Who is going to get into production, and who won’t?
First, to save people the trouble, let me state this is a fundamental analysis view, not a chart view. Chartists, please save yourself the trouble, and don’t read this. This is for genuine investors who are looking to get into a graphite company (or who are in one, and want to get some reassurance).
Something that many graphite industry people have been saying for a long time is that finding graphite is not difficult. It is, in fact, plentiful. Lots and lots of future pencils lying around, just without the little timber bits on the outsides saying “HB”.
Finding genuine buyers for all this graphite, on the other hand, is proving to be much more difficult than investors have realised, although insiders have been saying it for a long time for those who were prepared to listen and understand. It has in fact proven a lot more difficult than even most company boards had initially thought, and they will all have to account to their shareholders at some point as their chickens come home to roost over the next year or so.
So, I thought I would do my own little update or addendum to the Pattersons summary from July 2014 on the graphite sector, namely to highlight a discrepancy with regards to demand for graphite, and in particular highlight the difficulties many will face to go into production because of that lack of existing demand (relative to potential supply). Pattersons provided a rating system based on a whole bunch of various metrics, and came up with their top 3 (in order, SYR, VXL, KNL). While I don’t personally agree fully with all the report, I do believe it was a good effort by Pattersons to try and cover the ASX graphite companies, considering such a review hadn’t been attempted by an analyst in the ASX graphite market to that level of detail. While they (Pattersons) had been paid previously by VXL and TLG, their report was probably as unbiased as you’d find from a resource analyst in Oz. (note I’m not saying it was totally unbiased, merely that it’s nowhere near as rampantly blind as many of the broker reports on various companies).
They spent some time in their rating focussing on deposit metrics, so I thought I’d do something a little different. I’m going to ignore the deposits partly, and focus on the likelihood of which graphite companies have the most chance of making it into production (and by corollary, which ones don’t). There is a lot of chatter around all the graphite companies about whose JORC is biggest, whose is best, and why they are King of their respective hills.
So I wanted to inject some reasoning into the debate, and boil things down to what is ultimately important, which is: who is actually going to sell their production? (which is a vastly different question to “whose deposit is best”, and with much more important ramifications as to whether a company will actually survive, let alone make any money for investors).
While I’m inserting comments about other graphite companies, this is ultimately intended for KNL holders, and in particular for those “sitting on the fence” and trying to make sense of all the choices.
Why did I decide to do this? Well, I’m glad you asked. Take a look at the below table. It’s all the production targets for the ASX graphite companies (i.e. ignoring the significant amount from TSX). This list is taken straight from Pattersons, so it excludes some companies, but to be honest they wouldn’t really be of enough note to make the list anyway (apologies to those holders, but realistically they are way behind the curve in terms of a likely chance to production, and in particular with little to no chance of securing off-takes for production that is too far into the future).
Notice that on an approx total, there are 1 million new tonnes of annual graphite production supposedly in motion on the ASX. That is almost equivalent to the global supply in flake for each of 2013 and 2014. If I added up every single minnow, and included the TSX, then the globally planned production is well in excess of the current global graphite market.
I’ve taken some assumptions to fill in some holes that Patterson didn’t do, namely:
TON – I’ve put a nominal 200 ktpa, to bring to par with SYR. It’s above TON’s previously announced production targets, and above the Pattersons report, but given the amount of vitriol flying between TON/SYR on HC, their shareholders obviously believe that the deposit is at least the equal of SYR, hence I’ve put a roughly equal production target for it.
MNS (UNX) – This is left blank on the Pattersons report, however the company announcement of 8/9 clearly states they have MOUs for 2 x 100 ktpa buyers, so they would qualify under my definition of a super pits (also note that I didn’t make up that name super pit, I borrowed the name from another post I saw, so I don’t know whether it would be classed as an official term, but I like it anyway)
VXL/KNL/LMB all have published targets in their presentations, so hence their respective numbers.
There are a number of remaining companies that have 25 ktpa production targets, which is a nominal amount I made up. They were all left blank by Pattersons, most likely due to still being in exploration and not having come up with a formally adopted number. I’ve given them all a minimum of 25ktpa, because anything smaller than that is unlikely to seriously go into production as a newly constructed mine. If I’m wrong and there is one that goes in with only 5 ktpa, then my aggregate point will likely still stand as there will be others who will come out and say they will do 50 ktpa.
So, let’s go the the important bit. Hands up those who believe all those companies are going to be able to produce and sell their all their production targets?
No hands? Hmm. That means, we need to start culling. (BTW - hopefully people will realise that the intent of the above table is to highlight how much in aggregate is supposed to be in the pipeline, and this is not intended to be a discussion about whether individual company numbers are 100% correct).
How do we cull? Well I’m taking a bankers view as to who has a realistic chance of getting funded into production. You may disagree with me, but unless you genuinely believe that every single company is going to get funding and make it into production, then blind Freddy can see that there has to be a cull .. although we can use the more genteel term of “rationalisation” .
The single biggest thing a funder is going to focus on is whether you can sell your product. While they will seriously consider such things as flake, grade, near surface or at depth, opex, infrastructure, etc, ultimately every single one of those considerations can be mitigated by a funder if the company can demonstrate a genuine, binding buyer at a price above opex and capex repayments.
So here is a bigger table to show the current publicly available state of how buyer discussions are going (excluding the ubiquitous comment of “buyer discussions are progressing” because everyone says that whether it’s true or not):
The amount of “nil” cells shows up pretty starkly. All the talk of recent drill hits, high grades, JORCs, suddenly doesn’t seem to flow into many genuinely compelling cases for funding.
So who makes it?
Super-Pits
Let’s dissect the super-pits first. They deserve their own special case, because they all have marketing out there that they are going to be massive, with either a massive deposit, or massive buying interest, or both. And their management are being a bit cute with their shareholders by not informing them of the actual state of graphite today (excluding potential growth from EVs, graphene uses, grid storage, pebble beds, etc).
First off, in today’s demand (today being the operative word), none of them would make their proposed production targets. Not one. Leaving aside new markets (I’ll come back to that later) and focussing on existing markets, there are no large genuine buyers of that size around who would take up all that demand. It is naïve in the extreme to think that more than 50% of the current global graphite market is going to suddenly be met by these three mines within 2 years.
Further, in today’s market, small buyers are generally unwilling to commit to large mines, for a number of reasons:
1. They have to commit to a small portion of the mine, without having any surety that the mine will actually sell any more graphite and therefore may not get into production, thus leaving the small buyer high and dry without sufficient time to organise a new supplier.
2. As a small customer, they are less able to get confidence of supply consistency. A large mine could start delivering graphite from different parts of the deposit, of different make-up, and while this might not be any notionally less quality, the difference could still cause significant challenges for the buyer depending on how they tooled up their machines to cope with the previous unique part of the deposit.
3.
Ultimately, the relationship between graphite buyer and miner is much closer than say the bulk commodities. Small buyers are going to be hesitant to be a minor name for 10 ktpa on a 200 ktpa production profile, unless all they are interested in is the cheaper, inferior quality product. But how many of the super pits really want those buyers?
So, it’s unlikely (highly improbable actually) that all the smaller buyers of the world are going to turn up to any super-pit and say “we want your stuff”. To support my point, I note that VXL has signed up MOUs for 4 customers totalling 29 ktpa, and KNL has 2 customers (one off-take, one LOI) for min 30 kpta. So far, not a single small customer has gone the way of the super-pit.
Which leads us back to the new market potential. In the absence of an aggregation of small customers, then the super-pits need to target large deals, and those deals need to be for new markets as the existing graphite demand doesn’t exist from individual buyers of that size.
Likelihood? Personally, I don’t know for certainty, but I’d suggest it’s going to be very difficult. So far, there is no hard evidence. What I do know in banking terms is that for a binding deal to be genuinely bankable, the counter party risk is going to be heavily scrutinised by a funder, and in this regard the Chinese MOUs are going to be pushing the proverbial uphill. Funders have to consider their worst case scenarios, and that is that they may have to step in and take over the mine. And if they do so, and their off-take partner refuses to play ball, it leaves them with graphite that they can’t sell to anyone else, due to there being no spot market, nor any consistency between graphite deposits (and sub-grade product designed for low end market).
Of the 3 super-pits, barring any catastrophic share slump, SYR has the most likelihood of success, if it can convince the 2 MOUs to become genuinely binding off-take deals. In funding terms, there is a whole lot more margin for error, given their market cap. TON and MNS need to sign off-take deals with companies with massive balance sheets to obtain traditional funding, and may still struggle if their funders can’t mitigate the counter-party risk. SYR is potentially in the position where it could raise enough money to fund a mine without using a funder, although that would be a massive ask, and would need still something stronger than it’s “maybe” MOUs. And in this market environment, even they may suffer trying to raise that amount of money.
One exception that all 3 may be aiming for is that their alleged off-takes may come with the provision of funding. To my mind, the single best way to mitigate counter party risk from Chinese buyers is to have a Chinese lender.
In assessing the super pits, it’s clear that they are all hoisting their flags on the good ship China. Of the 3, SYR I deem the most likely. Their market cap is sufficient enough (even at these depressed rates) to make funders take notice. And their planning is sufficiently advanced. Those posters who believe that TON and MNS are quickly “closing the gap” in terms of a race to production are being naïve or living on hope, not reason. SYR have had the “world’s largest resource” some time ago (irrespective of whether TON believes they are now No 1), and started focusing their management on delivery, not drilling, quite some time ago. They are so far in front of the other potential super pits, not that the market necessarily realises this, as the actions taken behind the scenes aren’t those that are reported to the ASX on a regular basis until they yield reportable results. However, while I deem SYR “most likely”, they still have a significant headwind … in that they don’t actually have a committed buyer who wants their stuff. If they use their market cap to get funding, they still will run the risk that they will be stockpiling their graphite, not selling it. Given that an MOU of 100ktpa represents nearly 10% of the world’s current annual supply, I’d be asking questions of their (MOU) confidence. When I then add that the major shareholder and company insider has sold out and pocketed $55m+ and run (I don’t know if that number is accurate, but regardless, the real number is significantly large), that raises a significant concern about belief in longevity.
There is another alternative that super-pit investors won’t like, which is that the super-pits can’t actually start out life as a super-pit. They go and pursue smaller genuine buyers, build smaller mines, and supply smaller quantities, and build up over a longer timeframe. But that’s a dose of reality that they aren’t going to be prepared to hear until some time next year when faced with an existential question as to whether they even survive or not.
“Normal” Sized Graphite Mines
There are a few here, but as a banker it’s pretty easy to cull the majority. There aren’t many who are even in the realm of possibility of having buyers. But there are a few that rate a mention:
VXL – The mine that was supposed to be quickest to initial operation and ramp up of production facility (because they were kickstarting an existing facility with existing stockpiles). Of concern here is that they were supposed to be positive cashflow by now, based on the Phase 1 operations. They sent off numerous samples, but the buyers haven’t yet been materially forthcoming and buying today. On the positive side, they are engaged with numerous buyers about future production. While they are all relatively small, they are genuine buyers in the current marketplace. Investors need to realise that current buyers for current demand are smaller in size, especially outside of China (which can, behind the scenes, organise a few SOE’s together to make it appear like one big buyer). I think it was Simon Moores or Stephen Riddle who said in a recent article that a 20ktpa graphite buyer is a big buyer in the current global graphite market. I agree with that.
While VXL will continue progressing, they haven’t been knocked over in the rush for selling their production. Their sales were originally published at $1,400 per tonne, which is optimistic bulldust. I note that their latest presentation doesn’t state their previously stated $1,400 basket price (in fact, it says nothing on this).
My view is that they will get into proper production (I’m referring to phase 2 here, not the processing of stockpiled ore), but with a lesser production target than initially planned, and with a lesser basket price than originally published.
Additional note – I’m excluding the new small niche arm of the deposit they recently discovered, with some massive flake properties. I think this has some potential, but I don’t know if it’s large enough to make a big difference. We will see over the course of 2015. I hope for their sake that it is a game changer (that was their words, not mine).
LMB – their off-take is suspect, or an outright lie. They did not sign an arms-length off-take agreement at a minimum of $2K per tonne, only to then sign a JV agreement 3 weeks later with that buyer, completely out of the blue. The buyer (Hengda) knew what they were doing in advance, and the company would have too. The price was set at that level because Hengda knew it was only ever going to be paid to itself (i.e. after the merger or takeover, one arm of the business was going to buy the graphite from the other arm of the business. It would be paper/accounting entries, not $2K in hard cash for each tonne). The failing of the JV negotiations has been harsh, and I’d personally much prefer to have seen the JV go through. (disclosure, I personally purchased a small amount of stock in this after the offtake was announced, but sold the instant the JV was announced, as I recognised that the off-take deal wasn’t arm’s length, nor likely binding).
Which brings me to KNL.
They are the first graphite company on the ASX to achieve a binding off-take, and in the wake of the LMB fiasco, they are the only company on the ASX to have a genuine buyer on a committed deal.
They are
the first graphite company on the ASX to sign a sales agreement with a non-Chinese company. This is highly important when it comes to funding. Chinese buyers are great if you are dealing with Chinese bankers, but if not, then funders are going to have difficulty relying on agreements with Chinese buyers that they can’t legally enforce. An exception to this is if the Chinese buyers put up certain guarantees, issued by non-Chinese banks, or some similar structure.
They are targeting existing non-Chinese buyers, in the existing graphite market. They have two European buyers already, and are discussing with at least one Japanese and one US buyer.
Unlike other spruikers, KNL started out planning for a 20 ktpa graphite mine. They only increased it recently to 40 ktpa once they knew they had buyer interest coming in. If the other discussions go well in early 2015, then the production target could be raised one more time before the final BFS.
They have a buyer who has sufficient standing and balance sheet (ThyssenKrupp) to provide significant support to our funding, both implicit and explicit. Having a massive balance sheet and $39b in annual sales will do that. Their main area of operations (Europe) also provides a significant comfort to our likely funders.
Concluding comments
Ignoring individual broker reports, and instead focussing on sector reports, both Argonaut and Pattersons have put KNL in their top 2 and top 3 (respectively) graphite companies that will be going into production (in Argonaut’s case, they go further and state the company will be at least a $100m+ company within 2 years).
I agree with Pattersons that the top 3 likely to make it into production are SYR, VXL, and KNL. However, as an investor, I disagree with their ranking. As an investor, I’m concerned about the amount of money I will make long term, and on that metric, KNL is the front runner.
SYR has such a large market cap, that some element of future production is already built into the price. On a 6 times PE, it needs to be earning 50c per share, NPAT, just to justify it's current share price. Will it do that? Not in my opinion. I’d love to be proven wrong, but the lack of genuine buyers committing at a stage when they need to finalise their funding, is a concern. The likelihood is that SYR is going to be a bulk operator, which means high volume, low margins. While they will be profitable, they won’t be making the sort of return on their shares that other companies do, and not sufficient to justify the current share price.
VXL is also going to be profitable, but not massively so. Their share price already has a tremendous amount priced in. Their sales are already behind where they said they would be in 2014, and doesn’t bode well for 2015. I think they will start to stockpile a fair bit of their production, if they get to 74 ktpa next year.
KNL has a small market cap. Locked in cashflow. And is only planning for a mine size that matches it’s buyer order book. It’s ROE is, in my opinion, going to be significantly higher over the long term than SYR or VXL.
I could all be wrong, if graphite take up is suddenly astronomical (i.e. jumping from 1m tpa to 3m tpa in the space of a couple of years as some bullish people have suggested off the back of battery demand, and I'm not necessarily against that view). Or if some new markets are created for graphite. However, based on today’s graphite market, the majority of new entrants won’t ever turn a single sod of soil. So we have to choose wisely.
