Description

Sprott Resource has done it again, almost doubling their book value with another fantastic investment. And once again investors are not paying attention. Due to a well-timed investment in a distressed energy company, Sprott is now worth around C$6 per share thanks to the newly public Orion Oil & Gas (Toronto: OIP: C$1.50). Investors aren’t paying attention to the fact that Sprott’s stake in Orion alone is worth around $340 million. With further catalysts coming later this year including another Sprott investment going public, Sprott Resource is offering investors an opportunity to make an easy 50% plus returns this year even after last year’s impressive gains.

Eric Sprott, the Chairman, is one of the best resource investors around

Eric Sprott, the Chairman of Sprott Resource, is also the chairman of Sprott Asset Management, which has nearly $5 billion in assets under management in Canada. He is also the founder of Sprott Securities, which is now called Cormark Securities, a mid-size Canadian brokerage firm. He founded Sprott Securities in 1981 and split off from it in 2002 to focus on money management.

His main hedge fund, Sprott Hedge Fund, was only down 2.8% in 2008 (a year when most commodity stocks plunged over 50%) and is up over 22% annually since inception in 2000. In November 2008, due primarily to superior performance, Hedge Fund Intelligence nominated Sprott Asset Management in the “Management Firm Of The Year” category at the 2008 Absolute Return Awards.

Check out the Sprott website for more information on this impressive firm with great long-term results: http://www.sprott.com.

So what exactly is Sprott Resource?

Sprott Resource is a public company that is managed like a hedge fund or private equity fund, without the use of any leverage.

The advantages that Sprott Resource has as a corporate entity over mutual or hedge funds is that by having a captive pool of capital, they have the flexibility to invest in private companies or in long term deals, without the worry of clients pulling money out.

Further because of Sprott’s expertise and connections to management teams and resources all through Canada, management has access to a wide breadth of deals and opportunities that most investors never get to see.

And due to their non-levered structure and long-term capital, Sprott Resource is a very attractive partner to other companies; Eric Sprott’s positive reputation in Canada is a bonus as well.

Hedge Fund’s Style of Pay

The way Sprott Resource management gets paid is very unique for a public corporation. Management is paid like a hedge fund with a management fee of 2% of the assets and 20% of the profits at the end of every year.

The 20% incentive paid is based on pre-tax earnings (i.e. realized gains), so unrealized gains that flow through other-comprehensive income do not count.   Further, Sprott values privately held securities in which they own less than 20% of, at cost. Management evaluates valuations each quarter and writes down the carrying value if necessary.

Finally, there is a hurdle to the incentive payment being paid. The profit has to be over the average rate for the year of the 30-year Canadian generic bond index.  A copy of the Management Services Agreement can be found on their website, which outlines the incentive fee calculation in greater detail.

This is a unique way to get paid and some people may not like this at all. I will point out that there are no salaries or options or bonuses. What is very attractive about this set-up is that all compensation is very straightforward and there are no hidden expenses or dilution as is the case with most companies.

There is another example of a corporate entity being compensated as if it were a hedge fund and that is Greenlight Capital RE (NASDAQ: GLRE). GLRE is a reinsurer, which compensates, pays management 2% and 20% on its investment returns. For those who think that this type of payment structure deserves a discount, GLRE trades for about a 20% premium to book value.

Track Record with PBS Coals is quite compelling

Since Sprott Resource was formed, their track record has been quite good. In fact, they hit a home run with PBS Coals in 2008. Sprott had invested US$55 million in December 2007 through April 2008 and sold it in November for US$200 million to OAO Severstal, one of Russia’s largest steel companies.

PBS Coals is a low cost producer of private metallurgical coal in Pennsylvania that needed funding to expand production and also to buy out existing investors. This is an excellent example of what to look for in the future, since financing is harder for resource companies now.

Just hit another home run with Orion Oil & Gas

Just like with PBS Coals, Sprott took advantage of a tight financing environment to invest a little over $100 million into Orion Oil & Gas (Toronto: OIP), which is now public. That stake is now worth around $340 million, as Sprott owns 229 million shares of OIP.

Orion is a fast growing exploration and production, energy company focused on Alberta, Canada and has 2,650 boe/d of production on its way to 7,000 boe/d of production by year’s end. Orion has 18.0857 million barrels of oil equivalent (MBoe) in proven and probable reserves and is about 45% light oil and 55% natural gas.

There are number of ways to try and value OIP, which is important since it is the biggest piece of the valuation of Sprott. The two I am focused on is on a multiple of debt-adjusted cash flow for 2010 and on an enterprise value to reserves.

Orion currently trades for around 7 times cash flow for 2010. On a multiple of cash flow it appears a bit expensive compared to many other Canadian juniors, which trade for 4-5 times multiples to cash flow, but Orion, is growing really fast, much faster than comps. It should grow its production this year 180% from beginning of the year to year-end. Further, it has little or no debt and it has a well-capitalized partner in Sprott that removes financing risk.

On an enterprise valuation to reserves it comes out cheaper than comps with a valuation of about US$19 per barrel per barrel. Most comps trade on average for over $20 per barrel equivalent.

Here is the bottom line for investors in Sprott, OIP has to trade below $0.50 per share versus its current price of around $1.50 for Sprott to be worth less than its current stock price. Before getting to the valuation, let’s check out some of the other big Sprott investments.

Stonegate Agricom

Stonegate Agricom Ltd. is an approximately 79% owned subsidiary of Sprott Resource Corp., which indirectly owns and is working on exploring and developing the Mantaro Phosphate Deposit located in Peru.  Stonegate Agricom is independently managed.

Stonegate potentially has a very large phosphate mine in Peru and a recent report estimated that the inferred mineral resource on the Philip concession of the Mantaro Phosphate Deposit is 45.17 million tonnes grading at 15.4% P2O5. Phosphate prices have soared in recent years due tremendous demand for use as a fertilizer in agriculture, and a shortage of supply.

This is worth about $32 million (63.6 million shares at a recent financing price of $0.50), but a new resource estimate due out soon, could make it worth much more.

Waseca Energy

Waseca Energy Ltd. is a private oil and gas company and another subsidiary of Sprott Resource Corp.  In October 2008, Sprott Resource Corp. funded over $27 million to acquire over 79% of Waseca. Sprott recently participated in a follow on offering of $20 million and increased their stake to 81.3%.

Waseca’s primary focus is heavy oil production from the Lloydminster area on the border of central Alberta and Saskatchewan.  Waseca currently owns four prospective petroleum and natural gas leases, has started drilling, and will continue to drill on its existing leases as well as pursuing additional acquisitions.

The independent management team at Waseca has an average 33 years of technical and managerial experience in the oil and gas sector.  Prior to founding Waseca, management generated significant production growth in the Lloydminster area while employed at a major independent oil and gas company.

Management hopes to bring Waseco public by year-end just like Orion. Sprott owns 73.64 million shares of Waseco at a recent valuation of $0.60 per share indicating a value of $44.2 million. In IPO, this would garner a much higher multiple.

One Earth Farms Represents a Huge Opportunity

In March of 2009, Sprott Resource announced that it was launching One Earth Farms, a large-scale farm in the First Nations’ farmland of the Prairie Provinces in Canada. Sprott invested $27.5 million to establish operations, fund working capital and support its initial growth.

The plan for One Earth Farms is to start with an initial 50,000 acres and grow to possibly one of the largest farms or the largest contiguous farm in North America on untapped First Nation land (First Nations tribes are similar to Native Americans in the US).

I am huge bull on agriculture, the prospects for agriculture companies and for grain prices in general and think this could be an absolute home run. There are very few ways to invest in agriculture and One Earth Farms could be quite an attractive stock to many investors, especially considering it is in such a stable country as Canada.

The company has been an Active Buyer of its Stock

The company has bought back over 3.1 million shares at prices as high as $4.10 in the last year. The aggressive buyback should serve as a protection for investors on the downside. As the stock has continuously sold below book value the company has bought back over 15% of the stock in the last two years. If the stock continues to languish below book value, expect management to once again begin buying back shares.

Valuation

There is some work involved in getting to the cash balances and gold balances. Since the last quarterly report (9/30), the company has put money to work and bought some gold and sold some silver. Here is my analysis of what Sprott is worth today:

There are some caveats and important points to note. First, Sprott management gets paid a percentage of the profit, so there is an incentive fee that I have not taken out. The incentive fee should be about $25 to as high as $40 million, which would lower the valuation by $0.22 to $0.35 per share. Second, this lists the value of One Earth Farms, Stonegate and Waseca at their last financing as a valuation. They could be worth much more than what is listed above. Finally, this assumes that the warrants that convert at $4.25 actually convert. The fully diluted share count includes the exercise of the warrants.

Optionality of investing with Sprott should be worth something

I think that at a minimum, the stock should be trading around $5.50 per share (net asset value minus incentive fees). Even more, the stock really should be trading at a premium to book value of 1.1 to 1.2 times. Why? I think there is tremendous optionality and value to Sprott’s access to deal flow, management teams and insider type opportunities. The examples of the private equity investments in PBS and now Orion are an excellent example of how much value this team is creating. Further, One Earth Farms is exactly the type of investment that we as ordinary investors have no access to.

Finally, I will point out that when Sprott Resource went public, investors were so excited that they bid the stock up to over 2 times book value, which was initially C$1.50 per share. For this reason, my initial price target for Sprott is C$6.60 a share (1.2 times NAV), 57% higher than current prices. Twelve to eighteen months from now, Sprott could be trading as high as $8 based on a premium to NAV and a Waseco IPO.

Please note that I wrote this stock up in April 2009 at $2.65 per share, arguing that its then book value of $3.50 was worth $4 per share. That recommendation has proven to be conservative.

Summary

In summary, I think Sprott Resource is an opportunity to buy $1 worth of assets at $0.75, and the value of these assets are growing. With shrewd management, who has access to deals normal investors don’t with a history of creating value, there is no reason why Sprott should be trading for Benjamin Graham type prices. Once investors realize how much larger Sprott’s net asset value is, the discount is likely to disappear. With little downside, due to its incredible balance sheet strength, Sprott Resource offers investors an incredible risk/reward situation.

Catalyst

-Announcement of NAV with year-end results

-More news from Orion, driving Orion’s stock higher

-News on Stonegate

-Continuation of Sprott’s buyback

-IPO of Waseco

-News on One Earth Farms