Description

Most of my ideas are simple buys or sells, so I apologize in advance. This isn’t your typical meat-and-potatoes type of idea, but I felt it was compelling enough to write up and post.

Stillwater Mining Company (NYSE: SWC) operates two mines in Montana (Stillwater and East Boulder) that produce platinum (Pt) and palladium (Pd), which are platinum group metals (PGMs). PGMs have a variety of applications, including uses in dental fillings, electronic components, and jewelry. The largest consumer of these metals is the automotive industry, which uses them in catalytic converters to help convert engine emissions such as carbon monoxide and hydrocarbons into carbon dioxide and water. The tables below summarize recent supply and demand data:

2003 Platinum and Palladium Demand by Industry (000s of ounces)
Automotive 6,850
Recycled Auto (1,060)
Jewelry 2,695
Chemical/Industrial 1,850
Electronics 985
Dental 815
Other 105
Total 12,240

2003 Platinum and Palladium Supply by Country (000s of ounces)
Russia 3,900
South Africa 7,071
North America 1,135
Other 324
Total 12,430

The market prices for PGMs have been somewhat volatile in the past 5 years. Recently, the market price for platinum was $800 an ounce, while the market price of palladium was $260 an ounce. Platinum is typically more expensive than palladium, but since the metals are somewhat interchangeable in automotive applications, industry analysts expect the gap between the two metals to narrow. One reason the gap is currently high: Russia, by far the largest producer of palladium, significantly cut supply in 2000. This caused palladium prices to skyrocket to over $1,000 an ounce (platinum was $550 an ounce at the time). The automotive industry switched over to the then-cheaper platinum, and has yet to switch back with any conviction. The supply shock had a significant effect on the demand for each metal:

1999 Palladium Demand - 9.4 million ounces
2003 Palladium Demand - 5.6 million ounces

1999 Platinum Demand - 5.6 million ounces
2003 Platinum Demand - 6.6 million ounces

For the two metals combined, demand has declined significantly. While the automotive industry switched from one metal to another, other industries reduced consumption absolutely. For instance, the electronics industry found cheaper metals to replace palladium in capacitors and other components, and its PGM consumption is down over 50%. Inventory depletion also contributed to the decline in demand.

Getting back to Stillwater, the company has the following mine reserves (90% of which are classified as “probable” reserves):

Platinum 5.2 million ounces
Palladium 18.3 million ounces
Pd:Pt Ratio 3.5:1

And last year the production numbers for Stillwater were:

Platinum 134,000 ounces
Palladium 450,000 ounces

That’s about 5% of world supply.

INVESTMENT POSITION

OK, time to cut to the chase. Stillwater is currently trading for a little over $13 a share, which works out to a market cap of about $1.2 billion. For SWC to be worth $1.2 billion, I would expect them to have average net income of $96 million in the future. That’s an 8% return, which is a reasonable required rate for a company with Stillwater’s risk profile. Assuming a 25% tax rate, they should be making $128 million pre-tax.

So what would need to happen for Stillwater to make the $128 million pre-tax that would justify the current stock price? In 2003, excluding asset impairment charges of $325 million(!) (I’ll get to that later), Stillwater reported a net loss of $7 million. Their total expenses in 2003 (before charges) were $247.7 million, none of which was attributable to taxes. That works out to about $424 per ounce ($247.7M/584k).

With costs of $424 per ounce, at the current level of production, in order for Stillwater to earn $128 million before taxes, their revenue would have to be $643 per ounce (584k ounces * ($643-$424) = $128M).

How can revenue reach $643 per ounce? (This is starting to feel like a math proof from 8th grade...) Well, Stillwater’s production mix is 3.5:1 palladium to platinum. So, if platinum stays constant at $800 an ounce, the price of palladium would have to rise to $598 an ounce ( (3.5 x $598 + 1.0 x $800)/4.5 = $643).

So .... something has to give. If palladium is worth $598 an ounce, then SWC is worth $13 a share, but if palladium is worth its current $260 an ounce, then SWC is not even a viable business. And yet SWC trades for $13 even though the spot price for palladium trades is $260 an ounce.

How can you take advantage of this discrepancy? Easy. Sell SWC short, and use the proceeds to buy palladium. If the price of palladium stays low, then SWC will inevitably drop to $5 (book value) or lower, and you make money on your short position. If palladium rises to $598, then SWC really is worth $13 a share, and you make money on your palladium position. If you take an equal-sized long and short positions, the net investment would be zero (although you’d probably need to dedicate additional capital to the account holding the short position to meet maintenance requirements).

In the market, both the price of palladium and SWC stock are continuously changing. The following table shows -- at various market prices for palladium -- the potential profit for each 100 shares of SWC shorted at $13 (and each 5.00 ounces of palladium purchased at $260 with proceeds from the short sale):
...
Price of Pd SWC Net Income* SWC Value (share value)** Potential Profit***
$200 -$39M $470M ($5.22) $478
$300 -$6M $470M ($5.22) $978
$400 +$29M $470M ($5.22) $1,478
$600 +$96M $1.20B ($13.33) $1,667
$800 +$165M $2.06B ($22.92) $1,708

* = 584k ounces x ( (3.5 x Price of Pd + 1.0 x $800) / 4.5 - $424) x (100% - 25% taxes)
** = Annual Net Income / Required Rate (8%) ... minimum = $470M (book value)
*** = ($13 - SWC intrinsic value per share) x 100 + (Price of Pd - $260) x 5.00

While the net investment is zero, this position is by no means risk-free. As for specific risks, there are plenty of them, and the table above is meaningless if the assumptions it is based on break down, which are:

- Stillwater’s mine production is constant at 584,000 ounces per year.
- The market price of platinum is constant at $800 an ounce.
- Stillwater’s cost per ounce sold is constant at $424 per ounce.
- The required rate of return is 8%.
- It is economical for Stillwater to mine the entire 23.4 million ounces of PGMs in its reported “probable” reserves.
- Eventually, the market value of SWC will approximate its intrinsic value, and the position can be maintained for as long as it takes for this to happen.
- In the meantime, there will be no intervening events (such as an acquisition of SWC).
- Stillwater does not discover a more PGM-rich deposit on which it owns or acquires mining claims.
- In the future, Stillwater will not be able to renegotiate contracts to sell PGMs for significantly above market prices.

These are some significant assumptions. The question is: Is the margin of safety in this position large enough when considering the risks?

This is already shaping up to be a tome, but I’d like to take a look at a few of these assumption. I’ll start by looking at Stillwater’s accounting practices, which offer a significant margin of safety.

ACCOUNTING

As Stillwater spends cash developing the shafts and other infrastructure of the mines, they don’t expense all of it. They will use the infrastructure to extract PGMs for the next 10-20 years, so they capitalize these development costs and depreciate them over the life of the mine. I don’t disagree with this accounting principle. Quite the opposite, in fact. I agree with it. But what troubles me is the amount which is capitalized and the rate at which it is depreciated.

They’ve been mining at the Stillwater mine for 15 years. In this time, they’ve capitalized $434M in mine development, of which approximately $130M has been depreciated as of 2002. So there’s still $304M on the books as an asset relating to the Stillwater mine, which essentially represents prior cash expenditures that are “waiting” to be expensed.

Not only will they need to expense the $304M by the time the mine closes ... they’re still capitalizing cash expenditures! Management recently indicated they will capitalize another $52M for the Stillwater mine in 2004. So that will need to be expensed sometime, too. After 15 years you have to wonder: when will they stop capitalizing these cash outlays?

Eventually, the mine will be closed -- and that day may be sooner than is expected, since the ore grade (ounces of PGMs per ton) has been decreasing (from 0.80 in 1994 to 0.51 in 2003). As the mine’s retirement grows closer and closer, they will either have to substantially increase depreciation expense, or take a big accounting charge.

Taking the accounting charge scenario to the extreme, if you declare $300M in earnings from a mine and then take a $300M charge, you didn’t really earn $300M ... you broke even. So much for the matching principle, right?

I think Stillwater is not depreciating their capitalized mine development as quickly as they should be, and thus are overstating profits substantially. As evidence that Stillwater isn’t really making money, take a look at the earnings it has declared versus its free cash flow (defined as cash flow from operations minus cash flow used in investing activities):

Year Net Income Free Cash Flow
1996 -$2.8M -$36.9M
1997 -$5.4M -$13.4M
1998 +$13.4M -$23.4M
1999 +$37.2M -$126.5M
2000 +$61.5M -$73.8M
2001 +$65.8M -$88.9M
2002 +$31.7M -$3.8M

Total +$201.4M -$366.7M

In the end, this is a game. Huge cash expenditures are required up front to develop a mine. So if you’re management, and you’re having trouble making a profit, you just delay expensing for a while, and it will look like everything’s fine. Sooner or later, though, they’re going to have to face up to that $549M of cash they’ve used but not expensed. You can declare all the profit you want, but cash flow reveals the truth.

Based on reserves and past and projected production activity & costs, it is my opinion that Stillwater has understated total depreciation by $221M over the past 8 years. Thus, instead of earning a total of $201M during that period, the true economic condition of the company shows an aggregate net loss of $20M upon restatement of past depreciation expenses.

I wrote this section a while ago, and there have been some recent developments to update you on. In the fourth quarter of 2003, Stillwater took a $325M asset impairment charge to write-down their capitalized mine development ... that’s more than the $221M I had estimated (implying -- considering the date this was posted -- that I can’t even predict the past accurately!). Filling in the 2003 numbers in the above table:

Year Net Income Free Cash Flow
1996-2002 +$201.4M -$366.7M
2003 -$331.5M -$8.0M

Total -$130.1M -$374.7M

And now we’re getting closer to reality, with cash flow tracking declared earnings a little more in the vicinity of reasonable. Next I want to look at Stillwater’s production costs in light of this new information.

COST

In its 2003 earnings release, Stillwater claimed that its cash costs per ounce produced in 2003 were $283, and production costs per ounce were $354. I think a better picture of their true economic condition is: How much did you spend vs. how many ounces did you produce? You can play all the accounting games you want, but in the end, total costs per ounce is what matters.

Stillwater’s total costs per ounce were $424 in 2003 ($247.7M total expenses before charges/584,000 ounces of PGMs produced). But the asset impairment charge is the result of years of understated depreciation expense. Using the restatement of depreciation discussed above, I think Stillwater’s true costs are about $470 per ounce of PGM (which reflects a $27 million depreciation understatement for 2003).

If Stillwater’s true costs are $470 per ounce of PGM (not $424), this provides for a substantial margin of safety in my proposed arbitrage position, as I used $424 in the calculations presented above.

REMAINING ASSUMPTIONS

- The market price of platinum is constant at $800 an ounce.

Theoretically, platinum could rise to $2,000, thus making Stillwater profitable even if palladium stayed at $260 an ounce. This is highly unlikely, though, for reasons discussed above. However, for a more perfect hedge, a position in platinum could be taken. While you’re at it, you may want to look at the advantages and disadvantages of various weightings so the net investment is not exactly $0. And as long as I’m mentioning variations or alternatives, you may want to investigate shorting Stillwater and going long a lower-cost PGM mining company, such as North American Palladium.

- Stillwater’s cost per ounce sold is constant at $424 per ounce.

As discussed previously, there is a substantial margin of safety between the $424 per ounce used in the calculations and my estimate of $470 for their actual total costs per ounce. But any decrease in total costs per ounce would have a significant effect on the investment.

If Stillwater develops a substantial relationship to re-market Norilsk-produced palladium, this could reduce total costs per ounce sold. However, in its recent earnings release, Stillwater said it was decided (presumably by Norilsk) not to pursue such an arrangement at this time.

In 2003, Stillwater announced that it would begin purchasing scrap catalytic converter material from Power Mount, Inc. of Kentucky to be processed in its mills. If recycling activity becomes substantial, this could also reduce the cost per ounce produced. Signs that the recycling business is becoming large were apparent in the first quarter, but their contribution to profits has been minimal so far.

Finally, if mine conditions change or management improves efficiencies, this could also reduce total costs per ounce.

On the flip side, since the East Boulder mine (which will outlast the Stillwater mine by up to 20 years) has a much lower ore grade, this should put upward pressure on production costs per ounce.

- It is economical for Stillwater to mine the entire 23.4 million ounces of PGMs in its reported “probable” reserves.

There is an additional margin of safety here. The scenario I used before is the rosy one for Stillwater. It assumes (1) that their “probable” reserves become “proven”, and (2) that they will be able to mine 100% of these reserves. But do you think the proven & probable are as easy to get at and as PGM-rich as what they’ve already mined? The data (and simple logic) seems to suggest that overall they won’t be, as ore grade (ounces of PGMs per ton of ore) has decreased from 0.80 in 1993 to 0.51 last year. So for every ton of ore they mine, now they are getting only 64% (0.51/0.80) as many ounces of PGMs as they were in the early 1990s. This is a major reason why the cost per ounce has more than doubled in that time.

- The position can be maintained for the long-term.

The reason to buy actual palladium (in sponge form) instead of futures and short SWC instead of buying puts is you can maintain that position for as long as it takes for the market prices to return to equilibrium. In the short run a stock can do anything. This proposed position can be maintained for the long term, until the current "voting machine" for SWC turns into a "weighing machine", whenever that happens (days, months, or years).

- There will be no intervening events (such as an acquisition of SWC).

In 2000, even though the PGM market was booming and Stillwater had lucrative sales contracts, the capital-intensiveness of the business was a big strain. By 2002, Stillwater was desperate for cash, and solicited institutions to offer financing arrangements. Only two institutions made proposals. One was a rights offering which management rejected. The other was an offer from Norilsk Nickel to acquire 45.5M newly-issued shares representing a 51% ownership interest in Stillwater for $341M, or $7.50 a share. Stillwater management accepted the offer, which was cleared by the FTC.

The deal was approved by shareholders and closed in 2003. In the fall, Norilsk exercised its right to purchase an additional 4.35M shares in a tender offer for $7.50 a share. This majority ownership presents risks to shorting SWC in any capacity, as Norilsk could bail Stillwater out of future trouble, or make an offer to acquire the remaining shares outstanding at a price that is significantly above its intrinsic value.

- Stillwater does not discover a more PGM-rich deposit on which it owns or acquires mining claims.

While this is a possibility, it is somewhat unlikely. Stillwater has done a number of tests to find the most PGM-rich deposits that are economical to mine. As evidence that the Stillwater mine is the most PGM-rich, look at the East Boulder mine. Ore grade at the Stillwater mine is 0.65 ounces of PGMs per ton, while ore grade at the East Boulder mine is only 0.53 ounces per ton. And yet management has elected to pursue mining at East Boulder anyway. Absent major cost efficiencies, that could be taken as evidence they searched thoroughly for the best site and decided East Boulder was it.

- In the future, Stillwater will not be able to renegotiate contracts to sell PGMs for significantly above market prices.

Stillwater currently has contracts to sell about 90% of its palladium production for at least $360 through 2010. These contracts were signed in 1998, and adjusted in favor of Stillwater during the 2000-2001 mania when Russia cut supply. It seems unlikely palladium-consuming businesses would fall victim to a similar mania again anytime soon. But if Stillwater is able to sign additional contracts at above market prices, then their revenue per ounce will be higher than the market prices. This would significantly affect the investment position.

SUMMARY

Well, it sure took a while, but I’ve tried to present my idea and all the facts as thoroughly and objectively as possible. Each person should decide for himself whether it was truly objective or if “methinks thou doth protest too much.”

To summarize, in order for Stillwater Mining Company to be worth $1.2B ($13 a share), they should have earnings of about $96M. To achieve this, the price of palladium would have to climb to $596 an ounce (ceteris peribus). However, SWC is currently trading at $13 a share even though palladium is only worth $260 an ounce. As an arbitrage position, I recommend selling SWC short and using the proceeds to buy palladium.

My recommended position is not a bet that SWC is going to drop. Neither is it a bet that palladium will rise. It is merely a bet that SWC is not worth $13 a share if palladium continues to trade at $260, and that the equilibrium is far enough in between that there is a significant margin of safety in taking this position at the current market prices.

Selected Sources of Data:
Stillwater SEC Filings and Investor Presentations
Johnson-Matthey, Annual Platinum Review - http://www.platinum.matthey.com/publications/1059138410.html
Competitors’ Annual Reports, including North American Palladium, Amplats, and Norilsk
“Cut-rate Cats.” Automotive Industries, April, 2001, by Lindsay Brooke.
“Ford's Bad Bet on Palladium” The Wall Street Journal, February 6, 2002.
“'Unobtainium' producers smiling” National Post, Mon 15 Jan 2001.
“Recycled platinum, palladium & rhodium continue to grow rapidly” http://www.marketpredict.net/viewpoints-A1.htm.
“CARS IN CHINA: Despite regulations, a vast opportunity for industry” Published December 15, 2003. http://www.freep.com/voices/editorials/eauto15_20031215.htm.
“The Future of Palladium (and Palladium Futures)” Published March-April, 2000 In Infinite Energy Magazine Issue #30) by Les Case.

Catalyst

This is a tough one. The natural catalyst would be when Stillwater starts running low on cash, cueing the market for revaluation. But Stillwater received 877,000 ounces of palladium from the Norilsk deal, which they plan to sell over the next two years. So cash flow should be strong, at least for a while. If this drives the stock higher, then perhaps I am a bit early here. This is not to say the current opportunity is not compelling, only that a future opportunity could be even more compelling.

Another catalyst would be for the discrepancy to become so large that it compels the market to adjust. For instance, This opportunity may have been as good as it will ever be on April 1, 2004 when SWC was at $18.15 and palladium was at $304. But there is still compelling opportunity at current prices.