Newcomers outshine the old guard

Update: Newcomers Outshine The Old Guard
Sep. 11, 2015 3:41 PM

http://seekingalpha.com/article/3505796-graphite-industry-update-newcomers-outshine-the-old-guard

Summary

• The graphite sector is bifurcating as investors reject the "old-guard" strategy of developing large graphite deposits.
• Investors have realized these "old-guard" companies have generally taken an overly simplistic approach to the industry, thus rendering their feasibility studies incomplete.
• As these companies fade away or reinvent themselves the "new-guard" is emerging: this includes companies developing small projects with specific markets in mind.
• The "new guard" is beginning to outperform despite weakness in the TSX.v or the global stock market generally, and we believe this can continue.

The Canadian graphite junior mining sector is undergoing a shift. Investors have begun to wake up to some of the fundamental realities of how the market works, and as a result they're no longer buying several stories that are out there.

Before discussing this shift, its beneficiaries and its victims, it is critical to make a point that is obvious to any investor in small companies with no revenues and cash-flow but which needs repeating: company valuations are all based solely on what people think the assets are worth, and not on actual cash-flow estimates based on ongoing operations coupled with a history of data. Everything is a projection at this point. This is an especially great hurdle to understanding these investments for an industry as counterintuitive as graphite. What makes this hurdle to understanding worse is that graphite shares similarities with other industries, meaning that investors are liable to believe all sorts of things about graphite that aren't true.

This is a problem best characterized by the overlap between mining and graphite, since graphite has a mining element. Given that mining executives were developing these projects and marketing them to investors as mining investments we saw a certain kind of company generate market interest during the first graphite wave that started in 2011. Two ideas emerged. First, you mine graphite, and in mining you want to produce as much as you can as quickly as you can. The implication is that you want a bigger project. The second is that certain kinds of graphite are more valuable than others, and that only certain types of graphite can be used for the new applications that have been generating investor enthusiasm for graphite in the first place.

These beliefs brought capital into certain kinds of companies and led to unfounded statements such as "only such and such project is suitable as an investment or is suitable for certain (hi-tech) applications." Unfounded dogma pushed a lot of money into two companies in particular: Zenyatta Ventures (OTCQX:ZENYF) and Syrah Resources (ASX: SYR) (OTCPK:SYAAF) (an Australian name, but one that is relevant to this discussion). Both companies continue to trade at substantial premiums to the other graphite companies out there because of their cash-flow projections, not their cash-flows. It is interesting to note that as these companies' projects have developed the core misconception has grown to the point of utter lunacy. For Zenyatta it is that vein graphite is 10-times more valuable than flake graphite. For Syrah it is that they can successfully run a graphite business that is 10-times larger than the largest in the world.
The market has since cooled off on both stocks, but they are trading at extraordinary multiples to their pre-mania valuations. Zenyatta went from C$0.12/share in 2011 to C$5 in 2013 trough to peak and currently trades at C$1.35/share. Syrah traded at A$0.10 in 2011 before peaking last year at A$6 while trading at A$2.88 today.

Shareholders in these companies (and in new Australian companies with similarly gigantic projects: Magnis Resources and Triton Minerals) aren't going to budge from these beliefs very easily, since the beliefs that make these investments appear to be so compelling are core beliefs about the market.

We then have the group of Canadian juniors who came around in 2010-12 with large (not gigantic) flake graphite deposits, namely Northern Graphite, Focus Graphite, Mason Graphite, Energizer Resources, and Graphite One. Each of these companies has marketed its business very differently, but basically they have been represented as mining businesses as evidenced by their adherence to the typical mine development timeline (exploration, resource, PEA, FS). They all have plenty of graphite from the market's standpoint, but they all had/have production goals of ~40-50,000 tpa. Only Mason has emphasized the customer-oriented side of this business in its investor relations, and this is why we don't think the company's aspirations are out of reach. Northern has instead followed a path similar to Zenyatta although without the incredible exaggeration of its graphite's value (all companies have exaggerated to some extent). It has dubbed its large-flake graphite "battery-grade" despite the fact that graphite for batteries can and does come from small flakes. This myth has worn thin, however, and the company recently had a disappointing capital raise where it was only able to generate half of its goal. Focus emphasized batteries as well, although it has had numerous problems from outlandish expenditures, failed capital raises and managerial shake-ups. It is currently trying to raise money at less than 90% of its peak share price of C$1.50, and we are skeptical that it can succeed even in this. Energizer Resources has a massive deposit in Madagascar that poses an infrastructural nightmare. There have been management changes and the stock has crashed right as the company needs to raise money. We expect them to announce a capital raise shortly at a disappointing $0.04/share. Graphite One is behind in terms of mine development but it has generated interest as the "largest deposit in the US." Looking at the deposit size we can imagine that the company envisions a similar-sized project. This company is more than 2-weeks into a tiny yet crucial capital raise, which may not succeed.

If we look at these stocks over the past year (Energizer isn't included but it is down 65%) we'll see that the problem-stocks--Focus, Northern and Energizer--have all underperformed the TSX (and given obvious problems this isn't surprising) while Graphite One and Mason performed in-line. Mason has likely held up given its institutional interest and insider buying. I don't know what is holding Graphite One up although it is only valued at C$12 million, meaning it should take less capital to maintain a given share price.

It is worth noting that Mason's C$35 million valuation is the highest of the pack, with Northern Graphite's C$18 million valuation a distant second.

The trouble with these projects is that it is going to take an enormous amount of work to sell graphite to consumers. Mining investors who ventured into graphite were loathe to discover that a feasibility study with strong economics doesn't necessarily lead to financing. Financiers need to be sure that a company can sell the product for the price it says it can, and verifying this for a particular graphite deposit is incredibly costly and time-consuming (this could be why Mason's feasibility study has been delayed, which in the long run might be a good sign for them). Consider a feasibility study for a major gold project. I had the massive 713 page Rainy River (New Gold's next big mine in Ontario) handy and was curious to see how much information on gold pricing and sales would be there. The entire chapter amounted to this:

The company doesn't say it here, but basically it looked at past prices and used some formula to determine the project's value and rate of return based on these observations. There's no obstacle to get to the market, only price-uncertainty.

If we take another example: the Bissett Creek feasibility study (August 2012) and look at the "market" section it is clear why the company hasn't received financing. There is some more depth here, but we get vague and even incorrect statements regarding prices and future demand. Here are a couple that stand out:

• Industrial Minerals projects a Base Case demand of 1,235,000 t of natural graphite in 2016 with a Bullish Case of 1,528,000 t for a possible increase of 16-44% over five years. Also the refractories and batteries sectors require the same grade of medium to large flake graphite (+80 mesh, +85% C), which will correspond to the major portion of the Bissett Creek graphite concentrates and should assist its marketing because of its proportionally higher demand.

• Like for all commodities, it is near impossible to forecast accurately future prices for graphite. However, the increased demand of commodities mostly due to economic growth in developing countries has caused a major impact on pricing as supply is lagging demand in most markets. It is believed that this situation will also prevail on the graphite market because new supply in industrial minerals is particularly difficult to finance due to its of lack of visibility and relatively small markets.

In the first statement we note how far off Industrial Minerals' 2016 projects will likely be given that demand in 2015 is just 1.1 million tonnes in a weakening market environment. We also note that it is not the case that having more large flake graphite makes marketing easier. Northern Graphite's failure to market its graphite in the three years since its feasibility study was released is compelling supporting evidence of this.
The second statement is worse since it projects economic growth as bullish for commodities, and assumes that economic growth is axiomatic. In essence this says: "graphite will perform well because the economy will grow." We refuse to take such analysis seriously in the face of such a speculative investment proposition (as all graphite juniors, with out exception, are speculations).

Granted it isn't all bad information, but it is vague, and there is very little information on the logistics of selling graphite: the emphasis is all on price. Take, for instance, the sales contract. It is only discussed in the context of prices. No information whatsoever is given regarding standard duration, quality assurance and qualification periods, or quantities of material involved. As we couple this observation with the fact that Northern Graphite has yet to secure one of these sales contracts (which were supposed to be easy to secure given the company's "high quality" graphite) or to convince somebody with deep pockets that it can do so we can better grasp the larger problem facing Northern Graphite as it looks for financing and regular customers. .
I only pick on Northern because it was first. You'll find the same flaws in other feasibility studies' market assessments. These include:

• There is incorrect information regarding which kinds of graphite can be used in which applications. You'll find that the problem with most graphite isn't that it can't be used in these applications but rather that it costs to much to purify or refine in the form in which it is found. The only way to demonstrate the viability of graphite in any of these applications is to demonstrate the economic viability of the purification and refining processes, which no company has done.

• There are arbitrary assumptions regarding future demand that are based on vague observations of small, near-term trends. Any graphite demand projection you see coming out of the main research firms--financed by the graphite juniors who need bullish investors--says that demand will rise pretty much every year and that prices will rise as well. Of course the trend is down, demand is down, and supply is plentiful.

• Marketing is omitted and is assumed to cost nothing.
These problems can easily be addressed, but their solutions will not please shareholders. If these companies had to admit that there is a significant marketing cost and that graphite prices are way down and likely moving lower the end result would be smaller projects across the board with higher costs on a per-unit basis. Unfortunately these projects need economies of scale in order to make sense, and as a result they are destined to fail.

The "New Guard"

A few new graphite companies have popped up in the last several months or so: Eagle Graphite (TSX.v: EGA) (OTC:APMFF) Great Lakes Graphite ( TSX.v: GLK) (OTCPK:GLKIF), DNI Metals (TSX.v: DNI) (OTCPKMNKF), and Nouveau Monde (TSX.v: NOU) (OTC:NMGRF). These companies look very different when charted against the TSX.v.

I only went back to January 22nd when Eagle Graphite began trading, but as you can see we get a very different picture. Two of the companies--Great Lakes Graphite and Nouveau Monde are performing astonishingly well, dramatically outperforming virtually anything that is commonly used as an asset yardstick. DNI Metals has performed extremely well. Eagle Graphite has performed in line with the TSX Venture, but note the initial tumble of the shares after trade commenced. Since then they appear to have bottomed in April and are now trending higher.
There were no up-trends among the other group--the old guard--even if some were holding up better than others.

So, what sets these new companies apart?

The skeptic will point out that they are relatively new, and they have low market capitalizations. So one theory is that investors haven't yet been frustrated out of these names and they like the opportunity to own a bigger piece of a graphite company. There's probably some of this going on. But at the same time these companies all have a similar approach to the market that differs markedly from the first few companies. We will note first, however, that they actually have very different approaches to the market on the surface.
• Great Lakes Graphite is not mining, but rather micronizing graphite that it buys from DNI Metals.
• DNI Metals is mining graphite on a small scale in Brazil and Madagascar with Great Lakes Graphite as a primary customer.
• Eagle Graphite is preparing the small yet advanced Black Crystal Project for production. The project is fully permitted with essential infrastructure already in place. The company also has a long-term offtake agreement for 3,000 tpa. of graphite, or most of the project's productive capacity.
• Nouveau Monde is a prospect generator that is developing a deposit that could produce graphite that is suitable for Imerys' spherical graphite plant. The deposit is nearby and Imerys' Lac-des-Iles mine is nearly depleted.

While they are very different companies we note that they all approach the industry with a similar philosophy: they are focused on small projects and on forming relationships with specific customers.
We see a radically simplified approach in all four companies, and investors are taking notice as evidenced by the outperformance. Companies are aspiring to produce less (Eagle Graphite, DNI Metals) and are taking on smaller pieces of the value-chain (Great Lakes Graphite, Nouveau Monde). Finally, they are finding ways to minimize costs: only Nouveau Monde would be building a mine, and it would be able to get Imerys to put up the money in exchange for supply security. Eagle Graphite, DNI, and Great Lakes are all operating past-producing assets with useful infrastructure on site and few obstacles keeping them from production.

The Bottom Line

The graphite industry is changing. While Australian investors are still supporting their massive projects in North America we are seeing a different approach that is clearly conscious of the short-comings of the first wave of companies. The primary flaw is that they are too big: such projects require too much initial marketing work to justify the effort unless it is financed by internally generated cash-flow. This is why I think smaller companies are better positioned to produce in that 40-50 ktpa. range than those who are currently aspiring to do so: it will be easier to go from 0 to 10 ktpa, and gradually work up to 50ktpa. than to simply go from 0 to 50 ktpa. However that doesn't mean it can't be done.
Investors have to evaluate the "new" approach with healthy skepticism: we still need to see one or more of these companies develop into a sustainable cash-flow generating business. However we can certainly appreciate the logic behind its emergence, and suspect that it will prove to be a superior approach.

Disclosure: I am/we are long GLKIF.

I wrote this article myself, and it expresses my
own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.