The Impossible Situation For North American Palladium

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North American Palladium (PAL) is one of two North American producers of palladium and platinum. Palladium and platinum are both predominantly used by the automotive industry in the manufacture of catalytic converters which are used to control exhaust emissions. Both metals are also used in jewelry, in electronics as well as being subject to a growing amount of investment demand. These similarities lead to similar demand characteristics; both metals are typically mined together and therefore have similar supply characteristics. An overview of the platinum market can be found in my article The Case for Platinum ; the case for palladium is nearly identical, with demand increasing and supply reducing for both metals leaving each in a supply deficit. Too, each metal is currently priced below its all-in cost of production.

The research I undertook for the platinum article lead me to search for potential investments in the platinum group metals (or "PGM") space. What I found was not encouraging, as the majority of production comes from South Africa followed by Russia. Both are relatively unstable political jurisdictions, with South Africa going through significant labor unrest. I did, however, discover two producers in North America. The larger of the two, Stillwater Mining (SWC) is Montana-based and one of the few profitable players in the industry. I researched the company and published my findings here on Seeking Alpha. I concluded there was a strong investment case for SWC. This lead me to investigate PAL to see if it too was worthy of investment consideration.

PAL is well described on its website as:

"North American Palladium is an established PGM producer that has been operating its flagship Lac des Iles, LDI, mine in northern Ontario, Canada since 1993. The Company's vision is to become a low cost mid-tier precious metals producer with over 250,000 ounces in annual production.

LDI is one of only two primary palladium producers in the world, offering investors exceptional leverage to the rising price of palladium. The mine is currently undergoing a major expansion to increase palladium production and reduce cash costs per ounce.

The mine expansion consists of transitioning underground operations to shaft access mining while utilizing a high volume bulk mining method. Through the utilization of the shaft and the bulk mining method, LDI is expected to benefit from increased production at reduced operating costs and yield higher operating margins."

The LDI mine is located in Canada, near Thunder Bay, Ontario. Thunder Bay is home to many mines and as such has sufficient infrastructure and labor to support a growing mining operation. Canada is generally thought of as politically stable and a mining-friendly jurisdiction.

PAL has numerous positive attributes. But, unfortunately, its financial structure is debt heavy, and my analysis concludes that even under the most generous assumptions, this company has potential material risk of not being able to meet all of its financial obligations as they come due.

The Financial Picture

A review of the company's most recent quarterly report provides the information that is required to create a model that can be used to predict cash generation going forward. PAL has recently undergone a refinancing with Brookfield Asset Management (NYSE:BAM). BAM provided PAL with a $130 million loan, due in 2017, and bearing interest at 15%. In addition, PAL has a $60 million operating line (fully drawn), $43 million of 6.15% convertible debentures ($CDN 2.90 conversion price) and $17 million of operating and capital leases. This totals $250 million of long-term debt. The BAM loan is contractually due in 2017 and so is the convertible debenture, unless previously converted. The conversion price is roughly triple the current share price; to assume any conversion is highly optimistic. Including the leases, $190 million has to be generated between now and 2017, assuming the revolver is allowed to remain fully drawn throughout the next three years and is not called in before that time. Total interest costs per year are estimated to run close to $25 million.

During the last eight quarters, the company's production has not grown, averaging around 36,000 ounces of palladium sold per quarter with 32,000 ounces sold in the most recent quarter. Capex has averaged about $37 million per quarter or about $150 million annually, for no appreciable increase in production. Cash costs per ounce in the most recent quarter rose to $564 per ounce, up from $429 per ounce in the same quarter last year.

The game changer for PAL is the new mine shaft that will take them down to 825 meters. The company believes this new shaft, when that depth is reached, will lower cash costs to under $300 per ounce and allow production to increase to 250,000 ounces in 2015. Can they deliver on that promise? If they do, will that generate enough cash to allow them to meet their obligations in 2017? I think this is a near impossible task. And importantly, what will this mean to their equity?

A Simple Cash Model

Below I have constructed a simple cash model which is based upon some very generous assumptions. Those assumptions are that the company hits 825 meters before the end of 2013 and therefore cash costs throughout 2014 and beyond immediately drop to $300 per ounce and stay there. For that assumption to hold, there would have to be no diminution of the ore grade, an assumption not validated by previous experience at PAL nor at most other mines. I further give them credit for achieving their stated production target of 250,000 ounces in 2015. Finally, I grant them some healthy increases in palladium prices. I assume only modest growth in their G&A expense. I assumed no payment of income taxes, a not unreasonable assumption given the retained earnings deficit in excess of $500 million, but their note disclosure in the quarterly does not speak to taxes. I also assumed that there would be no further foreign exchange losses ($4.5 million in the recent quarter) and that none of the contingent liabilities (such as the $100 million class action law suit) came to fruition.

In the first model that I did, I used all of those generous assumptions, including keeping their revolver outstanding at $60 million. I then took capex as the plug and kept it down to the level so that sufficient cash was generated to pay off all of their fixed obligations (other than the revolver) in 2017.

Model 1 2014 2015 2016 2017

Palladium oz 185,000 250,000 250,000 250,000

Palladium Price $831 $914 $1,000 $1,000

Revenue ($000) 153,735 228,500 250,000 250,000

Cash Costs 55,000 75,000 75,000 75,000

Mining Margin 98,235 153,500 175,000 175,000

G&A Expense 8,800 9,500 10,000 11,000

Interest 24,794 24,794 24,794 24,794

33,594 34,294 34,794 35,794

Operating Cash 64,640 119,205 140,205 139,205

Capex 68,000 68,000 68,000 68,000

Cash Flow (3,359) 51,205 72,205 71,205

Total Cash Flow 191,257

The very generous assumptions as provided for above, allow for annual capex of about $68 million enabling payout of all fixed obligations at the end of 2017. It should be noted that amount is half of historical capex which had only sustained flat production, not an increase of 30%. If the company's actual results meet this forecast, then no shareholder dilution would be required and cash flow would have increased two-fold, allowing for, other things equal, a potential doubling of the stock price.

But model 1 is by intention, modeled to perfection. It is the "we hit all of our projections and absolutely nothing went wrong" model. How realistic are those underlying assumptions?

I think the palladium price assumption is the most conservative of the lot. I have no problem buying into it. But history just does not support the other assumptions, particularly the cost and capex assumptions. Going deeper into an underground mine to reduce cost below their open pit mine costs is a challenging assumption. Holding the grade at the initial grade is a further challenge. To all of a sudden have the sustaining capex drop while production rises also is a challenge. Each of these could happen, but each flies in the face of mining history.

PAL's problem is that the model is very sensitive to any miss. What would happen if costs came in slightly ahead of what they expected? Not a lot ahead of expectations, just 10% initially? And what if grade did decline, as has been their experience and most other mines' experience? And what if it took them to 2017 instead of 2015 to hit their 250,000 ounces of production? In other words, if there were a near miss, would there be much of a consequence?

I have loaded those assumptions into model 2. Look what happens when you keep all of their other optimistic assumptions but ramp up to 250,000 ounces produced in 2017 and start with 2014 cash costs of $330 per ounce and increase them by $20 per ounce each year:

Model 2 2014 2015 2016 2017

Palladium oz 185,000 200,000 2225,000 250,000

Palladium Price $831 $914 $1,000 $1,000

Revenue ($000) 153,735 228,500 250,000 250,000

Cash Costs 61,050 70,000 83,250 97,500

Mining Margin 92,685 112,800 141,750 152,500

G&A Expense 8,800 9,500 10,000 11,000

Interest 24,794 24,794 24,794 24,794

33,594 34,294 34,794 35,794

Operating Cash 59,090 78,505 106,955 116,705

Capex 68,000 68,000 68,000 68,000

Cash Flow (8,909) 10,505 38,955 48,705

Total Cash Flow 89,257

With this tweak to the original assumptions cash generation during the forecast period is cut by more than half. The fixed obligations of $190,000,000 will not be able to be paid out when due. This situation would likely trigger a cross-default on the revolver which would then become due as well. The consequences to this are very significant. The cash flow shortfall could be potentially filled by an equity issue. If that could be done (a difficult task in my estimation) it would be highly dilutive to the existing shareholders, increasing the share count by a third if it could be done at today's prices and potentially by much more if the price were to drop. Extensions for the loans might be able to be obtained. But at what price? BAM has already established a cost of capital for PAL of 15%. If the company is brought to its knees, that cost of capital won't go down. The worst case scenario would be to default on the debt, and the assets could be seized by the creditors leaving next to nothing for the equity.

It is difficult to handicap the probability of each scenario unfolding. Survival, not prosperity, relies upon perfect execution of their business plan. That perfection has proven elusive for the most established of businesses and shall most likely be more elusive for a capital-constrained junior miner. The costs of significant dilution are much more likely in my estimation and the apocalyptic scenario of a default and eventual cram down of the equity by a vulture lender is not one that I can rule out.

North American Palladium has got itself into a near impossible situation. As much as I like the PGM space, I don't like the odds of an investment in PAL.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.