Editor's notes: URRE's recent run-up has left it drastically overvalued and EFRFF.PK accordingly undervalued. A former hedge fund analyst who called OCLS's decline likes the combination as the market looks closer.
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Disclosure: I am short URRE. (More...)
EFRFF Should be Trading at Conservatively 10x the Valuation of URRE
As an analyst, I will admit to having a short bias by nature in the current market. This is mainly a function of the significant run-up in the overall equity market recently, and my thinking that a market correction may be in store in the near future. That being said, I know it is a much more difficult, and oftentimes futile, effort to try and time the overall market than it is to perform the diligent fundamental analysis required to find the best companies to both invest in and to bet against. As a result, I am always scanning for what seem to be the most primed stocks both to outperform and underperform in a given sector, looking to put on both a long and short trade at the same time in the same sector. A "pair trade" allows an investor to hedge out some market risk while also allowing for the potential of outsized gains by investing with the best and betting against the worst. Some of the largest and most sophisticated investment funds, including the largest hedge fund in the world at Bridgewater Associates, have been known to use pair trades often.
I found what looks to be a perfect setup for a pair trade with the recent run-up in the share prices of several uranium stocks. Not every stock in the sector enjoyed this run-up, including what I believe to be the strongest fundamental company in the uranium sector from a valuation perspective. This is a big positive in terms of timing an investment for the long side. I will get back to this company in a moment.
Unsubstantiated, Other-worldly Stock Price Takeoff in Two Particular Uranium Stocks
The shareholders of two uranium stocks in particular enjoyed quite spectacular elevator rides up in recent weeks: USEC Inc. (USU) has gone from $2.96 on July 8th to closing at $29.02 yesterday, rising almost 900% in just three weeks. Fellow Seeking Alpha author J Mintzmyer just put out a piece yesterday on why he thinks investors should stay away from USEC at the current price.
I had looked at USU before this article, and now, even after having read it, there is one uranium company that stands out to me as a significantly better short opportunity: Uranium Resources (URRE). There are several outside factors in play that caused an unjustified double in share price over just a one week period for URRE. In some ways, URRE reminds me of another company, Oculus (OCLS), that I covered thoroughly here and here on Seeking Alpha and recommended readers to short the stock when the share price was $6. Just as fast as Oculus had risen to $6, it came back to its current share price of $2.76. I expect a similar fate for URRE once investors realize this is not the stock to be holding to get the leveraged benefit of an upside turn in the uranium market.
As previously mentioned, there is one uranium company that I have found stands particularly poised to benefit from what seems to be a consensus among analysts will be a near-term significant rise in uranium spot prices. This rise in uranium spot prices will be a product of good old-fashioned supply and demand economics. I like when investment theses can be spelled out almost as simply as these three charts help show:
Here are two charts showing the increasing demand and resulting shortage of supply in the overall uranium market:
(click to enlarge)
(click to enlarge)
Now here is a Uranium Mine Production Cost Curve put together on 2010 data from the World Nuclear Association suggesting US$40/lb is a marginal price:
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The World Nuclear Association also notes at the bottom of this chart that "the cost curve may rise steeply at higher uranium requirements." It is pretty clear from the two charts above it that the uranium requirements have already risen significantly since 2010 and are set to continue to rise even more significantly. Production will not be able to keep up with supply. The U.S. alone consumes 55 million pounds of uranium each year while producing just 5 million pounds. The company I referenced earlier that I believe to be the long in the uranium sector is responsible for 25-30% of U.S. production while having the only operating conventional uranium mill in the U.S. This company is Energy Fuels (EFRFF.PK).
Here is the chart of Energy Fuels, where you can see the price run-up prior to Fukushima in 2011 when uranium spot prices went from $40 to $70:
(click to enlarge)
Here is the uranium spot price chart showing the price run-up from $40 to $70 prior to Fukushima:
(click to enlarge)
History Repeats Itself; Smart Money Again Backing Energy Fuels
Another key thing to note regarding the 10x jump in Energy Fuels stock price shown above, in addition to the rise in uranium spot prices during the same time frame, was the smart money that invested in Energy Fuels at $0.16/share in 2010 and experienced the 10 bagger potential here firsthand. Dundee Resources acquired a 19.8% ownership interest in Energy Fuels on July 7, 2010 at $0.16 per common share, right before the stock rose to $1.40 a share. Dundee Resources is a renowned smart-money investment fund in the resource space. Ned Goodman, the CEO of Dundee, and his firm have gotten so behind Energy Fuels that his son Mark Goodman joined the board. A top investment banker in the uranium space, Graham Moylan from Goodman's own Dundee, joined the company as CFO as well. This speaks volumes about Dundee's belief in and commitment to Energy Fuels.
More importantly for us as investors today, Energy Fuels' stock is back to $0.18 per share and Dundee just invested again at $0.14 per share last month. History repeats itself and smart money gets into the beaten down sectors ahead of the curve. Now is the time to get in alongside them and ride the wave again.
This table that Dundee Securities put together is an eye-opener as well in regards to the current severe mispricing of Energy Fuels' stock:
Further Analysis and Breakdown Between URRE and EFRFF
This past week URRE was up 112% vs 6% for EFRFF in the same time period. URRE's share price performance was likely primarily a result of the Japanese upper house election results last Sunday, which many believe paves the way for the historically pro-nuclear LDP party to re-start the vast majority of Japan's 50 nuclear reactors. These reactors have been idle since the March 2011 Fukushima incident. The re-start of Japan's reactor fleet could have an even further significant impact on near-term uranium demand and uranium prices.
The outlook for uranium prices is already very bright given the robust growth projected in nuclear power worldwide, but the re-start of nuclear reactors in Japan could be an important near-term catalyst. The uranium spot price has fallen from $73 per lb. pre-Fukushima to its current level of $34.50 per lb. The U.S. is the largest nuclear power market in the world, but is heavily reliant on imported uranium for ~90% of its supply requirements. The Russia-U.S. HEU agreement, which currently supplies the U.S. with ~50% of its imported uranium, is set to terminate in November 2013. As such, many market observers, including myself, believe that it is an ideal time to look at U.S. uranium producers.
A number of investors last week went to URRE as a means to get exposure to a brighter outlook for uranium prices. Below are eight reasons why I believe investors looking for exposure to a strengthening uranium market should be buying Energy Fuels and Shorting Uranium Resources:
1. Bona Fide Uranium Production
EFRFF is a substantial U.S.-based uranium producer, the second largest in the country with guidance of 1.175m lbs of uranium production for the current fiscal year. URRE will have no uranium production in the current fiscal year. URRE will most likely have minimal (50,000-100,000 oz) to no production next year either.
2. Control of the Only Conventional Uranium Mill
EFRFF owns the only licensed, operating conventional uranium mill in the U.S., the White Mesa Mill in Blanding, Utah. It is a very costly and time consuming process to permit and build a new uranium mill in this country, creating a very significant barrier to entry in the U.S. market (currently the largest nuclear power market in the world). URRE does not have a conventional mill and therefore its conventional uranium resources are "stranded" from a production perspective, unless it can actually permit and build a new mill or negotiate access to White Mesa from EFRFF (for example through toll milling).
3. Scalability
EFRFF has a truly scalable production base that can increase as uranium prices increase through its standby mines, other development projects as well as toll milling opportunities. URRE's potential production from its ISR projects is comparatively smaller with less scale.
4. Quality Uranium Sales Contracts with Utilities
EFRFF will deliver ~1 million lbs of uranium in its current fiscal year pursuant to contracts with three different utilities at a realized price of $56 per lb, a 60%+ premium to the current spot price. A key consideration for utilities when entering into long-term uranium supply contracts is security of supply. URRE has two contracts with foreign trading houses that have realized prices based on discounts to either the quoted uranium spot or long-term prices.
5. Analyst Coverage and Target Prices
According to Bloomberg, EFRFF has four covering analysts with an average target price of $0.3775, a 102% premium to yesterday's closing price. URRE only has coverage from one analyst with a price target of $3.90, a discount of 27% to yesterday's closing price.
6. Acquisition and Growth
EFRFF is growing. EFRFF is in the process of a major acquisition of Strathmore Minerals (STM-T, STHJF-OTCQX) which presents numerous operational synergies and greatly enhances EFRFF's production scalability. URRE recently announced significant cost-cutting efforts and in its most recent 10-Q indicated that it will likely need to issue equity pursuant to an ATM share offering program over the next 12 months to meet its funding requirements. This means shareholders are facing likely large dilution in the near-term.
7. Key Strategic Partner
KEPCO is Energy Fuels' (and Strathmore's) largest shareholder and is supporting Energy Fuels' acquisition of Strathmore (as announced last week). KEPCO invested $8 million in Strathmore in 2012 to develop Strathmore's Gas Hills project in Wyoming. There could be significant synergies between Strathmore`s Gas Hills project and its Sheep Mountain project in Wyoming which are only 28 miles apart. In 2012, Energy Fuels released a Pre-Feasibility Study on Sheep Mountain which described attractive project economics under three separate production scenarios, with the preferred scenario having a Net Present Value of $201 million (using a 7% discount rate and $65/lb. uranium price) and a production rate of up to 1.5 million lbs. per year and an initial mine life of 15 years.
Conclusion
M&A activity has picked up in the uranium market, which can typically signal a market bottom as major players eye value in the space. I believe Energy Fuels offers the best combination of limited downside in current market conditions and leveraged upside to rising prices in the Uranium spot price market. On the other end of the spectrum, Uranium Resources has significant downside risk, particularly after its share price just doubled in a week and there is the near-term likelihood of the company accessing its available $9 million in share value under ATM. Its future looks far bleaker as well in terms of any potential upside with no current or near-term production.
Upon completion of the Strathmore acquisition, Energy Fuels will have a fully diluted market cap of $180 million at its current share price. Uranium Resources currently supports a $110 million market cap. Being conservative, based upon Energy Fuels' current production of ~1 million pounds of uranium per year and an optimistic projection for Uranium Resources of 100,000 pounds of uranium next year, in addition to everything else discussed in this article, Energy Fuels should be trading at 10x the valuation of Uranium Resources.
I believe a pair trade of going long Energy Fuels and short Uranium Resources is the ideal way to play the uranium sector.
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