Stillwater Mining or North American Palladium: Which is the Better Investment?

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Includes: PAL, SWC
by: Mark Anthony

Both Stillwater Mining (NYSE:SWC) and North American Palladium Ltd. (NYSEMKT:PAL) are primary PGM metal producers. They are the only major PGM metal producers outside of Russia and South Africa. I expect the PGM metals, especially palladium, to be extremely bullish in the near future, due to booming demand from jewelry and fuel cell applications, or even the exotic cold fusion application. Investing in the physical palladium metal is a very good idea, but investing in the stocks of these two PGM producers may bring in much higher leveraged return.

So if you are to buy stocks of PGM producers, which one you would choose at today's price, SWC or PAL?

Stillwater Mine has a mine grade of as much as 0.55 ounces of PGM metals per ton of ores. That is the highest grade PGM mine in the world. But the SWC mine is mostly palladium, about 3/4 palladium and only 1/4 is the more expensive platinum. So for now it is not as profitable as the platinum mines in South Africa.

PAL's mine grade is much lower, at about 2.5 grams PGM per ton of ores. It also contains much less platinum, only 1/10. But PAL does have its advantages. It is mostly an open-pit operation, so the mining cost is much cheaper than SWC's underground mine. PAL produces more base metals, especially nickel, when compared with SWC. Furthermore, PAL has quite a few ongoing exploration and new mine development projects going on, while not a lot of new mine development is going on with SWC.

SWC has a current market cap of $839.72M, as compared with PAL's $273.40M (with new shares from secondary offering counted in). For the first nine months of 2007, its sales revenue was $470.50M, and only $210.877M was from mine production. $247.977M of the sales revenue came from its PGM recycling business, which is profitable but operates on a really thin profit margin business due to competition in the recycling business.

Counting only the mining production, SWC has a 9-month price/sales ratio of 3.982. Annualized it is 2.987, which is a low ratio. But PAL reported $149.426M (in Canadian dollars) sales revenue for the nine months. That's an annualized price/sales ratio of 1.372, which is much lower (cheaper) than SWC.

I believe the price/sales ratio is more important than the current P/E ratio, because as metal prices go up, the sales revenue will rise proportionally, while the cost of producing the same amount of metals will remain about the same. Any increase in sales revenue due to better metal prices will directly go into its pre-tax net earnings. With a price/sales ratio less than half of that of SWC, PAL is a much better value to buy here. And, I called a PAL bottom last Thursday.

Some folks may only like to evaluate stocks based on P/E ratio, but I think that in this case, the P/E is less meaningful. PAL's quarterly results are extremely volatile. In Q1, 2007, PAL reported quarterly earnings of $0.10 per share. In Q2, 2007, it reported quarterly loss of $0.17. And then in Q3, the loss widens to $0.25. Some may wonder how PAL could report increasing losses at a time when PGM metals are moving up.

In reality, the fluctuation of PAL's quarterly results is due PAL's accounting methods. For Q1 through Q3, based on its reported metal productions and realized sales price, the produced metal values are $59.911M for Q1, $51.041M for Q2, and $51.327M for Q3. There really is not a big variation between the three quarters. However, the reported sales revenues are $68.439M for Q1, $44.495M for Q2, and $36.492M for Q3. Here you see a huge difference between the quarters. No wonder PAL went from $0.10 a share profit in Q1 to $0.25 a share loss in Q3. The results are really just some temporary aberrations that do NOT reflect PAL's real operating results from the long-term point of view.

What causes those aberrations? For one thing, PAL may not sell all of the metals produced in current quarter. It may decide to hold some metals back for better prices in the future. But the cost of all metals produced in current quarter is nevertheless booked in current quarter regardless when the metal will be sold.

Another reason for the quarterly aberration is PAL records sales revenue in current quarter, using current metal prices, while the metals still need to go through smelters. The actual closing of the sale of the metals will occur about 6 months later at the new spot price, which may be higher or lower than the originally booked sales price. The sales revenue will also be converted back to Canadian dollars at the time of the actual sale, which may be converted at a different USD/CAD foreign exchange rate. Because of this reason, PAL needs to record the commodity price adjustment, as well as foreign exchange adjust, to its quarterly sales revenue. Both adjustments exaggerate the volatility of quarterly results, making one quarter particularly good and the next one particularly bad. Over the long term, both adjustments should NOT have any long lasting effect on PAL's quarterly results.

There are two factors that pushed PAL from its recent high of $12.65 to recent low of $3.40: The seemingly disappointing Q3 result is one factor, and the recent secondary offering to dilute shares is the other factor. Now let's take a look and see just how bad the secondary offering dilution is.

Before the offering, PAL had 55.23M shares. After the offering, there is 18.67M extra shares, so the new number of shares is 73.9M. 55.23M divided by 73.9M is about 75%. So that's a share value dilution of 25%.

But don't forget that the secondary offering also brings in $74M in cash, and that's an increase in book value of about $1 per share. PAL's current price is $3.70. Subtracting the $1 in extra cash, the market is pricing PAL at $2.70 a diluted share, or $3.60 per share before dilution. That is a rather ridiculous valuation consider that PAL has been trading between $6 to $12.65 before this secondary offering fiasco!

In summary, I believe PAL is deeply oversold. People should jump right in and buy as much as they can afford at current price level.

Disclosure: The author owns a lot of long positions in PAL and some long positions in SWC.

PAL vs. SWC 1-yr chart:

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