Uranium, Paladin

An inflection point
I realise Southern Cross was heavily involved in the deal, but I just can’t get out of my head that last night’s highly successful Fortescue Metals Group (FMG) book build will prove to be an inflection point for the entire next generation Australian resource sector.

It was just so pleasing as a resource bull and long-term believer in the strategic advantage of Australian resource companies to see Australian institutions bid hard into the FMG book build. We had our fingers crossed that this would happen and to their credit it did happen.

There’s been a long and distinguished list of non-believers in FMG who would today be stunned that the company could attract over $1bil of bids from high quality institutions and high net worth investors at $36.00 per share. There are probably a few jaws on the ground at Rio Tinto today. Surely this is a sign that domestic institutions are now going to back our next generation resource sector as it approaches genuine cashflow generation.

I have to admit I am quite drained writing this note today. Educating the global investment community about the opportunity in FMG has seen us all over the world in the last 7 days. But it’s been worth it because the biggest onshore resource project in Australia is now fully funded and it’s been funded mostly by domestic institutions. It’s the right outcome for Australia, and it shows you what can be achieved with the right education campaign. As a corporate it shows you what can happen when you engage Southern Cross Equities. Think global, act local.

The success of the FMG deal is now going to see the risk capital floodgates open. As our next generation resource sector approaches cashflow generation, analyst “modelability” (not sure that is a word) improves, and ASX200 index weights increase, you will see domestic investors move more wholeheartedly into this space.

Many of these companies are about to become mainstream investments and it’s our job to discover them and recommend them before that occurs. The clear lesson in FMG is that looking backwards is not how to approach this space. To think you had missed the boat when we first recommended FMG @$21.70 would have been a major mistake. This is about buying these companies as they move from speculative to investment grade. It’s about buying them as the real investment risk reduces. It’s also about educating the market about the true investment case as so little research is written on these stocks by global brokers.

Today we are going to keep on the theme and explore the Paladin (PDN) investment case (again). We are one of very few brokers who write on this $5bil market cap pure play on uranium.

Uranium

In this context we believe the uranium industry is both strategic, and on the verge of global consolidation. Xstrata has already confirmed that uranium is a strategic commodity target and there is no doubt that this view was a major consideration in the failed bid for Western Mining. In addition CVRD has recently farmed into two uranium exploration assets in W.A. The long term fundamentals of the uranium market remain very strong, with a significant increase in global demand, against a backdrop of future supply shortages, supported by the first synchronised effort by world Government’s to reduce global carbon emissions.

Supply constraints

Interestingly, the uranium market is supported by precisely the same supply characteristics as base metals. There are major production constraints and serious delays in the supply response against a significant increase in global demand. Since 1985 static mine production has resulted in up to 50% of reactor uranium requirements sourced from secondary supply. However, the security of this supply is problematic with the rundown in Western inventory supplies to critical levels of just 12 months reactor feed.

In addition the Russian government recently announced that it would not continue the “Megatons to Megawatts” programme when it expires in 2013. This program has been the major source of secondary supply. According to World Nuclear Association (WNA) figures, last year the deficit between mine supply of 39,655kt, and global demand was a massive 40%. In other words, last year secondary supply totalled 22,981kt.

Cigar Lake

However, the mine supply response has recently suffered a huge blow with the flooding of the massive Cigar Lake project in Canada. The reserve estimate of 100kt was expected to support full production of 8kt pa in 2010. However recent news from Cameco indicated that Cigar Lake production will be delayed until 2011.

The implications of the unexpected delay in the Cigar Lake project cannot be underestimated. This project was expected to provide 10% of global supply. Considering there is a 4-5 year lead time to convert uranium to a reactor fuel source, utilities require long dated contracts of at least 5 years for security of supply. This comes after the ERA announcement that FY 08 production will be 25% to 35% lower than last year’s production. Consequently, the massive spike in the uranium spot price is reflecting a significant gap in the supply horizon.

Uranium price upgrade

The prospect of a significant decline in secondary supply and the current production problems of Cameco and ERA have exacerbated the supply deficit. In addition considering these problems and the continuing strength of the uranium market, we have upgraded our price assumptions. Our forecast for FY08 is now US$125/lb (previously US$95/lb).

However the market is currently focusing on the recent fall in the spot price from $US138lb to $US129lb. At the same time analysts have conveniently ignored the long term price which has remained constant at its all-time high of $US95lb. In contrast, we believe the fundamentals for the uranium price have actually improved. We think this is a minor correction in a long term bull market which is providing another opportunity for the short termists to promote a negative view.

M&A activity

Unsurprisingly there was a rumour yesterday that Cameco, the world’s largest uranium miner, was poised to make a takeover bid for Paladin (PDN). The delays at Cigar Lake have left a “massive hole” in Cameco’s production profile and a takeover for PDN, which is currently in production, makes very good commercial sense. Subsequently PDN confirmed emphatically that no such offer had been received but interestingly Cameco made no comment. Mmmm interesting.

Paladin

Paladin is in the process of ramping up its first uranium mine, Langer Heinrich in Namibia, and is constructing its second, Kayelekera in Malawi. Further out, there is the potential to develop the promising Mt Isa region, which PDN has recently secured through a A$1B takeover of Summit Resources. PDN is in a unique position in the industry with an exciting growth profile exposed to the spot uranium market, whereas most of its competitors are locked into punitive long-term contracts.

The Langer Heinrich project, (aka Langer/Hayden), is located in Namibia and 40km south of RIO’s existing Rossing uranium mine. The area is highly prospective, but more importantly the Government is encouraging development. PDN has recently confirmed FY 08 production guidance of 1200tpa. Our current estimate of the mine life is 17 years which includes the Stage 2 project, and assumes a 76% conversion of current resources to reserves. Given the Heinrich mineralisation we think this is reasonably conservative.

However we believe the jewel in the crown is the Valhalla deposit. Valhalla is a large, high-grade deposit that should enable a high tonnage, long life operation near Mt Isa. The current resource is estimated at 31kt, but we think this will prove very conservative considering the ore body is open on all sides. After a proposed start up in 2H 11, Valhalla is expected to ramp up to full production of 3,465kt pa for 10 years. In addition it gives PDN access to the Bigrlyi deposit in the NT where the resource has recently been upgraded by 26% to 6400kts.

Production guidance

Paladin has recently downgraded its Langer Heinrich June 2007 half production forecast to 270klbs from 400klbs, due to problems associated with commissioning the new plant. Most of these problems have now been rectified and the company expects to meet its FY08 guidance for production of 1,200t pa.
Importantly we have not changed our long term production forecasts. We expect current production to rise 140% over the next 2 years to 2,953t in FY 10.However with first production from Valhalla in 2011 this will rise significantly. As a result we expect PDN to become a top 10 global producer.

Largely unhedged

PDN has already committed 50% of Stage I production to a long term contract at $US60lb with an escalator for price participation above $US80lb. This is well above the legacy contracts for the incumbent producers of $US15-25lb. However the other 50% of production is expected to be sold into the spot market where the current price has risen to $US129lb. Consequently PDN is totally unhedged, and fully leveraged for 50% of production at the spot price. As a result, PDN is in a very advantageous and highly profitable position compared to the global peer group.

While the market agonises over the small decline in the spot uranium market we think analysts are overlooking two very important issues. PDN is a current producer with an increasing production profile in a global market where supply is becoming increasingly constrained and demand is accelerating rapidly. Secondly PDN’s production is 50% unhedged providing a unique opportunity to lock in current prices which have risen from just $US 25 less than 2 years ago. The global mining consolidation is about scale and leverage and clearly PDN has both.

Valuation and 12 month target

Our analyst Rob Bishop on a base case, values PDN’s “non-producing” resources, other than Langer Heinrich, at US$7/lb which is just 15% of our long term price is $6.57. However using a US$12.50/lb figure based on prices paid for recent transactions in the uranium industry, our upside valuation increases to A$9.74 supporting our 12 month target of $10.00.

However on a global consolidation of the industry I think the takeover price would be in excess of $12.00. PDN is a serious company, with some very serious credentials, however it appears that institutional investors are viewing PDN with the same scepticism they previously viewed FMG. All I know is that through time perceptions change. PDN will either be re-priced to reflect its unique position, or will be re-priced by a corporate. I suspect the latter is more likely. PDN is a strong buy.

Go Australia.