Silex holds on for nuclear enrichment

Investing in Silex Systems (SLX) has come down to a three-way staring contest between its giant partner, the uranium market and the Australian market minnow. The question is, who’s going to blink first.

This could shock many, but my money is still on Silex even though its 75% plunge from grace over the past year would make hardened risk takers weak in the knees.

This is because it is more a question of “when”, not “if”, the laser technology developer can successfully commercialise its uranium enrichment system.

I’d admit that the prolonged weakness in demand for fuel rods from nuclear power plant operators has blindsided me. I first wrote about Silex in July 3 last year when the stock was trading at $2.32 and when yellow cake (the palatable name for uranium oxide or U3O8) was trading at $US39.40 a pound, 42% below where it was trading at before Japan’s Fukushima nuclear disaster in March 2011.

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Silex was trading between $5 and $6 before that fateful event, and I believed the halving of its share price was a good buying opportunity a year ago as it was only a matter of time before Japan restarted its nuclear plants. The country can ill afford to rely solely on coal and imported fuel for a protracted period.

Japan’s Prime Minister, Shinzo Abe, is pro-nuclear and has committed to restarting the country’s nuclear energy program, but the process has taken longer than anticipated as nuclear power is a political hard-sell even though many Japanese know it’s almost an inevitable outcome.

Japan has 48 reactors, which should generate around 30% of the country’s electricity needs according to the World Nuclear Association. Until a good number of these reactors come back online, global demand for uranium enrichment is likely to remain weak as nuclear fuel inventories are relatively high.

That means Silex’s partner, Global Laser Enrichment (GLE), will struggle to justify the capital costs of building a commercial facility using Silex’s technology. If a plant doesn’t get built, Silex cannot receive its generous royalties or further milestone payments.

GLE is a joint venture between GE, Hitachi and Cameco that was set up to license and advance Silex’s technology, which is cheaper and more efficient than current enrichment techniques. It was GLE’s decision on July 24 to slow the advancement to commercialisation in response to weak market conditions that triggered the worst one-day fall since 2003 in Silex’s share price, which crashed 39.4% to 57 cents.

The stock spent most of that day trading at or below its net tangible asset backing of 54.9 cents, before recovering to around 75.5 cents today.

Silex’s depressed share price could also well play into the hands of GLE. It’s the stuff of conspiracy theories and pure speculation on my part but, with Silex’s market cap dropping to around $130 million, it probably makes better financial sense in the longer run for GLE to acquire Silex than to keep paying royalties in perpetuity. The more distressed Silex is, the better a deal GLE can squeeze – in theory at least.

This is why the biggest question for shareholders now is arguably not the future of nuclear power demand, but whether Silex can keep its head above water for a number of years to wait out what is perhaps the darkest period for the nuclear power industry.

The short answer is, “yes”. Based on my estimates, debt-free Silex has the cash to ride out the next four to five years following its restructure and divestment plans. That’s significant because it will probably take that long for investors to see the first royalty payment from GLE, assuming that a commercial plant is built of course.

There are two potential plants that can be built. GLE has a site in Wilmington, North Carolina, earmarked for a commercial facility, while the United States Department of Energy (DOE) is negotiating with GLE to build a laser process plant in Paducah, Kentucky, to enrich depleted tails inventories at the decommissioned government-owned diffusion process enrichment plant.

The proposed plant at Paducah is as much to do with cleaning up the environment as it is about supplying nuclear fuel, but negotiations have nonetheless been complicated by the weak uranium market.

The uncertainty is great, but the potential upside is huge. A plant with a six million separative work unit (SWU) capacity charging $US135 per SWU will generate yearly revenues of $US810 million for GLE.

Silex gets a royalty between 7% and 12%, depending on the capital costs required by GLE to build the plant. At the lowest rate, that will contribute nearly $US57 million a year to Silex’s coffers.

There isn’t a sunset clause on the royalty stream (yes, we are looking at you Universal Biosensors) although there are rumours that Silex may agree to take a lower royalty to entice GLE to build a plant. I don’t think the royalty rate will change much, if at all, although this is a risk.

The tricky bit is working out what Silex is worth in light of the latest market update. There is really no ideal way to put a value on a speculative stock like Silex when the pay-off is years away.

Using forecast comparative multiples, like price-earnings (P/E) and enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA), Silex is worth $5.60 a share once a six million SWU capacity plant is fully up and running. But this methodology ignores the timing risks.

Using discounted cash flow (DCF), my price target comes in at 60 cents. But DCF is disproportionately impacted by the nearer term losses of the company and fails to fully reflect what Silex could be finally worth.

However, timing risks is a big deal for Silex and that is why I am putting a “hold” rating on the stock with a DCF driven price target of 60 cents, which is also close to Silex’s latest reported net tangible asset value.

Those already owning the stock should hold on. There is little point in selling at this juncture and there should be news about Paducah before the end of this year, if not sooner.

As for investors thinking about buying the stock, it is probably better to wait until the next company update before making an assessment. The fact is, even if Silex doubles in value from here, the stock will still have plenty of room to run once confidence about the viability of GLE’s laser enrichment plant recovers.

Let’s hope Silex won’t be the first to blink.

To see Silex's Forecasts and Financial Summary, click here.