Description

Overview

Investment Background: Many resource investors have long been confident that an eventual uranium bull market would occur. Unfortunately, those investors have been disappointed by what has been a near decade long slump.  Investors have also been confronted with a niche market that is poorly understood, exceedingly small, comprised of few operating companies, and a glut of pre-production exploration companies.  There have been few, if any, opportunities to execute a uranium investment.[1] There exist several speculative opportunities with significant positive upside optionality that may compensate for the lengthy wait, but nothing worth investing in.

The singular potential investing opportunity of the past decade has been Canadian producer Cameco. If you had invested in Cameco in 2008, at the most opportune time (21-NOV-2008), you would have paid $12.98 a share, you would now, more than a decade later be down 8.2% and during that time would have watched the spot price of Uranium fall from $53.0 to the current spot price of $28.9. The investment would have occurred at a PE north of 20 and with a dividend of less than 2.5% for most of the investment period. You would have been paid a pittance and sat around waiting as the company slowly melted.      

We believe that with the IPO of Kazatomprom (KAP), in November of 2018, that the situation has finally changed.  KAP is the first investable Uranium miner to hit the market in a decade and investors now have an opportunity to make a sensible investment for which the price of Uranium is simply an additional catalyst to appreciation, instead of the entire investment case.  

Investment Thesis:  KAP is the largest Uranium miner in the world (responsible for ~20% of global primary supply in 2017) and is the lowest cost producer in the industry.  At the current time, the firm operates or has an equity interest in, nine of the eleven lowest cost mines in the world.  Due to the firm’s complex structure, which includes ten asset level partnership with equity interests of between 30% and 65%, significant balance sheet value is obscured by IFRS equity method accounting rules for JVs. 

At current Uranium spot prices, and at a 10% discount rate, the mines the firm operates or has an interest in are trading at a 22% discount to intrinsic value.  This valuation ignores significant industry tailwinds, the firms dominate position within the industry and a dividend of up to 75% of FCF. We believe a more realistic valuation is between $22 and $24 a share, suggesting the firm is currently trading at a discount to intrinsic value of between 38% and 43%.

Milestones and Catalysts

(Positive Catalyst) Production

(Mixed Catalyst) Increase Free Float

(Positive Catalyst) Uranium Prices

(Positive Milestone) Dividend

(Uncertain Catalyst) Section 232 Petition

(Uncertain Catalyst) Kazakhstani Presidential Elections in 2020

Business Overview

KAP was formed in 1997 as a state-owned entity to run uranium mines that were discovered in Kazakhstan during the Soviet Era. At the time, the firm produced 2 Mil. Lbs. of U₃O₈ a year. Management and JV partners have since increased production to roughly ~60 Mil. Lbs. of U₃O₈ (~30 Mil. Lbs. of attributable to KAP).[2]  The significant increase is largely a function of the joint development of most assets with foreign partners including: Orano (French State), Cameco (Canadian Publicly Traded Firm) Uranium One/ARMS (Russian State-Owned Firms) and other producers from South Korea, Japan and Europe. The joint development strategy has enabled KAP to expand operations while sharing of portion of the risk. 

Mining Operations: Uranium mining represents the majority of KAP business accounting for 62% of revenue, with the share of results from Joint Ventures and Associates boosting pre-tax earnings (EBT) by ~40% in FY2017. Mining operations include three wholly owned mining operations, and ten asset level partnerships currently producing ~60 Mil.  Lbs. of U₃O₈ and capable of producing ~75 Mil. Lbs. of U₃O₈. Additionally, KAP has a portfolio of exploration assets: two assets with identified resources, one with a maiden resource expected later this year, three exploration projects and eight identified properties of interest.[3] We currently assign no value in to any of these assets but believe it is worth noting that the identified resources (Inkai 2 and Inkai 3 which are 100% owned by KAP), contain a reported ~325 Mil. Lbs. of U₃O₈.

Measured by attributable production, KAP is the largest producer of natural uranium globally, as well as being either the lowest or second lowest cost producer, depending on who you consult. For FY2017, the company, together with its subsidiaries produced ~20% of total global primary uranium production and ~40% of global in-situ leach recovery (ISR) uranium production.[4]  KAP’s mineral assets are in three of six known uranium baring geological provinces within Kazakhstan, a map of the provinces and mines can be found in Appendix C.

Mineral assets are held through 14 subsidiaries, joint ventures and associate companies, 13 of which are producing firms responsible for mining uranium and downstream processing, and one of which is focused on exploration. The subsidiaries and KAP equity interest can be found in Table 1. 

The aggregated Proved and Probable Ore Reserves[5] of all the subsoil use agreements that grant the company extraction rights is 884.7 Mil. tons grading 0.06% Uranium, the attributable reserves are 535 Mt grading 0.058% Uranium.  Aggregated production from the group was 60.5 Mil. Lbs. of U₃O₈, with sales of 60.2 Mil. Lbs. of U₃O₈ at a reported All in Sustaining Cost (AISC) of $14.51 per Lbs. of U₃O₈ with attributable production of 31.4 Mil. Lbs. of U₃O₈ and sales of 30.7 Mil. Lbs. of U₃O₈ at a reported AISC of $16.08 per Lbs. of U₃O₈. A full resource statement and mine by mine discussion can be found in Appendix C.

Metallurgical Plant, Nuclear Fuel Chain Businesses and Trading Arm: The Ulba Metallurgical plant was established in 1949 and became a KAP subsidiary in 1997.  The plant primarily provides uranium processing to KAP mining subsidiaries, converting ore into Yellow Cake, and uranium process tolling services for mining operations that produce a calcined U₃O₈ product as a final product instead of Yellow Cake.  The Ulb plant is also a top three producer of beryllium, tantalum and niobium.  At the current time Ulba can produce 472 tons per annum of U0₂ powder[6] and up to 108 tons per annum of fuel pellets, the majority of which are sold on to Chinese consumers.  

KAP has several additional opportunities and investments downstream of mining operations within the Nuclear Fuel Cycle.[7]  Although the company does not possess enrichment technology, the company does hold direct and indirect interests in two enrichment facilities located in Russia.  These investments include an indirect interest the world’s largest enrichment facility, an interest that entitles KAP to 2.5 million separate work units (SWU)[8] of enrichment capacity annually, which is equivalent to roughly 4.25% of annual global enrichment capacity. KAP has the option to use this enrichment capacity through 2043.  Additional downstream Nuclear Fuel Cycle investments include:

Joint-Venture with China General Nuclear Power Group (CGNPG) to build a fuel assembly plant that will start operation in 2020. $40 million of an expected $135 million of CapEx has been spent and upon receiving a long-term contract for offtake of fuel assemblies. KAP will sell CGNPC a 49% stake of the 100% owned Ortalyk subsidiary, at market prices. We expect that sale would generate north of $400 million in cash.

In 2008 KAP entered into an agreement with Cameco to build a Uranium conversion plant (conversion of U₃O₈ to UF₆).[9] The project has not moved forward, and Cameco has backed out, but pursuant to the agreement, Cameco will make the conversion technology available to KAP, at no cost, in perpetuity.

Sales and Marketing: KAP sells uranium products to more than 15 customers in eight countries.  In FY2017, KAP’s top three and top five uranium products customers account for 43% and 51% of the group’s revenue.  Sales by region are presented in Figure 1.  In 2017, KAP launched THK, a wholly owned uranium products trading arm.  The aim of THK is to better facilitate relationships with partners, promote sales of Kazakhstani uranium products and increase liquidity in the uranium spot market. Since founding THK has increased spot market sales by $37 million a year, acquired four new clients for KAP and entered into an unspecified number of long-term uranium delivery contracts, some of which have tenors lasting until 2029.   See Appendix C for a discussion of the sales and marketing relationship between KAP, its JVs and associates.

Uranium Outlook

Introduction: The uranium mining market is highly concentrated; the top three producers control 50% of the market and the top six producers control 77% of the market.  The market is also highly concentrated on the consumer side, with ~70 consumers globally.  Between mine production and final consumption is a global supply chain with multiple processing bottlenecks, lengthy timelines and limited flexibility due to both security and technology constraints. Uranium is principally sold on long-term contracts, typically 36+ months in length, and there exists no commodity exchange that transacts physical uranium.[10]^,[11],[12] 

Demand: The principal use for U₃O₈ is electricity generation, which ties demand directly to burn rates of uranium fuel in reactors and the number of reactors in operation. As of January 1, 2017, there were a total of 449 commercial nuclear reactors operating in 31 counties with 55 reactors under construction.  In total these reactors require ~163.3 Mil. Lbs. of U₃O₈ every year, this does not include utility purchases for inventory.[13]  In 2017, mined uranium totaled 154.5 Mil. Lbs.[14]  The gap between demand and mined supply has historically been filled by both reprocessing used uranium and from secondary supplies, such as government stock piles or government programs.[15]  Secondary supplies are discussed in depth below.

Utilities address their refueling needs with long term contracts of between three and ten years.  The last major contracting period was between 2005 and 2012.  This would suggest that many utilities have either already reached the point at which they need to be signing new supply contracts or will shortly. a result of the negligent re-contracting by utilities, new reactors coming online, and supply constraints discussed below, UxC[16] believes that if no new long-term supply contracts are signed in upcoming years, by 2021 23% of global uranium demand will not be covered by long term contracts and by 2025, 50% of global demand will not be covered.  More importantly perhaps, the longer utilities go without re-contracting the greater the probability that there is a rush by utilities to recontract simultaneously.

As with any commodity, demand is critically important, and a positive price move supported by growing demand is stronger and more lasting then a supply supported price move. In the case of Uranium, the demand is growing, despite post-Fukashima backlash in the west.  According to the World Nuclear Association and IAEA 2018 Nuclear Power Reactors In the World, there are currently 55 reactors under construction globally, and 49 with established dates to be turned on and connected to the grid between now and 2026.

These reactors will boost the global reactor fleet to 503 reactors by 2026. Assuming no existing reactors are shut down, annual uranium demand will increase from current levels of roughly 163 Mil Lbs. of U₃O₈ in 2018 to between 184 and 202 Mil. Lbs. of U₃O₈ a year in 2026.  In addition, the reactors that are being turned on will require an additional 26 to 28 Mil. Lbs. of U₃O₈ over the period 2019-2026 to account for the higher volumes of uranium needed when a new reactor is first turned on, referred here after to the first load volume.   

The forward-looking projection of demand for commodities is always difficult but nuclear reactor related uranium requirements over the short to medium term are fundamentally determined by installed nuclear capacity.  The charts above are based on the demand for U₃O₈from the existing global fleet and under construction reactors. The follow through on demand growth is very likely.  It is possible, given the many issues firms run into constructing Nuclear reactors that the demand growth is shallower, due to delays, over the period 2019 to 2026, but it is unlikely to change the final demand numbers.

Supply: Although more difficult to assess then demand, the limited number of producers and mines makes uranium supply easier to evaluate then other commodities. Currently, the top ten producers control 88% of the market and the top three producers control 50%.  KAP, is the largest of the big three with 20% of the global market.  In addition, KAP has the 2^nd largest reserve base in the world.  We have reviewed all the uranium mines operating globally in 2016-2017 and created our own cost curve.[17]  In total our cost curve represents ~160 Mil. Lbs. of U₃O₈ production vs. reported global primary Uranium production of ~160 Mil. Lbs. of U₃O₈ in 2016-2017. As such, we are confident we have captured substantially all the meaningful mines in existence.

The dashed red line in the graph is the current spot price for Uranium, the solid black line on the right side of the graph represents 2017 global demand.  Note that the market does not clear naturally, the mined supply of uranium is significantly less than annual demand for Uranium. The red line is at around 198 Mil Lbs. of U₃O₈, creating a demand gap of roughly 30 Mil Lbs. of U₃O_8.

That gap is filled by a combination of recycled spent fuel, inventories and other secondary supplies such as government stockpiles. Also note that the current spot price (absent inventories) implies a market that clears with only half of current global demand.  Additionally, several mines in the graph, have either been shut down or put into care and maintenance in 2018. Roughly 25 Mil. Lbs. of production represented on this graph is no longer in production. That’s principally the output of two mines, the primary one being Cameco’s McArthur River mine in Saskatchewan, Canada.  We believe that global production in 2018 will be between 130 to 140 Mil. Lbs., a production range that is likely for several more years.[18]

Secondary Supplies and Inventories: Because of the cyclicality, utility caution, and government activity, much of the annual demand for fresh uranium has been met by secondary supplies and inventory.  We believe, based on our supply curve above, that at least 40 Mil. Lbs. a year of supply has been met by secondary sources and inventories for several years. Inventories and secondary supplies include:

Of these secondary sources, we believe down blending of highly enriched uranium, and existing inventories warrant the most attention.  Other sources can add marginal supply, but not enough to tilt the supply-demand balance too far in any one direction.  A significant source of secondary supply since the end of the cold war has been the down blending of highly enriched uranium from Russian nuclear warheads to low enriched uranium through the government sponsored Megatons to Megawatts deal.[19]

The largest source of secondary supply is inventories at utilities. Currently, we estimate that inventory levels globally are equal to ~ 4.4 years of global demand.  Although this sounds problematic to our investment thesis, the reality is far from it.  To start with, most utilities like to keep between two and five years of uranium stock on hand, suggesting that current inventory levels are not nearly as high as they may sound. The reason that utilities like to keep inventory levels this high is a result of a combination of factors, but the lead times necessary to get natural uranium into a state it can be used in a nuclear reactor is a primary cause.[20]

The lengthy and complex supply chain from mine to reactor means that not all inventory is readily usable. Odds are if you have U₃O₈ in inventory you are probably at a minimum 18 to 24 months away useable fuel for a reactor. Additionally, tight refining and enriching infrastructure presents logistical challenges at each stage (there are only 5 enrichers globally, only 6 refiners, etc.). Furthermore, the actual geographic distribution of the inventory is important.  China currently has strategic stock piles for domestic consumption of 278 Mil. Lbs. U₃O₈ or 39% of global inventory. That inventory is not available for the rest of the world. 

The result is that EU and North American utilities appear to have less than three years of uranium stock on hand.  China is thus the big inventory question.  But there too the Chinese inventory levels appear relatively logical when one takes in account the fact the country does not have significant domestic uranium production and they have ambitious plans for building out their reactor fleet. New reactors require a first load of uranium, which is significant and usually three times the annual need.  We estimate Chinese inventory between 5.3 years (not including the additional uranium needed in a first load) to 3.1 years (again not including the additional uranium needed in a first load).

Valuation

KAP is a somewhat difficult company to value.  After a long bear market there exist no appropriate comparables, or frankly healthy companies in the industry.  Many might suggest comparing the company to Cameco but the operating jurisdiction, deposit geology, scale and operations are vastly different.

Additionally, the corporate structure obfuscates value.  Consolidation rules for the associates and JVs hide balance sheet asset value to a significant degree. The only legitimate valuation approach is to conduct a mine by mine, sum of parts valuation based on the life of mine plan for each mine. This approach uncovers significant asset value that is otherwise not apparent.  

The current tangible book value of the firm is $6.9 a share. Following a valuation of each mine, and the attributable KAP share in each mine, the tangible book value per share is $14.3 share. This assumes current Uranium spot prices and a 10% discount rate.  Additionally, JVs and associates are on the balance sheet for a $1.04 a share but have a real value of $5.2 a share under the same circumstances.

We tested our sum of parts valuation with a series of Uranium price curves including a spot rate curve, KAPs prospectus price curve, $30, $40 and $50 dollar per Lbs. U₃O₈, BMO’s cost curve and our own cost curve, which is a blend of KAPs curve in the long run and our own analysis in the short term.  We believe KAPs curve is a strong price curve, appropriately conservative in the long run (topping out at $43.4 in 2035) but overly conservative in the short run. [21] At the same time, cost curves by most investment banks, although possible, are wholly inappropriate for the purposes of investment analysis and evaluation of margin of safety. BMO foresees a price of $55 per Lbs. U₃O₈ in 2023. While certainly possible, that does not work for our base case.[22] 

This analysis results in a value of $14 per share on the low-end, which is derived from an NPV analysis at current spot rate for the life of existing mines, to $27 on the high-end using BMO’s cost curve.  Our cost curve, which we believe represents the most likely outcome, suggests a pure technical valuation of $20 per share, a margin of safety of 32.7% at the current price. The company will be paying a 2018 annual dividend in 2019 that management has already stated will be a minimum of $200 million or $0.77 a share.  After considering this dividend we believe it is appropriate to think of yourself as buying shares in KAP today at the market price less the dividend, implying that at $20 a share you have a margin of safety closer to 36%.

Given industry dynamics we believe that mine sum of parts analysis fails to capture the strength of the company, its ability to grow market share in the future, and the value of that industry dominance. Given the mines that have shut down, and the flexibility of the IRL production method, which allows KAP to dial up or down production far more easily than a more traditional mine, it is possible that KAP will increase its market share from 20% to north of 30% over the next five years.

The strength of the company’s balance sheet is also overlooked in the NPV analysis.  Unlike most firms in the uranium mining business, which are pre-production, and in need of financing and years away from production, or Cameco, which has $1.4 billion in debt (a debt to equity ratio of 30), and just shut down indefinitely its largest producing mine, KAP had manageable debt of just $235 million and cash of $261 million.

Finally, KAP entered into a supply agreement with Yellow Cake PLC, a London based financial buyer, in May 2018.  The agreement provides for the supply of up to 8.1 Mil. pounds (or approximately 3,674

tons) of U₃O₈ for US$170 million, and the right of Yellow Cake PLC to purchase up to an additional US$100 million of U3O8 annually between 2019 and 2026. An initial delivery of 3,100 tons of U₃O₈ was delivered in July.  Much, if not all of this came from existing inventories, which at the end of June 2018, stood at 10,095 tons worth $585 million at the current spot price or $2.25 a share.  The Yellow Cake agreement gives KAP an opportunity to monetize this significant inventory buildup.

Given these additional variables we believe that a conservative valuation of KAP is $22 to $24, with the potential that momentum could take it beyond a reasonable valuation on Uranium price appreciation and investable supply. KAP is the only well-established publicly traded Uranium miner that combines growth, producing assets, free cash flow, and a rock-solid balance sheet in one company. Most firms in the industry are either pre-production project firms or exploration firms which creates a situation in which there is very limited supply of investable assets, increasing the odds of positive momentum. 

Dividend Policy: Management has implemented a dividend policy geared towards returning 75% of free cash flow to shareholders assuming certain liquidity and solvency requirements are met and have already stated that the annual dividend paid for 2018 and 2019 will be no less than $200 million in the prospectus. Given the strength of the balance sheet there appears to be little risk that the group maintains a Net Debt to Adjusted EBITDA ratio of less than one, the key requirement for paying out 75% of FCF as a dividend. Year-end 2018 Net Debt to Adjusted EBITDA will likely by 0.5x, falling to 0.1x in 2020.  As a result, the dividend could rise to as much as $2.50 to $3.00 a share over the course of the next five years.

Risks to Thesis

Customer Concentration: The Nuclear fuel industry is highly concentrated and KAP only has ~15 customers, with 84% of sales coming from just 5 customers in 2017. In addition, KAP has significant exposure to China, who is KAP’s largest regional customer.  This exposure creates significant downside risk in the case of economic downturn in China.  It is unclear the degree to which growing demand for electricity in China is driven by economic growth or evolution in the composition and direction of the economy as well as changing lifestyles of the citizenry.

FX Risk: KAP has benefited significantly from a fall in the value if the Kazakhstani Currency (the Tenge) vs. the US Dollar.  Between 2015 and 2017 the Tenge fell 30% vs the dollar which coincided with the global fall in the price of crude and the subsequent floating of the currency. A reversal of the fall could significantly impact the cost structure of the business.[23]

US Related Risks

US Sanctions: Due to the deteriorating relationship between the United States and Russia, Joint Ventures that KAP has with Uranium One could create problems for the business.  We estimate the NPV attributable to Uranium One Joint Ventures is $1.8 billion, or 36% of the total company NPV. 

Section 232 Investigation: The US Department of Commerce has launched a Section 232 Investigation into whether the current level of imports of Uranium, for use by utilities, threatens the viability of US based uranium mining, and thus threatens National Security. Should the Department of Commerce decide that imports do, KAP will almost certainly trade down, but it is important recognize that the clear majority of KAP sales are to Asian and European consumers.  Additionally, it is not clear what impact a bifurcation of the market (like the oil markets in the US prior to 2015) would do to the price of Uranium.[24] We believe that the current administration is likely receptive to the argument made by domestic suppliers and thus assume the probability of tariffs being implemented is reasonably hight but it should be no utilities supported the implementation and it was widely criticized within policy circles.

Environmental, Health and Safety Overview: SRK, the third-party auditor of the mining operations for KAP, reviewed the degree to which KAP operations and management abide by Internal Finance Corporation (IFC) performance standards and World Bank Environmental, Health and Safety Guidelines.  SRK concluded that although the operations have been designed, and are being operated to minimizes Environmental, Social and Health (ESH) impact, there is room for improvement.  We are not surprised by this finding and would be more skeptical of the report if they found there was no room for improvement.  SRK notes that KAP is already subject to frequent inspections, that they are responsive to critique, and that management has a frank understanding of the potential negative environmental, health and safety impact of their operations. SRK’s review include five suggested areas of focus to improve and developed with the company action plans to address the report’s findings.[25] We will believe that a careful review of managements follow through on these issue will be important for investors to undertake over the course of the next two to three years because it will provide an indication of how responsive the management is to critique and a and provide an indication of the degree to which management takes their new role as a publicly traded company with additional responsibilities and stakeholders seriously. 

Uranium Prices: We believe that the Uranium market has turned a corner, but many have said this before and been wrong.  We have avoided investments in Uranium in the past because they hinged so much on the price of Uranium and nothing else, as outlined in the valuation section. We believe that KAP is different, and that although Uranium price appreciation is a positive upside catalyst, the large resource base and industry leading AISC of production means KAP can be successfully invested in absent a significant recovery in the price of Uranium.  Nevertheless, should the price of Uranium return to the low levels seen in 2016 ($18 per Lbs. U₃O₈) KAP will trade down.

Logistics: Another risk that we are surprised has gone overlooked in our research is logistics. KAP can only export uranium via an overland route, by rail, through either China or Russia. Sanctions against the right company, or persons, could mean that export via Russia is no longer feasible.  It is not clear what overland exports via China would do to costs (or who would bear the cost), as it is a route only used for exports to China. We view this as probably the most significant risk and would characterize it as a significant known unknown risk. 

Political Risk: We characterize the Kazakhstan as a stable but tense country, investable but not without caution and consistent monitoring.  The domestic political risk will decrease dramatically once it is clear whether the current president is running in the 2020 Presidential Elections. We believe the odds of the president running are greater than 50%.  Foreign political risk, because of the KAPs relationship with Russia, is of greater concern.  There is a high degree of uncertainty in the political risk to this investment, we advise managing that risk through position sizing, not through adjustments to valuation given the high level of uncertainty, which precludes a logically defensible integration into a valuation. See Appendix D for a more in-depth discussion.

For a complete report and full set of Appendices, please visit www.massifcap.com 

Catalyst

Postive Catalyst: Production, uranium prices

Mixed Catalyst: Increase free float

Postive Milestone: Dividend

Uncertain Catalyst: Section 232 Petition and the Kazakhstani Presidential Election in 2020