Cameco Corporation: Short-Term Pain For Long-Term Gain

| About: Cameco Corporation (CCJ)

Summary

Cameco Corporation offers an attractive risk/reward based on sensitivity analysis.

Cameco Corporation and KazAtomProm, which combine for 38% of annual global production, have made significant production cuts in an effort bring balance to the oversupplied uranium market.

Current uranium price is unsustainable as spot price is $23.75 per pound compared to the industry average cost of production of $60 per pound.

Description

Since the tragedy in Fukushima, the uranium market has been in a state of oversupply as Japan shut down their nuclear reactor fleet in the aftermath, cutting demand significantly while miners continued to produce at a record pace. In the wake of the tragedy, Germany decided to shutter their nuclear program entirely causing significant doubts over nuclear power's future.

The concerns over nuclear's future combined with ample supply and dwindling demand led to uranium enter a bear market as spot prices dropped from the $50-$60 range in 2011 to a low of $18 in late 2016. Uranium spot has slightly recovered from $18 to $23.75 as of January 1st; however, uranium still remains in a bear market. These market conditions have cause uranium miners to be viewed as uninvestable as the industry business model isn't sustainable as described by uranium producer Energy Fuels COO Mark Chalmers when he said, "At today’s spot prices, the primary uranium mining industry is not sustainable."

So why invest in uranium miner Cameco Corporation (CCJ) whose market is currently unsustainable? Well, exactly because it is unsustainable. The uranium market is at a point where either miners start facing liquidity concerns over the next few years as prices remain too low, or the price corrects upward to a sustainable level that can support further production and exploration. The logic may seem too simple; however, it is a truth the industry faces and echoes comments made by CCJ's CEO, Tim Gitzel, in CCJ's latest quarterly conference call, "At today's prices, or the prices used in those reports, apart from making sure we have uranium to fulfill our contract commitments our supply is better left in the ground." Uranium miners simply can't afford to continue production based on today's prices as there is no current incentive for uranium miners to continue to bring more uranium out of the ground or develop new mines.

Despite the tough times, I believe the uranium market could be nearing an inflection point due to the recent supply cuts by CCJ and KazAtomProm, Kazakhstan's state owned uranium miner, which account for 38% of the world's uranium supply according to the World Nuclear Association.

Uranium Production by Company

CCJ and KazAtomProm can essentially be viewed as uranium's version of OPEC as they control roughly the same amount of annual uranium production as OPEC does oil production. The announced production cuts signal a change in the supply-demand fundamentals in the uranium market at a time when long-term uranium demand is growing. According to Cameco, there are currently 56 nuclear reactors under construction with nearly 30 of these reactors coming online over the next 2 years. On top of these new reactors, Japanese reactors are starting to come back online with five reactors restarted and an additional 21 reactors in the restart process, according to the World Nuclear Association.

I believe these factors are signaling that uranium may be nearing the end of its six-year bear market as the market has two alternatives:

  1. The uranium market continues on its current path inevitably leading to further mine closures and potential liquidation.
  2. The uranium market rebalances with the uranium price correcting higher to a level that makes the business sustainable again.

Under the first scenario, most uranium mines will be shutdown as the cost is unsustainable. The industry average cost of production is $60 per pound with the recent spot price at $23.75, this means that the average uranium miner is losing roughly $35 per pound of uranium they mine. This scenario is simply unsustainable. As referenced in the following section, Sprott CEO Rick Rule believes that only about five uranium mines could operate if the current spot price environment continues. In this case, CCJ would more likely than not be able to survive due to its low cost operations and recent cost cutting measures. I believe this scenario is unlikely to play out due to the increasing long-term demand and supply cuts by uranium's version of OPEC.

In the second, more likely scenario, prices correct upward to a more sustainable price that provides uranium miners the incentive to continue current production and development of new mines. In this scenario, uranium miners will continue to deal with two to three more years of working through oversupply by cutting production and meeting contractual obligations using their excess inventory and spot market purchases.

CCJ is in a position to capitalize on a turnaround in the uranium market due to their industry leading uranium grades, low-cost structure, and longstanding customer relationships. CCJ has taken measures to cut costs by closing mines, consolidating operations, and cutting their annual dividend from $0.40 per share to $0.08 per share, saving over CAD 125 million. These measures taken by CCJ have reduced their cash production costs by 10% and direct administration costs by 20% year over year, resulting in a total production cost per pound of ~$32 according to the Q3 2017 Management Discussion and Analysis. While painful, these moves will allow CCJ to continue to generate positive free cash flow during the period of market rebalancing and capture meaningful upside when the market eventually rebalances given its low production costs and high grade uranium.

This scenario will prove to be volatile as a recovery takes place; however, I believe the risk/reward is favorable given the evolving supply-demand fundamentals. Based on the dynamics discussed, I believe CCJ is an attractive investment for the patient investor as CCJ trades at a discount of 36.5% to my estimate of normalized fair value of $15.06 at Monday, January 8th's closing price of $9.56.

Uranium Market

After the tragedy in Fukushima, the uranium market saw a number of reactors come offline including all of Japan's reactors. This caused the uranium market to move into a period of oversupply with CCJ's CEO, Tim Gitzel, estimating that the uranium market is oversupplied by 10-20 million pounds annually. This has cause the spot price of uranium to enter a prolonged bear market with prices falling roughly 70% from peak to current spot price.

It is always difficult (read: foolish) to call the end of a bull or bear market; however, given the recent actions by CCJ and KazAtomProm, I believe it is reasonably safe to say we are closer to the end of the uranium bear market than the beginning.

On January 10th, KazAtomProm announced a 10% supply cut, or 3% of the world's supply, for 2017. This supply cut produced a small boost in uranium prices, but has largely fizzled out since the announcement as long-term supply questions lingered.

These lingering questions have now been answered over the past month as CCJ and KazAtomProm have announced significant supply cuts that will change the supply landscape over the next few years. First, on November 8th, CCJ announced that it would close its flagship mine due to the oversupply of the uranium market. In the company press release discussing the disclosure, CCJ noted, "Cameco plans to meet its commitments to customers from inventory and other supply sources during the suspension, which will be reviewed on an ongoing basis until inventory is sufficiently drawn down or market conditions improve. The duration of the suspension and temporary layoff is expected to last 10 months."

The key phrase being "which will be reviewed on an ongoing basis until inventory is sufficiently drawn down or market conditions improve." CCJ expects the closure to last ten months, but will focus on market conditions to determine how long the mine is closed. Currently, CCJ can use its inventory to meet contractual requirements, or simply buy on the spot market as it's cheaper than CCJ's cost of production as CEO Tim Gitzel mentioned when commenting on the cuts. Gitzel echoed CCJ's commitment to balancing the uranium market in saying "cutting production further is an option."

A few weeks later on December 4th, KazAtomProm followed CCJ's announcement with another supply cut of their own, a 20% reduction for the next three years, which amounts the 7.5% of global annual supply. Over those three years, KazAtomProm will reduce production by 28.6 million pounds in total with 10.4 million pounds of reduction coming in 2018.

The two supply cuts combined amount to a 18.2 million pound supply cut for 2018, 10.4 million cut from KazAtomProm and 7.8 million cut from CCJ, or roughly 10% of global demand of 190 million pounds. These cuts are significant as they will help reduce inventory from the secondary spot market as well as the companies' own inventory.

These supply cuts aren't the only evolving market dynamic; there are currently 56 nuclear reactors under construction according to CCJ with 17 of those reactors coming online in 2018 according to the World Nuclear Association.

This changing supply-demand dynamic is outlined by Rob Chang from Cantor Fitzgerald, saying "We continue to believe a violent increase in the price of uranium is coming and we look no further than the following data points. According to data publicly released by UxC, 73M lbs of uranium demand remain uncovered for 2020, which is 38% of its projection for that year (34% of Cantor’s forecast). The figure grows to 174M lbs uncovered by 2025, which is 80% of UxC’s projected demand (77% of Cantor’s forecast). For context, the 174M lbs figure is Cantor’s forecast for uranium demand for all of 2016 and is about 8M lbs greater than UxC’s total expected production from new and existing mine production in 2025 – of which some of that production is pledged to the committed portion of the 2025 demand." Chang's comments are illustrated below:

Uranium Uncovered Demand

These figures point to the amount of necessary production in the years to come, which is currently uneconomic given the current spot price of $23.75. Simply put, uranium miners need an increased uranium price to be incentivized to develop new mines and continue current production.

In a recent interview, legendary natural resources investor Rick Rule said that the market could resolve itself at $70 uranium spot prices. At this level, Rule believes the miners could restore closed operations and continue development of new mines; however, under current conditions, Rule points out that "nobody is going to be building any mines at $25 uranium." Rule goes on to say that the time frame for rebalancing is years, saying "Do I measure this in months? Likely not. Years? Likely. Decades? Certainly not. If the current condition that we’re in extends longer than 5 years, you will see almost every uranium mine in the world with perhaps 5 exceptions shut down. Could it take 2 to 3 years? Absolutely."

A final point to reinforce the belief that we could be nearing an inflection point, Kazakhstan plans to IPO KazAtomProm in 2018, giving KazAtomProm every incentive to do its part to bring balance to the uranium market as quickly as possible.

Uranium Pricing and Contract Structure

It is important to note that uranium is unique in the commodity complex in that there is no formal exchange for uranium as outlined by Ux Consulting. Uranium prices are based on privately negotiated contracts between buyers and sellers with prices being published by independent industry consultants like the Ux Consulting Company.

Uranium prices have two quotes:

  • The Spot Price - the price of uranium available for purchase and delivery in the immediate future.
  • The Long-Term Price - the price of uranium to be delivered under a long-term supply contract.

Long-term contracts typically have a number of variables in them to adjust the realized price by miners as the contracts can last 15 years or longer. According to CCJ, their contracts typically have ratio of 40% fixed-pricing and 60% market-related pricing with variables that put in price floors and price ceilings.

The fixed-price portion of their contract is a based on the long-term price indicator at time of contract acceptance, while the market-related portion is based on the spot price at the time of delivery.

CCJ will start seeing some of their long-term contracts roll-off at the end of 2019, heavily incentivizing them to bring balance to the market over the next few years as they will begin renewing their long-term contracts.

Since the uranium market is priced in this manner, it causes any progress in the uranium market to be tracked slower than a recovery in something like oil might be, which could cause some volatility in CCJ's stock price in the short to medium-term.

Capital Structure

Due to the current fundamentals of the uranium market, it is important to focus on CCJ's capital structure and liquidity. CCJ currently has debt of CAD 1,494 million with annual interest expense of CAD 74 million, which should be easily covered now that CCJ has cut their annual dividend from CAD 0.40 to CAD 0.08, saving CCJ over CAD 125 million annually. CCJ also has an untapped CAD 1,250 million unsecured revolving credit facility available until November 1, 2020 that could be used if CCJ faces any sort of immediate liquidity issues.

CCJ has the following long-term debt, with amounts outstanding shown:

  • 5.67% debentures due September 2, 2019 - CAD 498,472 million
  • 3.75% debentures due November 14, 2022 - CAD 398,346 million
  • 4.19% debentures due June 24, 2024 - CAD 497,253 million
  • 5.09% debentures due November 14, 2042 - CAD 99,256 million

This structure benefits CCJ as the majority of their long-term debt is due after 5 years, which will allow CCJ to focus on current operations while the uranium market rebalances.

Business Segments

CCJ has three business segments as outlined below:

  1. Uranium - The uranium mining segment of CCJ which accounts for roughly 70% of CCJ's revenues. CCJ has some of the lowest cost production in the world with some of the highest grade mines in the world like Cigar Lake and McArthur River.
  2. Fuel Services - CCJ's uranium refining, conversion, enrichment, and fuel manufacturing segment which controls 25% of global UF6 conversion capacity.
  3. NUKEM - CCJ's uranium marketing and physical trading segment. NUKEM does not speculatively traded in uranium, but provides services to help consumers find suppliers within the uranium spot market.

In April 2016, CCJ announced that it would implement numerous cost cutting measures to deal with the decline in uranium prices, which management describes as necessary to "support the long-term health and sustainability of the company" in the Q1 2016 Management Discussion and Analysis.

In the announced restructuring, CCJ downsized NUKEM GmbH in Germany, and transferred essential support functions to NUKEM in the United States. In the same announcement, CCJ announced operational restructuring including:

  • Production cuts down to 25.7 million pounds from 30 million pounds.
  • Capital expenditures down to CAD 275 million from CAD 320 million.
  • Severance costs of CAD 19 million.
  • Care and maintenance costs of CAD 35 million at Rabbit Lake.

CCJ completed these measures by the end of 2016, and have followed up with even more cost cutting in 2017. CCJ further cut their capital expenditures to CAD 160 million in 2017, and have said in every quarterly call in 2017 that they can maintain ~ CAD 160 million in capital expenditures or go lower. Direct administration cost guidance for 2017 is CAD 150-160 million, which is lower than the CAD 195 million in 2016 and CAD 173 million in 2015.

Throughout the six-year uranium bear market, CCJ has managed to remain free cash flow neutral or positive for four of the six years with the ability to remain free cash flow positive for the remainder of the bear market due to the recent cost reductions and strong contractual commitments through 2021. CCJ has annual average sales volumes of 26 million pounds through 2021 with commitment levels higher through 2019 allowing CCJ to pick up market exposure beyond 2019.

CCJ CFO Grant Isaac highlights this desire for market exposure in their Q3 2017 conference call when discussing their contract structure, saying, "we don’t think these are rational nor sustainable prices, so we want that market exposure going forward."

CCJ has made it their goal to weather the current uranium bear market and position themselves for a recovery in uranium prices with their attitude summarized best in the Q3 Management discussion and Analysis, "As annual supply adjusts and uncovered requirements grow, we believe the pounds available in the spot market won’t be enough to satisfy the demand. The need to eventually contract for replacement volumes to fill these uncovered requirements will create opportunities for producers that can weather today’s low prices and provide a recovering market with uncommitted uranium from long-lived, tier-one assets."

Valuation

CCJ is a bit tricky to value as the valuation relies on the assumption that the uranium market recovers to a sustainable price. Since the spot price is so much lower than the industry average cost of production, it is important to look at a range of scenarios to see what the market might be pricing in and how different uranium price assumptions effect the valuation.

I use the following assumptions, based on the 2016 Annual Report MD&A, allowing the sensitivity analysis to focus on changes in operating margins and uranium prices.

  • 20% tax rate - based on guidance from the 2016 annual report.
  • Capital expenditures of CAD 160 in 2018 scaling up to CAD 250 in 2021 and beyond.
  • Use an exchange rate of $1 USD = $1.25 CAD based on CCJ's methodology.
  • Calculated WACC of 9.54% based on a 2.4% risk free rate, beta of 1.42 per Morningstar, 6% equity risk premium, and a cost of debt of 4.95% (CAD 74 million interest / CAD 1494 total long-term debt).
  • I assume that the uranium market takes two years to respond to the current supply cuts. Assuming the market will immediately respond is aggressive and would result in an overly aggressive valuation. Based on this, I assume 2.5% revenue growth in years 1 and 2 based on CCJ's annual contract inflation. In years 3 through 7, I assume the market corrects and I will use various growth rates in the sensitivity analysis based on different uranium prices. From year 7 on, I assume 2.5% annual contract inflation for any revenue growth.
  • I used a five-year recovery time frame based on Rick Rule's comment, "If the current condition that we’re in extends longer than 5 years, you will see almost every uranium mine in the world with perhaps 5 exceptions shut down."
  • 404.2 million fully diluted shares outstanding based on a current share count 395,792,732 plus 8,411,384 options outstanding.

Based on these assumptions, a sensitivity analysis can be developed to see how various operating margin and uranium price assumptions would play out:

Uranium Prices
Operating Margins $25.00 $40.00 $45.00 $50.00 $60.00 $70.00
10.00% $0.00 $0.00 $0.42 $0.90 $2.81 $4.75
15.00% $0.00 $3.27 $5.43 $6.14 $9.00 $11.92
20.00% $2.88 $7.41 $10.29 $11.24 $15.06 $18.95

Based on the Monday, January 8th's closing price of $9.56, once can see that the market is currently pricing in one of two possibilities:

  1. The uranium price recovers to $60 and operating margins expanding to 15% from the current 10%, based on CCJ's 2016 annual report after adjusting for impairment charges.
  2. CCJ continues to realize $45 based on their current contracts and margins expand to 20%.

I believe the market is more likely pricing in the second possibility. CCJ has completed many cost cutting measures as discussed previously, which should lead to CCJ's operating margins to move closer to 20% in the coming quarters. Further, I believe $45 is the market pricing assumptions given the state of the industry. No matter how rosy the outlook, the current state of the uranium mining industry is quite bleak so the market is justifiably ignoring any possible upward correction in uranium prices.

I believe it is fair to assume downside is limited to $5.43 based on sensitivity analysis. CCJ will continue to realize $45 per pound given their long-term contracts, so the question is how well will margins stand up over time. CCJ will have monthly costs to maintain their mines even while they're closed, so if these costs aren't controlled properly then margins could narrow to 15%.

Given current market sentiment, I believe a turnaround in uranium pricing is being completely ignored when it shouldn't be due to the rebalancing efforts by CCJ and KazAtomProm.

At a current price of $9.56, CCJ is trading between a 36.5%-50% discount to a fair value depending on where uranium settles and assuming CCJ maintains ~20% margins.

At $60 uranium, the industry will break even which would allow the average uranium miner to stay in business. In this case, CCJ has a fair value of $15.06 giving a margin of safety of 36.5%.

At $70 uranium, Rick Rule believes the industry would "resolve itself;" however, given the state of the industry this may prove to be a rosy assumption. In this case, CCJ is trading at a 50% discount to a fair value of $18.95.

In either case, I believe CCJ is a well-managed uranium miner trading at a significant discount to fair value.

Risks

Uranium Market - This is the largest risk to the thesis as an unresponsive pricing environment would most likely mean bankruptcy for CCJ. It is currently cheaper for uranium miners to buy at the spot market and deliver than it is to mine uranium then deliver. To be frank, the situation is unsustainable and the supply cuts by CCJ and KazAtomProm should give a boost to uranium pricing.

CRA Dispute - CCJ is currently in dispute with the Canadian Revenue Agency (CRA) as the agency is contesting CCJ's corporate structure covering the years 2003 to 2015. Final arguments were held in court on September 13th, and CCJ believes a decision will be made within the next 6-18 months. The worst case scenario for CCJ would be CAD 1,950 million according to the Q3 2017 Management Discussion and Analysis. It is difficult to foresee how this might play out since CCJ recently settled a tax dispute with the IRS for $122,000 compared to the $122,000,000 the IRS initially claimed. I wouldn't predict this generous of a settlement with the CRA; however, it's a scenario that could unfold.

TEPCO Contract Dispute - On January 24th, 2017, Tokyo Electric Power Company Holdings Inc. (TEPCO) issued a termination notice to CCJ of their long-term contract. Under this contract, CCJ was due to deliver 9.3 million pounds of uranium through 2028, which is approximately $1.3 billion through that time according to CCJ's press release. Tim Gitzel, CCJ CEO, said the following about the termination, “We are surprised and disappointed that TEPCO is seeking to terminate its contract given all the past productive discussions we have had to date,” said Tim Gitzel, president and CEO of Cameco. “For the past six years we have worked in good faith with TEPCO to restructure this contract, and would continue to do so if there was any basis for a commercial resolution." CCJ believes that they have good standing in this case based on their efforts of good faith as well as previous contracts that have gone through this process. According to the Q3 2017 Management Discussion and Analysis, "the three arbitrators have been appointed and based on the current schedule set by them, we expect the case will be heard in the first quarter of 2019." There is currently no timeline for resolution for this contract dispute. CCJ does not include the TEPCO contract in their revenue outlooks as mentioned by Grant Isaac in the Q4 2016 conference call. I have not included any resolution in my valuation, so any positive resolution would positively impact valuation.

Reduced Demand - There's a possibility that more countries move away from nuclear power following Germany's lead; however, I believe this is a relatively small risk right now considering the state of the market. Future demand means little when the spot price is $23.75 per pound compared to the industry's cost of production of $60 per pound. The main focus in the uranium mining industry should be to reduce supply to boost spot prices to a sustainable level.

Volatility - Despite the positive news in the market, CCJ along with other uranium miners will remain volatile until the thesis starts to play out in a clear manner. Uranium doesn't have futures, so one can't track any potential progress in the market balance except for the delayed pricing by the Ux Consulting Company. I believe that the attractive risk/reward in CCJ compensates for the potential volatility in the stock.

Conclusion

A quick google search will show exactly how futile calling a turnaround in uranium might be, so the question should be why now and why is this time different? The answer is simply supply. Throughout the uranium bear market, the mining industry continued to increase production; however, this has finally changed either by choice or economics.

CCJ and KazAtomProm have made significant supply cuts in an attempt to balance the uranium market, which includes cutting 18.2 million pounds of production in 2018 alone. Additionally, the average uranium miner loses $35 per pound during production, which calls into question the availability of demand from high cost miners if this trend continues.

I believe the changing supply dynamics combined with growing uranium demand as more reactors come online will lead to uranium prices correcting higher to a more sustainable level.

CCJ has continued to generate free cash flow during the uranium bear market highlighting their low-cost structure combined with a conservatively positioned balance sheet with the ability to draw on additional liquidity if necessary.

I believe CCJ is a worthwhile investment for the patient investor given the unsustainability of the uranium market and CCJ's position to capitalize on a turnaround in uranium prices.

Disclosure: I am/we are long CCJ.

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.

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