Cameco and Paladin: Buy on Strength of Uranium

by: Bill Herbert

The past two weeks were brutal for equities, with the S&P 500 dropping 11.1% over the period, to a twelve-year low of 735. The Best Portfolio got pounded along with most everything else, as resource stocks were marked “sell” on further global weakness, plus some really dicey and uncertain early moves by the Obama administration in terms of addressing the serious credit and banking crisis. We now have just a slim lead on the S&P, being down 9.33% for the year instead of 10.99%, but that is small consolation. At least one positive note emerges – the fact that our strategy of capturing call option premium and a few dividends has really paid off, due to the market slump, and has made all the difference in terms of keeping the Portfolio slightly ahead of the pack.

We bought more STEI at $2.85 on 2/17/09, only to see it really get cracked the next day, and the one after, as bank stocks took a scary plunge amid the “nationalization” panic that has economic traditionalists quaking in their shoes. Let’s face the facts – we have definitely nationalized Citi (NYSE:C) at this point, and have made serious bolstering moves in numerous other banks, despite their protestations of solvency. I sincerely hope we will kill the ludicrous mark-to-market nonsense, which doesn’t work in a non-market such as we have now. The banks are a ward of the state for now, like it or not!

The gradual “TARP” incrementalism is probably the worst course, and it seems that Geithner or hidden powers behind the throne are trying to steadfastly defend the old status quo, and its disgraced personnel, at all costs. That is absurd, as this is the group that basically caused this whole mess, thanks to no effective regulation for eight years under Bush/Cox/Greenspan, plus an executive wish list for off balance sheet secrecy, rampant derivatives speculation, and leveraged PE and real estate markets that went to great extremes in pursuit of phantom profits on which to pay outrageous bonuses. There is not much worth saving from that model – as a golf pro once said of my swing after seeing it for the first time – “it’s a total startover.”

Hardly anything performed well during this past fortnight, and HL continued its descent even with silver showing pretty positive price action until the 24th of February. As a matter of fact, we are left with only six winners from our original list – ANR, BRCM, FCX, IBM, STT, and WFR. I expect a gradual recovery, as the news everybody was waiting for – what will happen to Citi – has been answered for the short term. The vital signs of the U.S. economy are fading, but with tax refunds, stimulus checks and spending all coming out soon, I expect a stronger economy due to the need to re-stock inventories. China has already shown signs of increased, bargain-oriented buying of metals, coal and oil to be stored in massive reserve tanks that were built over the last three years. The much lower fuel prices in the U.S. should be aiding consumers a bit, and food prices are also down about 10% from last spring’s peak, so those basics have become much more affordable of late. Credit is reportedly flowing again, if you can believe the bankers and those who supposedly look over their shoulder – I don’t have a lot of faith in these guys, obviously, but I sure hope they’re giving us a straight like this time.

Turning to investment ideas, I have been a L/T fan of uranium plays, but fortunately did not own any over the past year, until recently. The spot uranium price is now $45 USD and has been dropping for over a year; it rose to $140 in 2007, but it will be a while before we get back to the $80 range, I believe. However, I view uranium as a core, L/T holding in view of the fact that there is steady demand, not many providers, and it makes a lot of sense as a baseload electric fuel. The global excess of processed uranium is being drawn down, and annual global demand for nuke fuel runs about double the amount of currently produced new supply, so that dynamic seems to point to sharply rising prices over time, as a lot of new reactors will come online soon.

We in the U.S. have fretted nonsensically over safety issues and waste disposal, while the French have provided over 75% of their electric power from nukes, and the Chinese, Indians, Russians, Japanese and Koreans all seem to think it’s definitely the way to go for the future. The IAEA, or International Atomic Energy Agency, lists 44 reactors currently under construction, as well as 436 in operation and producing power around the world. Perhaps as many as 100 more are in the planning phase. Korea, a fairly small country, is currently building five new, massive reactors with a capacity of 5 Gigawatts.

The total global capacity right now is about 370 Gw. That may grow very rapidly, as just a few years ago both China and India got less than 3% of their total electricity from nukes! Most people don’t realize the huge potential of this industry, not to mention the steady demand for processed uranium. According to CCJ’s website, Korea gets 37%, Japan 30% and the EU 32% of electricity from uranium reactors. The global growth for processed uranium demand over the next ten years is pegged at 33% to 40%, despite the current downturn. And by the way, the incidence of accidents is extremely low – only Chernobyl caused deaths, and the safety record of the industry is stellar around the world.

Which brings me to the two companies featured today – Cameco (NYSE:CCJ) which is now a 2.36% position in the Portfolio, and Paladin Mining (OTCPK:PALAF), an Australian uranium company that has great management, solid properties and a strong future once we get past the banking mess that is restraining growth around the world.

Cameco, on the other hand, has outstanding properties and is currently the world’s largest publicly-traded processor and producer of enriched uranium, with a 19% global share. CCJ is based in Saskatchewan and basically provides the nuclear fuel for Canada’s “Candu” reactors as well as exporting to several other countries, including the U.S. and other large users of nuclear fuel. CCJ has massive processing capability but has been plagued by a series of bad management missteps, especially the embarrassing and extremely costly fiasco at Cigar Lake. It is beyond the scope of this report to chronicle the blunders, failed promises, and apparent lack of management wherewithal that have created this godawful mess at CCJ and destroyed confidence in a once-solid enterprise. CCJ was pegged at a CA $47 NAV by RBC Capital Markets in a huge industry-wide report in March 2007. It now sells for CA $18.70 or about 40% of the RBC valuation, which was calculated after the initial breach at Cigar Lake.

Cameco is blessed with the richest uranium ore in the world in Northern SA, some of it at 100 times the uranium concentration of the world average. Cigar Lake is a large new resource for CCJ, but the mining is tricky, and their first attempt to access the ore resulted in a disastrous October 2006 breakthrough in the mine wall and a totally flooded mine, destroying millions of dollars worth of equipment and leading to what now appears to be an indefinite delay of years before Cigar Lake can be produced.

I will leave it to interested readers to explore the news around the company over the last 2.5 years, with a warning that it is almost all disappointing. it managed to develop environmental contamination trouble at the Port Hope processing plant in eastern Ontario that is now being resolved, but led to further uncertainty. However, hope for the future success of this company runs high, and they are entering a phase in which they should enjoy enormous demand growth from abroad, a return to higher pricing and the roll-off of low-cost legacy contracts, plus an inflationary global economy that rewards owners of very valuable resource bases.

Paladin Energy Ltd. is an Australian producer of uranium, with its HQ in Perth, that has seen its stock decimated until a small recent rebound. The stock trades on both the Australian and Toronto exchanges. Its production occurs in Western Australia and Namibia, and it is building a mine in Malawi. The stock at CA$2.43 has dropped around 63% since a year ago, and is 77% down from the all-time high in May ’07, although the mid-year report (through 12-31-08) shows that it was $11MM USD cash-flow positive from operations in the first half. Like many resource companies, PDN (trades as PALAF in the U.S.) took a huge impairment charge for some Australian properties, due to lower spot uranium, but had USD $192MM on its balance sheet at 12-31-08. The company provides excellent presentations on operations and the complete financial picture on its website – the video of the AGM is particularly informative and comprehensive. This is a straight-shooting management team that has both depth and breadth. I rate the shares a L/T buy and with the right scenario it could be a ten-bagger from here in ten years.

It seems more and more that mining has a built-in resistance to replacing top execs, despite some of the worst blunders you can imagine. Take a glance at CDE, TCK, NEM, and Rio Tinto (RTP) for glaring examples of value-destroying management teams who have little to offer shareholders other than chronic underperformance, a litany of blunders, and lots of excuses. Paladin is a refreshing change, and I hope Cameco becomes one as well before too long. Well, that’s all for now – the next update will likely be in two weeks, as my schedule is a bit tight right about now. Let’s hope we see a strong rebound in resource stocks, and a decent recovery in the broad market. For the current performance metrics, please see the spreadsheet below.