Why FMS is a Winner - Seeking Alpha
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Why Focus Graphite Is A Winner: My Conversation With President/COO Don Baxter
Sep. 22, 2014 2:29 PM ET
About: Focus Graphite, Inc. (FCSMF), Includes: NGPHF
Ben Kramer-Miller
Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in FCSMF over the next 72 hours.
Summary
Two months after I wrote my bullish piece on Focus Graphite I had an in-depth discussion with President and COO Don Baxter.
Despite his unavoidable bias he has reaffirmed my conviction in the company both as an undervalued investment on an absolute basis and as a "best-in-breed" late-stage flake graphite company. .
I summarize our conversation below and add some color commentary. .
A couple months ago I wrote a very bullish article on Focus Graphite (OTCQX:FCSMF), which is currently in the process of permitting and finding financing for its high grade Lac Knife Graphite Project in Quebec. In a subsequent article published a couple weeks ago I dampened my enthusiasm, stating that I was concerned about the company's lack of progress on the financing front and the fact that its recent financial statement shows a cash balance of just C$2 million, leading me to the conclusion that we are probably going to see some dilution in the near term. But that doesn't change the fact that the Lac Knife Project has robust economics and that it is the most advanced large scale flake graphite project in Canada.
Since then I had the opportunity to discuss the company with Don Baxter--Focus' President and COO. Don Baxter has been with the company for a year although he has extensive experience as a mining engineer in the graphite space. He was formerly the President of Northern Graphite (OTCQX:NGPHF), and was mine superintendent at a past producing graphite mine that ran in the early 1990's. He came over to Focus Graphite in order to refocus the company on the mining side of the business as the Lac Knife Project was at a critical development stage.
Since he has joined the company we have seen substantial developments not just on the mining side of the business, but on all levels. We have seen Focus release a robust feasibility study that shows the economic viability of the Lac Knife Project in a heavily stress-tested scenario.
The company has found a buyer for its graphite in China, the details of which I discuss below. Finally the company's graphene partner--Grafoid--has made advances and has added substantial value, and Focus' 19% stake is worth an estimated $40 million.
In what follows I summarize our discussion regarding the graphite market more generally and the Lac Knife Project in particular. While I think financing and shareholder dilution remain hurdles to near-term share price appreciation, I think it will become evident that Focus has an extremely compelling story.
The Graphite Market
Don Baxter is optimistic on the future of the graphite market, and he believes, like many others, that we will see an enormous upswing in demand from the burgeoning lithium-ion battery market and from fuel cells. It is for this reason that the company is focused on manufacturing value-added products such as spherical graphite--which is what will be used in lithium ion batteries found in electric cars.
A lot has been made about the Tesla (NASDAQ:TSLA) giga-factory that will be producing lithium-ion batteries beginning in 2017 and it will need roughly 48,000 tonnes of graphite annually. As a "green" company Tesla is naturally going to want to source its raw materials from environmentally friendly sources with a low carbon footprint, and this means using natural graphite as opposed to synthetic graphite, which is not only cheaper but far less energy intensive to manufacture.
Companies who have done research on spherical graphite are going to be at an advantage insofar as they will be able to approach Tesla with their product. Thus far only two companies have done extensive research on spherical graphite--Focus and Northern--and Northern did a lot of this work while Don Baxter was at the company, and he has since brought his key consultant with him to Focus. That isn't to say that Northern has no spherical graphite expertise, but I think if you look at a list of Northern's senior management personnel and their accomplishments this sort of knowledge is conspicuously absent from their resumes.
Aside from lithium ion batteries and Tesla's giga-factory--which are undoubtedly dominating the headlines--flake graphite is found in a variety of what are now common household items such as flat screen televisions, cell phones and laptops. These are all growing markets and they should drive demand for flake graphite.
Finally there is the steel refractory market which is currently the largest flake graphite market. This is a growing market as steel demand is growing globally (especially in developing economies), and while it is not an especially attractive market from the value-added end of things Focus Graphite's Lac Knife Project is going to be able to produce graphite cheaply enough so that it can service steel refractories and earn a solid profit doing so. What this means is that even if all of the exciting prospective aspects of the future of graphite fizzle out for whatever reason Focus should be well positioned to be a profitable business--"boring," but profitable.
So what will the graphite market look like in a few years time? There are going to be a handful of projects--say five or six--supplying a variety of markets, particularly those mentioned above. Graphite producers will need to show companies such as Tesla that they are able to consistently produce a quality product in order to make the switch to natural graphite from synthetic, and no one company can produce enough. Thus despite the mudslinging between the major graphite companies (and as somebody who has spoken with executives at nearly all of the major ones I can tell you that it is a battlefield) we will have to see some cooperation on the value-added side of the market, and there is ultimately room for several companies to succeed. I think as an investor you can take this same attitude and own more than one graphite company (and you probably should!).
The Lac Knife Project
The Lac Knife Project contains a unique deposit that really sets Focus apart from its peers. One issue with graphite deposits is that as ore grade increases then flake size distribution worsens. So for instance Northern has the best flake distribution but a low grade project. On the other side of the spectrum Mason Graphite (OTCQX:MGPHF) has the highest grade deposit but a small amount of large flake graphite.
(Just as a side note the bigger a company's average flake size the more emphasis its management places on its importance. So Northern's management thinks this is one of the most important aspects of a project while Mason thinks it is far less important.)
Focus is in the middle in both categories but its flake distribution is closer to Northern's than to Mason's, and its grade is closer to Mason's than to Northern's, and so it actually has the best economics with the highest differential between prices realized and production costs.
Furthermore, one of the misconceptions in the graphite conversation is that you can only make spherical graphite from large flake graphite, but this isn't entirely true. Rather, generally speaking it is a matter of economics rather than of science. So it is true insofar as larger flakes tend to have a higher carbon content than smaller flakes, so it is easier (i.e. less costly) to purify it. But the Lac Knife deposit has small flakes with a 98% carbon content, so the company has actually been able to cost-effectively manufacture spherical graphite using "small flake" (i.e. -100 mesh) graphite while its peers would have trouble doing the same.
Another unique quality of the Lac Knife deposit is that the impurities are not ingrained throughout the graphite, but only on the surface, meaning that the company has relatively pure graphite beneath the surface.
This means that its graphite will be relatively inexpensive to purify.
These points are lead me to the conclusion that Focus Graphite is extremely well positioned to service just about any market out there. If Tesla goes ahead with its giga-factory as scheduled then Focus has the means to supply a great deal of that graphite market. If not and the refractory market (medium and small flake) needs to be supplied Focus can supply it. Since its cost of production is going to be less than C$445/tonne it can easily produce this less valuable graphite profitably, as it is worth about C$1,000 - C$1,200/tonne by comparison.
Other Points Regarding Lac Knife
1--Lac Knife is well situated despite the fact that it is not located near a major city. The Lac Knife Project is located in Quebec near the Newfoundland and Labrador border.
Quebec is one of the best mining jurisdictions in Canada due to its general support for the mining industry, its favorable taxation regime, and its low power costs. Despite the fact that Lac Knife isn't located near any major cities it is located near iron ore mines and towns with workers with mining experience (and direct access to hydro-electric power, rail links, and a deep sea terminal).
2--As a result of Quebec's favorable regulatory environment Baxter and his team believe that the company can expedite the permitting process and get into production after a couple of years.
Offtake Agreements
This is a somewhat controversial issue for a few reasons. The supposed benefit is that a company that has offtake agreements has found an outside party or parties interested in purchasing its graphite in large quantities. This guarantees a revenue stream and speaks to the quality of the product. Skeptics claim that this is simply not possible, and that any offtake agreement made prior to actual production is too vague to have significant meaning. I should note that Focus Graphite shares doubled last December when it announced its offtake agreement. While the market loved the deal the skeptics can't be proven wrong until we actually see production.
Now there are some controversies specific to Focus' offtake agreement. The first is that the deal is with a Chinese conglomerate. The Western community often views the Chinese as competing for resources with the West, and this sort of agreement is "unpatriotic." On a more practical note this hypothetically leaves less graphite for Tesla. But Don Baxter told me that the press release announcing this agreement is misleading in that it has led many to conclude that Focus will be selling 90% of its graphite to this Chinese conglomerate when in fact the minimum is 200,000 tonnes over 10 years, or a little less than half at 44,000 tonnes of annual production. This leaves plenty for Tesla and other potential customers.
I should also point out that the fact that this offtake agreement is with a Chinese conglomerate is very telling. China produces about 70% of the world's graphite, and if a Chinese company believes it will have trouble securing the graphite it needs (and note that this could be a quality issue) this is a very bullish indicator. We don't know specifically what it is indicating, but it is almost certainly one of a couple of things, each of which is bullish for Focus:
Lac Knife has a unique graphite deposit (and we've already seen this to be true) that isn't replicated in China. The Chinese, for all of their graphite production, simply don't have enough. This could be due to the fact that the Chinese are regulating the mining industry more stringently and shutting down highly polluting operations, or it could simply mean that the Chinese believe they will need a lot more graphite than they currently produce or believe that they will be able to produce.
The second is the fact that the offtake agreement is with an unnamed counterparty, and that we don't know the specific terms of the agreement. Admittedly this unknown is a risk, and as an outsider I actually see this as arguably the greatest risk that investors face in that it is extremely difficult to pinpoint the downside--both qualitatively and quantitatively--of this unknown aspect of the offtake agreement.
Despite this criticism there is an advantage not yet mentioned, and that is the agreement's implications for project financing. Since Focus needs $170 million, and this is the next phase of the company's progress, this is a pressing issue.
But the company is looking to find ways to monetize the offtake agreement in order to address it. First, many potential financiers will see it as evidence of the quality of Focus' deposit and be more willing to lend based on that (even if they are wrong). Second, the company can monetize the agreement up front through a third party by taking money in exchange for some of the production included in the offtake agreement whereby Focus is taking out a "loan" that isn't like a traditional loan that is higher up on the capital scale than equity.
Financing
Financing is a significant risk but of the large late-stage development projects it seems that Focus is in a strong position. Here are the company's financing options, and keep in mind that it will utilize several, if not all of them in order to raise the $170 million it needs.
Focus has an offtake agreement which it can monetize.
Focus has a 19% stake in Grafoid--a graphene company--that is worth $40 million that Focus' management can use to raise capital.
Focus has access to government-sponsored funds being located in the state of Quebec.
Focus will have access to the debt markets.
Finally there is the possibility of an agreement not unlike a net smelter return royalty that we see in the precious metals markets with companies such as Franco Nevada (NYSE:FNV), although the actual structure of such a deal can take several forms.
So Focus has several financing options and a combination of these options can be used in order to minimize shareholder dilution.
My Final Remarks
There is ultimately no perfect graphite mine or company. Each of them has its issues. But it seems that Focus has distinguished itself from the pack in several respects.
First, its Lac Knife project has incredibly low production costs making it economical in many market environments. While its graphite may not be the most valuable on a per-tonne basis it is the most valuable relative to production costs.
Second, it has a management team that makes sense, and if you look at the management teams of its competitors by comparison you'll see a big difference. Focus is headed by a mining engineer who has built a graphite mine in the past. Looking through the resumes of Focus' competitors I see nobody else with that experience, and with all due respect to Northern Graphite, its management looks like that of a gold mining company.
Third, Focus is ahead of its peers in terms of its development. It has a feasibility study that it is working with to develop a mine. While Northern Graphite has a feasibility study its management went on to develop a PEA after the fact in order to show the economic benefits of a larger mine, and this effectively negates the feasibility study. Mason Graphite is currently at the level of a PEA and it won't have its feasibility study out until the end of the year,or more realistically in the first few months of next year.
Fourth, Focus has financing options that its peers don't have. Yes, it is going to dilute shareholders, and it will assume some debt, but as we saw above the company is exploring unorthodox financing methods that could minimize the impact of dilution, which is a primary goal of a mining company at this stage of the game.
That isn't to say that Focus is an ideal company in the space, as it still has its issues. Financing in this awful environment for mining companies looking to raise capital is the most immediate issue, and I think some investors are waiting on the sidelines for this issue to be resolved. As somebody who has made money in companies having waited for financing to be finalized I can sympathize, as I don't like making investments based on a possible scenario unless the upside potential is enormous (and even then I feel I am speculating).
There is also the issue of the offtake agreement, which remains shrouded in secrecy. I don't like secrecy, but it is unavoidable in the graphite space.
Finally there is the company's immediate financial situation: it needs to raise money, and this probably means shareholder dilution near-term.
But given these points Focus probably has more upside potential and the least amount of downside risk of the Canadian late stage flake graphite companies, and of the "big three" I think it is the horse to bet on. This is a conclusion I arrived at before and after communicating with board members from each company.
My conversation with Don Baxter last week, while far from conclusive, reinforced my conviction in this viewpoint.
