Description

I am recommending a long position in Uranium Participation Corporation (“UPC” for purposes of this write-up, ticker is U.TO)  The uranium thesis has been well covered on VIC over the last several years (STM CN, USU) and personally I think the long-term bull case for uranium is quite solid. This idea is very simple and to me the 2 questions that need to be answered about an investment in U.TO are 1) Why Uranium Participation? and 2) Why now?

Why UPC?

The very thing that makes the uranium thesis powerful makes most of the companies that mine it bad investments: it is a difficult and costly process. While companies such as CCJ and Paladin have been good investments (if timed properly) in the past, ultimately they have been plagued with mining problems (CCJ’s flood at Cigar Lake), financing problems (almost any junior miner you can think of) and general management ineptitude (Uranium One, etc.)

UPC does nothing but hold physical uranium. As of November 30, 2008, the company holds 5.425MM pounds of U308 and 1.492MM Kg of UF6. I’ll get to what that is worth in a minute, but for me it is important that UPC doesn’t explore for anything, doesn’t mine anything, and doesn’t need financing for anything. It is just an ETF for uranium. Normally, I would rather buy the company with leverage to the commodity rather than buy an ETF, but after spending 4 years following the uranium industry, I have come to the conclusion that the risk of a mining, financing, management problem is too great at an individual company. I just want to own the commodity.

Why now?

The price for U308 fell from a high of $135/lb in 2007 to a low in the high $40s in the fall of 2008. In retrospect, $135 was a clear overshoot due to the frenzy around commodities and the entry of non-traditional speculators (i.e. hedge funds) into the uranium market. Similarly, the move to the $40s was an overshoot to the downside, as hedge funds were forced to liquidate physical uranium holdings in a very illiquid market.  Perhaps the best example of irrational behavior came from Nufcor, the British equivalent to UPC.  Nufcor entered into an agreement to buy U308 and planned to float a public offering to pay for it, right as the global financial calamity unfolded in Q3. They had to scrap the offering, but were still on the hook for the uranium they had committed to buy.  Their only source of funding was to sell physical uranium they already held, only to turn around and buy physical uranium at an already-contracted higher price.

My industry calls indicated that the forced selling is now over, with even utility buyers shocked at how low the price went in Q308. Today the price has rebounded to $53/lb for U308 and is pretty stable at that level. The interesting thing is, longer term the world needs more uranium production than is currently available, and a price in the low $50s is not high enough to spur new production.  Junior producers I have spoken to indicate that at least $75/lb is required and even conservative utility types think a price north of $60 is required for a healthy uranium industry.

Valuation

 At current share prices around CAD 6.50, UPC is discounting a long term U308 price in the high $30s/lb. Said another way, the stock is trading at a ~23% discount to the NAV of  UPC’s assets.  While I don’t necessarily believe that UPC should trade at a substantial premium to physical uranium as it did 18 month ago, this is a fairly large disconnect that I believe should shrink as the world realizes the uranium market has stabilized.  Furthermore, there are a couple of scenarios where the price of U308 could increase substantially and/or UPC could be purchased for a premium to its NAV.

Growth in uranium production will be challenged in a number of ways in the coming years.  Cameco’s Cigar Lake project, which flooded in late 2006 and set the stage for U308 prices to run from ~$50 to $135, faces lengthy delays. This is a mine that was supposed to supply 10% of global production beginning in 2010 and operators in the uranium industry  have told me to expect delays in its opening ranging from “5 years” to “not in your lifetime” (I’m in my mid-30s, as a reference point.) Kazakhstan is having production problems at several of their mining sites, many juniors will simply go away due to lack of capital, and many potential new sources of uranium (such as the Olympic Dam project in Australia) are projects where the main target is some other metal such as nickel or copper and uranium is simply a byproduct (in other words, it will be the copper price, not the uranium price that drives the investment decision.) Finally, it is worth noting that CCJ’s McArthur River project currently supplies ~20% of the world’s uranium production.  In the second half of 2009, CCJ will move into a new mining zone, and our understanding from talking to folks in the industry is that for numerous technical reasons, there is a significant chance that this new section could have a water inflow problem.  I hope this does not happen, but if we were to see a flood at McArthur River similar to what happened at Cigar Lake two years ago, the price of uranium would very quickly move to multiple of today’s price.  In that scenario, UPC would have a very valuable asset in its physical uranium, which could be purchased by any number of interested parties (CCJ to fulfill contracts, a consortium of utility buyers, etc.)

Risks

The obvious risk here is that further selling pressure on commodities drives down the uranium price. The other thing to be aware of is that the stock price is pretty sensitive to the USD/CAD exchange rate as uranium is priced in USD and the stock is priced in CAD.

Catalyst