Uranium outlook and Paladin Energy risk profile

Ticker: PDN (TSX)

Current Price: $0.92 CAD

Our Entry Price: $0.88 CAD

52 Week: High $1.52 Low: $0.75c

Recommendation: SPECULATIVE BUY (VERY HIGH RISK)

PALADIN ENERGY Ltd is a uranium production company with two operating mines in Africa and has a strategy to become a major uranium mining powerhouse.

The Langer Heinrich Mine (“LHM”) in Namibia is Paladin’s flagship project. Having reached its initial production of 2.7Mlb U3O8 per annum in 2008, the mine completed its Stage 2 ramp-up to 3.7Mlb per annum in the 2010 financial year. Subsequently, the Company has completed a Stage 3 expansion and is now producing at a 5.2Mlb per annum rate.

The Kayelekera Mine (“KM”) in Malawi, the Company’s second mine, provides an excellent follow-up to Langer Heinrich. A Development Agreement with the Government of Malawi was executed in February 2007, which provides fiscal stability for the project for ten years. KM was officially opened in April 2009 and is now operating at design production rates of 3.3Mlb U3O8. Project life is expected to run for at least an additional 8 years with exploration underway to identify feedstock’s to extend the current project life.

The company also has significant exploration and development projects in Australia and Canada.

Key Risks / Issues

• Paladin operates large low grade open pit uranium mines which have higher cash costs. In a weak uranium pricing environment, the mines struggle to operate profitability. This is partially offset by a generally positive outlook for future uranium prices
• Paladin’s cashflow generating asset operates in higher-risk jurisdictions including Malawi and Namibia in Africa.
• Paladin carries a significant amount of debt, but the company has demonstrated the ability to undertake strategic initiatives (including prepayments for future uranium deliveries) to help lower debt levels. Further, the debt largely consists of convertible bonds which don’t require annual principal repayments. This provides the company with additional cashflow flexibility and partially mitigates the risk of default.
• Company is undergoing strategic initiatives, most likely a minority interest sale in its flagship LHM mine, which will help the market re-value the assets. The transaction is expected to lower debt levels and will likely propel the stock upwards upon announcement of the deal. The results are expected at the end of August.
• The company remains highly levered to the uranium price which has been soft in recent months but the general outlook is positive.
• Paladin’s shares are currently trading near multi-year lows, but it is cheap for a reason – namely due to high financial and operational risk.
• A significant portion of Paladin’s assets are ‘tied up’ in exploration and, due to current market conditions and lower risk-appetites, these assets will unlikely be valued by the market for some time.

Industry Risk: Medium

Spot Prices of Uranium

Source: Uranium Energy Corp, Ux Consulting

• From 2004 to 2008, uranium prices experienced rapid growth. Prices started at approximately $20/lb and bolted to almost $140/lb in 2007.
• The large drive up over this period is largely due to the expectation of a ‘nuclear renaissance’ and public acceptance of nuclear as a safe and reliable way to generate power. Nuclear renaissance is a term that was developed to characterize the dominate force nuclear would play in the global energy matrix, as evidenced by the rapid build out of reactors for the 30 years prior.
• The dramatic growth of nuclear energy capacity predominantly has to do with several factors including environmental concerns (Nuclear energy boast little to no carbon emissions) and provides base-load power.
• While nuclear plants require a high amount of upfront capital costs, given the long useful life of plants nuclear power is often noted as the cheapest source of energy on a per-MegaWatt basis.
• The events at Fukushima have kept a ‘lid’ on the price of uranium from its pre-fukushima price of $70/lb.
•  At the date of writing, prices are just under $40/lb.  As a result, these low prices have caused many uranium producers to throttle back production and shelf growth projects – damaging future supply outlook.

“The fall in uranium prices following Fukushima and the ever increasing capex and operating costs in the industry has stifled investment in new uranium projects and has adversely affected investor sentiment at the equity level. Explorers are in survival mode and cutting their spending to bare minimum, developers cannot raise the required capital for new projects and producers are deferring or cancelling growth projects while facing declining production from existing aging projects.”

– Paladin Energy 2012 Annual Report

Demand Outlook

• While some countries, such as Germany, have committed to reducing dependency on uranium (8 of its 17 plants are currently shut down in response to Fukushima) the demand for uranium globally remains strong.
• As at July 2013, there are 432 plants in operating condition worldwide. The majority of plants are located in the United States (100) with France firmly in second place (58), Japan follows (59) and behind Russia (33) we have South Korea (24),  India (20) and China (17).
• The plants online today require approximately 173Mlbs of uranium to operate. By contrast only approx. 130 Mlbs are supplied from uranium mines (a pretty large supply gap shortage of 50Mlb annually) with the balance being made up of a Russian secondary supply program that is about to end (discussed later)
• What is more significant is the growth story, which is being fueled by emerging markets. As at May, 2013, 65 plants are under construction globally. Another 167 plants are planned for construction. An eye-pooping 317 plants are proposed. Notably, these amounts are higher than pre-fukushima levels.
• China has committed to quadrupling its nuclear capacity by 2020. The country currently has 29 reactors under construction. Perhaps more fascinating is that  China plans to ramp up Generation to 400GW by 2050. The annual uranium requirements for this amount of electricity would be approx 195 Mlbs according to Casey Research – 150% of today’s global mine production.

Fukushima

• While Japan had suspended the operations of all but two nuclear power plants after Fukushima, the reality is that the country needs to import almost all of its energy requirements – and it is no secret that the economy of Japan is struggling.
• After the pro-nuclear Liberal Democratic Party won the December 2012 elections, in the interests of kick-starting the economy, the new government has already reversed the previous government’s decision to phase out nuclear power.
• After revised safety standards were issued by the Nuclear Regulation Authority in Japan (a new body set up by the government to regulate the restart of plants in japan), companies have been invited to apply for nuclear power restarts. It is unlikely the government would go through the expense of creating new standards and a new regulatory body if there was no intent to restart reactor.
• Further, at the time of writing, Nuclear Fuels News reported that state-run Japanese firm has entered into a uranium development and exploration agreement with a Uzebekistan state-owned national firm to carry out joint exploration for uranium.
• It is very unlikely that this would be an undertaking Japan would commit to, especially at a state run firm, if the country was not very interested in securing supply to continue its nuclear power generation for years to come.
• It’s important to note that while Fukushima had a huge impact on the spot price (and shares of uranium producers), the number of reactors under construction, planned or proposed have INCREASED pre and post the incident.

• It is largely expected that restarts of Japanese reactors will act as a significant upwards catalyst for the uranium spot price.

Supply

Future Supply and Demand, Uranium Energy Corporate Presentation, March 2013

• Not only does the demand-side look compelling, but the supply side appears to be setting up a perfect storm for uranium prices.
• According to the World Nuclear Association, total consumption of uranium was 176.7 million pounds in 2011. Meanwhile, total uranium output was 135 million pounds for the year.
• The recurring annual deficit has traditionally been made whole by the Russian HEU agreement (dismantling nuclear warheads and selling the uranium to the market). Nonetheless, this agreement is set to expire at the end of this year. This supply source is going to vanish from the market entirely.
• Further, almost all uranium companies have put expansion projects on hold (for example BHP’s massive Olympic Dam project) due to low prices. These producers have stated it will likely require prices beyond $70-80/lb before these projects become economical to bring online.
• In-fact, the threat of supply shortages was put in the forefront of market participant’s minds in August 2012 when Paladin Energy announced that it had signed a milestone 6 year off-take agreement with a major utility. The agreement bonded to deliver a total of 13.73Mlb of U3O8 from 2019 to 2024 but incorporating a prepayment of $200 Million as its key feature. The utility was willing to pay 7 years upfront to secure supply.
• Putting the supply-demand picture together, we have a serious supply demand gap. This will prove very positive for ALL global uranium producers are bargaining power will shift drastically to the producers.

Supplier Make-Up & Lead time to new Supply

• In normal markets, an increase in demand would normally be met with an increase of supply. Theoretically, this would limit any serious upwards price movements from scarcity of product. Nonetheless, there are several key factors unique to uranium mining that must be discussed.
  • Long lead time of new projects – The average construction cycle for a uranium mine is typically 6-9 years. This is due to the significant steps of permitting/licensing, financing, construction, development, production and eventual ramp up. When prices move upwards to make new projects economical, it is highly likely that it will take several years for new projects to begin supplying to the market. It is likely shortages will persist for some time.
  • Limited amount of suppliers – There are only 4 notable pure-play uranium producers: ARMZ / KazatomProm (Russian Government Owned), Areva, Navoi (Uzbekistan Government Owned) Cameco and Paladin. These producers control over 64% of global supply. The remainder of supply is made from global diversified uranium houses such as BHP and Rio Tinto with no significant growth appetite for uranium.  These producers have essentially colluded and told the market they will not increase production until prices rise to between $70-80/lb.

Sector Consolidation

• After engaging in a bidding war for Hathor Exploration with BHP, in 2011 Cameco bought the Yeelirrie uranium project in Western Australia for $430-million (U.S.)
• In early 2013, Russia’s ARMZ purchased Uranium One for $1.3B.  Further, also in early 2013, Dension Mines released intention to buy Fission Energy.
• More recently, in May 2013 Energy Fuels moved to acquire Strathmore Minerals.
• Typically, when you see increased M&A it is a signal of the bottom of the market is near as the ‘smart money’ moves to buy distressed assets cheaply.
•  This is a positive sign that demonstrates that we may be about to see a significant rise in uranium prices as the market heals.

Threat of Natural Gas

The abundant supply of natural gas, made accessible via fracking techniques, is the primary threat for future uranium growth.  Nonetheless, it is important to note this is partially offset by several factors

• Given the importance of a secure a low cost energy supply for a country, every country wishes to develop a balanced energy matrix of natural gas, renewable, coal, and nuclear. This is to diversify and ensure risks are mitigated.
• While natural gas is ‘cleaner’ than coal, nuclear remains the cleanest form of energy other than renewable projects such as wind, geothermal and solar.
• Uranium reactors already built, partially the over 100 in the United States, are unlikely to be shut down and will remain ongoing in the future due to their high upfront costs and significant remaining useful lives.

Thorium

• There has also been some chatter about the use of Thorium instead of Uranium in thermal reactors. As Thorium is more abundant in nature and noted to be safer and cleaner form than U308, this technology advancement could be a headwind against uranium prices.
• While thorium has been tested in some of the reactors known as CANDU reactors, to date, thorium has not proven itself to be commercially viable. Given the threat of substitution, this area will need to be closely monitored for anyone inventing in the uranium space.

Conclusion

Compelling supply & demand fundamentals, upcoming supply gap, and control of market by producers significantly offset industry risk factors including public perception and possible substitution threats. Nonetheless, monitoring of the business environment will be important for any investor in the uranium space to ensure they are not exposed to un-due risks.

Business Risk: HIGH

High Risk Jurisdictions

• Paladin’s main operating assets are located in Malawi and Namibia, Africa. Lengthy discussion is not necessary to highlight the nature of the risk the company is taking on by operating in these jurisdictions. Risks related to operating in higher risk jurisdictions included the risks of protests, military coups, and government nationalization of natural resources.

                                                                                                                            –  Paladin’s LHM Mine in Namibia, Africa

• Nonetheless, Paladin has attempted to offset these business risks by building strong relationships with governments (The Malawi government owns 15% of KM) and the company attempts to have a strong approach to Corporate Social Responsibility.
• The company focuses on local youth development, education and other community needs (ie upgrading highways and scholarship programs) in its CSR efforts. This is in addition to the employment opportunities the mines bring to the local economy.
• It should be noted that, given Paladin’s aggressive cost curtailment campaign (discussed later), that the company may throttle the quality CSR initiatives in an effort to control costs.
• While controlling costs in a lower priced uranium environment is key to Paladin’s ability to continue operating as a going concern, lowering CSR spend could risk straining relationships in the areas that Paladin operates.
• Paladin’s recent 130 layoffs at its KM mine and evidence of recent protests at LHM for working conditions (also likely pressured due to the cost cutting). This could put significant strain on relationships and have material adverse effects on the company.  News-flow related to these areas will need to be monitored carefully.

Management Compensation

• To put things lightly, management is overpaid. Further, most of the compensation for management appears to be short term in nature with little salary ‘at risk’. This could indicate managements focus on its own best interests rather than the interests of all shareholders.
• For the year ended June 2012, the CEO’s base salary compensation was approx $1.8MM ($USD), by contrast the CEO of Uranium One (a much larger company by market cap and production) total cash base awards were $1.1MM (including bonus) for the same year and had a greater balance between cash base awards and granting stock options to ensure align management interests with shareholders.
• Further, the CEO’s base salary is actually suppose to be $2MM (AUD) but was ‘voluntary reduced’ by 25% to $1.5MM ($AUD) annually.
• While it is nice to see management has made the gesture of reducing pay by 25%, there is a clear issue with overpaid management given the size of the company and Paladin’s financial performance.
• As a side note, the CEO ‘cashed out’ vacation allowance in 2012 brining total cash compensation over $3MM. In a company that is highly levered and looking to raise cash, one has to question the appropriateness of the timing of this payout.
• Given the high amount of salary, especially at the base salary level, there is risk that management may not have shareholder’s interests at heart (and are primarily concerned with collecting their salary). This is partially offset by the CEO’s shareholdings (over $21MM shares or approx 2.5% of the company).

Concentrated Production & Cashflow

• The company has only two operating mines which constitute 100% of the company’s revenue.  Given this lack of diversification, in the event that unforeseen issues, government expropriations, or disasters occur at either one of the mines, the profitability of the group would be materially impacted.
• This risk is elevated in the uranium industry in particular, given the ‘social issues’ surrounding uranium mining in combination with environmental hazards and high safety standards. When so much could go wrong, the chances of an unforeseen event impacting the company rise quickly.

• Further, the majority of the company’s production comes from the LHM mine. As a result, the company places the majority of success on the successful operations of LHM.
• While, as a result, the company becomes disproportionately exposed to the risks in Namibia and LHM, LHM is much more profitable than KM and it is encouraging to see higher production levels from the more profitable mine. This is discussed at length in the financial risk section.

Small amount of significant players in the Industry

• After the recent privatization of Uranium One, there are few alternatives available for investors that want exposure to uranium producers. In the public realm, the viable mid-cap and large-cap options producing assets appear to be only Cameco and Paladin.
• Given the little selection, shares of the companies will be tightly held, especially as the market recovers. More money moving into the sector could trigger higher premiums to be priced into the shares. This would be positive for Paladin shareholders.

Negative Press

• There has been some recent press about disgruntlement at the company’s flagship Langer Heinrich mine over pay and working conditions. According to the Namibian, 300 employees protested and picketed outside the mine.
• Key complaints include evidence of no annual increments, unfair performance bonuses, nepotism and corruption.
• While it is likely that the root cause of the complaints are driver by the aggressive cost-curtailment campaign which is discussed at length in the financial risk section, careful monitoring of the situation will be necessary.
• If Paladin cannot keep relationships in good standing with its workforce, the company could face significant issues such as pro-longed strikes, damages/vandalism to the mine and government intervention. All of this will need to be monitored closely.

Reserves, Resources & Grade

• As noted before, Paladin operates large but low grade mines.
• As a result, the company must apply the so-called open-pit or underground mining methods which are typically more expensive (and damaging to the environment) than the alternative in-situ leach method. It is largely due to this mining method that Paladin’s cash costs are higher than its peers.
• While the company has high cost projects, the resources at each project are quite large and can generate significant mine lives.
• For example, at current production levels, the flagship LHM mine is expected to last in excess of 20 years.
• While Measured & Indicated resources for producing assets are noted to be 178Mlbs, Paladin’s notes that total resources (reserves and resources) attributable to the parent company (including producing and development assets) are 559.2Mlbs.
• This figure will also grow over time as the company develops and ‘proves up’ its exploration & development assets, when the market begins to value exploration assets again, it is likely Paladin will benefit due to its significant development-project base.

Strategic Initiatives

• Perhaps the biggest catalyst on the horizon for the stock is the pre-announced strategic initiative that the company is exploring to ‘unlock value’ from Paladin’s significant assets.
• According to the company, two parties were selected to enter the final stage and a final bid was selected for closing at the end of June 2013.
• At the last moment, the other party came back with a revised offer and the Paladin stated “it is in the best interest of shareholders to review the bid” and has extended the expected results announcement from the strategic initiative to be August 2013.
• It is encouraging to see high interest in the assets and will ensure the company gets best price for its assets.
• After reviewing the last few conference calls, it has become apparent to those ‘reading between the lines’ that the initiative constitutes selling down a minority interest (likely 10-20%) in its LHM mine in order to reduce debt levels.
• Several analysts believe a 20% stake could be worth north of $200MM (implying a $1B valuation for LHM alone). If these estimates prove correct, it would mean the market is significantly undervaluing the company’s shares – this is discussed at length later in this report.
• When the deal is closed, it will likely accelerate the stock price as concerns over Paladin’s leverage will be reduced and the market will have a fresh valuation of the LHM mine.

Exploration Upside

While the market likely not valuing any of Paladin’s exploration assets, the following upcoming news items could end up being positive for the company:

• The Auror (Michelin Uranium Project, Canada) has recently completed its winter infill drilling program. An Updated mineral resource estimate is planned for any day now.
• The Manyingee Project in Australia is expected to update a mineral resource any day now. The Manyingee projected is expected to be a lower cost in-situ recovery operation.

Conclusion

Given the operating jurisdiction of Paladin’s key assets, lack of diversification of cashflow sources, and recent negative press which could be a signal of further problems, business risk is deemed HIGH.

Financial Risk: VERY HIGH

Income Statement Highlights     

• As per the table above, it is evident that the company’s income statement looks quite poor.
• This is largely due to continued low uranium prices, large asset impairments (caused by the same), and higher costs that peers. As a result, paladin has had difficulty posting sustainable profits.
• Losses appear to be accelerating – the group posted an $88MM loss in F2011 which grew to $200MM in F2012, on a YTD basis losses attributable to the parent are $247.3MM.
• Nonetheless, as discussed below, operations appear to be improving, and the large losses appear to be caused by either non-cash or one-time items.
• As a high cost producer, Paladin remains the most levered to a higher uranium price environment.

Production & Revenue

• The company has worked extensively over the past few years to ramp-up its operations at its flagship LHM mine as well as KM.

Source: Paladin Corporate Presentation

• The table outlines the output from Paladin’s operating mine, with the LHM coded in Blue and KM in grey. Though a series of ramp-ups, particularly 3 stages at the LHM mine, the company has finally reached name-plate capacity at both mines and is well on track to produce 8M-8.5Mlb of uranium this year (on a YTD basis for the 3rd Quarter ended March 31, 2013 the company has produced 6.112Mlbs).
• As noted before, based on a rolling 4 quarter calculation, the approximately 64% of the company’s production comes from the more profitable LHM mine.
• While, at current spot prices ($40/lb), annual production of 8Mlb should translate to approx $320MM in revenue per year, the company has been challenged with higher production costs (due to the nature of lower grade large mines operating via open-pit) and as a result, the increasing production levels have not translated into increasing profits.
• Nonetheless, it is important to note that the hard work at Paladin has been completed. The production levels have reached steady state and the projects are essentially ‘de-risked’. As a result, when uranium prices recover, which we expect they will, Paladin will benefit greatly from higher selling prices given its impressive production levels.
• While Paladin has the potential to expand production upwards of 10Mlb, the company has said they will only consider increasing production if uranium spot prices move towards $80/lb (At $80lb, Paladin’s existing production should be churning out healthy cashflow).

• As per the chart above, Paladin, in general, has benefited from increasing production year over year. Although, this has only translated into slightly higher revenue due to the sluggish uranium prices.
• The average realized price by Paladin is not necessarily the current-market rates. Paladin has a few mid-to-long term delivery contracts at have floor prices higher than current market prices ($70/lb and $60/lb).  It is expected these contracts will run off over the next few periods and Paladin will be more exposed to the spot price. This is a negative given that spot prices are lower than the fixed-price contracts.
• The spot prices have weakened considerably and are currently slightly below $40/lb. A $10 drop in the price of uranium translates, based on current production levels, to revenue losses of approx of $80MM. This will feed directly to the bottom line.
• Fortunately, Paladin has embarked on a cost-cutting campaign which should help limit the amount of impact the lower prices will have on Paladin’s bottom-line in the future.
• Given the above, it is evident that Paladin remains extremely exposed to both upside and downside pressures in uranium prices.

Cash Costs

• Now that the mines are operating at capacity and ramp ups are complete, the company has turned its focus to optimizing efficiency and lower costs. The program is working – costs are falling rapidly.

• As noted above, the cash costs for the LHM mine are significantly lower than the KM mine.
• Infect, due to the lower costs, LHM is able to post profits at current uranium prices – Paladin’s losses are largely stemming from the higher cost KM mine.
• Notwithstanding same, in a lower priced uranium environment, it is comforting to see that management is taking such a laser focus on controlling costs.
• Cash costs from the KM mine have decreased from $52/lb in Q4 2012 to $39.80 in the most recent quarter or 23.5%.
• While the LHM mine has not shown as much improvement, it is already at a lower cost base and generating significant profits for the company ($63MM YTD) which partially offset losses at the KM mine.
• Even though the cost reduction program has been significant, the spot price of uranium still is working against Paladin. Further, the low spot prices are causing the company to recognize impairment on the KM and will continue to do so if prices continue to fall (more on impairment later).
• The Company is targeting a 7.5% reduction in unit cash costs for the remainder of FY2013 at both LHM and KM   a further 7.5% reduction in unit cash costs at LHM and 15% at KK in FY2014. Given Paladin’s success so far, I am confident in the company’s ability to execute on the cost optimization program – although, this much be watched carefully.
• In the event that Paladin cannot cut costs fast enough to keep up with the slippage in uranium prices, there could be a drain on the company’s cash reserves which would limit its ability to continue operating as a going concern.

Impairment Expenses

• A significant portion of the company’s losses to date are due to impairment expenses, which due to their nature, I am not overly concerned with. According to IFRS, a company must essentially ‘mark down’ its assets to the higher of:
  • Value in use – an assessment of discounted cashflow using estimates such as the life of mine, cash costs and the current spot and long term prices of uranium.
  • Fair value less costs to sell.
• It is also important to note, that under IFRS, impairment losses can be reversed (and you can bet Paladin will do so when uranium prices recover) and essentially, at this point, represent an unrealized mark-to-market accounting loss that is a non-cash expense.
• Given same, I am not overly concerned with the impairment expenses. In the adjusted loss section below I have backed out the impairment losses to show what the true income/loss figures of Paladin have been for the past several years.
• Lastly, I note that the company has recognized inventory impairment at the KM mine. Given that inventory is recorded at the lower of cost or net-realizable value, inventory impairment can be a significant warning sign. This is due to the fact it highlights that the cost to produce the inventory is higher than what the company can sell it for.
• Nonetheless, the amounts appear to be nominal (approx $10M per quarter) and are typically reversed in the next period when the company sells the uranium for higher prices than what was used to calculate the net-realizable value.
• Further, as the company works to decrease costs at the KM mine, all else being equal, the quarterly inventory impairment should diminish in value over time (pending uranium prices don’t fall much further).
• On a cumulative basis, the company has taken over $300MM of impairments on KM, which will likely be reversed if we see uranium prices head north of $60-70/lb.

Adjusted Losses & Free Cash Flow

• Given the significance of non-cash impairment expenses, and some other one-time items, it is essential to adjust accounting based income to gain a clearer view of Paladin’s financial activities.

• Adjusted losses are surprisingly well controlled. Paladin posting only $22MM if adjusted losses in F2012 and a small $9MM loss year-to-date.
• While adjusted profits were healthy at $90MM in F2011 (even when production figures were much lower), it is noted that uranium prices were much higher in the period – this is further illustration of Paladin’s leverage to the underlying uranium price.
• I prefer to examine adjusted IFRS-based income that is calculated above to determine the ‘true profitability’ the company is generating for shareholders. Nonetheless, given the fact the company is struggling in a difficult operating environment it is also essential to examine free cash flow to determine if the company has the ability to continue operating for a significant period of time before causing undue strain on its balance sheet.
• As per the chart above, it is quite evident that the company is actively working to manage its free-cashflow (“FCF”)
• While FCF was negative $40MM in F2012, it is positive to date. This is largely due a throttle back in capex (which should be expected given the mines are now fully-ramped up) helped by a reduction in cash costs, higher production figures from the profitable LHM, and partially offset by weaker uranium prices over the period.

Leverage

• One of the key concerns market participants have over Paladin is the amount of debt it carries, which were taken out to build & ramp up its two flagship mines and the finance exploration & acquisitions.
• While debt levels can always pose strain on a company (especially when they have weak or negative FCF), when you pull under the hood, it’s not as bad as it appears.
• Although, it should be noted that the balance sheet slightly understates debt levels as transaction costs are amortized over the life of the debt. This analysis adjusts for transaction costs to capture the ‘true debt outstanding’.

• While debt levels are indeed high ($743MM at the last quarter) the company has made significant stride to reduce levels.
• Namely, a $200MM prepayment was made by a French Utility to make scheduled uranium deliveries over 2019 to 2024 (further demonstrating the fear utilities are having about upcoming supply shortages). Paladin used this prepayment to pay off the remainder of a convertible debt facility.
• It also should be noted that the majority of Paladin’s loans are convertible bonds (for which strike prices are very high – so shareholders likely won’t need to worry about dilution) and, due to the nature of convertibles, are not any large principal payments to be made each year.
• This gives Paladin significant breathing room and significantly mitigates the risks of default. The next tranche of convertible bonds are due in 2015 with another tranche in 2017.
• While the also company has an approximate $150MM in term loans outstanding with monthly principal and interest payments the amounts are nominal (only approx $20MM per quarter).
• These term loans will likely be paid off in full after the announced strategic initiative.
• Given that the 2013 convertible bond is paid off, the next balance-sheet stress window will occur in 2015 when $300MM of the convertibles are due. This will likely be refinanced by Paladin.

Working Capital

• The company has a history of remaining quite liquid. As at the most recent quarter, the company had approx $226MM in working capital, with a current ratio of 3:1. This was boosted significantly by the $200MM prepayment (eliminating the convertible facility which was classified as short term).
• Given the company’s difficult operating environment it will be prudent to closely monitor working capital as there is no evidence the company has a revolving credit facility to draw upon.

Book Value / Market Cap

• As at March 31, 2013 Paladin had 837MM shares outstanding. It is worth noting that this is quite a large amount of shares and the so-called ‘upside’ in the shares is limited due to the large ‘float’.  
• Given that the shares are currently trading below $1.00 (and would not likely meet certain minimum price requirements for either exchange listing of fund holdings) it would not be unreasonable to see the company do a reverse-split. If this event were to materialize, investors should be cautious as reverse splits are typically characterized by subsequent drops in the adjusted share price.
• At $0.90 per share, the company has a market capitalization of $735MM. Nonetheless, the book value of the company’s equity is $915MM. The market appears to be pricing in almost $200MM of ‘hidden’ or future losses on the balance sheet.
• While using book value to approximate market values is not always appropriate, it is interesting to note that the KM assets have already been written down by approx $300MM to their fair values – it is unlikely we could see much more (although, we should see some in Q4 due to prices slipping below $40 recently).
• Further, most market participants are estimating that a 15-20% interest in the LHM mine will generate a $200MM investment – implying that LHM is worth $1B on its own today.
•  It appears the market is only valuing the LHM mine and attributing no value to KM or the other $1B of exploration assets on the balance sheet.  It appears that, at this time, Paladin shares could be extremely undervalued – especially if we were to see a rise in the uranium prices. 

Conclusion & Recommendation

• Paladin Energy is not without its risks and blue-chip CAMECO remains our favoritealternative in the uranium space with its lower costs and diversified asset base.
• Nonetheless, as a higher cost producer, Paladin will likely have more leverage to any underlying increase in uranium prices and shares appear undervalued on several metrics.
• The overhang on the company’s shares (its debt levels) will likely be lightened at the conclusion of its strategic initiatives which the company is confident will be achieved in August.
• At that point, the market will have a more appropriate ‘yard stick’ to value the LHM mine and the shares will likely move upwards on the catalyst. The company continues to cut costs and has executed well on areas that are in their control.
• In the event that the company cannot close its strategic initiative, Paladin’s ability to remain a going concern becomes in doubt. Nonetheless, there appears to be a high amount of interests in the assets and the company has several bidders at the final stages.

Recommend entering Paladin shares on weakness but note the HIGHER RISK of this investment due to elevated financial and operating risk.

Disclaimer: I own equity in Paladin Energy and Cameco which are mentioned in this article. All facts are to be verified by the reader. These are opinions, and not advice. Always do your own due diligence and consult a licensed investment advisor before buying or selling any security. We seek Safe Harbor.