NexGen Energy: Undervalued Uranium Play
NexGen Energy (NXE) is an advanced stage uranium exploration company located in the prolific Athabasca basin in Saskatchewan, Canada. The basin is home to some of the highest grade uranium deposits in the world. Uranium major Cameco (CCJ) has both its Tier 1 properties, McArthur River and Cigar Lake, in the Athabasca basin. In fact, if you are looking to build a universe of uranium explorers to buy during the bear market, you need to look no further than the ones exploring in this region.
(Image: Exploration properties situated in the Athabasca Basin)
The Arrow zone outlined in the left of the image is NexGen’s flagship asset. As per the latest mineral resource estimate, the property hosts 256.6 million pounds of uranium grading 4.03% in the Indicated category and 91.7 million pounds in the Inferred category, making it one of the largest undeveloped deposits in the world.
The asset also has the advantage of being a basement-hosted deposit. What this means is that the ground conditions are favourable for extraction, unlike the deposits you see on the right which are sandstone hosted. For mineral extraction from sandstone hosted deposits, the ground first needs to be frozen, and there is always the risk of water flooding the mine. That was exactly what happened to Cameco at its Cigar Lake mine in 2006, when the project was in development stage. NexGen’s Arrow deposit won’t be as challenging to bring to market.
Uranium Price Outlook
Mining is a cyclical business. Even the best miner out there isn’t worth owning when the commodity they mine is in a prolonged bear market. In the case of uranium, prices peaked in 2007, had a mini-rally along with all the other commodities in 2011, and have been in a bear market ever since.
Market sentiment isn’t favourable to uranium miners, and looking at that price chart, it is easy to understand why. Every mini-rally since 2011 has turned out to be a bull trap, with prices marching lower and lower.
The cure for low prices is low prices.
A market darling during last decade’s uranium bull market, Paladin Energy (ASX: PDN) declared bankruptcy in 2017.
Cameco, the Saudi Arabia of uranium responsible for over one sixth of global uranium production, has shut down all but one of its mines, choosing to buy uranium in the secondary market rather than extract it out of the ground. They do this in order to fulfil long-term customer contracts. It is telling that they are able to buy it cheaper than they are able to mine it!
Signs of a bottom? Or signs that the industry is dying due to lack of demand? The last buggy whips and Sony Walkmans would have been sold at throwaway prices, but that didn’t signal the onset of the next bull market for those products. What makes uranium different?
Supply and demand.
While the bear market has thinned the universe of uranium explorers, shelved development projects, even caused miners to cut back on their production, the demand picture couldn’t be any rosier.
Above is the list (not exhaustive) of nuclear reactors that are in various stages of development. Reactor builds are at a 25-year high. To put the numbers in context, there are currently 450 reactors operating across 31 countries. The reactors in the planned and construction stage will contribute to a 42% increase in end users of uranium.
For a reactor operator, security of fuel supply is critical. Fuel costs would account for less than 2% of their total cost, making them relatively price insensitive. The reactor operator, typically a utility company, will sign a long-term contract with a uranium producer, procure uranium in the form of U3O8, and convert it into fuel rods for use in the reactor. With uranium prices in steady decline, the utilities have started to let their long-term contracts run off, choosing to replace contracted supply from miners with pounds purchased in the secondary (spot) market. According to the UxC, over the last five years only 396 million pounds have been locked-up in the long-term market, while over 831 million pounds have been consumed in reactors.
The supply from the secondary market is now close to being exhausted. According to Cameco, “In late March, we saw some motivated selling from a number of market participants. It seems these players had built up a uranium position in anticipation of short-term demand in the market, and misread the timing of that demand. When the demand didn’t materialize on the timelines expected, they began to sell material into a very illiquid spot market, which drew a few other sellers into the market as well. Once the market had found a floor, we issued a request for proposal for 1 million pounds. Despite price signals to the contrary, we found there was not enough material available to meet our specifications.” (Source: Cameco Q1 2019 MDA)
In other words, Cameco is saying that the spot market has tightened. The supply overhang is the primary reason the bear market lasted as long as it did. Without that supply, the drop in production from the miners would have shifted the supply curve to the left and sent prices higher. Instead, uranium prices dipped below the cost of production of the majority of the miners, and stayed that way. That situation has now ended.
The market is sleepwalking into a supply crunch. The coming uranium bull market is not only inevitable, but imminent.
How to play this?
One way is to own Cameco. Another way is to own an undervalued development stage company which has all the markings of becoming a profitable producer, right in time to capitalize on the next uranium bull market.
In my opinion, NexGen Energy is well placed to do that.
NexGen’s Value Proposition
In November 2018, NexGen released a Pre-Feasibility Study on its Arrow deposit.
The PFS outlines an after-tax NPV of C$3.7 billion and after-tax IRR of 56.8% on initial capex of C$1.25 billion. The operating cost of US$4.36 per pound of uranium makes it an extremely high margin mine. Factoring in all costs, including initial capex, the total cost is still extremely low at C$17.23/lb. If this mine were in operation today, it would be among the world’s most profitable mines.
All well and good, but what if this is already priced in? Let’s run through the numbers.
As of December 31, 2018, the company had 351.2 million shares outstanding. The company also raised debt capital of $151.7 million through issuance of convertible debentures in 2016 and 2017. Assuming full conversion, the company would have 412 million shares outstanding. Dividing the PFS NPV by the share count gives us NPV per share of $8.98. The company also has $119.2 million in working capital, or 29 cents per share. That raises the implied share value to $9.27. At the current share price of $1.88, this presents 393% upside. Put another way, the company is trading at 20% of the implied share value. Shares Outstanding (Fully Diluted) 412,059,194 PFS After-Tax NPV C$3,700,000,000 NPV/Share C$8.98 Working Capital C$119,200,000 Working Capital/Share C$0.29 Implied Share Value C$9.27 Current Share Price C$1.88 Discount to Implied Value 80%
Development stage companies normally trade at a discount to NPV for a number of reasons. It is a long road from pre-feasibility to production. Some companies fail because they are unable to secure the required permits. Some cannot raise capital. There is the risk of cost overruns, change in political climate, any number of reasons can derail a project that looks sound at first glance. NexGen has commenced its Environmental Assessment, beginning its long journey towards getting all the required permits.
Once that’s done, it still needs to raise financing. Fortunately, NexGen counts CEF Holdings, the investment arm of Hong Kong billionaire Li Ka-shing among its shareholders. On a fully diluted basis, CEF owns over 15% of NexGen. The company should be able to arrange a financing package when the time comes.
All this focus on valuation ignores potential upside from increasing confidence in the resource estimate. To that end, the company has commenced a 125,000 metre drill campaign focused on converting Mineral Resources from Indicated to Measured and Inferred to Indicated. Once that’s done, the results will be incorporated into a Feasibility Study.
This is an undervalued company with serious growth potential that is being ignored by the market.
In the last bull market, Cameco went up from under a dollar to peak at $56. The market rewarded early investors in spades. When utilities start panicking to cover their requirements, the market will wake up to uranium, only to realise that there are very few worthy investments in the space.
Patience will be well rewarded.
Disclaimer: I am long NexGen Energy and Cameco.