Strathmore STM CN
January 02, 2005 - 6:57pm EST by
2005 2006
Price: 1.60 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 80 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Strathmore (STM.V) is a call option on an exponential increase in the world uranium price because of a massive undersupply situation which has persisted for nearly two decades, yet was mitigated by demilitarized nuclear material, which has finally run out. Unlike many call options, Strathmore has minimal burn rate (theta if you will), plenty of cash, uranium in the ground and is trading at a very significant discount to where it will likely be if the uranium situation plays out like I anticipate. I really feel that this could be a 20-bagger type of situation over the next three to five years.

I know that your first reaction is probably, “uranium—they’ll never build another reactor in the US. Who cares?” I think this is part of why this story is so undiscovered and so unloved. Everyone simply dismisses it even though the facts themselves are the most appealing that I have ever seen in the investment world. No one ever takes the time to dig in and research the situation. Just so you know: None of this “play” is predicated on another reactor ever being built in the

To understand Strathmore, you need to first understand the uranium market. There are 439 reactors in operation around the world (103 of those are in the US). They all require uranium on a regular basis. Worldwide, they will require about 180 million pounds each year. Mining only supplies about 92 million pounds a year. As you can see, a massive shortfall exists and has existed for two decades. Let’s take a brief trip through the history books and see how this situation has persisted and how the supply gap has been closed.

Following the discovery that you can make bombs out of uranium, our government wanted it all. They guaranteed floor prices for uranium that were significantly above the cost of production. This ignited a major uranium bubble in the 1950’s stock market, as anyone with a Geiger counter and a few acres of New Mexican desert became a millionaire. As uranium poured into government stockpiles faster than it could be placed into missiles, the government slowly reduced its floor price into the late 60’s. Prices per pound dropped from a peak in 1953 of $75 (per pound in inflation adjusted US dollars) to a trough in 1969 at around $25 (per pound in inflation adjusted US dollars). As is natural in any commodity market with significant lags until production, uranium was found and financed when prices were high, then brought into production right at peak prices eventually crushing prices and leading to a very massive bust where most players went out of business. The figures are a bit fuzzy (governments do not like to tell all about their nuclear stockpiles) but about 336,800 tons of uranium were produced by the western countries between 1947 and 1969. (I’ll get back to Russia in a jiffy). Most of this was either stockpiled or shoved into armaments.

Just when it looked darkest for uranium producers, technology to turn radioactivity into electricity was becoming practical. Incidentally, the preceding wave of bankruptcies wiped out most of the industry and production collapsed. With low worldwide production, banks were hesitant to finance reactors unless the utilities could lock in a stable supply or uranium. Power companies scoured the world looking for production and competing for any available world supplies so that they could get financing. This created the second boom as competition for available supplies drove the prices higher. Prices peaked at $110 (per pound in inflation adjusted US dollars) in 1976 before beginning a three-decade decline. Natural resources take about a decade to bring from discovery into production. During the first boom, it averaged five years just to map out the deposits before production could begin. During this second boom, large deposits had been previously mapped and much of the machinery was already in place. This led to a more rapid mobilization of capacity that began to lean on prices rapidly once brought into production.

1979 changed the price dynamic forever. As you are aware, our country had a nuclear surprise when Three Mile Island had some engineering issues. Our country forever swore off new nuclear projects and began to curtail existing ones. Hundreds of reactors in various stages of assembly were forever mothballed. Unfortunately for the industry, most of these plants had locked in supply contracts that in some cases were a decade in duration. Furthermore, many existing plants had stockpiled uranium fearing further price increases. Utilities that no longer needed uranium began dumping it on the market because almost any price received would represent a partial recovery of their costs. This not only drove prices down, but it bankrupted most producers. For the most part, uranium production collapsed and by 1984 and utilities began using more uranium than was being produced worldwide (this trend would continue for 20 years).

During the years between 1970 and 1984, about 170,000 tons were produced beyond the total used. Another 30,000 were sold into the commercial sector and added to commercial stockpiles by various governments as the cold war cooled down. This left a total commercial stockpile of about 200,000 tons that no one wanted and now began the inventory liquidation period.

With prices low, production virtually ceased, yet few reactors were decommissioned. In fact, outside of the US, there was a net increase in total reactors and total uranium requirements. From 1985 until 2003, 339,000 tons more uranium was used than produced; yet prices remained in the low teens or even single digits (per pound). Meanwhile, the average cost for production was more than two times that—stifling any future exploration or production projects. Imagine the perverse scenario of a uranium producer who locked in prices in 1978 for a decade and anticipated a certain return on invested capital. By 1981, he could close his mine, buy on the open market and sell it at the prearranged price without any of the operating hassles involved in a mine. The utility, with no need for this uranium decides to monitize it, turns around and sells the uranium right back to this miner at $10 a pound and the cycle repeats, keeping prices way below production cost.

Lets do some math ( tU= tons of uranium).

339,000tU of excess demand over production – 200,000tU of supply means that 139,000tU over 18 years had to come from somewhere else.

While President Clinton was trying to balance the budget, he decided to reduce costs and save the expense of maintaining the national stockpile. 28,600 tons were transferred to USEC (USU: NYSE) and IPO’d. In theory, enrichment could be a good industry, but not when existing uranium on the market is much cheaper and plentiful. USU promised to pay a dividend and most of their stockpile was unloaded on the cheap to make this dividend possible. This leaves 110,000 tons of supply as still unaccounted for. Lets move back to Russia now.

Russia’s nuclear history was very similar to our—including those touches that are distinctly endemic to Russian and communist history (forced mining in gulags, nuclear catastrophes and supply disruptions). Eventually, our two countries put their differences aside and decided to draw down our nuclear weapons stockpiles (the Russians were further motivated by the need for cash to feed their people after the Asian crisis). About 20,000 tons were bought directly by our government from their weapons program and sold to utilities. The remainder of the world’s shortfall of about 90,000 tons has been made up by sales from Russia’s stockpiles directly to Western utilities.

In 1992, uranium prices bottomed at around $7 per pound and began a slow climb as the remaining western reserves were consumed. Prices then peaked at $16 per pound in 1997 before Russian supply capped prices. The Asian economic crisis sent Russia into a panic for hard currency and they began to sell anything not nailed down. During this period, they signed a contract to deliver a maximum of 9,000 tons a year every year until 2013. This has made up part, but not the entire shortfall. Our own government has continued to trickle out a few thousand tons a year from its stockpile as have a few other governments, but I believe this is changing now. Our renewed military focus will likely mean limited sales of weapon grade materials. Russia, scared of us and flush with dollars has reduced their sales significantly. They are embarking on a reactor program of their own and would prefer to conserve supplies. Other net sellers have also reduced or eliminated government sales. The Kyoto treaty means that they will build many more reactors for electricity generation and they want to keep remaining supplies at home. Finally, utilities have been drawing down their internal stocks of uranium. For most of the last 25 years, utilities have kept about 2 years worth of supply on hand. This peaked at almost 5 years worth in the late seventies and now is at about six months to a year worth. Once this is depleted, without foreign selling, prices should respond strongly in the uranium spot market.

Spot prices have already risen from $9 in 2002 to $20.70 as of last week. I feel that the smarter utilities out there are beginning to worry about future supply and are making sure they are covered. As always, plenty will be caught without supply. China intends to build 2 reactors a year for the foreseeable future. Many other countries are restarting their reactor programs. Interestingly, since uranium has been so cheap for so long, no one is even thinking about supply. This could create an explosive situation where uranium spikes to a few hundred a pound. At $100 a pound, it would still represent less than 1% of the cost of electricity generation. It isn’t worth it for the power plants to risk going dark because of a lack of supply. I feel that they will pay almost any price eventually, and with a ten-year lag until production, some will eventually have to go without uranium. Existing facilities can be ramped up to produce 10-20% more uranium a year within 3 years, but the supply gap is so massive that it will do little to close it—especially with more demand coming online soon.

I apologize for that lengthy history lesson, but it is the only way to explain Uranium. Cameco (CCJ: NYSE) is one clear way to play uranium, Denison (DEN:TO) is another. (I own both). These are the only large producers out there. A 20-year bear market knocked everyone else out of the game. The problem with both is that you miss out on some significant upside leverage to the price of uranium. They are forced to continue looking for more uranium to mine, and you also are invested in a capital-intensive business that can include numerous operational and environmental hurdles. No capital will ever be returned to shareholders. Finally, they have hedged and will continue to hedge most of their future production. Strathmore is different.

Founded in 1996 Dev Randhawa, the goal has been to focus on acquiring properties where others have already done all the work back in the 70’s. During the last few years while prices were low, Strathmore spent pennies a pound for over one hundred million pounds in the ground that were uneconomic at the time. For those of you who are familiar with Silver Standard (SSRI: Nasdaq), this is the Robert Quartermain strategy of having ounces in the ground that can be accessed when higher prices prevail. Not so incidentally, Quartermain is on the board of directors of Strathmore. The eventual goal at Strathmore is to wait for much higher prices and then either joint venture the properties where someone else puts up the cash and Strathmore contributes the land, or preferably land sales. If you look back at other panics in commodities, as prices go up, there is always someone willing to pay very top dollar for resources in the ground. If uranium is trading at $100 a pound, and it costs $30 to take it out of the ground, Strathmore could conceivably receive $30 or more per pound in the ground for a well-defined resource—especially if the buyer is bullish on higher prices. I feel that once they are caught in the dark, many utilities will take uranium procurement into their own hands and buy up land to ensure adequate production.

To sum up the strategy: They’ll spend cash to better map their property, define their resources and wait for higher prices to take them out of their land. They do not intend to spend shareholder money to mine or do greenfield exploration. All their land has already been well mapped in the past and the resources are already well defined—just not economic. Higher prices in the past six months are changing that fast and some of their properties are becoming economic.

Let’s take a quick look at the company itself.

All figures as of December 16th 2004 and in Canadian dollars.

Outstanding Fully Diluted

Shares 35.1m 49.4m

Working Capital 9m 16m

Working Capital $.25 $.324
Per Share

For the first few years, Dev bought properties but saved capital and did not do any work on them. So, even though they had mapping studies, core samples and reports thrown in with the land purchases, no one has yet to fully analyze them. The data actually sits in warehouses. They are finally hiring the people to piece the whole picture together.

The numbers are a bit rough on reserves for the above reason and because more stringent Canadian reserve requirements mean that 20 year old data will need to be updated somewhat to conform to newer requirements. In spite of this, the company has between 250 and 300 million pounds of uranium at various levels of classification throughout its dozens of properties in 8 main locations including Quebec, Saskatchewan, New Mexico (3), Wyoming (2) and Peru. Of this, 13.4 million pounds are at the reserves level or higher. The company has recently raised capital to better define these projects. Unlike most projects, there will be much less drilling required. Instead, all the drill data and core samples are in a warehouse. They just need to be examined to figure out what the company owns.

If you assume that half of these resources become reserves or better, you have roughly 150 million pounds owned by the company, or roughly three per share (50m fully diluted). The shares are currently selling at $1.60 Canadian or $1.29 USD. Hence you are paying $.43 per pound in the ground, plus some cash to figure out how many of these pounds are good. From talking to people, I believe that most of them are good. The company has a burn rate of about $100,000 a month excluding further exploration. With their cash hoard, they can hold out a long time and wait for much higher prices.

Final comments:

You may wonder about the continued share issuances and financings. I hate dilution, but unlike most operating companies, even though the share count is increasing, the pounds of uranium is increasing faster and hence the pounds per share increases making the issuances accretive. Surprisingly, companies who aren’t interested in uranium are still selling properties on the cheap—largely because spot prices are still below the cost of production.

This is a bit thinly traded.

Supply and demand numbers are estimates based on numerous reports. Government data is notoriously spotty, especially for Russia. No one knows the exact numbers and I could be off by a good deal. However spot prices are now rising which confirms a lot of my thinking.

There is likely uranium out there in warehouses someplace, but with 80-90 million extra pounds needed each year to cover demand, it will be chewed through fast. It will take a decade to bring significant production online. A 20 year bear market likely assures that most existing supply has been sold by now.

Even though uranium prices have gone up 250% recently, I think there is a lot more upside because prices are still below the cost of production. There is still no meaningful exploration underway because most deposits are not economical until prices reach $25 or so a pound. This will give Strathmore a few year head start and hence a premium valuation for their fully researched properties.

There is no central market for uranium. 95% of the market does not trade on the spot market. About once a month a spot deal is signed and they are reported every Wednesday morning at . Recently longer-term supply contracts have been signed from $23 to $25 per pound with a guaranteed delivery quantity for a number of years. I’ve heard rumors that a contract was signed with a floor at $25 and a ceiling at $30 based on quoted spot prices. This in spite of the current spot price being $20.70.

Insiders founded and financed the company for its first five years. Many of them put their life savings into the idea of a land bank for uranium knowing to buy when it was being given away. Insiders are now taking their initial capital out of the business and selling shares. I hate insider selling, but you have to live with it and follow their rationale. They have kept salaries reasonable.


Increase in uranium prices.
Eventual US listing.
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