Direct From the Desk: A deep dive into Paladin

In the final instalment of 'Direct from the Desk', Analyst Michael Clark and I take a deep dive into Uranium Company Paladin (PDN). We start by looking at Uranium more broadly, the difficult past and optimistic future for a commodity that will be important in a decarbonized world.

This podcast discusses:

• An overview of the uranium market; pre and post the Fukushima disaster
• Uranium's role in the ESG and decarbonisation thematic
• The dynamics of uranium supply and demand
• Why Paladin is a good pick in the uranium space 
• Other players in the uranium market listed on the ASX

If you missed the previous episodes, you can access them here:

• Episode 1 on Wisr (ASX:WZR)
• Episode 2 on Altium (ASX: ALU) 
• Episode 3 on Austal (ASX:ASB).
• Episode 4 on Oz Minerals (OZL) 
• Episode 5 on Zip Co (ASX: Z1P)

Webinar: Getting your portfolio into shape

Edited Transcript

Hello and welcome to Direct From The Desk, produced by Market Matters, a podcast that takes a deeper dive into a stock, a sector, a theme or an event that we think you should be across. I'm James Gerrish, portfolio manager at Shaw and Partners and the author of online investment site, MarketMatters.com.au. We run real portfolios and we write about our views, experiences and our portfolio decisions. To take a free 14 day trial of Market Matters, visit MarketMatters.com.au. 

Today's podcast is the final podcast in a six-part series, doing a deeper dive into six stocks that we like, we either own or are looking to buy them. Before we crack on today's episode, it will be remiss of me not to remind listeners that any advice provided today is of a general nature only.

I've been looking forward to this chat on a polarising stock in a pretty polarising sector. The stock's Paladin (PDN) and the sector of course, is uranium. So far in this series, we've covered consumer finance business Wisr (WZR) in episode one, software business Altium (ALU) in episode two, shipbuilder Austal (ASB) in episode three, copper company Oz Minerals (OZL) in episode four and buy now pay later juggernaut Zip Co (Z1P) in episode five. To join me this week to discuss uranium and Paladin specifically as analysts at Shaw and Partners, Michael Clark. And Clarky, thanks for joining me.

Michael Clark:

Thanks, James, for having me.

James Gerrish:

Now, I want to start with the bigger picture this week, looking at the commodity ahead of the company. I think it's probably the place to start when we're thinking about uranium. Can you give listeners a brief history of what's transpired in the uranium market pre and post those devastating events that we saw in Fukushima in 2011?

Michael Clark:

Yeah. Thanks, James, for the introduction. Uranium is a mined heavy metal, which is predominantly used as a feedstock for the nuclear power industry. Nuclear power forms about 10% of the world's electricity generation. The first commercial nuclear power stations, they started operating in the 1950s and the globe reached about 435 nuclear reactors in the mid 90's. Outputs increased marginally since then but as I said, it's roughly 10% of the world's electricity generation or 2,700 terawatt-hours converting it into energy units of nuclear generation. The leading producers are the US, France and China. And they combine for 60% of global demand.

As you said, in March, 2011, the sector was going along rosely and then there was the Tohoku earthquake, the great Tohoku earthquake took place and there was a subsequent 15-metre tsunami. And so that was about 10 years ago and the natural disaster led to an accident at the Fukushima Daiichi nuclear power plant. There've been no deaths or cases of radiation sickness from the nuclear accident but there are over a hundred thousand people that were evacuated from their homes as a preventative measure.

For me, the reason for this nuclear disaster, it boiled down a little bit more to poor engineering design and systems as the key cause of the issues there. There was a lack of electrical power for the cooling systems at this plant and that caused a hydrogen pressure build up in the reactor. And it led to a leak and a subsequent explosion. Now, just some quick observations. Their backup diesel system was located on the ground below sea level and you've just had a tsunami going on, so that wasn't great and subsequently shut down. You could've maybe argued that they could have vented the hydrogen to the atmosphere rather than let the pressure build up and have an explosion. There are all learnings and the sector is improving technologically but that caused a big down cycle, that event in the sector. And you have to get all these 1%'ers right. The past 10 years has been a period of consolidation and lack of investment in the sector and finds us to where we are now.

James Gerrish:

Yeah, so that obviously ... Obviously, it took a massive hit. It wasn't a terminal hit but it's obviously been a hit that's seen as you made mention of, prompted or no real investment or major investment developing new capacity. Where are we now in terms of ... 10 years on, where are we now in that cycle? Are we moving forward from that incident or is it still casting a major shadow over the sector?

Michael Clark:

Well, I think there's still ... There's plenty of caution in the sector in terms of operating nuclear power plants but there's no question that nuclear power is recognised as a source of de-carbonization. We hosted a call with Cameco, which is one of the world's top two uranium suppliers, a couple of months ago. And they said in 2011 after Fukushima, there was plenty of supply coming on, uranium supply that is, but demand was heavily impacted by the suspension of reactors and phase-outs all around the world.

Today, they see that demand firming and the risk to the supply is increasing. The lack of investment, the 10-year cyclical downturn, the time has come for re-investment and uranium markets are starting to respond. We think that presents a really appealing opportunity for investors. The turning moment for me on environmental social governance factors for companies and de-carbonization ... I was on a Santos field trip with one of the senior figures in Australian equity markets. And I sat next to him on a plane for a couple of hours and we were chatting about the ESG pressure from investors and de-carbonization. He said in 2018, he spent five to 10% of his time on ESG. And by the end of 2019, he was spending 40%. Now, I know post COVID, it would probably be even more than that. Investors are definitely responding to the whole de-carbonization thematic and uranium is front and centre of that.

James Gerrish:

That's a really interesting stat around ESG. Obviously, to buy uranium stock, we've got to believe that uranium plays a key part in that, as you made mention, of the de-carbonization and electrification of energy systems. You alluded to the fact that uranium is a major player in that, is it clear that it is going to play a role there, given the security, given the environmental issues and the safety issues that are overhanging the uranium space?

Michael Clark:

I think any credible de-carbonization scenario has got nuclear power uranium demand increasing by a factor of two, between now and 2050. And so you see that in the international energy agency's net-zero scenario they did a month ago, BP's statistical review, which was in September last year. And in any net-zero scenario, you've got nuclear power doubling and you've seen equity markets respond to that long-term demand outlook increasing over the past six to eight months.

We started covering formerly Paladin in June last year, the stock's up 360% since we started covering it. We did a big initiation report in November last year, the sector is up 170% since then. Equity markets and investors are really recognising the long-term thematic. In terms of balancing the safety element, it's ongoing technological improvements in terms of handling the dangerous material. And when things go wrong, engineering measures in place and then also storing the spent fuel once you're at the end of the lifecycle of the fuel. I think storing underground in tectonically stable locations, there's been a lot of inroads there. And I think that it's a complete 180 on five years ago, where nuclear power was considered evil type thing and it's now really considered an element of the de-carbonization solution and the risks can be mitigated in terms of handling and storage of nuclear materials.

James Gerrish:

All right. You made mention that uranium is going to be a key party in that de-carbonization story. How does Australia fit into it, into the whole equation around uranium moving forward?

Michael Clark:

Yeah. We're a pretty stable political environment. And as we said, uranium is highly sensitive to government policy settings. And it's a too politically sensitive commodity because you can enrich it to build dangerous weapons. And there is an imbalance between the supply and demand centres. 80% of supply comes from countries that consume little or no uranium and 90% of consumption occurs in countries that have no production.

Australia is one of those producers that doesn't have any consumption of uranium. And in Australia, you're lucky enough there's listed companies on the stock exchange where you can take a view on uranium and the commodity. And we cover six of those companies, Paladin, Boss Energy, Lotus Resources, Bannerman Resources, Vimy Resources and Peninsula Energy. And Australia has at the moment, two operating mines after Ranger closed down in the Northern territory in the first quarter of this year and we also have 29% of the global uranium resource base. And as I said, 9% of the global production base but Australia is definitely considered a stable political environment and the producer of the commodity supplying those countries, China, France, the US, that are those demand sinks.

James Gerrish:

Obviously, supply has taken a hit over the last 10 years. There's been a lack of new supply, supply versus demand obviously dictates the price of commodities moving forward. Let's start with the supply dynamic. You mentioned that Australia has 29% of global reserves. What does it look like elsewhere? What does the global supply dynamic look like right here for uranium?

Michael Clark:

Yeah. What you're seeing through COVID is a lot of supply discipline from the two key suppliers. The key producers are Canadian listed Cameco and Kazatomprom, which is the national uranium and nuclear fuel company for Kazakhstan. They're responsible for about 50 to 60% of global supply in a normal world. There are also French utilities involved in the supply chain but the key difference now from 15 years ago, is Kazakhstan production has ramped up from nothing to being 30 to 40% of global supply. It's a little bit like U. S. Shale, the way it's ramped up that analogy with oil markets.

And as I said, you're seeing COVID induced demand cuts to the two key producers, Cameco and Kazatomprom. And you're also seeing both of these organisations recognising that there's been an inventory overhang and you need to hold that production. It's been a double whammy if you like. Global demand for uranium is about 180 million pounds per annum. And you've seen in primary production that's about 160 of the 180. And what you've seen through COVID, is a pullback to a run rate of a hundred million pounds from 160 primary production and some key mines shut-in. And you're just starting to see things ramping up now as inventories have drawn down. I think in 2018, 2019, we would have had a drawdown of 20 million pounds each year, in 2020, a drawdown of 40 million pounds. And we're in a situation where you need mines to come back online to satisfy demand, which has been steadily growing in the low single digits over the past few years.

James Gerrish:

Yeah. Obviously, supply's being curtailed through this period and then it brings onto the question around demand. Is demand actually picking up or is prices an interest in the sector starting to build because we've had this supply curtailment over the last couple of years?

Michael Clark:

Yeah. Just in terms of pricing, uranium doesn't trade on an open market like other commodities. Buyers and sellers negotiate contracts privately. The prices that you see published are by market consultants, so UXC and TradeTech are two of the leading ones. Typically, the split between what these bodies publish and long-term contracts is about 70% long-term contracts and 30% spot markets. And in COVID, it was only 10% in spot markets and 90% on term contracts. And so you're seeing a pickup in activity in spot markets in the past couple of months and part of the reason for that is you've seen financial players taking a view that uranium markets are tight and more supply needs to come online. The theory is that you secure pounds now on the spot market and then you sell them later at a higher price.

James Gerrish:

That's what Peninsula did recently. They raised capital to buy in the spot market. Am I right in saying that?

Michael Clark:

Yeah, that's correct. What Peninsula did, they've actually got term contracts locked in in 51 to $53 a pound. And they took the view that they may as well secure supply at $30 a pound now and lock in a cash margin but you've also seen players all around the world, you're seeing the best part of US$350 million in equity that's been raised to purchase 11 to 12 million pounds of uranium in spot markets. And that's mostly financial players taking a view, as I said, on the commodity. You're seeing spot pricing starting to respond. Now, it was up 25% last year from 24 to $30 a pound, currently at $33 a pound. Mid-cycle pricing, the consensus view is it should be 55 to $60 a pound. There's still a way to go but coming back to our point before, there are still thinly traded volumes in spot markets compared to term contracts. The view of a lot of companies is once they can start to sign term contracts to get their projects up and going again, that may also bring spot markets moving higher as well. And it might happen quite quickly.

James Gerrish:

What do you need ... You made mention of 30 bucks a pound in the spot market. What does it need to get to, to incentivize new production coming on stream? Obviously, every company is going to be different. They're going to have a different cost base but if you're thinking moving forward, what is that ... What brings on new production? Is it 40 a pound? Is it 45? Is it at 50, 60? What's the number?

Michael Clark:

That's a good question, James. I think the existing producers can sign new contracts. You want to layer your contracts and you don't want to sell all your product in one but the existing producers, Kazatomprom and Cameco, the word is that they're looking to do contracts in the low 40's and continue layering them on the way up. And then the next wave of producers, some of the names listed on the ASX, like Boss Energy and Paladin energy, they can start to layer their contracts around $50 a pound. And then some of the more leveraged names, say in Australia, Lotus Resources and Bannerman, more towards $60 a pound. I suppose there are different break-evens for different names in the sector, which have different operational leverage to the commodity price as well.

James Gerrish:

All right, so let's now ... The topic of this podcast is Paladin. It's the number one pick you've got in the local uranium space. You've been covering it for a little over a year. You've been calling it very well. Just to give some background around where Paladin is trading, we've got a share price of around 45 cents at the time of recording. I think back in time and I remember when this stock was above $9, what makes Paladin a good bet here? It's obviously rallied from 20 cents up to 45 but it's a long way from its highs. Why do you like that stock so much?

Michael Clark:

That's right, James. Paladin is our top pick. At the peak of the last cycle, Paladin was a $4 billion company. They've now got 75% of the Langer Heinrich asset, they had a hundred per cent previously and they're currently a $1.2 billion company. With 75% of the asset, you might say that this cycle ends when they're a $3 billion company because they were four before. We're only six to eight months of the way into this upcycle...

James Gerrish:

But it needs ... Paladin is not going to ... That project is not getting off the ground with uranium prices at $30 a pound.

Michael Clark:

That's correct. Uranium prices do need to lift. One of the key ... We talked about financial vehicles participating in uranium markets early this year and that they haven't been present in the past 10 years. One of the things that a lot of market participants are talking about, is the listing of a vehicle called Uranium Participation Corp. And it's currently listed in Canada and what's happening is Sprott Asset Management is taking over the management of this vehicle and they're going to list in the US. That means a lot of investors in the US that previously couldn't access this vehicle, which owns physical uranium will be able to access it. You can't underestimate how important this news is for the sector because they are potentially looking to raise up to a billion dollars US to buy uranium pounds in the market to hold as inventory for this vehicle.

A billion dollars, at $30 a pound spot, translates into over 30 million pounds of uranium they may look to purchase. And you've got to remember, annual spot markets, we're seeing spot's about one-third of total markets, total market's 180 million, spots are then about 60. Then we're saying this vehicle alone might be looking to purchase half the spot market. That could put a rocket up prices in the next couple of months. They're looking to transition that listing from Canada to the US in the next couple of months. I don't think we're too far away. We need higher prices for the existing companies looking to restart operations. Paladin is the lowest cost producer that's listed on the ASX. They have an all-in sustaining cost of $32 a pound. And they're in a good position to be thinking about starting up again. They just need to get some contracts signed to financially de-risk that startup.

James Gerrish:

What timeframe are you modelling for a restart of the Langer Heinrich plan, just given where prices are? Is it going to be dictated by what the spot price is, the direction of spot prices or is it a fate of complete at the moment that they are going to restart?

Michael Clark:

I think it's a certainty that they will restart, it's a question of when not if. I think in the next 12 months, they'll take the decision to restart once they start getting some term contracts signed and you'll see spot price move in sync with these contracts being signed, I think.

James Gerrish:

They can sign those contracts before restarting, so they'll sign a contract on the proviso that the plant gets up and running.

Michael Clark:

Yeah. They need to sign the contract prior to making the decision to restart. Once they think ... It's a 6 million pound per annum operation and so once ... We talked about layering contracts previously, so they may look to have three or four contracts at say, four or 500,000 pounds per annum each. They may look to lock into several of those contracts in the 50's per pound and then over time, look to lock in more contracts as they get closer to starting up but they will definitely look to lock in some volumes prior to that.

James Gerrish:

What do you reckon in terms of volumes that you'll be looking for, that they sign before that all startup? Is it 50% of annual production? Is it more or less?

Michael Clark:

Yeah, I think so. I think they'll sign the contracts in the next 12 months. And I think that quantum is roughly on the mark, what you're suggesting once they make the decision to restart. Maybe it's early next year after they have the contracts in place. In another 12 months, they'll look to be putting first pounds into the market. And you can see a full ramp-up, say in calendar year '23. This isn't too far away and we're talking in our modelling, in an elevated price environment. We actually model a price spike to $80 a pound because it's been such a long period of under-investment and we've actually got the company on a dividend yield of 15% through that period, once they ramp up in FY 26, FY 27.

James Gerrish:

It's a good point there. Yeah, your ball case, if all goes well, you're ... Obviously, prices are going to progressively get to that point. How much cash are these guys going to be throwing off at that point in time? They're a $1.2 billion company at the moment. Obviously, you got to spend some money to get the plan up and running but what does it look like in the rose coloured glasses view over the next couple of years?

Michael Clark:

Yeah, James. On our modelling, we've got Langer Heinrich, which is the mine they had 75% off. We've got an NPV hundred per cent at about 1.2 billion US. If you convert that into Ozzy, that's roughly the market capitalization of Paladin at the moment. It's about 1.2 billion OZZY and that's about 45 cents per share. And Paladin's got exploration assets as well but just focusing on Langer Heinrich, we think the company's well-funded to be able to restart the asset post an equity raise. Their balance sheet, their net cash 30 mil, we think there'll be some sort of project finance once they have the contracts in place. It's US$80 million to restart this operation and the cash it's spinning out ... We've got a free cash flow yield of 30%. And as I said, dividends 15% yield once it's up and going. We think this is a multi-year upcycle that's going to be taking place. And Langer Heinrich is the focus at the moment but as this continues to take shape, you'll see some of Paladin's exploration assets also becoming more interesting and giving the company optionality as well.

James Gerrish:

I guess that's what I'm taking out of this, is that Paladin's got the clearest runway of launching into this rising price environment. They've obviously got the mind there. They've got 30 million on their balance sheet after raising equity recently, they've got all their ducks in line to launch into production and tap into higher prices as you say, in 2023. Obviously, this is high octane stuff. There are a few things that have got to line up for this to come off. There's a big upside if it does. Execution with these types of projects is really key. Give us a sense of the team steering the ship at Paladin.

Michael Clark:

The main man at the helm in Purdy, he's ex quadrant CFO, so very good pedigree. We've had a lot to do with him. I was actually just speaking to him prior to the call today. He's a very good operator, very sensible and the way he's thinking, he's trying to build a team out now in order to operate the Langer Heinrich asset, which is in Namibia in Africa, in a COVID world. And he's getting the right team in place to ensure they can do that. And we have full confidence that he'll be able to do that over the coming period.

James Gerrish:

How should we be thinking about valuations here? Obviously, it's 45 cents at the moment. What is your view of the stock over the next 12 months and where could it get to over time?

Michael Clark:

There is upside. We've got a 56 cent valuation on Paladin and that's composed of Langer Heinrich about 45 cents and the exploration upside, which is 11 or 12 cents. And the way we think about exploration, which is in Canada, in Michelin and Queensland in Mount Isa, we use US$1 per pound for the net 270 million pound resource that's high quality. It's an average grade of 700 pounds parts per million uranium, which some of the other producers listed in Australia have got grades of 200 parts per million. It's a good exploration portfolio. And as I said, $1 per pound on 230 million pounds, translates into 230 million US or about Australian 11 to 12 cents per share. We think some of that exploration upside is going to start to come to fruition in the market. It'll enter the discussion in the market over the coming period and gives the company optionality as uranium markets continue to tighten.

James Gerrish:

What are the ... You made mention of a few other ... The smaller companies in the uranium space listed on the ASX. Can you just run through listeners, some of these other stocks that are probably bigger bang for buck, a lot more risk, a lot more speculative, probably don't have the near term runway that Paladin have but obviously, higher uranium prices are going to get the whole sector rocking and rolling. What are they Clarky?

Michael Clark:

That's right. We covered six names in total, James. And each company, they're looking to lock in term contracts at higher prices than current levels, in order to bring their projects into operation. We're seeing pricing at the moment is in the 30's and in the 50's is of the baseline for all of the companies. They'll do well in a rising price environment. And I said, as we initiated on the sector last November, they're up 170%. Some of the other names like Peninsula Energy, we like Peninsula. They've got a restart project in Wyoming, the USA. We like them because it's uranium. They're the only company to have an existing contract book and inventory and it's a US-based operation. they're directly exposed to US government initiatives, which are pro-nuclear, pro-de-carbonization, looking at supplying ... Sorry, securing domestic supply. And then we also cover Boss Energy, Vimy Resources, Lotus Resources and Bannerman. And some of those names have a bit more operating leverage and will do really well in a rising price environment.

James Gerrish:

Just to give listeners a quick background around our positioning on Paladin, we own it in the emerging companies portfolio. We view it as obviously a high-risk player, as Michael has just alluded to here. Things have got to go right for the restart of Langer Heinrich but we think there's a good risk/reward play here, just as all stocks we've discussed in this podcast series, we either like them, we're looking to buy them or we own them already. There's only one stock that we've covered I believe, was Oz Minerals, that we don't own at the time but we're looking to buy at lower levels.

As a side note and based on some very strong feedback, we'll have some bonus episodes for you in this series. Keep an eye out over the coming weeks for a couple more deep dives into stocks that we like, we either own them or we're looking to buy them. Clarky, I think that was a really strong wrap-up of what's playing out in the uranium space. Obviously, as I said, it's a high octane area of the market but some plenty of upside. Is there things that we should be looking for in terms of markets moving forward from a price point of view? The key thing I'm taking out of this update is that we should be keeping a handle on the spot market pricing. How do we go about doing that?

Michael Clark:

You can actually go on the Cameco website. If you look up uranium price, Cameco, Google that and you get a two week lag on the key consultants, UXC and TradeTech, what their pricing is. And that's probably the most accurate way of gauging prices. I think the key catalyst in the next couple of months, is watching that Uranium Participation Corp, the vehicle that's now controlled by Sprott Asset Management, watch that as it lists in the US and the size of the equity raise that takes place there, so the amount of pounds they're looking to take out of the spot market to back this financial vehicle. I think that's a really key catalyst and that may get the spot price moving.

And then also, watch for term contracts being signed by some uranium producers looking to get back operating again, like Paladin and Boss Energy, some of the first to move in Australia. There's plenty going on in the sector. As you say, it's really high octane stuff. It's surprised us how well the sector has gone since we initiated. And we hosted a conference actually in early February and it was literally every key fund in Australia that dialled in to that conference, which you just would not have thought uranium, that could have happened, even a couple of months earlier when we initiated. Really interesting times in the sector and a lot going on.

James Gerrish:

It obviously speaks to the amount of interest in ESG de-carbonization, et cetera. Clarky, thanks very much for your insight. I got a lot out of that podcast today.

Michael Clark:

Good one, James. Thanks for having me.