Description

Disclaimer: This write-up represents my personal opinions only and is solely for VIC members. Do not distribute. Do you own due diligence. Not investment advice. Data subject to errors.

Recommendation:

This is an event-driven idea and I am recommending a long position in Uranium One (UUU-T C$2.72, C$2.6 bln mkt cap) for VIC members. Please refer to the company website, Sedar and the world nuclear association for background information.

Investment Thesis:

UUU is a uranium producer with assets primarily in Kazakhstan (minor ops in US, Australia and Tanzania). On Jan 14, 2013, UUU announced a go private transaction bid from its 51% majority Russian shareholder ARMZ (a subsidiary of the Russian state owned Rosatom) for C$2.86 with a 2Q13 expected close. The majority vote of the minority shareholders is required (+ 2/3 of total votes). Despite receiving shareholder approval on March 7, 2013, UUU is still trading at a gross spread of ~ 2.9% or ~32% annualized IRR. I believe ARMZ’s motivation behind the deal, valuation and industry fundamentals significantly limit the downside risk in this transaction. Further, there are some existing Russian/Kazakhstani arrangements that suggest the deal should be done on time. While remote, the chance of a higher outside bid is not zero. As an aside, I think this idea will be particularly relevant for those who are a little concerned about a near-term broader market pullback.

Generally speaking, in most workout situations, the key risk factors are: form of payment, deal-break risk, timing, and regulatory hurdles. Each of these risk factors are addressed below.

Downside risk analysis:

Form of Payment: All cash. Self explanatory as the absence of a share exchange limits variance to ultimate proceeds

Deal-break Risk: On the surface, UUU’s downside is ~ 13.3% as it was trading at C$2.41 before the go-private announcement. I contend, however, UUU’s valuation has already caught up to (if not surpassed) ARMZ’s bid price due to improving uranium market fundamentals including (and my personal view that the bid represents a “take-under” more than anything):

1)      Spot uranium prices are near bottom at US$40/lb, the est. marginal cost of production

2)      Uranium “term” prices (i.e. LT contract prices utilities enter into) is already in the mid US$50’s/lb range

3)      Despite the Fukushima incident, the inevitable restart of Japanese nuclear reactors due to high LNG prices and supported by newly elected Shinzo Abe. 50 Japan reactors ~ 14% global uranium demand.

The market appears to be pricing this in for Tepco: http://www.bloomberg.com/news/2013-05-21/tepco-surges-a-fourth-day-on-reactor-restart-speculation.html

4)      The Russian agreement to supply Highly Enriched Uranium (HEU, downblend warheads to commercial grade uranium) ends 2013, representing just over 10% of global supply.

I believe there are different valuation guideposts to help us make an educated guess as to where UUU would trade if the deal-breaks:

1)      How peers have traded since UUU’s take-private announcement – This is probably the most rudimentary form of valuation estimate, especially since there is only 1 large cap comparable uranium producer, Cameco (CCO-T, CCJ-US). At any rate, CCO has been up ~12.5% since UUU’s go private bid announcement. Apply that price appreciation to UUU would bring us to $2.71 per share.

2)      Independent advisor valuation in filed proxy – The independent advisors valued UUU at US$2.66 to US$3.21 per share. That equates to a midpoint of US$2.91 or C$3.00 per share.

3)      Discounted Cash Flow analysis – Having followed the company previously, I’ve updated my DCF model and get an NAV of C$2.81 per share, using a 10% discount rate and 1% terminal growth rate (see below). Generally I would say I’m reasonably conservative on capex and production growth. The greatest quibble would be my uranium price deck assumption but my price estimates are based on the combination of what the term price is telling us, and the upcoming supply (HEU) and demand (Japan restart + China builds in the medium term).

 4)      Sell-side NAV/Targets – Just prior to the take-private announcement, the sell-side had UUU price targets generally in the C$3 to C$4 range.

Timing: Now that I provided some comfort that UUU may not trade much lower in the event of a deal-break (in fact, there is some chance it could trade higher!), timing is probably the biggest risk, especially from an annualized IRR perspective. In UUU’s case however, I have some confidence the deal will likely close by end of 2Q13 because of ARMZ’s motivations. Since taking a majority stake in UUU in 2010, ARMZ has been active looking for acquisitions on behalf of UUU and also helped arranged Ruble denominated debt financing for UUU (to fund acquisitions). As an aside, Russia’s aggressive search for uranium assets ahead of the 2013 termination of its own HEU exporting agreement speaks volumes to uranium supply/demand dynamics going forward.

1)      Specifically, ARMZ (basically on behalf of UUU) purchased Mantra Resources for ~$1.2 bln for the Mkuju River project in Tanzania. The intention is for UUU to take over and develop the asset once UUU’s balance sheet and cashflow generation could support it. Unfortunately, a depressed uranium market and UUU stock price post Fukushima delayed this asset transfer and UUU’s option to acquire the Mantra asset was meant to expire June 7, 2013 pre-bid. While UUU’s Mantra acquisition option is “put on hold” according to management, any significant delay in closing the ARMZ transaction could bring this problem back in the spotlight. I believe ARMZ recognizes minority shareholders are probably against the Mkuju development in light of currently poor project economics – hence the motivation to complete the go private transaction in a timely manner to avoid this problem. (http://www.uranium1.com/index.php/en/development/mkuju-river-tanzania)

2)      Interestingly, Rosatom (of which ARMZ is a subsidiary of) and Kazatomprom (Kazakh National Atomic Company) signed an agreement late 2012 to implement a uranium enrichment centre project. I believe the spirit of the agreement is for the Kazakhs to supply the uranium and the Russian to provide enrichment services. Interestingly, deliveries are scheduled to begin in the second half of 2013. The inference here is by taking UUU private, the Russians and Kazakhs are in a better position to pursue this project of vertical integration. (http://en.trend.az/capital/energy/2091944.html)

Regulatory: This risk is really part of the deal’s “timing risk”. On the surface, gaining regulatory approval in 6 separate countries (Kazakhstan, Tanzania, US, Russia, South Africa & Australia) appear a daunting task. However, it seems UUU is moving forward in attaining approvals quite quickly. As of the March 27, 2013  press release, UUU already stated:

“The transaction is subject to applicable regulatory approvals and certain closing conditions customary in transactions of this nature, the details of which are outlined in the Corporation’s management information circular for the special meeting dated February 8, 2013. The Corporation has obtained US, Russian, Australian and South African regulatory approvals and continues to diligently pursue all required remaining approvals. The transaction is expected to close in the second quarter of 2013”. [Emphasis mine]

UUU has stated again in its May 13, 2013 1Q13 press release that “The transaction is expected to close by the end of Q2 2013.”

So at this juncture, the 2 remaining regulatory hurdles are Tanzania and Kazakhstan. With Tanzania approval, given that Tanzania has already given the Mantra asset a special mining license (i.e. giving ARMZ the license), it would seem illogical for the government to block the deal. Further, the filed proxy suggests under the “Covenants relating to pre-acquisition reorganization” section that UUU shall reorg as suggested by ARMZ in order for the transaction to proceed. I take that to mean ARMZ can probably keep Mantra outside UUU for the purposes of the deal anyway (i.e. UUU just has option to acquire the asset). So this brings us to the last and most important regulatory approval UUU needs – Kazakhstan. I don’t have direct confirmation from government officials but I would say the relationship between Kazakhstan and Russia is a symbiotic one (with Kazakhstan presumably more dependent on Russia). With the mentioned uranium enrichment project cooperation between the two countries already in place and their 2011 rare earth metals agreement between Rosatom and Kazatomprom, it seems rather unlikely the Kazakh government would block the go-private transaction in light of their existing relationship, agreements and cooperation (http://en.trend.az/regions/world/russia/1852768.html).

Potential Upside to Bid Price:

Generally the market does not appear to be pricing in a higher bid and I would generally concur the perceived unwillingness of uranium producers to “upset the Russians” given their heft in the uranium space. However, I still attach some probability of a higher bid from another uranium producer or mining company.

I attach a very low probability to this scenario although it is non-zero, given the non-prohibitive $45 mln break fee. Clearly, from a political perspective, producers and miners are unlikely to join in to bid for UUU given the Russians’ heft in the uranium space generally and its relationship with Kazakhstan in particular (which again supports my theory Kazakhstan would give approval on time, otherwise the signal could be a go-ahead for others to bid, which could be a good thing).

From a fundamental perspective, ARMZ’s bid seems to represent a “take-under” given the valuation considerations I outlined previously. In light of Cameco’s production growth strategy, CCO recently acquired a US$500 mln development asset expected to have less than half of UUU’s production in ~ 5 years (with significant development costs). In comparison, this should make UUU a much more attractive acquisition (likely in the $3 bln range) as their assets are in production and much lower cost. Despite negative uranium market sentiment post Fukushima, I also point to the bidding war for Hathor Exploration between Cameco and Rio Tinto that saw the initial hostile bid of $3.75 ending up at $4.70 (+25%) in late 2011. Finally, I personally believe GMP’s valuation work outlined in the proxy was weak as it stated "GMP considered whether any distinctive material benefits would accrue to ARMZ…. But had insufficient information to quantify any benefits to ARMZ". My English translation is “we know UUU is worth a lot more from a fundamental basis and specifically to ARMZ for strategic purposes and its ability to dump Mantra into UUU, but we won’t quantify it”. The bottom line is other players interested in uranium know this is a take-under but are hesitant to step on the Russians’ toes. Any significant delay/problem in closing the deal will probably open the door for others to bid, in my opinion.

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