Description

I am recommending Sprott Resource Corp (SCP on the TSX and SCPZF OTC), which sells at a material discount to NAV that I believe provides a substantial margin of safety.  SCP has been posted twice to VIC, in 2009 and 2010.  Although the asset mix is different, the structure of SCP is well documented in the previous writeups, and I refer you to them for background. 

SCP is basically a publicly traded private equity fund focused on investments in the commodity sector, particularly energy, oil and gas services, and agriculture.  SCP was founded by and remains affiliated with the Sprott group of companies (see http://www.sprottinc.com), which has a long track record in precious metals, mining, and other commodities.  Although SCP’s longer term investment track record is pretty solid, it has not particularly distinguished itself in recent years in a difficult environment for commodities investing generally (which could make this a propitious time to invest).  This, together with confusing strategic moves and a change in management, has led the stock to depart substantially from NAV.  More specifically, in December 2012, the Company instituted a dividend policy whereby it intended to pay a monthly dividend at least equal to 0.833% of book value.  The press release went on to declare that “management believes that it can sustain the Dividend Policy and grow SRC’s Book Value per common share over the long term.” 

I should note that SCP had a policy of holding gold in lieu of cash, and at year-end 2012 the Company held some 74 million ounces of gold worth $123 million (over $1600/ounce).  You may also recall that gold had peaked in 2011 and by late 2012 had begun a sharp decline.  Fast forward a few quarters and a 25% plunge in the price of gold.  When SCP reported second quarter results in mid-August last year, it also announced that it would “cease paying monthly dividends in order to preserve capital and protect our ability to continue effectively executing our business plan.”  The Company subsequently sold all of its gold holdings and eliminated its debt (which was effectively margin debt secured by the gold and thus subject to margin calls).

SCP’s stock had already begun following the gold price lower by the time of this announcement, however, it traded down a further 10+% that day and would continue to be puked out by investors holding the stock for the dividend.  From the day before the announcement through year-end, SCP declined roughly 35%.  In the interim, the CEO was sacked and replaced by the sitting CFO, who was in turn replaced in that role by a Sprott Inc. Finance VP.

At year-end 2013, SCP reported its NAV at $3.64/share consisting of the following:

It’s pretty clear that a small number of large investments drives SCP’s value, starting quite obviously with Long Run Exploration, which trades on the Toronto Exchange (ticker LRE) and currently changes hands at $5.67/share, which is up 7% from the $5.31 price at year-end that is embedded in SCP’s NAV calculation above (SCP owns ~28% of LRE).  We are fortunate that LRE was posted to VIC just five months ago by cnk123 so please see that writeup for more detail on LRE.  I also invite cnk123 to weigh in with his variant view on SCP.

LRE is an intermediate oil and gas company that acquires, explores for, develops, and produces crude oil and natural gas in Western Canada. It primarily focuses on controlled exploitation and strategic acquisitions within the Peace River and Edmonton regions of the Western Canadian Sedimentary Basin.  LRE is pursuing a yield-driven model (current yield ~7%), and at current dividend rates provides over $14 million annually to SCP.

LRE recently announced the $225 million acquisition of liquids-rich natgas assets that provide a sizable, additional core area in close proximity to its existing Peace River and Redwater core areas.  This synergistic acquisition is accretive and has been well received.  Concurrent with the deal announcement, LRE increased its annual dividend by 5% and provided solid 2015 guidance.  Although cnk123 positioned LRE as a trading idea based in part on the expected disposition of SCP’s 28% stake (which according to cnk123 was being shopped) and thus the removal of an overhang, that appears not to have been the case.  In any event, we agree with his assessment that LRE is cheap in its own right and should prove to be an attractive asset for SCP going forward.

SCP owns 31.7% of Independence Contract Drilling (“ICD”), a Houston-based onshore drilling services provider founded in March 2012.  ICD (and Stonegate Agricom) are accounted for using the equity method (unless it is determined that the equity investments are impaired), and as such are marked to market at each balance sheet date.   According to SCP:

ICD's custom designed and company built ShaleDriller series rigs are designed for unconventional resource plays, incorporating the newest technologies fielded in land drilling operations. ShaleDrillers are land rigs targeted for the development of U.S. exploration and production clients’ exploration and development programs. The ShaleDriller series rigs are alternating current, programmable, energy efficient and offer BiFuel capabilities. Unlike skidding rigs, ShaleDriller’s true multi-directional "walking" systems are not slowed down by mis-aligned well bores or uneven locations and can walk over existing wellheads.

ICD's fleet has grown to eight rigs, including one rig that is in the final stages of construction for mobilization in April 2014 and one rig being upgraded. In addition, two additional rigs are currently under construction. ICD has a $100 million senior secured credit facility, expandable to $125 million subject to certain conditions, and ICD's fleet has achieved utilization above 90% at premium day rates in the $21,000 - $25,000 range depending on application. ICD believes its operating costs per operating day are among the lowest in the industry and believes there is growing demand for its premium fleet and drilling services as development of unconventional and shale resources in the US drives demand for technologically advanced equipment such as the ShaleDriller rig which is custom designed for these applications.

As a private company, we have limited information regarding ICD’s financial performance and prospects, but given the asset heavy nature of the business and the recency of the investment, valuing SCP’s stake at book value appears reasonable and may in fact be conservative.

Let’s take a step back for a moment because LRE and ICD together are worth more than the entire market cap of SCP.  If you believe these two assets are worth what they are indicated (in the case of LRE, we think they are worth considerably more), then all the other assets add to an investor’s margin of safety in SCP.

SCP has invested $28.7 million and owns 6.9% of Union Agriculture Group (“UAG”), which CapitalIQ describes as follows:

[UAG] engages in agricultural and agricultural-related activities in Uruguay. It involves the breeding, purchasing, and/or fattening of beef cattle for sale to meat processors and local livestock auction markets; and breeding, purchasing, and/or fattening of sheep for sale of meat and/or wool to meat processors, wool product manufacturers, and wool cooperatives. The company also engages in the planting, harvesting, and sale of wheat, soybeans, sorghum, and rice; and breeding and/or purchasing dairy cows for the production of raw milk for sale to local milk and milk-related products producers. In addition, [UAG] grows blueberries; and engages in apiculture activities, such as sale of products, including honey, pollen, and propolis, as well as provides pollination services to third parties. Further, the company leases agricultural properties.

According to UAG’s website, it is the leading agricultural business in Uruguay with over 100,000 hectares of agricultural land over 35 farms.  It is impossible to know what UAG is worth, but this is a substantive business that has raised significant capital (most recently $110 million in February 2013).  Inasmuch as SCP is an audited public company, it is likely that it carries UAG at a value no higher than the price at which UAG last raised capital.

One Earth Farms (“OEF”), now 54% owned by SCP, was formed in 2009 as a large grain and cattle farming business operating in Western Canada and, since inception, has operated livestock ranches as well as grain and oilseed farms in the provinces of Alberta and Saskatchewan. In early 2013, One Earth Farms also began to vertically integrate into branded food products with the purchase of Beretta Farms, a purveyor of hormone free and antibiotic free natural and organic branded meat products.  Beretta is a brand of fresh beef, poultry, deli products and meal solutions in six Canadian provinces.  In connection with the transaction, Mike Beretta joined the executive committee of One Earth Farms as COO and has since become CEO. 

It is pretty clear that the original agricultural strategy for OEF was not working, and SCP has changed course with the acquisition of Beretta, with which came new management.  It is difficult this early in the implementation of this new strategy to draw any firm conclusions, but we view the book value of OEF as likely overstated relative to current intrinsic value, though it is difficult to say exactly what it is worth.

One Earth Oil & Gas (“OEOG”) was formed as a partnership between SCP and the First Nations (Canadian Indians) for pursuing oil and gas exploration and development opportunities on First Nations land in Western Canada, primarily in Alberta, where it has oilsands leases that it intends to develop though current production is de minimus.  Like OEF, it is difficult to assess what the current intrinsic value of OEOG is, but it appears likely that some discount from book value may be appropriate.

Stonegate Agricom is a microcap (ticker ST on the Toronto Exchange) that produces and supplies phosphate rock concentrate that is used in the manufacture of phosphate-based fertilizers. Its principal project is the Paris Hills phosphate project that consists of 3 patented lode mining claims and 21 contiguous fee parcels covering an area of approximately 1,010.5 hectares located in Bear Lake County, Idaho.  Stonegate Agricom will continue to pursue the necessary permits to begin construction at the Paris Hills Project, subject to market conditions and the availability of necessary financing to proceed with construction and ultimate operation of the Paris Hills Project.   SCP’s stake in Stonegate is valued at market, but this is obviously a speculative venture and should probably be viewed as a lottery ticket.

In sum, SCP’s investments in LRE and ICD are worth more than SCP’s current share price, and I believe they should limit downside risk.  Meanwhile there are numerous upside opportunities from SCP’s remaining investments that you are not paying for.  The nature of private equity investments is that returns are not linear.  The owner typically controls the manner and timing of exit, and when monetization happens, NAV can gap up materially.   It only takes one or two other winners to emerge for this investment to work nicely.

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