Robert King's  Instablog

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Sprott Resource Corp.

Who here would like to pick up some gold bullion for 20-40% off the current market price?

Sprott Resource Corp. (TSE:SCP or PINK:SCPZF) presents us with an opportunity to do exactly that.  SCP is a Canadian company that invests and operates in the natural resources sector.  The Chairman of the company is Eric Sprott, who is widely known as one of the best natural resources and energy investors around.  Incidentally, Eric Sprott owns about 7% of the company and insiders own at least 10% of the company.

SCP is a fairly under-followed small cap company with a unique compensation structure for management.  In essence, Sprott Resource Corp. is run like a hedge fund where management gets paid an annual 2% management fee of Net Asset Value and receives an annual performance fee of 20% of the difference between the pre-tax profits for the year and the average month-end NAV multiplied by the average yield of the Canadian 30-year Generic Bond index.  The fact that some of us, myself included, had to read the second half of that last sentence again to figure out what it means is likely a contributory factor to why this company is overlooked.  Note that as a publicly traded hedge-fund-type vehicle, it’s not alone -- Greenlight RE (NASDAQ:GLRE) and Biglari Holdings (NYSE:BH) are both companies that have similar compensation/corporate structures to Sprott Resource Corp.

The company holds approximately 20-25% of its assets in cash and gold bullion, 53-65% of its assets in oil & gas companies, and 17-22% of its assets in agriculture and agriculture-related businesses.  (The percentages depend on how you calculate the book value of the company, which I’ll explain later.)

I’ve compiled a spreadsheet that shows the value of each individual component of Sprott Resource Corp.  Please note that while the spreadsheet lists value in both CAD and USD, I’ll be using the CAD values in this writeup.

Cash & Gold Bullion

The company has a cash & cash equivalents (C&CE) balance of C$28.597 million.  Although the balance sheet indicates a C&CE balance of C$81.069 million, that amount includes C&CE in some of SCP’s subsidiaries.  Since we’ll be doing a business valuation of the subsidiaries later, we don’t want to double-count those assets.  Additionally, the company has 73,971 ounces of “physical” gold bullion.  The distinction between “physical” and “paper” is key.  If you’ve read Passport Capital’s missive on its rationale for holding physical gold rather than shares of a gold ETF like the SPDR Gold Trust (NYSE:GLD), then you’ll immediately know why that’s important.  (I’d suggest that everyone read the Passport Capital writeup -- it’s very interesting.)  The gold bullion is worth C$89.38 million @ a gold spot price of USD $1166/oz.

Energy Assets

The next group of assets that the company holds is energy assets in the form of Orion Oil & Gas and Waseca Energy.  Both companies are exploration & production oil & gas companies operating in and around Alberta.

Orion Oil & Gas is a publicly traded company (CVE:OIP) that IPO’d at the beginning of this year.  SCP owns 78.9% of OIP on an undiluted basis, and, with a market capitalization of about C$290 million, SCP’s stake in OIP is worth roughly C$229.34 million.  As a separate check, recent transactions in western Canada have sold for about C$64,000 per boe/d and Orion Oil & Gas has reached production of a bit more than 4,000 boe/d, so a market capitalization of about C$290 million or C$1.00 per share seems to be about right.  Orion believes that it can increase production to about 7,000 boe/d by the end of 2010.  If that happens, Orion would have a market capitalization of C$448 million and SCP’s share of that would be C$353.47 million.  I would note that SCP’s cost for Orion was a ridiculously low C$100 million.

SCP also owns 81.3% of Waseca Energy.  I wasn’t able to find out very much about Waseca because it’s a private company, but SCP is targeting a production level of around 1,500 boe/d.  SCP currently holds Waseca on the books at cost of C$44.3 million, but given the prior history of SCP’s energy deals, I’m sure that wildly underestimates the value of the company.  If Waseca were to hit the targeted production level of around 1,500 boe/d (it currently has a production level of 443 boe/d), then it would be worth about C$96 million, and SCP’s share would be worth C$78 million.

I’d also like to take a moment to mention PBS Coal here.  PBS Coal is a company that SCP picked up in 2007 for roughly C$55 million and sold to a Russian energy company in 2008 for about C$240 million.  In light of its, admittedly short, history of value creation in energy companies, I don’t believe it’s out of the question that Orion Oil & Gas and Waseca Energy might be worth C$350 million and C$78 million, respectively.

Additionally, SCP has a subsidiary called One Earth Oil & Gas, which seems to be related to One Earth Farms, which I’ll describe in the next section, to which I’ve applied no value.  (I know literally nothing outside of the name of this subsidiary.)

Agriculture and Agriculture-Related Assets

The final group of assets that SCP holds is agriculture assets in the form of Stonegate Agricom and One Earth Farms.

Stonegate Agricom (TSE:ST) is a company that is involved in the exploration and production of phosphate in Peru and Idaho.  ST also IPO’d earlier this year in April, and it currently has a market capitalization of C$85.04 million.  SCP owns 54.3% of ST on an undiluted basis.  As a result, SCP’s stake in Stonegate Agricom is worth roughly C$46.37 million.  An added bonus is that, if the estimates of ST's reserves pan out correctly, Stonegate Agricom may hold one of the most significant phosphate reserves in the world.  (Phosphate is one of three major plant and crop nutrients.)

Finally, we come to One Earth Farms, which happens to be my favorite part of the investment.  One Earth Farms is SCP’s attempt at creating the world’s largest farm.  SCP is bullish on agriculture given the effect of the seemingly inexorable long-term population growth on the world’s food supply.  One Earth Farms is targeting the creation of the world’s first 1 million acre farm.  (As a comparison, most farms are 25,000 acres small.)  By the end of 2010, SCP plans on having developed 100,000 acres of farm land, making it the largest farm in Canada.  Now, I’m not even sure where to begin valuing something like this.  SCP keeps One Earth Farms on the books at a cost of $30 million, and while I believe that the value of the farm will be accretive to shareholders progressively faster as One Earth Farm grows and begins to take advantage of the efficiencies afforded to scale, I’m already fairly confident that One Earth Farms is currently worth more than $30 million.  However, since I have no idea how much more it’s worth than $30 million, I’ll just keep it at cost.

The Discount

If you’ll refer again to the spreadsheet, you’ll see that on a conservative basis, we’re getting SCP at a 21% discount to intrinsic value.  This is a calculation that keeps (1) Orion @ market price, (2) Waseca @ cost, and (3) One Earth Farms @ cost.  On a less conservative basis, we’re getting SCP at a roughly 40% discount to intrinsic value based on (1) Orion @ 7,000 boe/d targets, (2) Waseca @ 1,500 boe/d targets, and (3) One Earth Farms still @ cost.  Now, I don’t like to buy things for less than a 40% discount or more than 60% of intrinsic value, but on the other hand, I don’t believe that the conservative estimate of SCP’s value is... well, believable.  It’s far more likely that the company is worth C$666.85 million than C$508.98 million.  Add to that the fact that, currently, Greenlight RE and Biglari Holdings both trade for roughly 1.4x book value whereas SCP trades for less than book value, and I’m pretty comfortable entering into this investment at these prices.  Besides, with gold, oil, phosphate and agriculture in the portfolio via SCP, we should be pretty well insulated against the almost certainty of long-term future inflation and the possibility of hyper-inflation -- plus, where else are we going to find insurance trading at a discount?

Show Them the Money

Based on the compensation structure, we’re likely overcounting about C$30 million of assets that need to be paid as compensation for SCP’s home-runs.  Unfortunately, the way I deal with this may not be quantitatively satisfying though it might be logically compelling.  We can either look at it as taking away the value differential in One Earth Farms (which we can’t calculate) or taking away a small portion of the 40% premium to get SCP near relative value to GLRE and BH (which I can’t justify as an appropriate premium one way or the other).

C’est la vie.

Qualitative Considerations

There are three qualitative considerations that I’d like to touch on with this investment.

The first consideration is that by mixing gold, oil and agriculture, it seems like SCP is pretty well-insulated against sovereign default risk here.  If you believe the chance of a sovereign default is high, then gold will appreciate short-term (fiat currencies will be questioned) as a safe haven and oil & gas will likely crash short-term like they did when Lehman imploded in 2008.  In other words, SCP’s dry powder in the form of gold bullion would increase precisely as oil and gas companies implode because their margins are getting squeezed due to lowered commodity prices.  This would be great for SCP as distressed energy companies (such as PBS Coal) are their specialty.  (Note that I think longer-term, gold, oil and, to a lesser extent, natural gas, will increase as a result of inflation.  I’m just thinking about the short-term shock effect here.)

The second consideration is that, by a strange stroke of luck, I had been looking into Quest Capital Corp. (AMEX:QCC) when they popped 20% in stock price because Eric Sprott decided to buy the company and turn it into a natural resources lending company.  I don’t want to get into a completely separate writeup about QCC here, but Sprott was smart enough to buy the lending company for less than the value of its loans (probably a 20% discount even with the 20% premium it offered to the prevailing stock price).  In any case, I can imagine a relationship between SCP and the re-branded QCC wherein SCP gets access to lending and/or access to natural resources companies whose common stock tanks because they’re close to defaulting on a re-branded QCC loan.  Then SCP and re-branded QCC could work out a forebearance program of some sort to allow SCP to perform a turnaround (like they did with PBS Coal).

The last consideration is that it’s a Canadian company with operations denominated in Canandian currency.  I’m not a currency trader, but I’m a lot more bullish the Canadian dollar than the US dollar.  Canada is much less exposed to huge structural deficits, inflationary pressures and suffered a much milder housing bust.  Although gold is pegged to the U.S. dollar, the Canadian operations, which are 75-78% of the company, get their revenues in Canadian dollars.

I can’t turn any of these considerations into quantitative numbers, but they’re worth considering nonetheless.

Risks

The most salient risk here is obviously commodity prices.  If beef, phosphate, oil, natural gas and/or gold tanks, we’ll be exposed.  However, since I think we’re buying into this company at a discount, commodities would have to tank a lot in order for us to be at risk for loss of principal.

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I’d like to note that I purchased shares in Sprott Resource Corp. (SCPZF) on July 30,2010 @ $3.997 a share. Unfortunately, Sprott Resource Corp. only comprises roughly 5% of my portfolio.

I’d like to have put in a full 10% position, but that would put too much of the portfolio into oil & gas companies.  I wasn't comfortable with that level of exposure.  My plan was originally to wait until the Cano situation unwound itself in the next two to three months, so that I could put in another 5% position, but it doesn't seem like I'll get the chance to pick up the remainder of the position near my original entry price.

As always, please contact me if you have any questions.