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A Weekend Retreat With Uranium

|Includes:BHP, Cameco Corporation (CCJ), RIO, SXRZF, UEC

Absent a valentine during the holiday weekend (feel free to message me your condolences) and in the midst of a strong sell off in uranium producers, I thought a weekend buried in uranium data would be an appropriate “retreat” for a young, single male trapped in Saskatoon, Saskatchewan. Call me crazy.

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 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 and explorers alike are selling off over the past few weeks in the face of weak earnings. And like any good value investor, I wondered if there was a deal to be had.

Unfortunately for the uranium bulls out there, whose fanaticism is outmatched only by the cult-like gold bugs, it appears the pessimism is warranted. First some quick background on uranium, then a recommendation on the company Energy Resources of Australia (ERA.AX; that’s right, Down Under!).

Worldwide nuclear energy accounts for some 15% of all electricity, about 2,738tWhs annually, and is distributed among markets as per the following:

 

Share of Nuclear

 Power

Nuclear Power (tWhs)

Europe

44.7%

  1223

US

31.0%

     849

South Korea

5.5%

     151

China

2.5%

       68

India

0.6%

       16

Brazil

0.5%

         7

Other

15.2%

---

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 Demand

Liquids

Nuclear

Renewables

Natural Gas

Coal

Total

-0.1%

1.5%

2.9%

2.7%

2.5%

2.4% 

Nuclear 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 more in the pipeline:

Reactors

Operating

Under Construction

On Order / Planned

Proposed

World

436

53

142

327

China

18

20

37

120

India

18

5

23

15

Russia

31

9

8

37

USA

104

1

11

19

South Korea

20

6

6

0

Other

245

12

57

136

At first blush, this is pretty exciting. 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%.

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 much.

Pick a Horse
There are a handful of pure play producers and a lot of exploration companies. Uranium exploration is a tough gig. It’s really 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 sure 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 Canadian pure play with 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. 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 (NYSE:ERA). ERA is 66% owned by Rio Tinto, but the minority shares trade on the Australian Securities Exchange (NYSE:ASX) or over- the-counter 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.

Here’s some historical performance:

 

2009

2008

2007

2006

2005

2004

Profit Margin

0.35

0.45

0.21

0.14

0.16

0.16

D/E

0.41

0.54

0.63

0.57

0.60

0.69

ROE

0.28

0.29

0.13

0.08

0.08

0.07

P/E

47.31

163.79

48.87

90.83

46.60

34.68

 

 

2003

2002

2001

2000

1999

Profit Margin

 

0.10

0.11

0.07

0.19

0.13

D/E

 

0.23

0.37

0.34

0.34

0.40

ROE

 

0.03

0.03

0.03

0.06

0.03

P/E

 

34.00

15.55

24.25

12.83

15.45


10-year CAGR , Sales

16%

10-year CAGR , Income

29%

Average Growth in Production

4%

Price, 19Feb2010

AUD 18.41

AUD per USD, 19Feb2010

 1.122









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. 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 market
5.       Strong AUD Currency
6.       Majority-owned by Rio Tinto
7.       Transactions costs: if you’ve got a quick trigger finger on trades, the fee will provide you a good incentive to stay invested.

The Dark Side
1.       Poor production growth. Production has grown just 4% annually.
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. 

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 use a DCF model with Owner Earnings as a proxy for Free Cash Flow. 

Scenario 1 – Base Case

Stage 1

 

Average Annual Production Growth

10%

Average Annual Change in Price per lbs of U3O8

10%

Average Profit Margin

25%

Average Depreciation per unit of Sales

20%

Average Capex per unit of Sales

15%

Average appreciation of AUS vs. USD

0.5%

    Stage 1 – Value

AUD 5.61

Stage 2

 

Long-Run Growth Rate

3%

    Stage 2 – Value

AUD 4.47

 

 

Intrinsic Value

AUD 10.08

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.

30% Production Growth, 20% Profit Margin

$16.89

30% annual Price Appreciation, 40% Profit Margin

$20.48

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. If you think a quick return to the bubble appreciation of 2 years ago is are likely, I suggest you look at charts of the Dow, 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.

You can find a more detailed analysis of ERA at my new blog: Random Walk Off a Short Bridge randomwalkshortbridge.blogspot.com/2010/...



Disclosure: I am not long ERA. Not with a 10-foot pole. And I am not invested in any of the other stocks mentioned.
Stocks: CCJ, RIO, BHP, SXRZF, UEC