Description

OVERVIEW
Stillwater Mining Company (SWC) produces platinum group metals (PGM) from two mines in southern Montana. The Stillwater Mine is located on the east end of a 28 mile long ore body. The East Boulder Mine, which just recently began production, is located at the western end. The J-M Reef, from which both mines draw, is the only known significant source of PGMs within the United States. The company also operates a single refinery equidistant from both mines.

Total proven and provable reserves of ore were 41,943,000 ounces at 12/31/01. At an estimated grade of 0.60 contained ounces per ton, these reserves are expected to produce 24,964,000 ounces palladium and platinum in a ratio of approximately 3.5 parts palladium to one part platinum .

Trading at $7.64, there are approximately 43.5 million fully diluted shares outstanding for an equity market capitalization of $332.4 million. Net debt (inclusive of capital leases) total $180.1 million at 9/30/02. On expected EPS for the current fiscal year (ending 12/31/02) of $0.87, SWC trades at 8.8X. With $12.87 in book value, the shares trade at 59% of tangible book value.

This year has been a difficult one for the company. After a spike in palladium prices during the early part of 2001 to around $1,100 per ounce, prices fell precipitously and hovered just below $400 for most of this year. Platinum prices likewise spiked and fell, but fluctuated within a much narrower band of $400-$600 per ounce.

The fall in prices coincided with the company’s heavy capital spending program intended to bring the East Boulder mine on line. As a result, resources were stretched thin and its financing came into question sinking the shares. Months later it was announced that the SEC had initiated an investigation into how the company estimated provable reserves. This announcement knocked the shares down another peg. Also, just months ago, the company encountered labor problems and announced that it might trip a bank covenant governing production volumes...yet another blow.

With these negatives one might wonder what’s to like in these shares.


INVESTMENT THESIS
Each of the issues that knocked the steam out of these shares, with the exception of metal pricing, have either been resolved or receded in significance. With stable metal prices and better productivity at East Boulder, these shares could appreciate by 70% in fairly short order.

SWC resolved the SEC provable reserve challenge by modifying a measurement methodology in place for over 16 years. Provable reserves were adjusted downward by approximately 10%, increasing amortization by about $5 per ounce and reducing annual earnings by about $0.04 per share.

On the financing front, the company has twice amended its $250mm credit facility (December 2001 and September 2002) and privately placed $60 million in equity in February of this year. The labor issues were also resolved with only minimum impact to the company.

Considering that a large portion of production is now under pricing contracts, the company is not fully exposed to metals market pricing. In fact, almost all production in 2003 is subject to average pricing floors as follows:




Palladium
PRICE FLOORS PRICE CAPS
% of Prod Price % of Prod Price
2003 95% $357 28% $400
2004 100% $351 39% $644


Platinum
PRICE FLOORS PRICE CAPS
% of Prod Price % of Prod Price
2003 98% $404 28% $569
2004 80% $425 16% $856


The pricing structure for 2002 produced realized prices in excess of market as follows :

3 Months to 9/30/02 9 Months to 9/30/02
Market Realized Market Realized
Palladium $325 $431 $355 $455
Platinum $542 $517 $523 $506


With regards to production and sales volumes, the addition of East Boulder has resulted in dramatic increases in tons mined, milled and sold year over year (9/30). The start up of East Boulder has not been without problems though. The grade of ore reaching the mill head is markedly inferior to that produced by the Stillwater Mine (combined mill head grade of 0.36 versus 0.57 for Stillwater). As a result, the East Boulder mine is relatively expensive to operate at this stage of its development.

To reduce capital commitments associated with East Boulder in the face of declining market prices, the company launched an optimization plan in 11/01. Total capital required to maintain ore production at 2,500 tons per day (lowered from 3,000 tons per day) at the Stillwater Mine are estimated to be $60 million in 2002, $40 million in 2003 and $45 million in 2004. The total capital required to maintain ore production at 1,000 tons per day (lowered from 2,000 tons per day) for the East Boulder Mine is estimated at approximately $15 million annually. The company incurred one-time charges totaling $11.0 million in connection with the optimization plan, which were recognized in the fourth quarter of 2001.

Production volumes are expected to be in the range of 700,000 ounces annually going forward, though through 9/30/02 the company seems to be below this annual rate.

In summary, price floors have resulted in realized prices for palladium exceeding market prices, production volumes have increased (though not by as much as initially planned), capital has been reduced, but total costs have been impacted by the start-up of East Boulder. Additionally, much of the financing risk has been managed through an equity raise and amendments to credit agreements.

I expect that production costs, assuming no further labor disruption, will trend downward over time as a result of improved ore grades reaching the mill head from East Boulder. Market pricing seems to have stabilized as supply and demand dynamics have improved and, with so little of its production subject to caps in the coming years, any increase in market prices will be realized by SWC.

The current discount to book is not justified. Though the shares have appreciated significantly during the last month as a result of the reduction of perceived financing risk , there is much more room to move upward from here.


INDUSTRY OVERVIEW
Demand for palladium and platinum have increased dramatically since 1992.

(million ounces) 1992 2001 % Change
Palladium 3.9 6.8 74%
Platinum 3.8 5.9 55%

Approximately 50- 60% of PGM metals are consumed by the automobile industry where the metals are used in catalytic converters. Tougher worldwide emission standards are likely to drive further demand growth in the future. The metals are also used by the electronics industry, in dentistry, jewelry and a diversity of industrial uses. In addition to the secular trend in the auto industry, the metals are expected to see their demand increase as the economy improves.

The metals are mined primarily in South Africa and Russia.


FINANCIAL OVERVIEW
(Please see company documents for further detail)

VALUATION REVIEW
Given the uncertainty surrounding metal prices, the best way to get your arms around what these shares might be worth is to make plausible and conservative assumptions for key drivers of cash flow and to qualitatively assess upside opportunities.

2002 Performance
Sales $290
EBIT $ 70
EBIT Margin 24%
Cash (9/30) $42
Debt (9/30) $222
Shares (9/30) 43.5

Projected Performance (2003-2008)
Sales Growth 3%
EBIT Margins 25% growing 1% per year and remaining flat at 27%
beginning in 2005
Tax Rate 28%

Incremental Capital
W/C 10% of sales
Net Capex 2003 $15
2004 $15
2005 $10
2006 $10
2007 $10
2008 $10

Discount Rate 10%
Perpetuity Growth 3%

These assumptions produce an estimation of value in the $11 per share range.

For upsides, this point in time assessment doesn’t capture the impact on equity value of the deleveraging likely to take place from the 9/30 balance sheet throughout the holding period. Additionally, short of significant metal price weakness, the 3% revenue growth assumption, particularly in the early years, seems conservative considering the additional capacity at East Boulder. Finally, as that mine gets up to targeted production levels the impact on costs could be more dramatic that the improvement modeled.

In summary, getting to book value is not implausible. Such a move represents 68% appreciation potential and might be had in as little as a couple of reporting cycles.

Catalyst

Improvement in operation of the East Boulder mine. PGM price improvement.