Summary:

Uranium Participation Corp is trading a 6% discount to its NAV.  The company's assets are solely made up of physical uranium and cash/short term investments.  Uranium future contracts trade on the NYMEX allowing one to arbitrage the spread between the price of Uranium Participation Corp, its NAV and the price of uranium future contracts. 

Background:

Uranium Participation Corp, UPC, is a Canadian listed investment fund, which buys and holds uranium oxide concentrates, U3O8, and uranium hexafluoride, UF6.  UPC was created in 2005 as a vehicle to allow individuals to gain exposure to uranium.  UPC invests in physical uranium and stores it in their licensed facilities in Alberta, Canada.  The aim of the business is to gain from long term price appreciation of uranium.  With that said, UPC does have the ability to sell some or all of its uranium. However, management has firmly stated this is not its intention.  From time to time, UPC lends some of its uranium for a fixed fee, typically 3.5%-5% of notional value.  These characteristics make UPC a stable pure play vehicle to invest in uranium. 

UPC has strict corporate bylaws which require that 85% of any equity offering be put aside or used for the purchase of uranium.  In the event that the company seeks to use debt to purchase additional uranium the company has limited itself to a maximum of 15% debt to NAV.

I believe there is a low level of risk stemming from UPC as a company.  However, uranium is a highly volatile commodity subject to wide price swings and exposure to political, environmental and regulatory risks.  Supply can be drastically affected by the decommissioning of weapons, the sale of excess inventories from nuclear energy plants, and increases or decreases in uranium mining.  As we have all witnessed over the last few months with the Japanese Fukushima Daiichi nuclear disaster, public opinion of nuclear power can change quickly resulting in lower expected future demand.  European countries have begun to reevaluate nuclear power for their future needs.  Even China, and its nearly insatiable appetite for energy, has blinked and suspended their approval process for new nuclear power plants until at earliest mid-2012. 

In the last few weeks, the extent of the changes to national energy policies in various nuclear power producing nations has become clearer.  I think a contrarian bull argument could be made for the price of uranium, however, that goes beyond the scope of this write up.

The Opportunity:

UPC has traded to a substantial discount of net asset value, NAV.  UPC as of July 13^th 2011 is priced at a 6% discount to its June NAV.  I don't believe that there is a clear logical reason for UPC to be trading at such a large discount to its NAV.  UPC is a liquid security trading around $5 million Canadian a day.  The business model is straight forward and has very limited moving parts and really no employees other than its board of directors.  The board isn't overly paid in my opinion.  Compensation is $25,000 a year plus $1,000 per board meeting.  It could be argued that the management service agreement with Denison Mines, Inc. is expensive, however.  With that said, UPC has outsourced all of its actual operating functions to Denison Mines, so one will need to make their own assessment of what is a fair price to pay for that service.  A breakdown of the management service agreement is available in the annual report.

Over the last 24 months, UPC has traded at an average discount of -3% to its monthly report NAV.  UPC has traded at a premium to its NAV as recently as February of this year.  Management has recognized this wide discount and in a press release on June 10^th, 2011 they stated their intention to purchase up to 10% of the shares outstanding.  They have been authorization by the Toronto Stock Exchange to do so at a rate not to exceed 2% per month till June 13^th 2012.

Uranium trades via future contracts on the New York Mercantile Exchange.  One contract is equal to 250 pounds of U3O8.  The current forward curve for Uranium is in strong contango.  The chart below is the forward prices provided by the CME Group for a U3O8 Contract.  Keep in mind that this is not the most liquid futures product out there and some of these longer dated contracts do not trade often.  I also converted these contract prices from USD to Canadian Dollars at a rate of .9594.

The trade I'm proposing is to go long UPC stock and simultaneously sell a U308 futures contract.  This trade is designed to capture the spread between NAV and the current share price as well as profit from the contango spread between the current spot price and the higher price future contract prices.  In effect one is selling uranium in the future and delivering UPC stock when the contract comes due.  This trade is not going to make you rich, but on a risk adjusted basis it is an attractive way to lock in a return and put some money to work without taking market risk.  This trade can also be easily levered to enhance one's returns.

Sizing:

UPC holds two types of uranium, U3O8 and UF6.  There is only a futures market for U3O8 and as such to determine the size of the trade we will need to convert the UF6 UPC owns into U3O8.  There are formulas for making this conversion.  However, I took a different approach to this and took a ratio of the monthly average price of UF6 to U3O8 from 1/31/2006 to 6/30/2011, as reported by the company, and got 2.765.  The predicted price of U308 and the actual price had a standard deviation of about 2.5%, which is not perfect, but a good approximation.  Thus taking the quantity of UF6 the company owns currently, 2,374,230 KgU and multiplying this by 2.765 we have the converted quantity of UF6 or 6,565,755 lbs of U308.  The reported average monthly price of U308 for June was $52.31 per lbs.  UPC currently has 7,250,000 lbs of U3O8 as reported June 30, 2011.  With the converted quantity of UF6, the company has approximately 13,815,755 lbs of U306 or $722.702M worth.  The company reported a market value of $729.56M for its Uranium or a difference of .9%.  So it's not perfect, but we are pretty close.

Assuming one wants to invest about $100,000 in this trade they will need to determine the number of contracts of U308 they will need to purchase.   A 1 year forward contract is worth $52.58 (converted to Canadian at .9594) and we are sizing our trade around $50,000 worth of U308.  So 250 lbs per contract times the 12 month forward price gives us a per contract value of $13,143.78.  So four contracts gets us $52,575.12 worth of U308.  The company has 13,815,755 lbs of U308 based on our conversion.  So 4 contracts worth of U308 is equivalent to about .0072% of the company's U308.  To size the equity portion of the trade I just take the .0072% times the current market cap to get dollar value of the equity, which in this scenario is $50,997.45 which is roughly equal to 7,786 shares of UPC's stock.  The spread between the one year forward price and the stock is 3.1%

2.765 (ratio of UF6 to U308) x 2,374,230 KgU of UF6 = 6,564,745 lbs of U308

6,564,745 lbs converted UF6 + 7,250,000 lbs of U308 = 13,815,755 lbs of U308

$50,000 trade size / ($54.40 per x 250 lbs per contract) = roughly 4 contracts

4 contracts x 250 lbs per contract = 1,000 lbs of Uranium U308

1,000 lbs trade amount of U308 / 13,815,755 lbs of U308 = .0072% of the company's U308

.0072% x $704.516M Market Cap = $50,997.45 the dollar equivalent percentage of U308 four contracts equals

$50,997.45/ $6.55 per share = 7,786 shares needed for the trade.

The spread between the stock, its NAV and July 2012 contract price, is 9.1%.  These are not huge returns, but given that one is not taking a significant amount of risk, I believe these to be attractive.  Moreover, this security has a tendency to overreact relative to the underlying commodity on bad news about Uranium.  Putting this trade on opportunistically and taking advantage of short term widening of the NAV spread will further enhance returns.  Conversely this is a risk that needs to be carefully considered, particularly if one intends to leverage this investment or does not have the ability to roll over the futures contracts if needed.

With that said, one flaw in my analysis is that I'm using a fixed monthly NAV price and the value of Uranium changes constantly.  One will need to do their own calculation to ensure the NAV they are using is actually reflective of the value of the company.  With that said, the NAV from the company is only a few days old and the price of Uranium has changed little in that time.  UPC uses UX Consulting Company for uranium pricing.  One will want to use their pricing when determining NAV as opposed to the spot price on Bloomberg or NYMEX.

For convenience I've included my data set which is otherwise only available as monthly NAV sheets in PDF format from the company. http://www.uraniumparticipation.com/

Conclusion:

UPC is a clean play on the price of Uranium and the availability of futures contracts on the underlying U308 commodity makes this a great vehicle to arbitrage the discount to NAV as well as the contango in futures prices.  While the spread is not huge, one does not need to take much commodity or market risk to generate reward. 

Management and begun to purchase stock with the stated intention of closing the gap between NAV and price.  As recently as February UPC has traded at a premium to its NAV.  This trade's positive carry due to the futures curve's strong contango may not last.