Like any romantic weekend retreat, this had the potential to be a huge waste of time. And like most weekend retreats, it was. I’ve heard that some of the best investments are the ones that are never made … and if that’s the true, then boy do I have a non-investment for you!
Mmmm ... Yellow Cake
Uranium prices have been under serious pressure in the aftermath of the classic bubble that popped in 2007. Producers (such as Cameco and Uranium One) and explorers alike are selling off over the past few weeks in the face of week earnings. And like any good value investor, I wondered if there was a deal to be had. I pick up on some decent first-hand news here in Saskatoon. The world’s largest, high-grade ore mines are just hours to the north … in a place so remote and desolate it makes Saskatoon look like Miami.
Here’s U3O8 spot prices over the past 10 years:
Is the pessimism warranted? Unfortunately for the uranium bulls out there, whose fanaticism is outmatched only by the cult-like gold bugs, it appears so. I am going to start high level and work my way toward a recommendation on the company Energy Resources of Australia (ERA.AX; that’s right, Down Under!). ERA is one of the world’s largest uranium producers, but is a relative unknown here in North America.
Demand for uranium is almost entirely driven by demand for electricity generated from nuclear power plants. There are also scientific research labs and some medical applications, but their contribution to the market is small.
I was surprised to learn that the United States is the largest nuclear market in the world (if we do not consider the EU as a single market). For all the negative press nuclear power receives in American media, I thought it would be an endangered, if not extinct, species in the US energy ecosystem. Turns out reactors grew like gangbusters in the 1960s and 1970s. And without a new reactor built in more than 2 decades, nuclear energy still accounts for 20% of all US electricity generation, good enough for 30% of all nuclear electricity generated in the world.
Worldwide nuclear energy accounts for some 15% of all electricity, about 2,738tWhs annually, and is distributed among markets as per the following:
Growth in nuclear energy generation over the last 15 years has been less than impressive, averaging just 1.5%. The US clocked in at 2.2% with growth presumably coming from increased utilization at their existing reactors. China grew at 17% and India at 5%.
How about the future? The US Energy Information Administration has nuclear demand growing just 1.5% on average until 2030. That’s less than all other fuels!
WorldWide Growth in Energy Generation
Why such poor growth? The nice thing about nuclear is demand is pretty easy to predict. Reactors are large capital projects that take years to build and even longer to plan and approve. And any proposals for new reactors are made public. There are presently 436 nuclear plants in operation in the world with many planned or proposed for construction.
At first blush, this is pretty exciting. Nuclear plants could double over the next 5 to 10 years. But if you’ve ever tried to build a nuclear plant, you know just a fraction of those Proposed or Planned plants will ever make it to operation. If 50% of Planned and 10% of Proposed plants make it to operation, then we are looking at 25% growth over 10 years, not 100%.
On top of that, European growth plans are muted. Countries such as Germany are actually looking to phase out nuclear power entirely. Then there is competition from renewables such as wind and solar, which don’t have nearly the same social stigma.
The one bright light is projected 9.9% and 8.9% growth expected in India and China respectively during the same period. Remember, however, that these two countries are a very small portion of total demand. They don’t move the needle that much.
Pick a Horse
With that macro information in tow, what companies in the uranium sector should I consider? There are a handful of pure play producers and a lot of exploration companies. Which should I favor?
In the oil and gas sector, a lot of traders do pretty well speculating on non-producing exploration companies. This can work in other mining sectors as well, as the recent purchase of Athabasca Potash can attest. Your average overpaid geologist won’t like me saying this, but carbon fuels are pretty easy to find. In some cases like the Bakken Formation, reserves have been known for decades before technology made them economically viable. For a junior exploration company, all you have to do is raise the equity and drill the holes.
Uranium exploration is a MUCH tougher gig. In most instances, it’s like looking for a needle in a haystack, except that the needle and the hay are buried hundreds of feet underground. Geologists spend years theorizing about the ores whereabouts, drilling test wells, adjusting assumptions, drilling more test wells, and repeating until something is found. I’m not convinced I’d be any less effective if I just licked my finger and stuck it in the air.
So, while I naturally tend toward a cash-making enterprise anyway, I am even more inclined towards one in this case. There are only a few pure plays on the production side. The largest uranium producers are diversified mining companies like Rio Tinto, BHP Billiton, and a few Russian giants I can’t pronounce.
Cameco is a pure play (having just sold its small gold unit) that actually ranked 2nd in 2008 with 15% of total uranium production. Cameco has the highest grade deposits in the world. Unfortunately, it has a history of things going terribly wrong … you know, like having their prized asset Cigar Lake get flooded and submerged underwater for several years, which is great if you have mermaids on staff. Plus its valuations and profitability ratios have always left a little to be desired.
Energy Resources of Australia
There is one seldom discussed company that captured my attention: Energy Resources of Australia (ERA). ERA is 66% owned by Rio Tinto, but the minority shares trade on the Australian Securities Exchange (ASX) or you can buy ERA on the pink sheets in North America.
ERA has been producing since the early 1980s from northern Australia. ERA owns Ranger, the 2nd largest uranium mine in the world, though the ore is of the low-grade variety. They own the rights to another significant deposit, Jabulika, but disputes with aboriginal organizations in the northern Australia make the future development of this deposit very uncertain.
Here’s some historical performance:
You can buy ERA 2 ways:
1) It trades in North America over the counter as EGRAF. Its quite illiquid, the bid-ask spread is some USD
0.50.
2) You can buy it direct from the ASX through your North American retail broker, but it’s going to cost you.
The lowest estimate I received was USD 200 per trade.
The Bright Side
1. At least 10 years of profitable production
2. 10 years of substantial sales and income growth
3. Low debt levels historically
4. Proximity to emerging Asian markets.
- Presumably ERA has a competitive advantage over other producers without such close proximity
to China.
5. Strong Currency
- Relative to the USD and the CAD, the AUD has and should continue to appreciate. This is a little
bonus for US and CAD investors.
6. Majority-owned by Rio Tinto.
- It never hurts to have the support of one of the world’s largest mining companies.
- Potential for buyout of minority shareholders.
7. Transactions costs
- I know this seems like a stretch, but if ERA is truly a great investment for the long-term then 200
bucks shouldn’t even be a blip on the radar screen.
- If you’ve got a quick trigger finger on trades, this will provide you a good incentive to stay
invested.
The Dark Side
1. Poor production growth
- Substantial improvement in profitability metrics result solely from rapid increase in uranium prices.
Production has grown just 4% annually.
- In 2009, ERA scored its first production increase in 3 years, however, it is still below peak
production of 5,605 tonnes in 2004.
2. Are you kidding? The ****in transactions costs!
3. P/E of more than 40 times!
- This number would make Benjamin Graham roll in his grave. It stinks of overvalued.
As with many investments, ERA has a lot of positives, but it appears those positives have been priced in and then some.
ERA Valuation
So what’s it worth. To value ERA, I used the following model:
• Scenario Analysis using a 2 Stage Discounted Cash Flow (DCF) model
• Owner Earnings (OE) are used as a proxy for FCF
OE = Net Income + Depn – Capex +/- any other major non-cash items
• Stage 1
- 16 year horizon to 2025
- Estimated Growth of Production
- Estimate Change in Realized Price of U3O8
- Estimate of Profit Margin
- Estimate of Depn and Capex per $ of Sales
- Estimate AUD/USD: start @ 1.124 AUD/USD, appreciate 0.5% per year
• Stage 2
- Estimate of long-run growth in Owner Earnings
• Discount Rate = 12%
Scenario 1 – Base Case
The base case shows ERA is overvalued by a little less than 50%. YIKES!
That might seem ludicrous, but consider that the estimates used in the base case are actually somewhat aggressive. 10% annual production is well above the company’s annual 10-year average and the average growth expected in uranium demand of 1.5%.
As for price appreciation, at 10% annual appreciation the price of uranium would be USD 170 in 2025. A profit margin of 25% accounts for increasing reliance on lower grade ore to increase production over time.
Scenario 2 – Justify My Price
I always like to consider what must happen in the future to justify a stock’s current price. Then I can assess how reasonable the expectations are. So I adjusted Scenario 2 in the following ways,holding all other factors equal.
In the first case, ERA itself would be producing 31% of all uranium output in the world by 2025 as per EIA estimates. Ya, right.
In the second case, U3O8 prices would reach USD 226 per pound by 2025. 30% appreciation is 6 times the appreciation in uranium since 1988 and not far behind the 57% appreciation of uranium from its trough in Dec 2000 to its peak in June 2007. If you think a quick return to those bubble growth rates are likely, I suggest you look at charts of the Dow Jones Industrial Average, the Nikkei, and the Nasdaq 10-years after their respective peaks in 1929, 1991, and 2000.
Nuclear Waste
In a fantasy world where commodity prices increase parabolicly ad infinitum, mining companies can achieve spectacular growth in earnings. Unfortunately, in reality where I choose to reside from time to time, the law of supply and demand tends to pull commodity prices to their relative mean over time (massive fiscal and trade deficits debasing the American currency not withstanding). If you can’t increase production, you can’t grow. And ERA certainly hasn’t shown an ability to grow at the rates it needs to justify its valuation.
So whatever you do, don’t buy it. Should you short it? I wouldn’t do that either. Uranium bugs are so fanatic that these valuations could remain inflated for years on end. There have to be more effective uses of capital elsewhere.
I would handle uranium stocks in the same I would handle actual uranium … with a HAZMAT suit.
Set your PVR for Part 2 of the series, where I discuss the wildcard that is electric vehicles. Given the disappointment I have endured with uranium thus far, it might end up like Guns N Roses’ “Chinese Democracy” or Dr. Dre’s “Detox”.
Full Disclosure: I do NOT own ERA. I wouldn’t own it with a 10 foot pole.
Here’s some links if you want to read up:
http://en.wikipedia.org/wiki/Uranium
http://www.world-nuclear.org/infomap.aspx
http://www.eia.doe.gov/oiaf/archive/aeo09/demand.html
http://www.financialpost.com/creditcrunch/story.html?id=2495120
http://en.wikipedia.org/wiki/Bakken_Formation
http://www.newgeography.com/content/00766-germanys-green-energy-goals-are-potentially-unrealistic
http://www.energyres.com.au/
http://www.riotinto.com/resources/3608_financial_reports.asp
http://au.finance.yahoo.com/q?s=ERA.AX&x=15&y=14
http://www.lowrisk.com/nasdaq-nikkei.htm
