Description

Executive Summary

Largo Resources (Ticker: LGO CN) is a vanadium miner.  For reasons laid out below, the vanadium industry has been operating in a supply/demand deficit and global inventories are now depleted.  Further, new Chinese rebar policies could lift market demand for vanadium even further.  The stock is a compelling long opportunity with 80% upside potential if vanadium prices return to their previous high in November 2018.  In addition, LGO is currently constrained from maximizing its revenue and profitability due to an off-take agreement with Glencore which expires in May 2020.  This is a Company-specific catalyst which could generate even further upside to the stock.

Company Description

LGO is a Toronto-based mining company focused on the production of vanadium (flake, high purity flake and high purity powder) at the Maracas Menchen Mine located in Bahia State, Brazil.  The mine is the Company’s only operation, so LGO is a pure-play vanadium producer. 

In early 2014 construction at the Maracas Mine was completed and the Company received its operating license.  First production at the mine occurred in August 2014.  In 2016 the Mine reached its full design capacity rate.  In 1H17, LGO implemented improvement projects in the leaching and kiln sections of the chemical plant and further increased the recovery levels.  Following the completion of the main improvements in July 2017, production volumes stabilized at ~5% above nameplate capacity. 

For 2019 LGO management has guided to total production of 10,000-11,000 MT of V2O5 at a cash operating cost of US$3.45-3.65/lb. of V2O5. 

Vanadium

Vanadium is a hard, silvery-grey, ductile, malleable transition metal.  Vanadium is a strategic metal primarily used as a strengthening alloy to steel and titanium.  Small amounts of vanadium added to steel makes it stronger, tougher and lighter.  Almost 91% of vanadium produced is used in the steel industry.  Principal applications include:

·         High strength steel structures

·         Rebar for construction

·         Buildings, bridges, tunnels,

·         Automotive parts

·         Aviation and Aerospace Parts

·         Pipelines

·         Power lines and power pylons

·         Rail lines, railway cars and cargo containers

·         Construction machinery and equipment

Investment Thesis

LGO is a compelling long opportunity as its stock price should be driven upward for the following reasons:

·         Vanadium prices are poised to move higher due to supply/demand dynamics

·         Implementation of new rebar standards in China may increase vanadium demand even further

·         LGO should be able to increase its revenues and profitability post the expiration of an offtake agreement with Glencore in May 2020

·         LGO may choose to list its shares on the NYSE, affording not only increased investor awareness of the Company and liquidity to the stock but also the potential for stock index inclusion

Additional detail on each of these aspects of the thesis is as follows:

·         Vanadium Supply/Demand Dynamics – The global market for vanadium is ~88,000 MT annually.  On the demand side, 91% is used as a steel alloy, 4.5% is used in aerospace applications, 3.5% is used as a catalyst for chemical reactions, and the remaining 1% is used in other applications.  On the supply side, vanadium is produced from three main sources:

o    Co-Product of Steel Slag - About 72% of vanadium is produced as a by-product of blast furnace steel manufacturing.  Many of the types of iron ores, especially in China, that are used for producing steel contain vanadium minerals as well.  In the steel making process, the vanadium is produced as a co-product which is contained in the remnant slag.  The slag is then processed and the vanadium extracted.  Importantly, co-product vanadium is directly linked to steel production and is thus inelastic to vanadium prices.  China produces 55% of co-product vanadium, Russia produces 18% and South Africa products 10%.  According to LGO, the projected cash costs of co-product vanadium range from US$3.23-9.47/lb.

o    Primary Vanadium Ore - About 18% of vanadium is produced from primary vanadium ore.  According to LGO, the projected cash costs from primary mined vanadium vary from US$4.15-4.50/lb.

o    Secondary Production – About 10% of vanadium comes from secondary production in which vanadium is extracted from spent chemical catalysts.  According to LGO, the projected cash costs from secondary produced vanadium range from US$8.22-11.88/lb.

For the past several years, the vanadium industry has been operating in a structural deficit, causing a steady decline in inventories.  Supply and demand became imbalanced largely due to changes in environmental regulations in China.  China is the largest steel producer in the world, and its domestic iron ore contains relatively high levels of vanadium compared to imported ores which contain very little.  Accordingly and as noted above, China is the largest producer of co-product vanadium.  In 2014 the Chinese government revised its Environmental Protection Law and introduced much tougher penalties for corporate polluters, particularly the steel industry.  To comply with the regulations, Chinese steel producers significantly increased their use of higher grade, less polluting imported iron ore.  As a consequence, these same steel producers now generate that much less co-product vanadium.  According to LGO, total global vanadium demand in 2018 was 88,000 MT while total global supply was 80,000 MT, an 8,000 MT deficit.  Because of this structural deficit over the past few years, global vanadium inventories have effectively been drained.  For reference, during the Company’s 3Q18 earnings call, LGO’s CEO provided a lot of commentary on what they are seeing as far as global vanadium inventories, which is effectively nothing.  The inventory shortage is a key reason vanadium prices rose from ~US$5.00/lb. in early 2017 to a high of $34.00/lb. in late 2018.  Vanadium prices have since fallen back down to ~$17.00/lb. currently, however their upward trend should likely continue as only limited supply is scheduled to come on-line and the market will remain imbalanced.  At present and outside of LGO, there are only two scheduled vanadium production increases of scale: (i) Bushvelt’s Vametco mine in South Africa is expected to add 2,300 MT of additional vanadium capacity in 2019 and (ii) Droxford International, a subsidiary of Indonesia’s Salim Group, is expected to start 4,300 MT of vanadium capacity in 2020.  Of note, historical vanadium prices in both China and Europe can be found on Bloomberg using the indices VNCNZAQA and VNEUJOQT, respectively.  They can also be found on the website www.vanadiumprice.com, which is updated by publicly-traded industry participant Prophecy Development Corp. (PCY CN).  As commented by LGO’s CEO during the Company’s 3Q18 earnings call, the fact that vanadium prices were higher in China than in Europe during September through December in 2018 is extremely indicative of how supply-constrained the market is.  Historically, China has been a net exporter of vanadium.  However, with inventories now depleted and domestic production sharply reduced, China will likely shift to becoming a net importer of vanadium.

 ·         Implementation of New Rebar Standards in China May Increase Vanadium Demand Even Further – China’s rebar market makes up 35% of global vanadium demand.  In February 2018 China announced a new standard for rebar that took effect November 1, 2018.  The new policy requires Chinese steel mills to eliminate the original 335 megapascals (MPa)-tensile strength rebar and start producing 600MPa-tensile strength rebar which has better earthquake resistance.  Further, the new policy seeks to restrict the production of rebar via the water quench and temper (Q&T) process, which produces rebar that has lower durability because it rusts easily and therefore poses risk to building safety.  Morgan Stanley estimates that the new policy could increase China’s annual demand for vanadium by 16,500 MT.

 ·         Expiration of Off-take Agreement with Glencore – In 2014 LGO entered into an off-take agreement with Glencore International AG.  According to the agreement, LGO sells all of its vanadium to Glencore.  While LGO can’t discuss the specifics of the agreement, it is clear that it constrains LGO from maximizing its revenues and profits.  Specifically, the agreement appears to only allow LGO to sell to Glencore its vanadium at the European Metal Bulletin listed price.  In times when the listed price in China exceeds the European listed price, LGO can’t capture the additional revenue and profit.  Further, the off-take agreement appears to prevent LGO from taking advantage of pricing for its high-purity vanadium products, such as those used in for aerospace applications.  When the off-take agreement expires in May 2020, LGO should be able to achieve much greater revenues and profits through expanded market flexibility.

·         Potential NYSE Listing – While no specific plans are currently in place, it is speculated that LGO may choose to list its shares on the NYSE.  This would afford not only increased investor awareness of the Company and liquidity to the stock but also the potential for stock index inclusion.

Valuation / Price Target

In terms of valuation and price target, the back-of-the-envelope math is the following.  LGO is guiding to 10,000-11,000 MT of V2O5 production in 2019.  At the mid-point of guidance, that’s 23.1mm lbs.  The current European Metal Bulletin price for vanadium is $18.35/lb., and LGO is guiding to cash costs of production of US$3.45-3.65/lb. of V2O5.  At the mid-point of cash cost guidance, LGO could generate $14.80/lb., or ~$342mm in total cash gross profit.  At the current CAD exchange rate of 1.33x, that’s C$455mm.  With operating costs and S,G&A conservatively being another ~C$20mm, that equates to C$435mm in EBITDA.  At a conservative 4.0x EV/EBITDA, that’s C$1,740mm in EV.  Net debt is minimal at only C$35mm, so the equity value would be C$1,705mm.  With 648mm FD shares out, that equates to C$2.63/share, or basically where the stock is trading now.  Using this same math and keeping the valuation multiple and CAD exchange rate the same, for every $1.00/lb. price increase in V205, LGO’s EBITDA increases by ~C$30mm and its value per share increases by ~C$0.19/share.  Accordingly, if European vanadium prices return to their previous high of $28.75/lb., LGO stock could be worth C$4.60/share, or 80% higher than current levels.

Catalyst

Increase in vanadium prices

Expiration of off-take agreement with Glencore in May 2020

Potential NYSE listing