump nicely.

Catalyst

The Ukraine conflict resolves or, at the least, its effects on KAP don't get worse. 

KAP does not suffer collateral damage from Russian sanctions.

Significant earnings growth as the uranium thesis continues playing out.