Phoscan Chemical (Toronto Stock Exchange: FOS, Pink Sheets: PCCLF) is a Canadian development-stage phosphate mining company that currently trades at a deep discount to net cash per share, and in addition to its large cash position owns mining property in Ontario with phosphate and niobium resources potentially worth more than its current market capitalization. In sharp contrast to many resource firms, shareholder-friendly management has kept close control over cash expenditures and has been buying back shares at the maximum rate allowed by the exchange. In addition to the significant repurchases by the company itself, which are becoming increasingly accretive to net cash per share as the share count continues to decline, there has been consistent insider buying by the CEO (over 280,000 shares in 2013 alone). Interestingly, the impending depletion and shutdown of a major nearby phosphate mine operated by Agrium is likely to create unfulfilled demand that could act as a catalyst for an eventual outside acquisition of the FOS property.
Market background and price history


Background

Phosphate rock (or phosrock) is used as an input for synthesis of fertilizers, phosphoric acid, and other agricultural and industrial chemicals, with the majority of current production vertically integrated by fertilizer producers, and increasingly limited amounts available on the spot market. Over the past decade, pricing has seen unprecedented volatility with sharp price spikes due to continued depletion of a limited resource base and growing demand from the developing world, ranging from $47/ton in 2007 to $430/ton in 2008, $90 during the 2009 financial crisis, and $170-$188 over the last year.

http://www.indexmundi.com/commodities/?commodity=rock-phosphate&months=120

After Phoscan’s stock price rallied to over $2.00 per share on a spike in phosphate prices in 2008, the company showed opportune timing in issuing a $55.1 million secondary offering at $1.90 per share in May 2008; with commodity prices subsequently plunging in the wake of the credit crisis, management acted prudently to limit further development expenses and conserve cash while buying back shares at a discount. Slowing of expenditure on mine development has alienated the former growth-oriented shareholder base, and the stock price has continued to stagnate and now stands at $0.28 per share, more than 85% below its 2008 high. For value investors, this conservative behavior is like a breath of fresh air in an abandonded mine shaft dug with shareholder capital, and appears consistent with an attractive strategy of maximizing shareholder value by limiting cash burn rate, increasing value of remaining shares, and likely positioning the mining property for an eventual sale.


Balance sheet and Martison phosphate project

FOS currently holds cash and cash-equivalent short term investments of $59.2 million as of the latest report in June, for a net cash position of 35.7 cents per share given 166 million shares outstanding. The stock has been further depressed by the broad-based selloff in Canadian resource stocks and currently trades at $0.28, for a discount to net cash alone of over 20% while assuming zero value (or actually negative value) for its potentially highly lucrative mining property further described below.

In addition to its $59 million cash hoard, Phoscan owns 100% of the Martison phosphate mining claim in Ontario, Canada, which is currently undeveloped but has had over $92 million of exploration & development capital invested by Phoscan and several predecessor companies over a 30 year period, a figure more than double the current market cap before considering net cash. The Martison deposit was believed to be economically exploitable at the much lower phosphate prices prevailing in the 1980s and 1990s, but immediately development was deferred in favor of the nearby Kapuskasing deposit, which is currently being mined by $13.6 billion fertilizer giant Agrium Inc (NYSE: AGU) and is nearing final depletion next year.

While still only partially explored, the Martison site contains 62 million tons of measured and indicated resource averaging 23.5% P2O5, a relatively high-grade deposit compared to many others currently in development (see below). Of note, millions in capex were invested in Martison by several predecessor companies from 1980-2000, with phosphate rock prices in the $30-40 per ton range, emphasizing the fact that this relatively high-grade deposit is likely to be economic to extract at much lower prices than today’s. Development of the large neighboring deposit in Kapuskasing, Ontario was much further along at the time which led to further immediate development at the Martison site being shelved, a situation that could soon be reversed with the impending exhaustion of the Kapuskasing mines. In contrast to the sedimentary deposits that make up the majority of world supply, Martison contains igneous deposits which are increasingly preferred by many agricultural buyers due to their significantly lower cadmium content. Recent work has focused on recovery of niobium (a metal increasingly used in superconducting alloys and industrial steel applications) as an additional byproduct. The company’s limited current operations are focusing on validating niobium recovery from existing ore samples, which could significantly increase the value of the property to prospective buyers while limiting near-term consumption of shareholder cash.

Agrium’s large phosphate mine in nearby Kapuskasing, Ontario is scheduled to shut down in 2014 after exhausting its remaining reserves, removing a significant source of local supply. Agrium currently plans to source replacement phosphate from Moroccan imports, and Canada itself is projected to become a net importer of phosphate rock for the first time in 2013. The US has been a significant importer of phosphate rock since the mid 1990s; and based on US Geological Service estimates, US production capacity is projected to decline by ~75% from 2010 to 2030.

http://www.northernontariobusiness.com/Industry-News/mining/Agrium-prepares-to-pack-up-in-Kap.aspx
http://minerals.usgs.gov/minerals/pubs/commodity/phosphate_rock/

The USGS also estimates that over 74% of the world’s total phosphate reserves and 25% of current production are concentrated in Morocco and the Western Sahara, a politically unstable desert region disputed by Morocco, Mauritania, and the Polisario Front, an Algerian-backed rebel group. Morocco continues to be ruled by 61-year-old monarch Mohamed VI, and with the exception of Algeria is the last remaining North African Arab state not to have undergone a populist revolution since 2010. The rapid spike in phosphate prices seen in the mid 2000s emphasizes the magnitude of the potential upside that could result from inflationary pressures on food prices or from any threatened disruption to supply. In buying FOS shares for less than cash, this is certainly not something which is expected or necessary for the valuation to work; but I mention it as a source of potentially extreme upside optionality that can be obtained for free. With an exceptional degree of supply concentration coupled with highly inelastic global demand due to the need for fertilizer, any regional instability could lead to an extreme spike in spot phosphate prices, and cause deposits in developed and politically stable jurisdictions such as Canada to become disproportionately scarce and precious.


Resource valuation versus comparable firms

Phoscan’s Martison deposit has a measured and indicated resource of 62.2 million tons at a relatively high grade of 23.55% phosphate, in addition to potentially valuable trace deposits of niobium at 0.34%. Only 35% of the 28 square kilometer deposit found on geomagnetic surveys has been drilled to date, with only one of three major carbonatite pipes included in reported M&I resource estimates, leaving significant room for resource expansion from exploration.

Due to its significant negative enterprise value after adjusting for net cash, FOS is obviously by far the least expensive of its peers on a price-to-reserves basis. Interestingly, a review of the range of valuations of comparable firms suggests that the approximate market value of the Martison property may significantly exceed Phoscan’s current $46 million market cap even before considering its substantial net cash.

The comparable publicly-listed exploration and development stage firms I was able to identify are shown below, together with reported figures for measured and indicated resources:

MBAC (MBC.TO)
A company developing phosphate mines in Brazil with a current $268 million market cap, which just closed $85 million of additional equity financing this year. Properties chiefly include:
58.8 million tons of M&I resource at 5% grade
33.5 million tons of M&I resource at 12.4%
6.3 million tons of M&I resource at 8.4%, plus trace rare earths

Stonegate Agricom (SNRCF.PK)
Market cap $41.5 million, with $4 million of cash more than offset by $8 million of current liabilities. Developing phosphate mines in Peru (39.5 million tons of M&I resource at 10%) and Idaho (30 million tons of M&I resource at 30%)

Arianne Resources (DAN.V)
Market cap $80.3 million; developing a phosphate-titanium deposit in Quebec (590 million tons of M&I resource at 6.5%)

While none of these projects are exactly comparable, the valuation disparity between MBAC and the higher-grade Martison deposit seems particularly striking, especially given the favorable North American location of the latter. Stonegate’s $45 million enterprise value approximates the entire market cap of Phoscan, even before considering the $59.3 million in additional net cash at FOS.


Summary

While growth-oriented resource investors have shunned FOS shares based on management’s conservative behavior, value investors will find much to appreciate in an deeply undervalued net-net where both management and the company itself are buying back shares at a significant discount to net cash alone, and an extreme discount to cash plus the likely value of the Martison property.

With net cash significantly exceeding the purchase price in addition to an attractively positioned tangible asset that could rise sharply in value in an environment of inflation or global instability, Phoscan represents a clearly undervalued investment which uniquely has the potential to outperform in either a deflationary or inflationary environment. Deep value investors interested in an uncomplicated net-net with a clear margin of safety should consider joining management and the company in accumulating FOS shares.

Continued share buybacks at below net cash value per share

Impending shutdown of Kapuskasing deposit creates unfulfilled local demand

Validation of niobium byproducts increases resource value while limiting cash burn

Free optionality from inflationary pressures or political instability / supply chain disruption