Description

Largo Resources was first written up in February of this year by quads1025.  Quads did a great job of providing background to the company and the key exposures, so I will refer the reader to that VIC entry for further background.  

The stock has been hit very hard through 2019 due to a number of factors and I believe that we are the point that represents very attractive value for anyone who is able to weather short term volatility.  

As a very brief background, Largo is a pure-play, single-asset vanadium miner, listed in Canada with its primary asset located in Brazil. Largo’s key asset, the Maracás mine, first started producing in August 2014, reaching nameplate capacity in 2016 and further improving recovery levels through its leaching and kiln processes. The company achieved record production and recoveries for the year-end 2018 after a challenging ramp up (operationally and financially) from initial production.   

Largo’s cash flow generation is extremely sensitive to vanadium prices, although perhaps less so than historically given a much cleaner capital structure.  

Vanadium prices rose dramatically through 2018 (i.e. US$6/lb to US$30/lb), driven by a number of factors:

1. New Chinese rebar quality standard requiring higher use of vanadium (or niobium, to be discussed more)

2. Excitement regarding the potential for vanadium demand through the development of vanadium redox batteries

3. Speculation and inventory building by traders

Since year-end 2018, vanadium prices have crashed to lows of under $8/lb, taking Largo’s share price from C$4.50 to C$1.75.  The reasons for the crash in vanadium prices are as follows:

1. Chinese steel production quality has not been actively enforced, limiting the real vanadium demand increase

2. Given the exponential rise of vanadium prices, vanadium redox batteries become uneconomic and the key project to advance redox battery technology was effectively cancelled; further, general hype regarding electric vehicle battery demand has certainly waned

3. Niobium began being used in steel rebar as a substitute for vanadium, despite its poorer attributes for welding and steel mill configuration changes required

4. Previously uneconomic coal stone vanadium production in China became economic and Chinese vanadium supply started to increase

5. Significant speculation and inventory building took place in advance of the above items, resulting in the price crash as inventories were liquidated at any price 

Why invest in Largo now?

First, there are a number of company-specific factors to consider:

1. Through the vanadium price “bubble” over the 12 months, Largo has repaid all of its debt and now remains with a net cash balance of US$ 120m as of Q1, likely to grow throughout 2019

2. The company’s operations are running smoothly with recoveries reaching all-time highs for vanadium production globally; production guidance is 11k tons per year going forward

3. Largo’s offtake contract with Glencore will end within the next 9 months, which will allow the company to achieve much-improved pricing going forward (the exact terms of the offtake are not disclosed but the company states that the impact is as much as $3/lb during times of high prices)

The below chart illustrates Largo’s enterprise value in US$ from 2017 to current.  Given the operational improvement, financial deleveraging and visibility to improved price realization, it is very difficult to justify how the company now trades at a lower enterprise value than it did back to 2017.  

Further, there is strong valuation support at this level even if vanadium prices remain at $8/lb (more on vanadium price improvements below).  The following illustrates the implied multiples using the companies 2019 guidance on a run-rate basis, excluding the Glencore offtake (i.e. 10,500tpa production, US$3.65/lb cash cost, US$25m G&A, US$6m maintenance capex).  

Why do I expect Largo’s share price to increase going forward?

First, an 11% free cash flow yield is an attractive starting point.  However, at today’s share price there is considerable asymmetry in terms of upside opportunity to downside risk due to the floor prices in vanadium.  As vanadium inventories have been liquidated we are starting to see a stabilization in vanadium prices. Further, a number of the previously negative vanadium price drivers are being addressed:

1. Chinese steel production quality is starting to be enforced, starting with the Chinese state-owned enterprises and rolling out further from there; I have been told that the 6 largest Chinese rebar producers will undergo inspections in the coming months

2. Vanadium prices have now reached a level where it is no longer economic to substitute with niobium; in fact, the reverse is now true with the ratio of ferrovanadium to ferroniobium at less than 1 (substitution only begins to be economic in some applications at 1)

3. The production cost of Chinese coal stone vanadium is estimated to be $10 - $13/lb, therefore Chinese stone coal producers are losing money on each margin lb of production; I would expect Chinese stone coal production to stop almost entirely if it hasn’t stopped already

4. The optimism and speculation that took vanadium to +$30/lb has now reversed, causing inventory liquidation and irrational pricing on the downside

5. Longer-term, the global vanadium cash cost curve requires $8/lb vanadium to keep 80% of production above cash flow breakeven, therefore long periods with the vanadium price below $8/lb are not sustainable

For these reasons, I believe that we are very near a floor in vanadium prices and therefore a floor in Largo’s share price.  As that floor is developed, and as vanadium demand does increase from Chinese steel quality regulation, we are likely to experience a period of sustained higher vanadium prices once again.  I do not believe that the previous +$30/lb will be seen in the near future but a moderate recovery can be expected.

At a vanadium price of $10-12/lb, Chinese stone coal production remains uneconomic and niobium substitution will remain limited.  At these prices, Largo would be generating 17% to 25% free cash flow yield, which is unlikely to remain as Largo’s share price increases to reflect these improved economics.  

Finally, while this is not the primary reason for an investment, Largo remains the only pure-play vanadium asset globally and is certainly strategic to a number of parties.  A take-out is very conceivable.  

Catalyst

• Chinese steel mill quality compliance
• Vanadium price stabilization and recovery
• Take-out