"They've got significant skin in the game." -Wyoming Business Council's Ben Avery after awarding the company a $20 million bond issue.
I can't say I've ever seen an opportunity as promising as Uranerz Energy (NYSEMKT:URZ) in the context of the wide open Uranium industry. At the end of a year in which the Solar Energy ETF (NYSEARCA:TAN) posted gains of 129%, I have to wonder whether investors' appetite for clean energy has already been sated. The more I look at the trajectory of spot Uranium and Uranium miners, the more sure I am that the answer is no; Uranium has a good chance to be the top dog of 2014, with Uranerz at the helm.
Since Fukushima in 2011, spot Uranium has been in a downward spiral from $65/lb to the current price of $34.4/lb. The following shows the price history of spot Uranium Oxide (U3O8) in dollars per pound...
The abysmally low prices have caused investors to turn a cold shoulder to any company whose livelihood is aligned with Uranium. At $1.25 per share, Uranerz has been hit hard by the falling prices over the past few years.
Impending catalysts in global supply and demand of Uranium, coupled with substantial accumulated tax credit and recent strategic moves by Uranerz make the company my top pick for 2014. I will discuss these factors in detail, and conclude by laying out upside/downside potential for the future.
Uranium Stocks Are Out Of Fashion
At $34.40/lb, Uranium is at its lowest spot price since December of 2005. As an industrial metal, most of Uranium's demand should be attributable to the operating needs of the world's 435 nuclear power plants (with 72 under construction, 173 planned, and another 314 in the proposal stage), as well as the needs of scientific reactors and military vehicles such as submarines and aircraft carriers. At no point in time has there been a significant decline in quantitative need for Uranium, yet public sentiment regarding the ethical and scientific consequences of Japan's Fukushima meltdown has given the buy side much more leverage against producers of Uranium. In some ways, Uranium stocks have entered the "sin stock" category, next to which we might place tobacco, casino, and firearm stocks. Fukushima has given most investors some level of aversion to owning anything nuclear related, at least until this sentiment erodes and owning nuclear-related stocks is no longer a "sin."
Despite this sentiment, there are several impending catalysts that are quietly making Uranium a sleeper for the early stages of 2014.
December, 2013 - End Of The 20 Year HEU Agreement
In the near future, the world's Uranium producers will be called upon to fill the gap in supply that was previously filled by converting Cold War era high enriched Uranium (weapons grade) into low enriched Uranium (commercial grade) over the last 20 years via an agreement between the United States and Russia called the HEU Agreement. Furthermore, conversion of weapons grade Plutonium into MOX (mixed oxide fuel) has helped satisfy the needs of MOX-equipped nuclear power plants. Ending as of this month, the cooperative program has reportedly eliminated 20,000 warheads. The World Nuclear Association estimates that the conversion of weapons grade Plutonium and Uranium through this program displaced 13-19% of necessary Uranium mine production on an annual basis through 2013. This 13-19% will have to be filled by either the depletion of already shrinking reserves, or a ramp up of Uranium mining.
The remainder of Uranium and MOX converted by the program is reported by USEC to be only enough to satisfy the United States' nuclear fuel needs for the next 2 years if absolutely necessary. However, the United States has a track record of stockpiling Uranium fuel reserves in case of emergency, and may not put any of these stockpiles to use in the near future, which would mean the entire 13-19% gap must be met instantly by production, or drive prices straight up if production is not sufficient (decrease in total supply). In either case, Uranium miners will reap the benefits of this "win-win" scenario. Since global production of commercial grade Uranium is already far less than global demand, and miners are already working at high capacity, it's likely we will see a change in the price of spot Uranium to reflect the decrease in supply from this 13-19% gap rather than significant ramp up of production.
Japan Is Ready To Resume Nuclear Power Generation
With the election of Prime Minister Shinzo Abe in December of 2012, Japan indicated a major shift in sentiment toward the use of nuclear power. Immediately following the Fukushima Daiichi disaster in 2011, as much as 74% of Japanese had supported the idea of gradually decommissioning all nuclear reactors in the country. In the latest election, Prime Minister Abe stressed the need to reduce pressure on Japan's 9 regional utility companies, which are incurring costs that nearly double what they were 3 years ago at full nuclear reactor utilization, making up the energy gap by importing high quantities of liquefied natural gas and oil at great expense. This illustrates a furious debate that is unfolding in Japan. Excessive imports of fossil fuels and wasted costs on idle nuclear reactors are major contributors to Japan's current trade deficit. Leaders must decide between a long-term solution that will appeal to the Japanese but will punish the economy in the short term, or the option of resuming nuclear power generation. Abe's election may just tip the scales in favor of the latter choice.
Any indication that Japan's 50+ operable reactors will resume would mean an instant boost to Uranium demand, as that would represent an 11% increase in global demand for commercial grade Uranium in an extremely short period of time. It is highly unlikely that this scenario will unfold in the next few months, but it is clear that resumption of nuclear activity is on the table in Japan for 2014.
Supply And Demand In The Uranium Market
Despite the Fukushima disaster, construction and planning for future nuclear endeavors has not halted. One would expect that if Uranium production is much lower than demand, and demand is still increasing with the completion of new reactors worldwide, Uranium prices should be on the rise. The logical conclusion is that Uranium is set to rebound in a big way.
Prevailing depression of spot Uranium prices is attributable to 2 major factors. First, stockpiles created from the conversion of weapons grade Uranium and Plutonium have always historically filled the gap between production and demand. Whatever can be purchased at a reasonable price from the production of miners is used for power generation, and the remaining demand for energy is filled by pulling from utilities' stockpiles or from HEU Agreement stockpiles. The implication that utilities have stockpiles and do not "need" mined ore gives them enormous bargaining power in a highly illiquid Uranium market. Miners are bullied into selling at depressed prices because they have no choice. Very soon, the bargaining power of utility giants will erode as their Uranium stockpiles begin to dry up.
The second factor is the volatility inherent in Uranium prices due to the cost structures of miners versus utilities. For most miners, variable and variable overhead costs of extracting Uranium Oxide amount to roughly $30/lb extracted. At a sale price of only $34.40/lb, the contribution margin of Uranium is dismal and not enough to cover fixed costs in many cases. For utilities, the purchase price of Uranium Oxide has very little effect on the contribution margin, since their cost structures are largely comprised of infrastructure and processing, both of which are far larger than the cost of raw material (Uranium Oxide). An NEA report estimates that a 100% increase in the price of Uranium would cause less than a 5% change in utilities' costs due to the huge difference in cost structure. Thus, Uranium miners are highly sensitive to changes in spot Uranium price, while utilities are only slightly sensitive.
This presents an asymmetrical trajectory for the future price of Uranium. As the current price of $34.40/lb is barely enough to keep miners afloat, it cannot conceivably fall much lower before miners will be universally unprofitable and unable to secure much debt financing. Some estimates had put the price floor for spot Uranium at $40/lb, though clearly the price has broken through this floor and is now sitting squarely in the basement, so to speak. As it stands, many miners are reluctantly making secondary stock issues as a last resort, at the cost of severe dilution of shares. However, the loss of utilities' bargaining power from declining stockpiles, combined with their relative indifference to increase in Uranium prices could send the price of Uranium straight upward from its current price floor very soon.
Given the above realities, almost any Uranium miner presents a compelling play to start 2014. However, the unique position occupied by Uranerz, alongside several advantages the company has recently secured make it a candidate for being one of 2014's top performers with the tailwinds of a Uranium rebound.
After 14 Years, Uranerz Is Ready For Production
As an exploratory stage company that has never recorded revenue, it will be a major moral boost for the company to record its first production, expected in early 2014 from the company's Nichols Ranch mine facility in Eastern Wyoming. Initial estimates put starting production at 600,000 to 800,000 lbs of Uranium Oxide, which would equate to $20.64 million to $27.52 million in revenue at current Uranium prices. The facility is licensed to produce as much as 2 million lbs of Uranium Oxide yearly, or $68.8 million in revenue at current Uranium prices.
With significant debt already incurred in financing the purchase and exploration of land, as well as capital expenses associated with the mine facility, this will go a long way toward establishing the company's credit with banks and convincing shareholders that more dilution is not necessary. Since inception in 1999, the company reports that its total expenses have amounted to over $159 million, $110 million of which was financed by common stock issuance. Failure to see any returns on this infusion of equity has frustrated shareholders and pushed shares down to a price of just $1.25. Investors may be losing their patience with Uranerz, but there are several company-specific catalysts, in addition to the catalysts that are aligning to drive up the price of Uranium, that they seem to be missing in their current valuation of the company.
Short Term - An End To Dilution
Earlier this month, Uranerz announced the closure of a $20 million state loan that will take much of the burden of financing its capital off the shoulders of shareholders. The seven-year, 5.75% bond issue is the result of Wyoming's Industrial Development Revenue Bond program. Wyoming's Business Council was very impressed with what they saw in Uranerz, saying, "They've got significant skin in the game." With Uranium prices at rock bottom and no track record of revenue, Uranerz should be very grateful for this stroke of luck. With revenue in the cards for Q1 2014, and credit now being established, shareholders can feel much more confident that the company will be able to secure debt financing instead of relying on equity financing, as it has in the past.
This is a stark contrast to the rest of the Uranium mining industry, which faces a similar dilemma. Other miners must either rely on their limited credit history or force shareholders to accept more dilution from equity offerings.
Mid Term - Three Appealing Contracts
Uranerz announced that it has already signed three off-take agreements, one of which will supply Uranium to nuclear energy giant Exelon (NYSE:EXC). Each of these contracts calls for delivery of Uranium over the course of the next 5 years. Furthermore, 2 of the contracts are structured to price Uranium at a fixed, escalating rate, though the exact terms have not been disclosed.
What this means for Uranerz is that it has hedged some of its future revenue against volatility in Uranium prices, with at least some level of upside locked in from the current price of $34.40/lb. Since the company estimates that the variable costs of extracting each pound of Uranium will be $35 (including taxes and royalties), it seems highly likely that they have locked in an escalating price that starts above $35/lb for each of its current contracts. Barring any technical setbacks, the company should have no problem recording $25 million in revenue for 2014. This will definitely not result in a net profit, but it will be much more promising than the yearly $10 to $30 million deficit that we have seen over the past few years.
Long Term - Superior Property Holdings
Part of the attraction of ISR (In-Situ Recovery) mining is that Uranium is extracted within a water solution, meaning that a production site can draw oxidized Uranium from a large underground area. Furthermore, it means that short pipelines can be used to transport dissolved Uranium from multiple production sites to a single processing facility, eliminated a great deal of costs associated with operating multiple production sites. Since Uranerz has already constructed a central processing facility for its ISR operations, and has already purchased the deeds to several more properties with attractive Uranium deposits, these sites can be developed at a fraction of the cost that it took to get the Nichols Ranch facility operational, sharing a single processing facility. The following map shows just how superior Uranerz's land holdings are in comparison to competitors...
Shown in light blue are properties owned by Uranerz in the Powder River Basin of Wyoming, the largest Uranium production region in the United States. Cameco (NYSE:CCJ) and Uranium One (purchased by Rosatom in January) also have significant property holdings in the area. The potential economies of scale that could be reached by leveraging the same processing facility for production sites throughout the region are tremendous. The company emphasizes this potential in its latest shareholder presentation, referring to "cost savings/synergies with potential satellite operations." Alongside the ramping up of the Nichols Ranch facility in 2014, the company will be looking into establishing satellite production sites to increase future capacity. Both the Jane Dough and Hank properties constitute viable opportunities for sustained Uranium extraction at relatively little cost.
Possible Acquisition By Cameco
Cameco operates several operations adjacent to Uranerz properties, and has signed a toll processing agreement by which Cameco will perform some of Uranerz's processing. At its current depressed price and the certainty of near-term production, a move by Cameco to acquire Uranerz would make perfect sense. The large property holdings of both companies would be consolidated and allow for even greater economies of scale by connecting Uranerz's production sites with Cameco's processing facilities, which is already being done by agreement. At a market cap of $8.14 billion and current assets of 1.6 billion CAD (roughly 1.78 billion USD), Cameco has ample capital and occupies the perfect position to acquire Uranerz. Furthermore, the acquisition of neighboring Uranium One by Rosatom (Russia's state atomic energy corporation) in January illustrates that conditions are ideal for consolidation in the Uranium mining industry with current prices being so low.
Finally, the announcement that Uranerz has hired former Cameco President Paul Goranson earlier this month means that leadership is now in place that has an intimate understanding of both companies' operations in the area. With Cameco struggling to grow revenue against the falling price of Uranium over the last several years, inorganic growth is the company's only logical option. The stars are aligning to make this acquisition a real possibility in 2014.
Any sort of DCF valuation for Uranerz would be highly imprecise and would rely on major assumptions, so I will refrain from doing so here. As an exploration stage company, Uranerz has never recorded revenue or earnings. Furthermore, most US Uranium miners have failed to record positive earnings for the last several years (with the exception of Cameco, which trades at a P/E ratio around 26). It's clear that investors are giving Cameco the credit it deserves for posting positive earnings against daunting headwinds, but this also means that if Uranerz can turn a profit sometime in the next several years, investors will give the company a generous valuation.
Assuming a gradual ramp up of production over the next 4 years, here is what Uranerz EPS might look like from the Nichols Ranch facility alone (production from other facilities may add to revenue)...
Traditionally, Uranium companies are able to secure a sale price somewhat higher than the spot price. In its initial stages of production, Uranerz should be able to see an effective price of around $40/lb. However, Uranerz will need to the price of spot Uranium to pass approximately the $50/lb mark before turning a profit in the next few years. Any higher and the company is looking at surging EPS beginning in 2015. For the purpose of making EPS comparable to other companies, I have shown EPS estimates net of taxes, despite the fact that the company has substantial accumulated tax credit from posting losses for the past decade. Each of the positive EPS calculations above will be approximately 54% higher after tax credit (applying a conservative tax rate of 35%).
It's probably too soon to start guessing what exact price investors would place on these earnings, but obviously there is a tremendous amount of upside to be captured at the cost of no downside. The beauty of the situation is that as an exploration stage company in a badly battered industry, the market has already priced in the worst case scenario because the current Uranium price is already the worst case scenario. It can only go up.
What The Market Is Missed This Month
The market has failed to recognize that this month saw the alignment of several strong catalysts in favor of Uranerz in a very short period of time as the company...
- has announced plans to begin production and secured sales contracts with Exelon
- was awarded a $20 million government bond issue that will establish credit and end dilution
- has hired of former Cameco President Paul Goranson, laying the framework for the possibility of a smooth takeover by Cameco
- has seen the end of the US-Russia HEU Agreement that filled 13-19% of the world's annual nuclear energy demand over the last 20 years
The simultaneous occurrence of these catalysts makes now the best time to initiate a long position in Uranerz. Whether by the effects that these events will have on the company's performance next quarter, or by elevated interest in Uranium miners when the price of spot Uranium inevitably climbs, the price of this stock can only rise. This is an asymmetrical risk profile that's hard to find in a stock that is nearing penny-stock territory.
This brings us to what can go wrong. We must face the fact that, to date, no Uranium has been produced by Uranerz. There is every indication that next quarter will see the start of Uranium extraction (off-take agreements have been signed, infrastructure is in place and ready, and processing facilities are lined up), but if a logistics problem arises, you can be sure that this already volatile stock is going to be hit hard. Uranerz absolutely needs to begin production, at the very least, to make payments on its newly secured government bond issue. More stock offerings are simply not a viable option going forward.
The other consideration that must be made is what could happen in the unlikely scenario that spot Uranium declines further. Uranerz has stated that a "portion" of planned production is already committed to signed off-take agreements with a fixed price, but the exact numbers have not been revealed. A decline in the price of Uranium would have an extremely damaging effect on investors' perceptions of future profitability. As it stands, spot prices are below what the company considers to be viable for making a profit. However, a lower Uranium price would actually make Uranerz a more attractive takeover target for Cameco. Share prices would certainly decline based on the expectation that lower Uranium prices would bankrupt the company, and make acquisition much cheaper for a company like Cameco, which has adequate capital and financing to withstand a temporary decline.
Finally, Uranerz's monthly beta of 3.16 (as reported by Google Finance) will send up a few red flags with conservative investors. A beta that high should definitely cause concern, not because it implies a high level of exposure to the market's returns, but because beta that high is usually statistically insignificant (beta is a regression analysis that compares 2 data sets and must always assign a line of best fit, even if the data sets have no real or strong relationship). Uranerz's beta regression has an R squared significance of only 0.21, which essentially means that market exposure explains only 21% of returns. Compared to most other stocks, this level of significance is quite low, implying that other factors are more powerful in explaining price movement.
When using Fama and French's Three Factor model to explain returns, there is much more explanatory power. This is the raw output of Uranerz's multiple regression...
Most of these numbers are sanity checks, but the important outputs are highlighted. A Fama-French three factor regression still only explains 31% of price movement, but more importantly, it reveals that the price of URZ is far more sensitive to the size factor than to the market (the size factor is a calculation of how much small stocks outperform large stocks in a given month). Thus, if small stocks outperform large stocks by 1.00% on average for the month, the model predicts that Uranerz will outperform by 5.06%, all else being equal. This implies a great deal of volatility, but not due to beta as most of the market assumes. When the size factor is included in the model, price movement is best explained by a beta of only 1.7. In this light, Uranerz presents an extremely attractive January Effect play for the start of 2014 due to its high degree of size sensitivity, but it cannot be overlooked that there will be a massive amount of volatility in future price movement.
*Note that while this stock does not qualify as a micro cap by Seeking Alpha's cutoffs, it comes very close by both share price and market cap considerations. Please be aware of the volatility and illiquidity risks associated with micro caps, some of which have been quantified above.
Contrary to my normal analyses, I have been cautious about putting a number on the upside potential of Uranerz because of the company's exploratory nature and the depressed Uranium industry. It's a near certainty that Uranium prices will rise, but when and by how much are different questions entirely. Uranium futures contracts are complex and highly illiquid, making direct exposure impossible for most investors and probably for most funds as well. However, Uranerz presents the best way to capture the upside of Uranium as well as the opportunities created by the catalysts I discussed.
Conditions are right for Uranium to double or even triple in 2014 alone. If this is the case, investors will have no problem bidding up Uranerz shares to several times its current price of $1.25. Supposing Uranium doubles by 2015, Uranerz is looking at EPS of approximately $0.16 ($0.25 with tax credit) from Nichols Ranch alone (at 70% of Nichols Ranch licensed production capacity) and an implied P/E ratio of just 7.8 (5.0 with tax credit) at its current price, compared to Cameco's current P/E multiple of 26. If Uranium doubles and investors price Uranerz to match its competitor, we are looking at a share price of $4.16, or a gain of 230% by 2015, even without the tax credit factored in. If investors price Uranerz to match just half of its competitor's P/E, we would still be looking at a 66% gain. In the end, it doesn't matter which assumptions are applied; this stock has nowhere to go but straight up.
Disclosure: I am long URZ. 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.