(Editor's Note: Investors should be mindful of the risks of transacting in illiquid securities such as PALAY. Paladin's listings in Australia and Canada, PDN.AX and PDN.TO, offer stronger liquidity.)
I haven't been very bullish at all about the prospects for uranium miners, as I believe investors have overestimated the near-term impact of Japan's plans to restart its nuclear reactors and China's intentions to add nuclear power. I'm not surprised, then, that uranium spot prices have broken through $30/lb, nor that Paladin Energy (OTCPK:PALAY)(PDN.TO) shares have fallen another 15% or so since my last article.
Like Ur-Energy (NYSEMKT:URG), I believe Paladin remains a very highly leveraged play on virtually any good news in the uranium sector. Paladin is going to have to get creative about its financing/liquidity options if spot prices don't increase into the $50's/lb, but the company does at least have a quality operating asset and good exploration assets if prices do recover. I do think uranium prices should find a bottom fairly soon and that the risk is to the upside, but investors considering Paladin Energy need to appreciate that outsized exposure to uranium price appreciation comes with outsized operating risk should prices stay below $50/lb indefinitely.
Monetizing Langer Heinrich, Closing Kayelekera
Paladin Energy is responding to the current environment the way most mining companies respond to abnormally low pricing environments - shuttering high-cost assets and using whatever means are at its disposal to preserve liquidity until prices recover.
Earlier this year, Paladin announced that it would place the Kayelekera mine on care and maintenance, ceasing acting mining operations and using existing reagent and ore inventory to produce uranium until they're exhausted. As a reminder, this is a higher-cost mine in Malawi with production cash costs about 15% above Langer Heinrich and above current spot uranium prices. Taking higher-cost production out of production is what is supposed to happen during weak commodity prices.
Kayelekera is still a viable mine with respect to remaining reserves, but not at these prices and with its current cost structure. Management had hoped to reduce costs by hooking the operations up to grid power (versus on site diesel generators), but the Electrical Supply Corporation (or ESCOM) of Malawi wasn't able to make that happen. Although grid power and improvements to workflow would likely make this mine cashflow positive and worthwhile at uranium prices in the $60's, management has said that it does not intend to restart production until/unless prices improve to $70/lb or higher (which could refer to term prices instead of spot).
Management has also leveraged its Langer Heinrich mine to generate liquidity. It was no secret that the company wanted to sell a minority stake, and the company got a $190 million cash investment from China National Nuclear Corporation for a 25% stake. Management took a roughly 15% haircut to my estimate of fair value for the LH mine, but that's not a bad discount for a minority stake in an asset during a severe bear market and a relatively weak bargaining position. That a large existing miner like Rio Tinto (NYSE:RIO) or BHP Billiton (NYSE:BHP) didn't invest is not so surprising given their aversion to M&A right now, and the participation of a Chinese entity fits in with the thesis that China will be a major driver of future uranium demand.
Navigating The Pinch
Selling that stake in Langer Heinrich has certainly helped Paladin's liquidity, but the company is looking at a $300 million convertible that comes due in November of 2015 and another convertible ($274 million) about 18 months late (April 2017). At current prices, Paladin is likely to burn around $40 million/year in cash, and that will make it a tight squeeze to pay off that convertible and maintain an adequate cash cushion.
Management has a few options, but successful outcomes are far from certain. First, management is continuing to work on reducing cash operating costs at the LH mine - management hopes to lower LH's costs to close to $23/lb (from around $29/lb) by 2016 through lower reagent costs and better workflow management. At present, Paladin appears to be at around the 66th percentile in terms of cash costs, while it target would push it up closer to the 50th percentile. That's a nice idea, but Paladin has found it difficult to meet cash cost targets in the past and this may prove to be too ambitious.
Paladin management is also likely to consider various refinancing options. Issuing equity seems like a bad option at current prices, but refinancing at a higher rate could be possible and maybe some sort of hybrid preferred equity issuance could work. I would be surprised if management turned to asset sales - selling Kayelekera may be an option, but selling more of LH will undermine investors' upside to higher uranium prices in the future and it may well be difficult to get a worthwhile price for the company's exploration assets.
On a more positive note, Paladin should see better realized prices as more of LH's production is delivered at contract prices instead of spot. These contracts were signed at considerably higher prices (over $45/lb and over $60/lb in some cases) and offer some much-needed upside. It would also greatly help the company to see spot prices head back above $30/lb and much higher. The biggest near-term factor in pricing appears to be the restart of Japan's reactors - management is expecting two restarts this year and 12 to 16 over the two following years, but a faster pace of restarts would be a very welcome development for uranium equities.
Estimating The Future Value
Beyond $50/lb uranium prices, things get considerably better for Paladin's outlook pretty rapidly, and most analysts are still projecting long-term uranium prices in the high $60's to low $70's. Dealing with the upcoming convertible maturities is a real risk, particularly with respect to dilution to current shareholders. If prices were to double over the next year or so, Paladin would likely be facing a much more constructive refinancing environment and could likely even consider moving forward with the Michelin project in Canada. With that, I think it's worth remembering that in a positive pricing environment Paladin is one of the best-positioned uranium miners to generate significant production growth.
Using the current price curve, I estimate a net asset value of almost $5/ADR (or nearly 40% above today's price). The average sell-side estimate is about 25% higher, but those analysts then discount their NAV estimates (which are already supposed to include a discount rate) by varying amounts to achieve their target prices (which average out to about $4/ADR today). Were uranium prices to quickly recover back into the $60's/lb, that net asset value estimate would nearly double.
The Bottom Line
I believe Paladin Energy is almost a long-dated call option on uranium prices. You could argue that the convertible maturity next year serves as something of an expiration date, but the point stands that Paladin's shares will likely outpace any rebound in uranium prices. I would not go so far as to say that uranium is a "must-own" commodity today, but while I think that the Japanese restart and China nuclear growth stories are often overplayed by uranium bulls, today's prices do look too low from a long-term perspective. As such, Paladin is a high-risk/high-reward play on a recovery in uranium that is uncertain as to both magnitude and timing.
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