Why I'm Passing On Mason Graphite

| About: Mason Graphite (MGPHF)
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Mason Graphite's Lac Gueret Project is large and high grade, and therefore seemingly appealing.

However it lacks the large flake graphite that commands a higher price ad which will be in demand for use in "green" technologies such as lithium ion batteries.

Furthermore, the company's PEA uses an outdated graphite price, which means the stock isn't as undervalued as the PEA's NPV statement would have investors believe.

The shares aren't overvalued, but they won't give you the exposure you're looking for assuming you want to participate in the secular uptrend in graphite, which is a large-flake story.

Mason Graphite (OTCQX:MGPHF) shares have risen 30% in the past couple of months as investors have once again become interested in the graphite space. Mason Graphite in particular has garnered investor enthusiasm with its large resource expansion announced towards the end of last year as well as with support from infamous commodities investor Jim Rogers. Bulls like the fact that the company's Lac Gueret Project is very high grade, and the fact that it is enormous.

But unfortunately that is not the whole story. Mason Graphite has a few problems that should make investors hesitant to choose this as their preferred bet on the exciting graphite space. These problems include:

  • The remoteness of the Lac Gueret Project
  • The fact that the Lac Gueret Project has the least amount of large flake graphite of the major graphite producers.
  • The outdated price assumptions used in the Lac Gueret PEA which don't reflect the bear market from 2012 - today.

Let's look at each of these points a bit more closely with an emphasis on the last two. The first point simply makes infrastructure and transportation more costly, and while it isn't favorable it shouldn't be a deal breaker.

Lac Gueret has the least amount of large flake graphite of the major graphite companies.

As graphite investors know flake size matters. Large flake graphite is rarer, more valuable, and it is used in the technologies that make the future of graphite so promising such as lithium ion batteries, which should show double digit growth for many years . Small flake graphite demand, which is used mostly in steel refractories, should grow more or less in line with the global economy. As you can see in the following table most of Lac Gueret's graphite is small flake (the last category), and only about a third is large flake graphite (the first two categories).

(Source: The Lac Gueret PEA)

What is the differential in valuations? This question doesn't have a simple answer because there are literally hundreds of graphite products that companies can produce and market. However according to Mason Graphite's own figures, which as we will see in a moment are outdated, large flake prices are nearly small flake prices.

As demand for large flake graphite outpaces demand for small flake graphite there is little doubt that this differential will widen.

The outdated price assumptions used in the Lac Gueret PEA don't reflect the bear market from 2012 - today.

Mason Graphite's management suggests in its presentation that it uses a conservative C$1,525/tonne assumption for its graphite. This figure uses a 2-year trailing average of prices through June, 2012, which is misleading in today's graphite price environment. While management also states its belief that graphite prices will rise again this is not grounds for an investment, but rather for speculation.

While there is no single graphite price the way there is a copper price recent data suggests that we have experienced a considerable fall in prices from what we see in the above figures. For instance, the following chart shows what has happened to +80 mesh graphite, which is in the second row in the above table at C$2,000/tonne ($1,827/tonne).

(Source: Norhern Graphite)

And while the different sized flakes don't trade precisely in tandem there is a strong correlation as we can see from this admittedly outdated data.

(Source: CEO.ca)

This would mean that Mason Graphite's average realized graphite price is closer to C$1,000/tonne, or $920/tonne in the current market.

This is a big deal. I will put forth my own analysis in a moment, but consider the following two charts illustrating the Lac Gueret Project's sensitivity to varying inputs using 8% and 10% discount rates, respectively.

(Source: Lac Gueret PEA)

(Source: Lac Gueret PEA)

Considering the company's $63 million valuation these figures don't look terrible, but when we consider that the company will almost certainly be issuing stock in order to raise the capital it needs to develop the Lac Gueret Project these low figures become problematic.

Valuing Lac Gueret

We've already seen what has happened to the graphite price with respect to Mason Graphite's PEA assumptions--the company will probably realize an amount around C$1,000/tonne for its graphite. It is going to cost approximately C$427/tonne to produce, which is fortunately relatively low, although given that we are dealing with a PEA this figure could potentially be 35% higher. I will be "generous" and assume a 10% contingency bringing the figure up to C$470. Sustaining capital throughout the mine's 22 year life is expected to be just $6.3 million, which on a per-tonne basis is just C$6 bringing the total cost per tonne to C$476. At 50,000 tonnes per year the mine's operating cash flow is C$26.2 million.

Initial capex is expected to be C$130 million and this includes a 20% contingency which is acceptable. Now the company doesn't have any money and so naturally it is going to have to raise this. Assuming it can get 80% debt financing at 6% for 10 years it is going to borrow C$104 million and pay C$6.2 million in annual financing costs. I will assume financing for 10 years. This means the company will also have to issue C$26 million in stock, which at the current share price minus 10% --C$0.71 (dilution almost always brings the share price down)--the company will issue 36.6 million shares bringing the total basic share count up to about 122 million.

Note that I'm also adding a $4.5 million expense for mine closure at the end of the 22 year mine life.

Given these figures the project has an after tax NPV of C$117, or C$0.96/share at 8%. Now this actually gives the shares 21% upside. But at a 12% discount rate, which is more appropriate for a conservative investment thesis, the project's value is just C$84 million, or C$0.69/share, leaving 13% downside risk.

Conclusion: Mason Graphite Is A Mixed Bag

Given these numbers, and considering that the company's assets other than Lac Gueret are relatively insignificant, the stock is fairly valued with graphite prices where they are. However there are potential drivers in both directions.

Regarding the company's upside potential the mine plan put forth in the PEA only encompasses a portion of the total resource base. In fact the company came out with an expanded resource estimate late last year, or about 18 months after it came out with its PEA. The company will almost certainly be able to produce more graphite than the mine plan indicates. In fact at the estimated rate of production the company could produce for decades beyond the 22 year mine plan.

But as great as that sounds consider the following. First, the updated resource is lower grade ore, meaning that it will cost more to exploit. Second, the additional graphite production would come at the end of the mine's life unless the company decides to expand its output capacity which would require a larger processing plant and more equipment. This means that its value from a DCF standpoint is significantly diminished.

Regarding the negatives we need to keep in mind that the above NPV calculation assumes that the mine goes into production on schedule--at the end of 2015--which means that the company needs to get financing in the next few months. It also assumes that the company gets financing, period. There are quite a few graphite projects that need financing and Mason will be competing with companies that have more large flake graphite and that have already released feasibility studies (e.g. Focus Graphite (OTCQX:FCSMF) and Northern Graphite (OTCQX:NGPHF)).

Finally there is the fact that Mason Graphite doesn't have a lot of large flake graphite. I know this is a point that I've made but it is worth repeating that Mason will not participate in the secular uptrends that have drawn interest from investors to the extent that other companies will, and this makes me more reluctant to pay a "fair" price for the shares.

Ultimately Mason Graphite isn't a terrible investment, and it might be worth owning at a lower price, or as a trade as the company goes into production. But considering the risks involved in owning a junior miner the upside potential that Mason Graphite presents just isn't that great, and I'm going to pass on the stock for the time being.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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