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I covered Sirius Minerals (SXX) in a piece here in 2016, tipping the stock at 38p with a target to sell at 50p. When I wrote the piece I expected the 50p target to take at least 12 months to reach. The stock though raced ahead just two days later when it hit an intraday high of 52.5p in a very bullish summer market on AIM. The company later in the year closed its financing for its Potash project late in 2016, but rather disappointingly for longer term holders the stock trades hands today for just 18p, less than half of it recent highs and actually even 10% below the recent placing price.
Sirius is developing a mine in North Yorkshire extracting the fertiliser Polyhalite (POLY4). Here are the quick facts on Sirius as at 12th February 2017:
|Current Share Price||18.25p|
|All Time High||52.5p, August 2016|
|52 Week Low/High||Low 10.5p on 12th Feb 2016
High 52.5p on 23rd August 2016
|Enterprise Value||£760m – Expected to increase as debt used.|
|Fully Diluted Market Capitalisation||£1bn (includes convertible loan note)|
|Others||EPS, P/E Ratio and Dividend Not Relevant|
What has happened since your last coverage and why the sharp decline in share price?
One of the biggest hurdles was securing finance for the project, which was completed in November 2016. The total raised was $1.1bn dollars (£900m), a significant amount for a company that started 2016 capitalised at £350m. The terms of the funding were as follows:
- $250m Royalty agreement. The contract is for 70 years and gives a 5% royalty on the revenues from the first 13 million Tonnes produced per annum and 1% on any excess.
- $400m Convertible Bond. The coupon is for 8.5% and convertible at a 25% premium to the Placing Price, i.e. $0.30 or 25p at today’s FX rate. The duration of the loan is 6 years and Sirius can call the bonds from December 2018 subject to terms. This gives Sirius potential flexibility to refinance the bonds, albeit the call premium is between 50%-75% of the nominal amount, so not so cheap to do so.
- Placing and Open offer raising £370m through the issue of 1.8bn shares at 20p, a 46% discount to the share price close on the day prior to the announcement.
The financing was the last major piece of the jigsaw to get the project going and yet the shares are now trading at less than 50% of their peak, why? The shares got well ahead of themselves, on a fully diluted basis the shares were valuing the company at almost £3bn, it seemed the market had forgotten that a significant equity injection was required and the debt funding was likely to have a convertible feature. The new equity holders and loan note holders needed a much larger discount to take part in this placement to ensure a satisfactory return, particularly if their valuations were inline with my own, which I outline later. The secondary market initially didn’t know how to react to the placing price being at such a steep discount, consequently it took some time for the price to fall towards the placement price, this allowed opportunists participating in the placing to take a quick profit.
Around 1.8bn new shares were issued as part of the placing and around 30bn shares have been traded since, so much of the overhang is likely to have cleared now. The daily volumes as indicated in figure 1 have also started to fall away, so it’s now time to think about what is a fair valuation based on fundamentals alone….
So what is a fair valuation for Sirius Minerals?
The company is well covered by brokers who all have BUY targets of varying degrees. The company has also communicated a Project NPV of $15bn, but this doesn’t take account of the financing. I have done a crude valuation myself based on a Risked Discounted Cash Flow and my calculations show a risked NPV of £2.4bn and a fully diluted fair value of 44p per share.
I have adopted a prudent price assumption for POLY4 and assumed the convertible loan note will be turned into equity. I have also only ran the model to 2038 to cover the probable JORC reserves of 280 Million Tonnes as opposed to the full contingent resources. I have further risked the NPV at 60%, this is perhaps excessively harsh but there are still fairly large risks to the project. I would look to lower the risking once further offtake agreements are signed and the Muriate of Potash spot price starts to recover. I have discussed these risks in more detail below.
For those that are interested, the full detail behind my NPV calculation is here.
WHAT ARE THE RISKS AND POTENTIAL FURTHER UPSIDES FROM HERE?
1) Polyhalite Price (Poly4) and Offtake Agreements
Traditional fertiliser is what is known as Muriate of Potash (MOP) which currently accounts for the majority of fertilisers sold worldwide. Sirius Minerals are mining Polyhalite (POLY4) which contains four of the six macro nutrients needed for organic growth. POLY4 contains though just 14% potassium which is the principal product used as fertiliser. This compares to around 60% for MOP, this has led to some commentators to label it as an inferior product. However, trials commissioned by Sirius indicate the product has resulted in impressive boosts to the yields of crops compared to its more common cousin MOP. For example, the use of POLY4 increases Tomato yield by 73% compared to 20% for MOP. The other stated advantage of POLY4 over MOP is a lower Chloride content which makes it ideal for crops sensitive to this input.
Based on research Sirius estimate a price of $140-$160 per tonne can be achieved based on a 10-20 Million tonnes per annum supply, see the supply and demand curve below in Figure 3. The good news for Sirius is that it currently only has one competitor, the nearby by Boulby Mine which mines and markets a similar compound under the name Polysulphate.
The overall fertiliser demand is estimated to be around 200 Million Tonnes per year by 2018 according to the United Nations. Sirius believe that its product can actually be a substitute for up to 376m Tonnes of products based on a different study though. Given that the combination of Boulby and Sirius Production will be initially only 10 million tonnes it is therefore safe to assume, that that the POLY4 price is likely to be driven by the global spot prices of MOP intially. Based on information released by Sirius it appears that POLY4 attracts around a 33% discount to MOP, I have based this on the current contracted volumes weighted average of $145 per tonne as released by Sirius in its most recent investor presentation in December, this being when the MOP price was $215 per Tonne.
MOP prices are currently at a 10 year low as indicated in figure 4. Longer term I believe the demand for Potash will continue due to a growing global population. Projections are that the world population will grow at 1.1% a year. Supply though is predicted to continue to outstrip demand in the short term, Sirius alone adding between 5%-10% of global supply by 2027, depending on which study you believe. This excess supply means that in the next two years the MOP price is predicted to fall a further 10% to $190 per Tonne, given the discount implied by the offtake agreement this could be as low as $133 per Tonne for POLY4. It is worth noting though that the discount to MOP and to the nutritional value of POLY4 has the potential to narrow once the product is marketed further and is tested in commercial quantities.
There is also evidence of mothballing of some less profitable mines, so this downtrend in prices may reverse and with Sirius having a very profitable mine it is likely to be able to carry on producing even as far down to prices to $50 per Tonne i.e. 1/3 of the current spot price and continue to be be cashflow neutral. The ability to do this for periods of time allows Sirius to benefit from the potential for much higher prices in the longer run. In the valuation I have adopted $145 per tonne for 2017 and inflated by the 1.1% year population growth. Any further downside is captured in the general risking I have applied. The POLY4 price is likely to be volatile depending on supply/demand but given the long term demand growth and with the current MOP Spot price being at a decade low the downside risk is likely minimal.
Sirius still needs to secure further offtake agreements for it product too. It has so far signed 5-10 year ‘take or pay’ offtake agreements for 3.6Million Tonnes per year with customers over 3 continents. This issue is not urgent as Sirius will not hit this level of production until 2023, so it has plenty of time to further market the product toward securing offtakes for a good proportion of the 20 Million Tonnes per annum capacity by 2027. The company also has a further 4.5Million Tonnes in Letter of Intent agreements which it can hopefully convert into binding agreements over the coming years.
2) Project Overruns
The mine is four years to first production and it will be six years before the initial phase of the project is complete. There will be ‘ups and downs’ in a project of this nature. I’ve lost count of the number of horror stories that I’ve heard over the years from EPC contractors in the extractive industry. A recent case I heard was production wells being drilled and tied into a gas plant only to find the first well produced oil and not gas! For Sirius it is unlikely to come across a fundamental flaw in the project such as that one, but there will be technical challenges for sure, the bottom line is that you can do as much exploration and appraisal as you want, but Sirius will only know what they have once they start developing the project. Perhaps not a great surprise then that according to EY the average budget overrun on ‘mega’ mining projects is a staggering 62%!
Management though are hugely experienced and have impressed me greatly with how they are on track to take an AIM minnow to the FTSE250, if not higher. I have confidence therefore that Sirius will deliver close to budget. The project is also using standard techniques and the existing mines in the area derisks the geological challenges somewhat. The NPV also isn’t hugely sensitive to modest CAPEX overruns given the huge project return, but overruns will require further funding and depending on the magnitude this could result in more equity in the company being needed which could dilute the existing equity holders.
3) Stage 2 Financing
This feels fairly low risk, various banks are already tasked to secure debt funding for the remaining financing needed. Assuming the project execution is on track there should be limited risks of securing the next stage financing at competitive rates.
4) One Trick Pony
Sirius minerals has just one asset and one product, this means that a combination of some or all of the above risks will be more concentrated here than those in a more diversified company. This naturally leads to a risk discount in the value versus a more diversified peer. However, if you have a well diversified portfolio already then you can use this discount to your advantage, particularly if you intend to hold for the long term.
5) Further Resources
On top of the 280 Million Tonnes of Polyhalite included in reserves there is a further potential reserve of 2.6bn tonnes. This should stretch the mine’s life well beyond 2038 and further exploration is likely to take place once the initial mine is on well on track.
6) Transfer to Main Market
Sirius has stated it is seeking to transfer to the main market of the London Stock Exchange by the end of 2017. Based on current market capitalisation it is currently the 329th largest company on the exchange. This makes Sirius a potential FTSE250 candidate and if the share price increases further within the next few months it is almost certain to guarantee entry to this index. This means tracker funds and ETFs will need to buy Sirius on entry, which is likely to add further buying pressure.
BUY – Target 41p, 124% upside
Initial target for 41p with significant further upside beyond as the project matures and is further derisked. The biggest risk is the development of Potash prices but Sirius with the margins of the project is in a very good position to survive any weakness in prices.
Further share price growth is possible over the longer term too. A share price of over 100p on first production, i.e. 400% gain would not be a fantasy. This is a ‘one trick pony’ stock though so ensure any holdings are part of a well diversified portfolio.
This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.