Description

Uranium is currently out-of-favor and largely underfollowed. The same can be said about Paladin Energy (“Paladin”) – listed in Australia (ticker: PDN AU). There are only a handful of vehicles available for direct exposure to uranium prices. I believe the Paladin converts in the 80s* (~13% yields for 2-3 year paper) give investors attractive upside to both a recovery in prices and company-specific events while its strategic asset value provides downside protection.

*These bonds have appreciated since I started on this report. One catalyst occurred today when the company announced a new bank facility. I have not seen updated levels on the converts. For the purposes of this report I assumed the converts moved up an additional two points post the project debt refinancing news.

Prior to the Fukushima disaster, uranium prices approximated $68/lb. This compares to current spot prices of $35/lb. So what will cause these bonds to appreciate? The main industry catalyst is the restart of Japanese nuclear power plants. While I believe Japanese nuclear power plants will restart and both China and Russia will add new nuclear power plants, the more important catalyst is a sale of a minority interest in Paladin’s Langer Heinrich mine.

In a press release issued on January 14^th, the company said the following: “strong interest from a variety of parties to sell a minority interest in Langer Heinrich continues…Paladin has confidence in an outcome which will alleviate shareholder concerns regarding debt.” To me, this signals an offer which implies all debt is covered by this one mine.

Paladin is a pure play uranium producer with a portfolio of producing and developing assets in Africa, Australia and Canada. The company’s two producing mines are Langer Heinrich (“LHM”) in Namibia and Kayelekera (“KM”) in Malawi. The non-producing assets are in Australia, Canada and Niger.

The crown jewel is the LHM asset which has a mine life of 20+ years and cash costs of $28/lb which is at the lower end of the global uranium cost curve. Pro forma for cost reductions, cash costs are expected to be $25/lb. Annual production is ~5.4 MM lbs. 

The other producing asset KM is 85% owned by Paladin and 15% owned by the government of Malawi. KM has a mine life of seven years (plus extension potential) and cash costs of $39/lb are expected to decline to $30/lb once grid power is installed and acid-recycling measures are implemented. Annual production is ~3.1 MM lbs.

Development projects were put on hold in light of the weak uranium prices but these assets represent option value. The main potential developments include the Manyingee project in Western Australia, the Aurora assets (mostly Michelin) located in Canada near several other uranium deposits and Mount Isa projects which capture at 82% interest in Mt Isa North and a 91% stake in Valhalla, Skal and Odin deposits.

Recent Performance:

-Paladin reported solid fiscal 2Q (December) production numbers as both LHM and KM hit record levels.

-Cash cost lower than previous quarter (specifics not released).

-Reiterated fiscal 2014 production of 8.3-8.7 Mlbs.

The management team is led by the forever bullish John Borshoff who owns 16 MM shares. Borshoff is the founder of Paladin and has over 30 years of experience in the space.

The vast majority of uranium production is used for nuclear power. Most uranium is supplied from mines in Australia, Canada, Kazakhstan and Africa, but there are also secondary sources, such as the conversion of military uranium. For example, as part of the Megatons to Megawatts program, Russian agreed to convert weapons-grade uranium into fuel. This program augmented supplies until 4Q13 when it ended. 

This supply reduction in addition to deferrals of the Olympic Dam, Kintyre and Wiluna projects in Australia and an AREVA project in Africa should help stem to tide caused by post-Fukushima demand reductions. Japan’s annual demand has declined from 21 MM lbs (12% of global demand) to virtually zero.

Of the 50 idled Japanese reactors, applications for restart have been filed for 14 units*. I expect to see these reactors come back online as the Japanese government appears to be focused on reducing imports of fossil fuels. This is one key event that should lead to higher uranium prices once excess inventory (held at Japanese utilities) is exhausted.

*According to Cameco, Japan has spent $10-$12 BN getting these assets ready for restart.

Despite shutdowns in the US, the phasing out of German reactors (in 2022) and the current Japanese situation, several countries are adding nuclear power plants, specifically China, Russia and India. According to the World Nuclear Association, there are 71 reactors (38 MM lbs of yearly uranium demand) under construction.

Current average uranium cash costs (including corporate SG&A) are estimated in the low $30s. The marginal cost of production (higher end of the cost curve) is in the mid $50s. As a result, I would expect projects to be put on “care and maintenance” if spot prices remain at current levels. To incentivize new supply prices need to be in the $60-$70/lb, or even higher price range.

While I expect uranium prices to recover over time, one issue is that utilities have ample inventories, so major players will not come back to the market near-term. As such, this shrinking supply-demand imbalance may not translate into higher prices until after 2015-2016. However, this does not mean that strategic buyers of assets/supplies, such as China, AREVA or Cameco will not see the value in purchasing a minority stake in LHM when prices are depressed. I think buyers will look through the trough prices and apply more of a mid-cycle price when bidding on the LHM stake.  

Projections - Sensitivities

Note that CEO's compensation increases if spot uranium prices exceed $45/lb.

The current uranium environment makes it difficult to value mines using spot prices. This would effectively result in zero value for many assets. Since I do not believe these prices are sustainable, I use two main valuation methods: 1) a range of normalized uranium prices to get EBITDA (and apply a multiple) and 2) precedent transactions on a $/2P (proved and probable reserves) and $/resource (M&I @ 100% / Inferred @ 50%) basis. 

Post-Fukushima, transactions for non-producing assets have ranged from $1/lb to $10/lb on a resource basis with an average of ~3.50/lb. More recent deals (2013 – 2 transactions) averaged $2.75/lb but these were small resource bases. For larger producing assets, the post-Fukushima average is ~$27/lb on a 2P basis (few transactions and wide range – ex. Kazakhstan asset multiple drops by half) and ~$7/lb on a resource basis. Small developing uranium names trade at $3.50/lb on a resource basis, but Paladin is unique in comparison as it has two operating mines not merely developing assets.

Assuming a normalized price range of $50-$60/lb*, I calculate that LHM EBITDA in the range of $100-$150 MM of EBITDA. At a 7x** multiple, this implies between $700-$1,050 MM of value. On a reserve basis, a multiple $5-$10/lb comes to a similar value of $625-$1,250 MM.

*Typically Paladin receives a premium to market prices. This assumes zero premium.

The same price assumptions implies $25-$50 MM of EBITDA at KM, or $125-$250 MM at a 5x multiple. I use a lower multiple at KM because its costs are higher and its reserve life is lower. On a reserve basis, a multiple $5-$10/lb comes to a similar value of $80-$160 MM.

Net, net, this comes to value of $700 MM on the low-end and north of $1 BN on the higher-end. My own view is that LHM is worth close to a billion on its own. Adding incremental value is Aurora, Mount Isa and other developing assets. Aurora was purchased for C$261 MM in 2011. At $1/lb, this is worth $110 MM. The Mount Isa projects are owned through an illiquid company listed on the Australian stock exchange (SMM AU). The shares do not trade much but the market capitalization does imply $80 MM of value. This is roughly in line with the $1/lb multiple.

These conservative values compare to total debt of $922 MM, or debt at market of $830 MM*. Both figures are before netting out cash of $125 MM, albeit this balance has been declining.

*Assumes liability to EdF is senior as this is partially secured by Aurora assets.

Conclusion

Catalyst

-Sale of stake in Langer Heinrich mine

-Restart of Japanese nuclear power plants

-Equity offering