We think some of our comments on the graphite market have been misconstrued, or interpreted out of context, and we hope to clearly state why we think the graphite sector is a good place to find quality investment opportunities.
The key to finding any good investment opportunity is to find market inefficiencies, and we think that such inefficiencies exist in the graphite space because certain aspects of conventional wisdom in the resource sector are wrongfully applied by investors in evaluating graphite companies. Conventional resource investing wisdom would tell us that the best opportunities can be found in companies with large, high grade resources. With respect to graphite in particular--because the growth market is in the battery space--conventional wisdom has led investors to favor those companies that have outlined paths to battery material production.
One-by-one companies that emphasize their so-called advantages in this respect have shed investors, who have either wised up or simply given up in frustration. Occasionally new ones pop up re-emphasizing these so-called advantages, and they have been able to generate investor enthusiasm, at least for a little while. But while the "this time (i.e. "this company") is different" routine may satisfy some, we've become frustrated with not just individual companies, but with the entire sector insofar as it continues to promote the popular graphite narrative rather than a cash-flow generation model.
The Popular Graphite Narrative
Graphite is a unique material. True, it is comprised of the abundant element carbon, but quality graphite found in forms that can be used in industry is relatively scarce. What's more, graphite is a small market, yet it is a key input as anode material in lithium ion batteries ("Li-Bs"). Li-B demand is about to skyrocket as the technology is being used more in EVs. Not only is the EV market expected to grow rapidly but the size of the Li-Bs found in EVs is much greater than that of most Li-Bs produced today because they are found in smaller electronic devices.
This has the potential to change the supply/demand fundamentals of the graphite market. Since large amounts of this material (often used in small amounts) will be used in this rapidly growing industry graphite is a compelling investment.
What the Graphite Companies Tell Us
This is the story that every graphite company tells. Each company then tells us specific reasons that its approach is the right one, making it a superior graphite investment. Whatever these reasons are they fall into one of two categories:
- We have special graphite that is preferable for manufacturers, especially those in the battery industry.
- We have special attributes (e.g. patents, people) that enable us to prepare graphite for use in high-value markets, and anode material in particular.
We certainly don't want to dismiss these attributes outright, but at the same time we note that like with any investment in the development stage we need to see a compelling reason to believe that these attributes can be utilized to form a cash-flow generating business.
Why We Invest In Graphite
Before we discuss this let's first get into the reason for making an investment, period, which is that the cost of the investment is lower than the risk-adjusted cash-flow that it can generate. While such a definition is trivial, and perhaps academic, we're shocked at how quickly it is overlooked by investors, who are easily bamboozled by stories about "special" graphite, "special" processes or unparalleled talent.
Graphite companies have focused far too much on how much their graphite is worth and how they can process their graphite in order to augment this figure. "Special" graphite (i.e. hydrothermal or large flake) is worth more. So is graphite processed for the Li-B anode market (aka coated spherical graphite or CSPG). As graphite companies want to maximize the value of their graphite in the minds of their investors they naturally emphasize these attributes.
But how does this get us to cash-flow? Graphite companies have to convince financiers to finance their projects. Then they must execute, meaning that graphite production has to come in at or under budget, and there must be customers.
In order to get financing a financier has to be confident in the project. Considering that most financiers aren't so familiar with the graphite market--a small, niche market--we suspect they will be hesitant to put up funds as they have been to date. Companies that have "special" graphite may be able to argue that their products are more valuable on a per-unit basis, but these are even more niche markets whose opacity will further dis-incentivize financiers.
Meanwhile those companies claiming to have special processing capabilities have not demonstrated this at scale, and they will be forced to work with engineers and laborers who likely have little to no experience in developing a graphite processing plant or in actually processing the graphite. Nearly all of the world's commercial capacity for CSPG production is in SE Asia. Some Westerners "know" how to produce it in the sense that they have detailed blueprints of a processing facility and have seen them in action, although they've not built or operated such facilities themselves. We suspect that financiers will therefore be reluctant to provide funds to companies focused on more complex processing techniques as a primary source of cash-flow generation.
We therefore see financing as a fundamental barrier to cash-flow generation, and one that has a unique character for graphite when compared with the financing risk for other mining projects. In the latter case, e.g. in the gold market, financiers are often putting up money for projects that share most of their attributes with many other projects that have been financed in the past. The engineering firm that develops the feasibility study and related test-work has often-times done this for dozens if not hundreds of gold projects, while even the companies with the most experience in graphite analysis are working with a small fraction of this experience. This is an inherent risk that comes with investing in niche materials, and those who aren't ready for it should stick with mainstream materials where the processing capabilities are better known by greater numbers of people.
A gold project with a feasibility study developed by a well-known engineering firm is a much lower risk project than a graphite project with feasibility study (or lesser technical document). This isn't just because the processing is less well-known, but because economic assessment is more involved. Engineering companies who carry out feasibility studies on gold projects simply state that there is a highly liquid market for gold at a range of purification levels, and they use the recent market price, a 3-year trailing average, or something to that effect in order to generate the gold price input. Graphite is sold on a contract basis, meaning the economic assessment must be more involved than it is in the gold space. It is also necessarily more opaque as many graphite transactions take place under the radar, and their details are considered by the relevant parties to be trade secrets.
Some companies have come about with specialized graphite market knowledge, and they have been hired to carry out the market assessments in recent feasibility studies. However these studies all read like the above paraphrased "story" that graphite companies want to promote. Furthermore, all the companies involved benefit from a rising graphite price, or the perception that the graphite price will rise: such assessments are therefore subject to bias. They further omit the details of the contract-based sales phenomenon and merely pay it lip-service. We don't get details as to how the company will find customers, the cost of marketing, or the risk of a failed marketing effort. The thinking is consistent: "If they produce it someone will buy it at the 'market' price." In short the efforts acknowledge the atypical attributes of the graphite market with respect to more common commodity markets, but they don't show us real solutions. Rather, these efforts try to mold the graphite market in order to fit the model developed for gold or other commonly traded commodities.
Financiers are therefore not able to gather as much information from a graphite feasibility study as it would from a gold feasibility study. In fact, given how the graphite market operates it might be the case that a feasibility study is considered to be invalid without the graphite company having a pre-existing customer base (just like non-producing gold miners have a pre-existing customer base), and that graphite junior miners are forced into an endless "chicken-egg" dilemma.
It is for this reason that we think that any business plan that involves building a graphite mine is risky unless initial capex is extremely low and unless opex is sufficiently low so that the mining company could feasibility exist as just a mining company that sells run-of-mine product to graphite processors. No company to our knowledge fits this model, although a couple come close. For instance Mason Graphite (OTCQX:MGPHF) has low opex but high capex. Syrah (OTCPK:SYAAF) has low opex, low capex needs (high capex but the company raised it), but it can't possibly sell the large sum of graphite it claims it will.
Those looking for leverage to a rising graphite price may look to companies with undeveloped graphite mines, but those looking to invest in a business should look elsewhere.
So Why Invest In Graphite?
Remember our initial question was "Why invest in graphite?" and our rant essentially got us to the point that graphite is not a good investment, or at least there don't seem to be any opportunities among the companies looking to develop mines. Not every company is looking to develop a mine or has to. Those that aren't will face their own difficulties, but they do not need to raise large sums of capital. The market, in valuing graphite juniors, appears to overlook this: the highest valuations have been assigned to the graphite companies looking to develop mines, and therefore with relatively high initial capex requirements (e.g. in the tens to hundreds of millions vs. just a few million).
This hardly mitigates the processing, sales, and marketing risks faced by graphite companies. In fact while mining is expensive it is among the simplest parts of the value-chain from an operations standpoint. Thus it is no surprise that the companies we're singling out as maintaining this advantageous position have struggled.
We should also note that just because a company has an advantage doesn't mean it will necessarily succeed. Flinders Resources (FLNXF) looked to refurbish Woxna--a small mine in Sweden--and to start generating cash-flow by selling its raw graphite, a strategy that failed as the company reached production as the price of raw graphite was falling. While this could be viewed as a failure, the aforementioned advantage still applies. Flinders could benefit before all of its peers in the event that prices rise (although that is unlikely in the near-term) as it would be one of only a few Western companies actually ready to mine and sell graphite.
Despite this advantage Flinders trades at a discount to most of its peers with undeveloped mines. There are a couple reasons for this. The first is that its Woxna Mine cannot generate positive cash-flow in this graphite price environment. Technically speaking, neither can companies such as Mason, which can only tell us that it could make money hypothetically.
The second is that we suspect that Flinders' reputation is tarnished given that it promised production to the market and failed to deliver. To an extent this is true--the plan put forth did not succeed--although that doesn't mean the company is out of the running even if the current valuation appears to be pricing in this assumption. Flinders shares trade at a fraction of the valuation of its peers that need to build mines, and it can finance its reduced-activity budget for more than a year, meaning there is still a chance that Flinders will not have to raise money unless it decides to move forward on a purification plant. It would only move on the latter should internal studies indicate that such a plant can generate a high IRR and be developed with a small amount of capital (again, this means just a few million dollars and not tens or hundreds of millions of dollars).
Flinders' valuation today is just ~$5 million, which puts it among the lowest valued companies in the graphite space.
Great Lakes Graphite (OTCPK:GLKIF) is another company that doesn't need to raise large sums of capital in order to develop a mine. It is buying and processing graphite, and we can hardly stress the extent to which the company faces the aforementioned risks, namely processing, sales and marketing.
However it is the one company that has shown us that it can sell graphite. Great Lakes is producing micronized graphite, which means it takes graphite flakes and grinds them according to customer specifications. This last point is key: the company can't simply grind up its graphite into different flake sizes and put it on a shelf for consumers to peruse. Great Lakes is working closely with prospective customers, and it is customizing products. By outsourcing the mining aspect of its business management has been able to devote its efforts fully to processing, sales and marketing.
As a result it has just announced its first sale. Yes, it is only for 40 tonnes (~$100,000 worth assuming a $2,500/t price tag, our estimate), and yes, micronization is not beyond the capabilities of most of the hopefuls in the junior space, but Great Lakes actually has its foot in the door, and it has clearly illustrated that its path to cash-flow--while more arduous than initially thought--can be realized. When we first recommended Great Lakes Graphite it, too, had a low valuation relative to its peers: ~$7 million. It has risen since then but the valuation remains below many of the companies with undeveloped resources.
We have since updated our research on the company.
The Bottom Line
The primary appeal of the graphite market isn't the Li-B potential, although that certainly doesn't hurt. To understand the Li-B appeal through an analogy consider the situation of a fairly popular junior mining company called Pretium Resources (NYSE:PVG). Pretium has a huge project called Snowfield that has incredible potential. It is one of the world's largest undeveloped gold projects. But the market has to change and a lot of development efforts have to be carried out for this potential to be realized. The "real" value of Pretium is in its Brucejack Project, which is currently under construction and which is expected to generate cash-flow shortly, and after a carefully drawn-out plan is executed. While this is perhaps a crude analogy it reflects the fact that the battery market requires certain market conditions to develop, and it also requires a lot of complex and costly work. The value can be realized, but it is hardly the stable foundation for a business proposal.
Our feeling is that if you want to bet on the Li-B revolution don't do it through commodity producers. Do it by investing in a battery company. If a company developing a graphite deposit calls itself a "battery" company (or a graphene company, a tech company...etc. ) it is trying to do a lot right at the start. This takes a lot of capital, and it means investors take on more technical risk.
So the appeal of the graphite market, in addition to anode-material optionality, is that its characteristics make it relatively easy for investors to misinterpret the opportunity. It is therefore easy for wise investors to spot market inefficiencies. This is not a commodity business although the junior graphite investors treat it like it is one. They are taking their cues from NI 43-101/JORC compliant documents because that is how they have been trained. This has resulted in a misallocation of capital into companies that provide the most attractive NI 43-101/JORC compliant documents to the market.
Meanwhile, investors have grossly undervalued those companies that do not have this false appeal, and within this group we believe lie the opportunities that offer the best risk/reward profiles.
Finally note that these are all start-up businesses in a market where we have well-capitalized and highly knowledgeable established players. Even the best ideas in the sector are risky.
Disclosure: I am/we are long GLKIF.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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