Strikes At Major Suppliers Are Making North American Palladium And Stillwater Mining Shine

Jun.18.14 | About: North American (PAL)

Summary

South African palladium miners have been on strike since January 2014. Those mines supply about 40% of the world's palladium. The strike has meant a 24% cut in world supply.

Russia's Norilsk Nickel supplies about 41% of the world's palladium. Many are worried about sanctions against it due to the trouble in the Ukraine.

World auto sales are expected to be up 5% in 2014. About 72% of the world's palladium is used for auto catalysts.

PAL is in the early stages of a ramp up to more efficient, greater quantity, and higher grade production. This should help its stock price rise.

On June 11, 2014 Palladium Nymex futures hit a near-term high of $864.60/ounce. It has since fallen to $810.35/ounce as of this writing June 16, 2014. Still this is up substantially from the $695.50/ounce on February 4, 2014. The main reason is that mines in South Africa, which account for about 40% of world palladium production, have been on strike since January 2014. About 60% of the South African production has been curtailed by the strikes (about 24% of total world production). On June 12, 2014 there was speculation that a deal had been reached. For the first time the leaders of the Association of Mineworkers and Construction Union agreed to take an offer to their members. Palladium prices have fallen about $50/ounce to $810.60/ounce from their recent highs as a result. However, Bloomberg says, "A Reuters report that stated the parties had reached an agreement was incorrect, Johan Theron, a spokesman for Impala, said today (June 17, 2014) by phone". The two sides are now closer than they have been; but no one knows when this strike will end. Still even if the strike ended tomorrow, it would take many months for the mines to get back to normal production. Palladium prices will likely be pressured for the rest of 2014; and they may continue to be pressured in 2015.

Many are worried that sanctions against Russia due to the Ukraine situation (seizure of the Crimea, etc.) could lead to a partial or complete loss of Russian palladium production. MMC Norilsk Nickel (OTCPK:NILSY) accounts for 41% of the world's palladium production. Many are worried that sanctions in their next phase could be placed on Russian companies, and Norilsk Nickel would almost certainly be included on that list. This is a real worry, although there has been no great impact so far.

In addition the US May light vehicle sales were at a 16.7 million per year rate. The China Association of Automobile Manufacturers showed May 2014 auto sales climbed 13.9% year over year to 1.59 million units. New car registrations in Germany rose 5% in May 2014. Overall one would have to say auto sales are doing well worldwide. They are forecast to rise 5% in 2014 and 5.4% in 2015 according to LMC Automotive LTD. Since auto catalysts accounted for 72% of palladium use, an increase in auto sales means an increase in demand. Palladium demand is also benefiting from more stringent fuel emission standards from the US EPA and other international environmental organizations.

All told palladium supply is expected to trail demand by an all-time high of 1.6 million ounces in 2014; and that is without considering any cuts to supplies from Russia. To put this in perspective, total world supply in 2012 was 8.7 million ounces. Of this only 6.3 million ounces were from mine production. 2.4 million ounces came from secondary recovery.

Prices have already gained about 17% since January 2014. They are expected to jump another 16% by year end to $950/oz according to a Bloomberg survey of 15 analysts. If Russian palladium is curtailed to any significant extent, prices could push far higher.

All of the above means that North American palladium producers should do well in 2014. The tight supply situation is a substantial tailwind. The two big North American palladium producers are North American Palladium Ltd. (NYSEMKT:PAL) and Stillwater Mining Co. (NYSE:SWC). SWC stock has been going up dramatically for most of 2014, seemingly triggered by demand and by the South African strikes. Then on May 16, 2014 SWC signed a five-year deal with Johnson Matthey -- a leading manufacturer of auto catalysts. Johnson Matthey agreed to buy all of SWC's palladium production and a significant share of its platinum production based on an annual pricing mechanism linked to various industry benchmarks (essentially at market prices). SWC retains the right to opt out of the agreement.

SWC also gets to use some of Johnson Matthey's services, such as its refining services. In other words, SWC has essentially sold all of its palladium production and a good part of its platinum production at market varying prices for the next five years. This guarantees a huge portion of its income. Plus it should cut down on marketing and other expenses over the next five years. SWC won't need too many salesmen to sell what has already been sold. This means more profits for SWC. The stock may move even higher after its already roughly 30% move upward in 2014.

SWC looks like a strong stock; and many may wish to own it. However, PAL may be the stock that is due to make investors the most money in 2014 and 2015. PAL has been losing money for some time now. However, it is a turnaround story. It got rid of its money losing gold mining business in 2013. Since then it has completely focused on improving the its palladium mining business (mainly the Lac des Iles mine). This is starting to pay dividends; and PAL was already predicting profitability by the end of 2014 even before the South African strikes.

PAL's major change for 2014 is that it is converting to shaft mining (from ramp mining). It will in 2014 be able to mine a much larger amount of higher grade underground palladium from the Offset Zone of the Lac des Iles mine. The following table shows the results from 2013.

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A few items stand out. The amount of palladium produced in Q4 2014 was only 30,979 oz. The cash cost per ounce for FY2013 was US$560/oz. The average mill grade was 2.8 g/t of Pd. The Palladium mill recovery rate was 80.7% for the year. The table below shows those items had already improved substantially in 2014 by the end of Q1.

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The amount of palladium produced in Q1 2014 was 42,641 oz. The cash cost per ounce was a much lower $492/oz. The average mill grade was 3.3 g/t Pd for Q1 2014. The mill recovery rate was 84.5%. These are huge steps in the right direction, and they are only the beginning. In Q1 2014, underground mining, which yields higher grade tonnage, averaged 3,065 tonnes mined per day. Operational guidance for 2014 was only 3,000 tonnes for the first half of 2014. Then PAL was supposed to average 5,000 tonnes per day for 2H 2014. If PAL was already at 3,065 tonnes per day of underground mining for Q1 2014, PAL seems almost certain to average substantially higher than 3,065 tonnes per day for Q2 2014. The 2014 Operating Guidance also called for 3.0 g/t Pd grade and an 82% recovery rate in Q1 2014. The above numbers are substantially higher than that.

In addition the company forecast an average price of $750/oz for palladium for FY2014. However, the price is already higher than that; and many analysts believe it may go to $950/oz by the end of 2014. This would make the average price per ounce for 2014 much higher than the forecast average price of $750/oz for the entire year. For Q1 2014 the realized sales price was $739/oz on average.

Further the reduction of the cash cost per ounce to $492/oz. for Q1 2014, illustrates that the forecast production cost of $450/oz by Q4 2014 is very much achievable. In Q1 2014 this resulted in a margin of $247/oz for Q1. When you realize that PAL will in all likelihood increase that margin to about $400/oz ($450/oz in production costs and a conservative average of $850/oz in revenues), it is easy to see why I and others think PAL will soon be profitable.

How far is PAL from profitability? Its Q1 2014 revenue was $48.7 million. Its net loss for Q1 2014 was -$26.7 million (or $0.11/share). EBITDA was $1.0 million; and adjusted EBITDA was $9.8 million. The underground mining tonnage had an average grade of 5.0 g/t in Q1 2014. PAL mined an average of 3,065 tonnes per day. PAL is expected to mine 5000+ tonnes per day in 2H 2014. Assuming the same grade of 5.0 g/t and the same recovery rate of 84.5%, then PAL would mine 159,232 ounces of Pd in 2H just from the underground tonnage. This would mean the number of ounces mined would be substantially larger than the 170,000-175,000 ounces forecast by the FY2014 guidance given at the end of 2013. 80,000 of those ounces times an extra $150/oz of extra margin would yield an extra $12 million in revenues. If the average price obtained per ounce for Q4 were $900/oz, that would yield an extra $16 million in revenues in Q4 2014. When you add in the ounces of Pd that would be obtained from the above ground mining (much lower grade), the revenues in Q4 2014 would increase even more. When you consider that PAL will in all likelihood become more efficient as the year progresses, PAL should really see more profits by Q4 2014.

As much as PAL has been bad mouthed, the only pro analyst now covering PAL apparently agrees roughly with my appraisal. The analyst sees PAL with a 2015E PE of 10.93. This is a highly profitable state; and it should mean the stock price will go up between now and then. The analyst is predicting a next five years EPS growth per annum of 50.00%. This should allow the stock price to rise considerably over those five years. This makes PAL a good to great investment. Yes, there are some risks. Any small, currently unprofitable stock represents significant risks, so you don't want to put all of you money into it (or perhaps even a significant amount of your money). However, an investment of 1% to 5% of your portfolio at this time seems appropriate. The fundamentals for palladium are fantastic; and the company is making good progress on its journey to profitability.

In fact the results from Q1 2014 were so good that PAL was able to improve the terms of its second tranche offering. With all of the positives in PAL's future, it is a stock worth at least a small buy by many investors. At the very least investors and/or traders may wish to trade the stock. It seems almost sure to go up in 2014 with the acute shortage of Pd that is expected. If the Russian supplies are impacted too, the stock price and profitability would be elevated that much further.

In addition to the operational improvements, on March 21, 2014 PAL released its new update on reserves and resources and life of mine plan for Lac des Iles. Total reserves and resources amounted to 5.2 million ounces of Pd. This was a 24% improvement over the January 2013 report. This extends the life of the mine by approximately one year to 2019 with annual production peaking at over 200,000 payable ounces of Pd. Further exploration funds are expected to be allocated in 2014 to conduct conversion and extension drilling below the 1000 metre level in the lower part of the Offset Zone in support of a potential shaft expansion and future life of mine extension.

A further point to keep in mind is PAL's loans from Brookfield. They have a 19% rate. Once PAL achieves profitability, that rate will automatically fall to 15%. Once PAL achieves profitability, it should be able to replace some of its higher rate loans with lower rate loans. These things will all result in greater profitability for the company.

The two-year chart of PAL provides some technical direction for this trade.

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The slow stochastic sub chart shows that PAL is near overbought levels. The main chart shows that PAL has likely bottomed recently. It now appears to be headed upward. The fundamentals of the company and the fundamentals of the palladium market worldwide both suggest that PAL should continue to head upward. Now is likely a good time to buy. PAL has an FPE of 10.93. It has a next 5 years EPS growth estimate of 50.00% per annum. If it becomes profitable by year end 2014, this means that its EPS will grow at a 50% per year rate for the next 4-5 years. This leaves room for the stock price to multiply several times at least. The one analyst's recommendation is still a 4.0 (a sell). I disagree with the current analyst's recommendation. I think the fundamentals both of the company and of the palladium industry are too bullish for a sell rating. I recommend PAL as a low buy. I believe in the profitability story.

However, investors may want to wait to be more sure of the story until after the Q2 2014 earnings report. They may wish to wait until after the Q3 2014 earnings report. I cannot answer that question for them. If they do they will miss a lot of the upside. A number of analysts have suggested PAL might go bankrupt; but the fundamentals have continued to improve. PAL does not appear to be a candidate for bankruptcy. Instead it appears to have a lot of upside. With the bottom apparently already in, it is time to invest (or to at least nibble).

To me SWC has been rising all year. It is much more overpriced than PAL. It likely has upside. However, I am more worried that it is overextended. It only has a next 5 years analysts' average EPS growth estimate per annum of 10.00%. That doesn't suggest it has unlimited upside. Rather it again suggests it may be near a top, especially since it has no PE (is not profitable). Yes, SWC has a lot of positives, but they may only push the stock up for the duration of the current rally. I rate it a hold at the current price, although some momentum traders may wish to play it for further upside.

The two-year chart of SWC provides some technical direction for a trade.

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The slow stochastic sub chart shows that SWC is neither overbought nor oversold. The main chart shows that SWC is coming down off a likely too high high. Investors will probably wish to wait to buy it until it is more clear where it is headed. There are continued rumors that the South African strikes are near resolution. However, in each case market followers have been disappointed thus far. The two sides do not appear to be particularly close in their negotiations. Just the same, the strikes will eventually end; and SWC, which seems joined at the hip to the strikes, will likely fall then. I would not buy SWC now. I might want to buy it at a later time. Still it has an analysts' mean recommendation of 1.8 (a strongish buy). It has an FPE of 17.43. It is a stock a lot of investors may want to keep on their watch lists. If Norilsk Nickel has sanctions levied against it, such actions could give SWC a lot more upside; but it is a hold for me at the moment.

NOTE: Some of the above fundamental financial information is from Yahoo Finance.

Good Luck Trading.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in PAL over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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