|Shares Out. (in M):||567||P/E||0.0x||0.4x|
|Market Cap (in $M):||14||P/FCF||0.0x||0.4x|
|Net Debt (in $M):||0||EBIT||0||10|
|TEV (in $M):||14||TEV/EBIT||0.0x||1.4x|
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Introduction: A $14 million market cap nickel mining company which will probably have $10 million in EBITDA in 2014 from its new frac sand business, has a long runway for growth due to its entrance into the growing market for frac sand, trades at 70% below replacement cost and at a discount to peers, with a strong balance sheet.
Overall, an investment in NI over the next year could return up to 5-10x, and over the next three to five years it has the potential to return 10x – 40x, with somewhat limited, but difficult to quantify, downside.
1. In 2014, NI will establish its presence in the frac sand market and will produce 400,000 tons per year (tpa) of frac sand at a probable EBITDA margin of $25 per ton for EBITDA of $10 million.[i] Additionally, NI has competitive advantages over other frac sand suppliers in the immediate area where it will sell.
2. Beyond 2014, NI has a long runway for growth as the market for frac sand is Canada is growing rapidly, one of NI’s mines has potentially 2BN tons of high quality frac sand, and NI has a plan to sell up to 1.4 million tpa of frac sand.
3. The downside is limited, though admittedly difficult to exactly quantify, as NI is currently trading at 70% below replacement cost of assets, well below peers on an enterprise value to book basis, and has a solid balance sheet (with only $2 million of long term debt versus $54 million of equity including $2 million in cash).
4. Based on reasonable valuation assumptions and peer multiples, NI could potentially return 10x – 40x over the next three years.
Business Background: NI was originally formed in 2007 and bought the rights to three nickel projects in Canada: Mel and Minago (in Manitoba), and Lac Rocher (in Quebec). (It then added a fourth, Lynn Lake, in 2008, which is currently being transferred to another company.) At the time, nickel prices had reached stratospheric highs, having increased from $7 per pound in Jan. 2004 to nearly $23 a pound in January 2007. The company, in an almost embarrassing miscalculation of projecting future trends, wrote “The market for nickel is expected to remain robust for the foreseeable future.”[ii] They were wrong, and nickel prices precipitously declined in 2008 and remain around $6 per pound today. (It is currently not profitable to develop their Lac Rocher mine at nickel prices under $10 per pound.)
Frac Sand Business Plan:
One of NI’s nickel mines, Minago has a large quantity (possibly up to 2BN tons[iii]) of frac sand. Frac sand is used in the hydraulic fracturing process as a “proppant” - or to “prop” fractures open – that is pumped underground and holds open the fissures that allow oil and gas to flow up to the wellhead.
In June 2012 Victory Nickel established a subsidiary, Victory Silica, and hired Ken Murdoch, a 25 year veteran of the frac sand industry, to run it. Murdoch developed a three phase plan for Victory Silica to enter the frac sand market:
Phase 1: Establish initial entry into the frac sand market. In January of 2013, NI bought a sand processing plant out of bankruptcy near Medicine Hat, Alberta called the Seven Persons (7P) facility for $300k. (The 7P facility had gone bankrupt because it used to recycle blowback sand from shallow gas drilling and sell the recycled sand to fracking companies, but there is no more shallow gas drilling in the area so it shut down.[iv]) NI is currently upgrading the site to process frac sand and will commence operations in Q1 14. The initial plan is to buy frac sand from a mine in Wisconsin (which has the highest quality sand in all of North America) and then ship it to the 7P plant for dry processing and sell it to fracking companies in the Medicine Hat area.
NI has made substantial progress on Phase 1. Restoration of the plant is complete, senior management positions have been filled, plant scope and design changes have been made to increase the equipment utilization rates to 95%, and numerous contracts have been completed or are in the final review stage.[v] NI will begin to sell sand in Q1 14.
NI’s competitive advantages in Phase 1 of the Frac Sand Business:
While some view frac sand as a commodity, NI has three advantages over other frac sand providers in the Medicine Hat area in Phase 1:
1) NI will process the frac sand within a few miles of the end-user. Before selling to the end customer, frac sand must be processed at the mine or at a secondary facility before it can be used as a proppant. The raw sand is washed, dried and sorted to remove unwanted material. Most frac sand companies dry process at one central plant and then ship (this is what U.S. Silica and Hi Crush Partners do) but this can lead to degradation of the quality during shipping.[vi] Because NI will process its frac sand within a short distance of the fracking in Medicine Hat, Alberta, there will be almost no degradation due to shipping and NI can charge a higher amount for its sand.
2) NI’s 7P facility will be one of only two manufacturer controlled frac sand sites in Medicine Hat with large dry sand storage. Normally, in the event of delays at the well, oil and gas companies can pay high demurrage charges (charges for sand idling in trucks near the well) which can be up to $300/hour per truck. Because NI’s plants are so close to the fracking wells, NI will be able to store the sand at the processing facility and not need to charge the customers for demurrage. This means they will probably be able to sell their sand at a premium.
3) NI will sell the highest quality sand in Canada. Currently, “the highest quality sands are imported into Canada from the old, in geological age, deposits around the US great lakes, and more specifically from sands in Wisconsin. At times, this sand is only available to service companies in the USA.”[vii] Due to sand needing to be imported, there is a deficit of high quality frac sand (measured by crush resistance and gradations) in Canada, with at least three competing Canadian frac sand companies (Sil Industrial Minerals, Peaskie Minerals, and Canfrac Sands) selling lower quality sand.[viii]
Phase 2: Within three months of commencing frac sand sales at the 7P facility, NI plans to then acquire and operate a frac sand mine in Wisconsin, which will ensure security of supply for its business, and lower costs to increase margins to greater than $25 per ton. Under Phase 2, NI will still be doing 400,000 tpa of frac sand production. (NI will need to spend $4.4 million for this and at this point it is unclear how they will finance it, but will probably do so through a combination of internal funds generated from Phase 1 and external financing.)
Phase 3: Within 18 months of commencement of Phase 1, NI plans to build an additional frac sand processing facility in Winnipeg which will process up to 1,040,000 tpa, to include sand from Minago. (This will require capex of $26.1 million and working capital of $15.3 million and at this point it is unclear how they will finance this.)
A $25 per ton EBITDA margin is very reasonable, and possibly a conservative estimate, when compared to publicly traded comparable companies. In the nine months ending 9/30/13, U.S. Silica (SLCA), Emerge Energy Services (EMES), and High Crush Partners (HCLP) had EBITDA margins/ton in their sand segments of $30.37, $36.11, and $30.22, respectively.
2. The market for frac sand in Canada has grown, and will continue to grow, very rapidly. According to Freedonia, Silica Sand demand in Canada is expected to double from 3.67 million metric tons in 2011 to 7.69 million metric tons in 2021. “Silica sand demand in Canada is forecast to climb 7.2 percent per year through 2016 to 5.2 million metric tons, valued at US$260 million. This pace of growth will be a significant improvement from the 2006-2011 performance and the fastest of any major national market. Suppliers will benefit from a robust increase in hydraulic fracturing activity.”
Past 2016, “Canada is also a significant player in the shale gas market, and the nation is projected to post double-digit annual gains, greater than 16% annually, in frac sand demand through 2021. Alberta and British Columbia are the sites for the majority of the nation’s hydraulic fracturing activity, principally due to liberal policies on drilling activity and the dynamic presence of a number of oil and gas firms in the provinces.”[ix]
Furthermore, shale gas drilling in Canada is at a cyclical low due to depressed prices of natural gas, so there is considerable room for upside.
And even if there were to be a pullback in the number of wells drilled, the frac sand market can still grow even if the rig count does not. This is due to drillers’ utilization of more frac stages and focus on increasing operational efficiency, and larger quantities of frac sand used per well.[x]
3. While the downside is difficult to quantify, at NI’s current valuation it is trading at 70% below replacement cost of its assets, at a discount to peers, and with an extremely conservative balance sheet.
Replacement cost of the assets is calculated by adding up NI’s expenditures over the last five years which are listed on their balance sheet as “mine property and development projects” and “exploration and evaluation projects.” All of NI’s $50MM in assets are based on Canadian dollar amounts of capital expenditures since 2007. (Exploration and production activities are capitalized on the balance sheet and then depreciated once they enter into use.) Upon formation of the company in February 2007, NI acquired exploration and development costs of $5.8MM. It then spent $9.9MM (2007), $13.6MM (2008), $3.2MM (2009), $5.2MM (2010), $4.7MM (2011), $2.4MM (2012), for a total of $46.8MM on its nickel mines. It also spent $3.5MM in 2013 on improvements to the 7P processing facility, for a total of around $50MM. Canadian inflation from 2007-2013 was only 1.6% annually, indicating that the prices paid are indicative of replacement cost.
Risk of financial distress is also low because NI has only $2 million of long term debt (not reflected on the 9/30/13 balance sheet since it issued convertible debt of $2 million – convertible at $0.10 a share - in November 2013) compared to $55MM in equity (mostly made up of mine property and development and exploration and evaluation projects).
Finally, NI is valued at a discount to peers. While the current market valuations of unprofitable Canadian junior mining companies are potentially not indicative of their true value, it is worth pointing out that NI trades at a 36% discount on an Enterprise Value to Book Value basis compared to peers of VMS Ventures, North American Nickel, Nuinsco Resources, Cadillac Ventures, Rockcliff Resources, NSGold, and Anglo-Canadian mining.[xi]
4. Under reasonable valuation expectations, if NI can get Phases 1 – 3 up and running it could return anywhere from 10x – 40x its current price in the next 3 – 5 years.
By year end 2014, if NI is selling 400,000 tons of frac sand at a $25 per ton EBITDA margin and therefore has $10 million in EBITDA, assuming it trades at a reasonable 5-10x EBITDA or a $50-$100 million market capitalization. Peer U.S Silica trades at 13x TTM EBITDA and peer High Crush trades at 19x TTM EBITDA. Therefore, the upside is 5-10x the current market capitalization of $13 million.
Assuming NI can get to Phases 2 and 3 up and running within 18-24 months and sell 1.4 million tpa of frac sand at a $25 EBITDA margin and then do $35 million in EBITDA at a 10x multiple it could have a market cap of $350 million, or 35x the current market capitalization.
Pricing: The biggest risk is a decrease in frac sand prices due to a glut of supply entering the market. There exists the possibility that prices could decrease to the point where it is not economical for NI to produce frac sand.
While it is difficult to get a handle on the overall increase in Canadian frac sand supply, there is anecdotal evidence of an increase with several junior companies developing frac sand projects in Canada.[xii] Larger players are entering the market as well, as Emerge Energy Services (EMES) entered into a partnership with Canadian National Railways to establish 40 miles of track to tie into its Barron, WI frac sand facility.
However, even with an increase in frac sand supply, there are several reasons to suggest that barriers to entry do exist and that a glut of supply leading to a decrease in pricing will not occur:
1) Not all sand is good quality frac sand: Frac sand must meet demanding standards to be used and NI is selling the highest quality frac sand on the Canadian market. Frac sand must meet American Petroleum Institute standards and the best sand is found in Wisconsin and Minnesota.
2) Logistics: The main barrier to entry is not even ownership of frac sand, but rather having the logistics to transport it to the end customer. “The cost of raw frac sand mining and processing is low compared to the cost of transport to the wellhead.”[xiii] This is backed up by NI projections which suggest that transport costs of $79 per ton are the largest cost.[xiv] “Sourcing and transporting frac sand remains a challenge and is the most meaningful bottleneck in the service supply chain in North America.”[xv] [xvi]
One sell side firms says it best:
“We agree that a significant amount of “new” sand has the potential to enter the market, but we do not expect pricing to implode or the large players to cede market share. Given the growing importance of logistics and the significant market share of the larger frac service providers such as Schlumberger, Halliburton, and Baker Hughes, we do not believe small providers with a mine of good sand but no logistical scale will be able to compete successfully in a balanced or even slightly unbalanced market. The small providers without transloads, unit trains, or processing facilities and mines co-located along a class 1 railroad are similar to companies that address the peaks in electricity usage during hot summer months. They are rarely called on for capacity but can make money when they are; however, the majority of the year their capacity sits idle or operates with poor economic returns.”[xvii]
3) While it is unclear what kind of contracts NI will get, frac sand is normally sold through long term take or pay contracts and ensure a reasonable price over a set amount of time.
4) In certain areas, there are moratoriums on new sand mines in WI and the permitting process for a new sand mine could moderate supply.[xviii]As an example, U.S. Silica believes that the permit and approval process for a new sand excavation facility likely takes one to three years.[xix]
5) There is a longer lead time to get a frac sand processing plant established than to start an oil and gas drill well as “industry capacity increases have a long lead time (2+ years) and can be visible for a long time.”[xx] Moreover, while the longer term issue of a glut of supply is a potential one, for Phase 1 of the project NI has several competitive advantages (as mentioned earlier) including dry processing near the 7P facility in medicine hat (while competitors have to transport over a heavy distance, degrading the sand), storage near the site, and higher quality sand.
6) Rapid nature of the frac sand ramp up derisks the project. NI will be processing sand starting in Q1 14.
Finally, even if a glut of supply does cut NI’s EBITDA margins by, let’s say, 80% (from $25 per ton to $5 per ton), then they will still be doing up to $2 million in EBITDA in Phase 1 on a market cap of only $14 million.
[i] Victory Silica, ltd, “The Right Product, The Right Place, The Right Time,” November 2013, available at http://www.victorynickel.ca/victory_presentation/#1. See also, Victory Nickel Inc., Management’s Discussion and Analysis for the Three and Nine Months Ended September 30, 2013, November 11, 2013, p. 6.
[ii] Victory Nickel Annual Report, Management Discussion and Analysis, March 28, 2008, p. 4.
[iii] Victory Silica, p. 23.
[iv] Yuri Belinsky, “Victory Nickel Valuation Report,” CHF Capital Markets, September 5, 2013, p. 7, available at http://victorynickel.ca/victory_new/ It is worth noting the CHF Capital Markets “provides remunerated consulting services to Victory Nickel” p. 32.
[v] Victory Nickel Inc., Management’s Discussion and Analysis for the Three and Nine Months Ended September 30, 2013, November 11, 2013, p. 6.
[vi] For example, US Silica does it this way. See Judson E. Baily, “U.S. Silica Holdings, Inc.: Initiating with Buy: Mr. Sandman, Bring Me a Dream,” Jefferies Equity Research, March 26, 2012, p. 4
[vii] Victory Nickel Inc., Management’s Discussion and Analysis for the Three and Nine Months Ended September 30, 2013, November 11, 2013, p. 5.
[ix] Freedonia Report, World Industrial Silica Sand, October 2012.
[x] Ethan H. Bellamy, Kathleen Morris, and Justin J. Agnew, “Hi-Crush Partners, LP (HCLP): Hi-Crushing It; Initiation at Outperform Predicated on Drop-down Potential,” Baird Equity Research, September 10, 2012, p. 8
[xi] Belinsky, p. 4.
[xii] Belinsky, p. 28.
[xiv] Belinsky, p. 10.
[xv] Baily, p. 5
[xvi] Blake Sobczak, “Rail Arteries Make or Break Frac Sand Growth in the Midwest,” MidWest Energy News, 6/18/2013.
[xvii] Brandon Dobel, “Hi-Crush Partners LP: Leading North American Frac Sand Provider; Initiating Coverage
With an Outperform Rating,” William Blair Equity Research, July 11, 2013, p. 3
[xviii] Trey Grooms, “U.S. Silica Holdings: Attractive Entry Point for a Leading White Sand Play: Initiating with OW rating,” Stephens, Inc, April 1, 2013.
[xix] Bellamy, Morris, and Agnew, p. 10
[xx] Grooms, p. 8.
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