Bull Markets and Bear Markets, Uranium Part Two

"Bull markets are income statement driven, while bear markets are balance sheet driven"

-Don Coxe

After a one week hiatus, I want to refocus our attention to the previous post in relation to uranium and the outstanding opportunity. But for now, I want to direct your attention to the quote above because I believe it screams simplicity. Over the past month and half, the market place has asked the question of survival. In fact, by checking the archives, the very first post, titled "Cancer and Random Gleanings" highlighted the possibility of liquidity problems. Now, the question is who will survive?

Banks, Mortgage lenders, and anyone that has anything to do with real estate, financing, equity, etc. have been beaten up. Is this the start of a bear market? That is not a question I like to answer and I really don't care where the market goes. As a value investor, a 50 cent dollar is a 50 cent dollar, the search for an undervalued business does not care where the market is going, given time the intrinsic value of a business will/should meet the price quoted in the market. Sometimes it takes a long time and other times it's shorter, not having patience is a problem. In fact, most value investors are in the business of time arbitrage. The average holding period of a business today is around 11 months, a little under a full year business cycle. So a value investor places a value on a business that is bought and sold on a daily basis in Wall Street fashion, if there is a high margin of safety with a high risk to reward ratio, a purchase is made.

If not, you wait! Often times it takes a long time for a business to meet a criteria for purchase. In that first post I stated: "Personally, I want to see some volatility because I am itching to buy at discount levels not seen today." And that's the cost of being in business; you wait for the fat pitch. Now the question everyone asks is which of the financial stocks will kaput? The way to gain a better perspective is to understand the balance sheet, because the income statement doesn't matter if you are burning cash and are over leveraged. That is why the quote at the top makes so much sense, if you are looking to buy a business involved in finance, real estate, mortgage, don't salivate over the P/E ratio, it is meaningless, worry about the balance sheet. Don't look at the yield and nod to yourself thinking you have found a fat pitch, that was before, some of these businesses will slash dividend for the sake of liquidity.

The above paragraph might sound facetious, but take it at face value. Look at the balance sheet! For me the decision is easy, finance was my major and although I have studied these businesses, they are not yet in my circle of competence. If I don't understand it, I don't buy it. Doesn't mean that someone who buys it will face losses, it just means that it is not my cup of tea. Furthermore, they are still too popular, now I understand Sir Buffett made some purchases, but he made the acquisitions when there was extreme pessimism short-term. He simply sits on his 45 plus billion war chest and has ample purchasing power. As soon as he made the purchase, suddenly everyone thought, "Well if he is buying, they must be undervalued." Again, I don't agree or disagree, but the logic of the lemmings is fallacious and based on the confirmation bias.

moving on...

From Balance Sheets to Income Statement

Tangible assets and intangible assets have an obvious difference, one you can touch and the other you can't. Intangible assets can be created out of thin air and if you are in the wind power business it is good. Tangible assets can't! A tangible asset that creates or allows for the creation of an intangible asset is smart. Take for example a bank, they take deposits ("tangible") and make loans ("intangible") to buy a house ("tangible"), it's a circular cycle, once you purchase the house ("tangible") you can use it's equity ("intangible") to make another ("tangible") purchase. You get the idea.

Uranium is tangible, used in a nuclear reactor, it provides an energy source such as electricity (intangible) that you could use to operate machines (tangible). The market has undeservedly punished the mining businesses. Now there is a distinction, there are producers and hopeful producers, and the hurdles are very high for the hopefuls. It takes a number of years to approve a location, then you need to get the authority to mine (very tough!), then you have to get the working capital to work on the mine (even tougher!), finally you run a bunch of tests. To run those tests, you need equipment, and if you are in a business that has been through one of the worst 25 year periods, there are not a lot of companies that are interested in providing you business. Even worse, the location, in real estate (commercial or residential) the three things you look for are location, location, and location. In mining it is similar, but each of the three locations are different and rightfully so, they include:
1) Location- what kind of country are we mining in?
-What are their property rights?
-Tax system? Royalties?
-Politics? Honest? Corrupt?
-Working Conditions?
2) Location- How is the weather like?
-How many months out of the year can you mine?
-Flooding?
3) Location- Transportation
-Highway system?
-Easy to move equipment?

I'm pretty sure I left some things out, but you get the point. Cameco's Cigar Lake is faced with the problem of number 2. They have delayed production from '07 to '11, that is a whopping four years. However, I also believe that number 3 is just as important, the highway system in many of these countries is very poor. Uranium by itself is just uranium, if you are mining 1000 miles from a mill, it doesn't matter what cost structure you have, you will not realize the profits. Denison has a mill, one of the very few in the U.S., the only operating one, because the other three are on standby. According to this article the process to build another mill takes about 7 years, maybe less but no less than 5. Unfortunately, this isn't an industry that improves its' productivity every six months, like tech.

Depending on your investment style, the hurdles above do not bother me one bit. So lets say you have the three location descriptions under control, have a permit to mine, in a friendly country, your competition is very little. Why? because I don't remember the last time there was a surge in Geology majors at major university. I don't think that anyone during the past 25 years at the age of 17 or 18 said, "Hey I think uranium mining is going to make a comeback", or any other mining for that matter. There is limited supply of talent in this industry, and the supply is in demand from other mining companies like coal, copper, oil sands, etc.. If you are an operating mine that happens to produce, you are in a sweet spot, and the saying "Those who having will prosper, and those who don't won't" rings true.

Secondly, those who have this talent are in their 50's, and after one of the worst bear markets, many mining companies disappeared. The few that survived, their balance sheet had something to do with it. When I listed in the previous post the amount of production for the past three years, the production in '04 was higher than '06. Now the estimate for '07 is in, RBC capital states that they have reduced their expectations from 117 to 112. Because get this, "There were difficulties and delays in many mines, including: "Langer Heinrick, Dominion Rossing, McClean Lake, Rabbit Lake, White Mesa, and Olympic Dam." This doesn't surprise me one bit, and neither does the next warning, "Kazakhstan remains the biggest unknown for uranium production in 2007 and beyond...[they] should be able to meet their 18 million pound target, but could struggle to meet 2008 targets as multiple projects are scheduled to come online and labour and resources could be stretched thin." The only word I will change from the previous quote is "Could" to "Will." So the four year production, three actual, and '07 a guess looks like this:

2004- 104.6 pounds (actual)
2005- 108.1 pounds (actual)
2006- 104 pounds (actual)
2007- 112 pounds (estimate)

Take it for what it's worth, but if the price of whatever I was producing increased from 15 and change in 2004 to a high of 136 (now 90) in '07, and the increase in production was a whopping 7%, there is something wrong with that picture. Also noteworthy is that 90 is the spot price, not the long term price, which during all this free-fall talk of spot moving from 136 to 90 has remained at 95. I mentioned in the last post, "Long-term pricing has not moved lower; in fact, I wouldn't be surprised if spot prices move lower than long term pricing by a difference of $1 or $2 based on historical pricing. The parabolic move in spot could be as Denison pointed out, hedge-fund buying." Now, the difference in spot versus long term is 5 in long-terms favor, the prediction was right, and that is why even after continued decline in uranium mining businesses I continued to make sensible purchases.

The choice to sell usually has one price, but uranium has two (long term and spot). Cameco is locked in legacy contracts, Denison and Uranium One have very little exposure, they choose which price to sell. The August 14th RBC update stated "The long-term market remains active with 9 buyers looking for a total of 26 million pounds." The August 21st RBC update stated "The continued lack of actual, reported, spot transactions also frustrated the market observers. With only 3 deals totaling 100,000 pounds of material versus an annual spot volume of 20-25 million pounds." The 3 deals in total represent between .4% and .5% (2o mil. and 24 mil., respectively) of spot volume, not total volume. If I did the same calculation for total volume, well...I'm just not going to do that.

The E-Mail and Voicemails

Last Thursday, Mr. Market was a nervous wreck and he was willing to sell businesses at a lower price than the day before and the day before. At one time, the Dow was down close to 350 points. Now usually I'm pretty occupied with my job and don't get the time to check up, but I decided to check my e-mail, and saw this from my former boss, whom I will withhold his name and business. For qualification purposes, he is a hedge fund manager and is very well informed. The e-mail was this:

"I've left mesages, no response, you must be busy. Listen to them. DNN is down to $7.60 right now...I would liquidate out of everything you hold, we are free falling."

After reading it, I checked some of my holdings, and found out that Mr. Market was giving me the opportunity to purchase current holdings at unreasonably low prices. I subsequently made purchases in uranium mining businesses. They included on a daily basis for the past month:

8/16/07- DNN- 7.55
UUU- 9.09
8/15/07- DNN- 8.22
UUU- 9.84
8/10/07- DNN- 8.92
8/7 /07 - UUU- 10.70
8/6/07 - DNN- 9.08
7/26/07- DNN- 10.07

Both DNN and UUU have been positions for over a year, so my cost at original purchase are lower, and because of the recent buying, both have increased by 100%. Once again, I offer the same disclosure as I made in the previous Uranium post:

"While there is selling, and it may continue for weeks to come, I will be a buyer, opportunistic and aggressive. These purchases offer a high margin of safety and I have great confidence in my analysis and judgment."

Later that night, on the 16th, I listened to the voicemails, there were three of them with similar messages as the e-mail. These are signs that I look for and while I shy away from making market predictions as a whole, I don't make purchases on market direction, but rather on businesses that offer a high margin of safety selling at a price that meets my buying regimen. The extraordinary proclivity that these businesses have fallen by over 50% over the past three months, while being producers of a commodity with high barriers of entry (emphasis added) is ________(fill in your own positive or negative adjective).

Listening to the Denison conference call, Peter Farmer (CEO) said something along the lines of "I can't believe that a company that is doing so well is getting treated so badly." The Uranium business also enjoys another benefit, the fixed costs can be leveraged to earn outstanding returns on cash flow. Both DNN and UUU will experience growth in free cash flow in the next few years when production increases.

Purchase Inquiry

There are certain requirements that should be looked at when purchasing anything that has to do with commodities, just like any other industry. Don Coxe stated his requirements recently:

1) Something tangible, real
2) Not subject to being created electronically
3) Absolutely needed by the most dynamic economies in the world, not in trouble for creating assets.

Without sounding humorous, I consider the United States, France, Canada, China, and India dynamic economies; the latter two more so. I also know that I left a few dynamic economies out, but those are the ones off the top of my head. Now here is where you have two choices to consider: 1) invest China and India, or 2) invest in what they need. What they need is more reliable, just my opinion.

Indeed, once again I am short on time, and knowing that I left off important details on DNN and UUU which I promised to do in this post, please excuse me. These blogs write themselves and even though my intentions were to expand on these two businesses, it didn't. Maybe next time!

Until next time, I hope you enjoyed this post, if you have any questions or arguments for/against what I write, please e-mail me. I enjoy intelligent and rational discussion, with the operable word being intelligent.

Thank you,

S.K.