Sprott Resource SCP
April 03, 2009 - 2:59pm EST by
issambres839
2009 2010
Price: 2.65 EPS na na
Shares Out. (in M): 82 P/E na na
Market Cap (in $M): 217 P/FCF na na
Net Debt (in $M): 0 EBIT 0 0
TEV ($): -48 TEV/EBIT na na

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Description

Want to buy a dollar for 75 cents? What if I told you there was a company out there that was predominantly sitting in cash, gold and silver bullion with no debt, whose tangible book value is approximately C$3.50 per share, with little expenses, that was selling for C$2.65 per share? Better yet, what if I told you that it is run by one of the best resource investors around, who has a proven record for making investors money and has increased book value from $1.50 to over $3.50 in two years? In a normal market, opportunities such as Sprott Resource don’t exist, but this is no normal market, especially for small cap stocks.

Eric Sprott, the Chairman, is one of the best resource investors around

Eric Sprott, the Chairman of Sprott Resource, is also the chairman of Sprott Asset Management, which has $4.6 billion in assets under management in Canada. He is also the founder of Sprott Securities, which is now called Cormark Securities, a mid-size Canadian brokerage firm. He founded Sprott Securities in 1981 and split off from it in 2002 to focus on money management.

His main hedge fund, Sprott Hedge Fund, was only down 2.8% in the last year and is up over 25% since inception in 2000. In November 2008, due primarily to superior performance, Hedge Fund Intelligence nominated Sprott Asset Management in the “Management Firm Of The Year” category at the 2008 Absolute Return Awards.

Check out the Sprott website for more information on this impressive firm with great long term results: http://www.sprott.com/

So what exactly is Sprott Resource?

Sprott Resource is a public company that is managed like a hedge fund or private equity fund, without the use of any leverage.

The advantages that Sprott Resrouce has as a corporate entity over mutual funds or hedge funds is that by having a captive pool of capital, they have the flexibility to invest in private companies or in long term deals and without the worry of clients pulling money out.

Further because of Sprott’s expertise and connections to management teams and resources all through Canada, they have access to a wide breadth of deals and opportunities that most people never get to see.

And due to their non-levered structure and long-term capital, Sprott Resource is a very attractive partner to other companies; Eric Sprott’s positive reputation in Canada is a positive as well.

Check out Sprott’s recent presentation on the company from March:

http://www.sprottresource.com/docs/SprottResource_InvestorPres.pdf

Hedge Fund’s Style of Pay

The way Sprott Resource management gets paid is very unique for a public corporation. Management is paid like a hedge fund with a management fee of 2% of the assets and 20% of the profits at the end of every year.

The 20% incentive paid is based on pre-tax earings (i.e. realized gains), so unrealized gains that flow through other-comprehensive income do not count.   Further, Sprott values privately held securities in which they own less than 20% of, at cost. Management evaluates valuations each quarter and writes down the carrying value if necessary.
 
Finally, there is a hurdle to the incentive payment being paid. The profit has to be over the average rate for the year of the 30-year Canadian generic bond index.  A copy of the Management Services Agreement can be found on their website, which outlines the incentive fee calculation in greater detail.

This is a unique way to get paid and some people may not like this at all. I will point out that there are no salaries or options or bonuses. What is very attractive about this set-up is that all compensation is very straightforward and there are no hidden expenses or dilution as is the case with most companies.

There is another example of a corporate entity being compensated as if it were a hedge fund and that is Greenlight Capital RE (NASDAQ: GLRE). GLRE is a reinsurer, which compensates, pays management 2% and 20% on its investment returns. For those who think that this type of payment structure deserves a discount, GLRE trades for about a 20% premium to book value.

Track Record with PBS Coals is quite compelling

And since Sprott Resource was formed, their track record has been quite good. In fact, they hit a home run with PBS Coals last year. Sprott had invested US$55 million in December 2007 through April 2008 and sold it in November for US$200 million to OAO Severstal, one of Russia’s largest steel companies.

PBS Coals is a low cost producer of private metallurgical coal in Pennsylvania that needed funding to expand production and also to buy out existing investors. This is an excellent example of what to look for in the future, especially as resource companies are starved for capital right now.

Balance Sheet is mainly cash and gold and silver bullion thanks to PBS Coals

Due to the huge sale of PBS Coals, Sprott Resource is mainly cash, gold and silver bullion. In fact, they have over $265 million in cash, gold and silver, or over $3 a share in liquid assets, with no liabilities.

One of the real benefits of investing in this company in this current economic climate is that management is very conservative and also quite bearish on the economy. This basically means that they aren’t going to be doing anything rash or stupid with the capital.

Other investments

Some other investments they have are Stonegate Agricom Ltd. and Waseca Energy Ltd.

Stonegate Agricom Ltd. is an approximately 79% owned subsidiary of Sprott Resource Corp., which indirectly owns and is working on exploring and developing the Mantaro Phosphate Deposit located in Peru.  Stonegate Agricom is independently managed.

Stonegate potentially has a very large phosphate mine in Peru and a recent report estimated that the inferred mineral resource on the Philip concession of the Mantaro Phosphate Deposit is 45.17 million tonnes grading at 15.4% P2O5. Phosphate prices have soared in recent years due to a shortage of phosphate and tremendous demand for use as a fertilizer in agriculture.

Waseca Energy Ltd. is a newly created private oil and gas company and a subsidiary of Sprott Resource Corp.  In October 2008, Sprott Resource Corp. funded over $27 million to acquire over 79% of Waseca.

Waseca’s primary focus will be heavy oil production from the Lloydminster area on the border of central Alberta and Saskatchewan.  Waseca currently owns four prospective petroleum and natural gas leases, has started drilling, and will continue to drill on its existing leases and pursue additional acquisitions.

The independent management team at Waseca has an average 33 years of technical and managerial experience in the oil and gas sector.  Prior to founding Waseca, management generated significant production growth in the Lloydminster area while employed at a major independent oil and gas company.

One Earth Farms Represents a Huge Opportunity

Last month (March) Sprott Resource announced that it was launching One Earth Farms, a large-scale farm in the First Nations’ farmland of the Prairie Provinces in Canada. Sprott will invest $27.5 million to establish operations, fund working capital and support its initial growth.

The plan for One Earth Farms is to start with an initial 50,000 acres and grow to possibly one of the largest farms or the largest contiguous farm in North America on untapped First Nation land (First Nations tribes are similar to Native Americans in the US). They are setting this up as a separate company that they can possibly bring in other investors, bring public or even sell sometime down the road.

I am huge bull on agriculture, the prospects for agriculture companies and for grain prices in general and think this could be an absolute home run. There are very few ways to invest in agriculture and One Earth Farms could be quite an attractive stock to many investors, especially considering it is in such a stable country as Canada.

So if the prospects are great why is the stock selling so far below cash?


I think the main reason is that small caps around the world have been crushed. Further, small cap Canada has been obliterated for no good reason other than money managers and investors bailing from the Canadian market.

For some reason, investors never rewarded the company for its huge gain in PBS Coals, which happened when all hell broke loose in the stock market last year.

Basically, I believe the market is just incredibly inefficient right now and this is just one of the more egregious opportunities out there.

Insiders are buying and a buyback will be coming if discount persists

While the market may not be buying, insiders sure are. The Chairman, Eric Sprott, has bought 631,200 shares in the last four months and the CEO, Kevin Bambrough, has bought 412,000 shares. And they have done this buying despite already owning large stakes. As of right now, Eric Sprott owns 6,918,100 shares. Kevin Bambrough owns 1,562,000 shares.

Last year, the company bought back 10% of the shares, due to the compelling discount in the stock. Per Toronto Stock Exchange rules, you can only buy back 10% of your stock once a year. Management has communicated to me that if the discount persists, they will once again launch a large buyback when they are allowed to in August.

Optionality of investing with Sprott should be worth something


I think that at a minimum, the stock should be trading around $3.50 per share. Even more, the stock really should be trading at a premium to book value of 1.1 to 1.2 times. Why? I think there is tremendous optionality and value to Sprott’s access to deal flow, management teams and insider type opportunities. The example of the private equity investment in PBS is an excellent example. Further, One Earth Farms is exactly the type of investment that we as ordinary investors have no access to.

Finally, I will point out that when Sprott Resource went public, investors were so excited that they bid the stock up to over 2 times book value, which was initially C$1.50 per share. For this reason, my initial price target for Sprott Resource is C$4 a share, 45% higher than current prices.

Summary

In summary, I think Sprott Resource is an incredible opportunity to buy a completely liquid company for 75 cents on the dollar. I think you can take advantage of a dysfunctional market and buy a stock with quite a bright future for Benjamin Graham type prices. With little downside, due to its incredible balance sheet strength, Sprott Resource offers investors an incredible risk/reward situation.

Catalyst

-exposure to ridiculous valuation

-share buyback coming in August

-more lucrative investments announced

-further developments on existing investments

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