Perfectly placed Paladin

The chart below, borrowed from a Global Mining Investments (GMI, thanks Evy) presentation, puts into perspective the damage in resource stocks.

While 2005, 2006 and 2007 annualised percentage returns from the HSBC Global Mining Index were three of the seven best years recorded by the benchmark resource index over the past 20 years, 2008 is not just the worst performance year ever recorded by the index, it's the worst by double the previous worst annual performance.

The 2008 performance is a statistical aberration and to my way of thinking that must mean there are unbelievable medium to long-term investing opportunities in the sector right now. There must be stocks trading below their true replacement value or true strategic value. If investors won't price these stocks appropriately the corporate will. Look out for mass resource sector mergers and acquisitions in the new year.

Despite the considerable fall in the uranium price and the significant correction for Paladin (PDN) the long-term fundamentals for the industry and the company remain firmly intact. The resources bear market has claimed many victims and, unfortunately for many investors, Paladin has fared badly. However, despite the share price carnage and the poor sentiment the current share price represents an excellent opportunity for investors to buy into a very powerful and positive long-term theme.

While the equity market meltdown and the collapse in the oil price have distracted investors in the short term, there is no doubt that climate change and energy security will remain key future long-term issues for global governments worldwide.

It is worth noting that electricity generation accounts for 40% of global greenhouse gas emissions. As a result, at the recent world climate conference, the consensus aim was to cut carbon emissions by 30–50% out to 2050. Considering electricity generation from nuclear power generates zero greenhouse gas emissions, I have always believed in the long-term future of the uranium industry as a "green" alternative energy supply.

In a recent report, the International Energy Agency (IEA) outlined two energy mix solutions with the aim of reducing carbon emissions by 50% to 2050 for G8 countries including China. The IEA forecasts that between 2010 to 2050 a total of 24 to 32 new 1000 Mw nuclear reactors will need to be built each year to just to meet current emission targets. This implies a total of 960 to 1280 reactors to be built by 2050.

Currently nuclear power supplies about 16% of global electricity generation. However, nuclear power generation is concentrated in only a few countries and a significant proportion have little or no capacity. China is the clear example with just 2% of electricity capacity currently supplied by nuclear power.

As a result I have always believed the uranium industry would be faced with a significant supply deficit in the future. However, with the continuing new capacity delays, particularly Cigar Lake in Canada, and the scrapping of new projects with the global credit crisis resulting, I expect this deficit to widen. Yes, the credit crisis has even hit uranium supply.

Uranium; spot price is the worst guide

Despite the positive long-term fundamentals, Paladin has been caught in the broad resource meltdown. However, I think Paladin has also fallen victim to the collapse in the spot price, which is not reflective of the genuine demand/supply fundamentals. It is worth noting that the spot price represents just 10–15% of total global industry sales and represents a top-up mechanism for utilities to balance short term supply requirements. The real uranium price is the long-term or contract price, which has traditionally traded at a 10% premium to the spot price, considering it represents the long-term security of supply for electricity utilities.

However, there is no doubt that speculative hedge fund positions significantly influenced the spectacular rise in the spot price to $US137 a pound in mid-2007 before a recent collapse in October to $US44 as part of global deleveraging and the commodity meltdown.

In the meantime, however, the spot price has rebounded 25% to $US55, on the news of several Canadian mine closures and a corresponding supply deficit. This represents the bottom for the spot price and the negative sentiment for uranium stocks. In this regard the recovery in the Canadian sector has been impressive.

Nameplate capacity '¦ impressive

I recently met Paladin chairman Rick Crabb, technical general manager David Marsh and operations manager Simon Solomons for an update on the operational performance and the future growth outlook.

In 2007, the total global production of uranium was about 108 million pounds. At the end of 2007 there were 316 planned and proposed nuclear reactors. The simple fact is that the industry is ill-prepared to meet future demand. However, Paladin is very well placed as a current producer, and with its project pipeline, to become a significant player in the industry.

Management recently achieved nameplate capacity for Langer Heinrich stage 1. In addition, Langer Heinrich stage 2 is currently under construction, while Kayelekera is expected to begin commissioning in the March quarter of 2009. In terms of total production, management is hoping to produce about 3.6 million pounds in 2008-09; 6.6 million pounds in 2009-10; 8.4 million in 2010-11 and 9.3 million in 2011-12. There is also significant upside potential in the resource inventory. There is no doubt that Paladin is a genuine strong growth story in a resource environment where projects are been cancelled left, right and centre.

As the global credit crisis undermines the expansion plans for major resource producers, Paladin has no such problems and remain well funded through the process, having completed a convertible bond issue earlier in the year. The balance sheet is strong currently with about $US280 million in cash and a $US167 million Kayelekera project facility, which is to be supplemented with an additional debt facility.

One of Paladin's key advantages is the fact that it has an experienced team operating in an industry where experience is very low. The management have BFS capability, construction capability and now production capability. The plan is to take advantage of this expertise over the existing portfolio and to look at merger and acquisition opportunities with the aim of building a global tier one uranium house over time.

Langer Heinrich

The good news is that Langer Heinrich is performing well, having hit nameplate capacity in the September quarter of 650,560 pounds of U3O8. In the December quarter the company is expecting to produce 750,000–900,000 pounds.

There is not a great deal of current information on the cost outcomes for stage 1, but I would expect cash costs to settle out in the mid-$US20s per pound of uranium produced.

Langer Heinrich stage 2 is on schedule and designed to increase production from 2.6 million pounds to 3.7 million for an expected capital cost of $US50 million.The expansion is expected to be completed this month, with a minimum disruption to the existing operation.

Langer Heinrich stage 3 is the big expansion project, designed to take production to 6–7 million pounds. The feasibility is currently being completed and is waiting for board approval. The timing of stage 3 may ultimately be determined by water availability, but a start time of mid-2010 is envisaged.

However, before such expansion, the immediate objective for Langer Heinrich is to produce in the order of 3.1 million pounds through to June 2009.

Langer Heinrich: in production and expanding

Kayelekera

Kayelekera is getting into the final stages of construction and they expect to begin commissioning in the first quarter of 2009. This is a 3.3 million pound a year project using acid leach/resin in pulp technology, which is pretty stock standard – the same sort of technology as the Ranger Mine in the Northern Territory.

The capital budget expected for Keyelekera is $US200 million (currently on budget). Construction is well advanced with the long lead time items in place. The power plant is commissioned, SAG mill installed and the acid plant is currently being delivered. The tailings dam and other water structure construction is under way as is open pit pre-strip. In addition, all senior management are in place, and between now and year end the operators are expected to arrive. The aim is to produce in the order of 500,000 pounds through to June 2009.

Keyelekera - Due to start commissioning in Q1 2009

Other projects

Beyond Langer Heinrich and Kakelekera, management are working on the advancement of projects in Queensland where a resource upgrade on the Valhalla resource is due this month. A feasibility study is expected to begin at the end of 2009/beginning of 2010, and on the new Angela Project in the Northern Territory which is a 50/50 joint venture with Cameco. The tenement was granted in October 2008 and the deposit has a pre-jorc resource of 27 million pounds of uranium and is still open. Currently land access is being negotiated and a project team assembled.

Summary of Paladin's project status

I believe Paladin has passed an important milestone in attaining design production rate at its flagship mine Langer Heinrich. At the same time, the uranium market appears to be stabilising with the spot price up 25% from the October low. Since our downgrade in October, Paladin has fallen in line with the deleveraging of the resource sector but also due to forced selling after the removal from the MSCI.

As a result, Paladin is now trading at a 35% discount to our valuation of $3.50 and at current levels it represents a very attractive and unique energy investment. Currently Paladin has an impressive project pipeline that should see it grow into a major uranium miner. Stage I (2.6 million pounds a year) has been established at Langer Heinrich in Namibia and stage 2 expansion, to 3.7 million pounds, is due for commissioning early in 2009. The second mine, Kayelekera in Malawi, is on target to add another 3.3 million pounds beginning also in early 2009. Further growth potential lies in its highly rated prospects in Australia: the large scale Mt Isa project, Angela and Pamela deposits and EME's Bigrlyi deposit.

At a time when global uranium production is falling and projects are being delayed, Paladin is a current producer with an impressive rising production profile. I forecast is for production to rise from 1.4 million pounds this year, to 7.48 million by 2011. Assuming a conservative average uranium price of $56 a pound over the next three years, I forecast a maiden 2008-09 profit of $11 million, rising to a 2009-10 profit of $71 million, and a 2010-11 profit of $93 million.

Considering the long-duration nature of uranium pricing, I believe Paladin's target product market is unique and relatively low-risk in a world experiencing wild swings in traditional materials markets. In addition, the industry fundamentals remain positive with increasing demand and long-term undersupply, especially as an environmentally clean energy source for the base load power industry.

Further, with an aggressive production profile and strong balance sheet, I believe Paladin has significant corporate appeal. It is worth noting that ERA is the second-largest operating mine in the world, with expected 2009-10 production of 5.4 million tonnes. At the same time, I expect Paladin to produce just under 3 million tonnes at a cash cost that will make the company a major global low cost producer and a genuine takeover target. My target is $3.50; around $2, Paladin is low-risk medium-term buying, in my view.

Charlie Aitken, head of institutional dealing at Southern Cross Equities, may have interests in any of the stocks mentioned.