“Wisdom is learning what to overlook”
- William James
“…a fiery growth engine, the kind of business we like to own: one that doesn’t require enormous sums of cash to generate annuity-like cash flow”
- Sardar Biglari
For part 2 of the ongoing review of the high quality assets backing Sandstorms M&E streaming portfolio, I want to turn our attention to Sandstorm’s flagship Metallurgical Coal assets. I’ve chosen to follow up with the met coal deals primarily because I think that they offer yet another powerful illustration of the fact that SND’s highly attractive streaming assets can be purchased at a price that is by any rational measure completely out of proportion to economic reality, and almost certainly unsustainable assuming pretty much any future scenario where the world doesn’t actually end.
So, without further ado let me introduce you to NovaDx and its low cost, long-lived high quality metallurgical coal play(s), the Rosa and Rex No. 1 mines. Like with nearly all of SND’s streaming assets, the potential to increase value above and beyond the initial 2013 reserve/production estimates is substantial (to say the least) and the potential for a true moonshot type of homerun when all is said and done is very, very real. Of course, I would do a disservice to not mention that SND shareholders at current prices are quite literally paying nothing for this high probability, heads I win, tails I don’t lose call option on high quality silicon based met coal, so definitely keep that in mind as we go.
My hope is this latest rational walk will highlight the above reality and in the process, provide the breadcrumbs that ultimately persuade other bargain hunting investors to really roll up their analytical sleeves so to speak and do the work necessary to get to know these assets, their respective competitive/cost positions, the guys running the show, and last but not least, to come to a firm conviction as far as what is, and is not, an appropriate valuation after weighing all of those factors. While I’m not certain of many things, I am certain that the price implied expectations are one thing, but reality here is another – and so I think the real rewards (as always) will accrue to those that can tell the difference and position themselves accordingly.
So lets get to it.
Thoughts on the Silicon Metallurgical Coal Market
Before I begin I want to note that I’ve chosen to focus on the silicon coal aspect of this story as opposed to met coal utilized in the coking and activated carbon markets, primarily because the vast majority of the potential value creation here resides in the continued development of SND’s Rex No. 1 stream and the high quality silicon coal it produces. For those who aren’t familiar with silicon coal and its uses, silicon is a key input in silicon metal and hence by extension in thousands of industrial and consumer products unrelated to steel production – typically within the chemicals and aluminum industries. So I think its crucial to understand this nuance, as NDX – and SND by extension – and its Rex No. 1 mine is well positioned to capitalize on the anticipated growth and widening supply/demand imbalance of silicon coal over time.
Keep in mind that demand for Silicon metals is a secular growth story that is both firmly intact and driven by a confluence of global macro “mega trends.” These “mega trends” make silicon coal somewhat unique amongst the coal family, given it possesses multiple sources of end market demand. Much like the difference between silver and gold, silicon coal’s supply/demand dynamics are driven by multiple uses in more a more varied set of end markets. The takeaway is that pricing isn’t solely reliant on the relentless shift of China’s rise as the economic center of gravity as far as the consumption of met coal is concerned. This is an important and salient point to understand as far as thinking about the value of these streams long-term to SND and the associated supply/demand dynamics (and hence pricing) of the silicon coal that is produced. Granted, concerns over the pace of growth in China, the European financial crisis and the strength of the U.S. recovery have caused downward pressure on steel demand. Yet, even with these short-term concerns, U.S. coke plants are running near capacity and global steel mill percentage utilization remains in the mid-70s. With seaborne metallurgical coal demand expected to grow by more than 170 million tonnes to 428 million tonnes by 2020 (which is nearly 70 percent higher than the 2011 level) clearly the long-term fundamentals are still in tact.
What is not as well known are high quality silicon coals other industrial uses/underlying drivers, and thats a big part of this streams story. Consider silicon coals role in the production of silicon metal, which is the key component in the production of silicon chips and therefore everyday electronics. The increasingly global focus on renewable energy & energy conservation is another big piece of this puzzle that is expected to continue to benefit silicon producers and their bottom line.
For example, the use of silicon metal in aluminium alloys makes it both stronger and lighter. As a result, silicon metal is a key component in the aluminum that is being increasingly used in the automotive industry in order to replace heavier cast iron components. The benefits of this transition are obvious, as it allows car and other vehicle manufacturers to garner weight reductions. This leads to less fuel consumption and increased efficiencies and hence benefits the environment by both reducing greenhouse gas emissions and conserving fossil fuels. This is a trend thats here to stay.
Other drivers of the increasing demand for Silicon Metal (and hence silicon based coal) come from (1) the solar power industry – as solar panels are made from silicon, which use the sun’s energy to produce domestic and industrial electricity and (2) silicon based polymers – which are used as alternatives to hydrocarbon based products and appear in many other every day staples such as lubricants, greases, resins, skin and hair products. So while this is not meant in any way to be a comprehensive overview of the end markets and/or the underlying supply/demand equation that should support silicon coal pricing, I did want to briefly discuss the issue in order to highlight that numerous secular tailwinds are supporting the value of SND’s Rex No. 1 assets long-term. Taken together the tailwinds here are VERY powerful, not entirely dependent on Chinese consumption, and unlikely to relent long-term for obvious reasons, so the fundamental underlying reality governing the supply/demand imbalance of silicon coal appears here to stay and I think its reasonable to expect a stable to rising price over time.
In sum then, who knows what pricing will look like over the next year or two or how much met coal China will need to import in the meantime. I certainly don’t. Our downside here is well protected either way and the good news is that I don’t think one has to know the answer to that question anyway – at least if we’re patient, long-term investors evaluating a 2-3 decade premier coal asset with a long-term time horizon in mind.
I would also be amiss if I didn’t mention another attractive attribute of these assets that I believe is relevant in regards to thinking about the intrinsic value of SND’s stream(s), especially in context of the cyclical nature of all commodity assets generally and there potential vulnerability to external shock. Investors should understand (and appreciate) that high quality silicon producers can, and usually do, strike long-term contracts with customers for all or at least a portion of their expected production (think manufacturers of silicon metal).
As a sucker for stable, predictable cash flows with a high degree of visibility, I honestly can’t help but do a little dance when I think about this – as the combination of (1) SND’s locked in low fixed costs and well covered economics with (2) the cash flow visibility provided by long-term contracts, should will provide SND with what will be an unheard of combination of outsized and growing cash margins on production volumes coupled with a degree of cash flow stability that is honestly something approaching perfection as far as the typical commodity producer is concerned (so eat your heart out upstream MLP’s!!! Ha!).
I think its fair to say that the combination of low cost assets, sound financial footing, and long-term contracts is as close to a match made in heaven as it gets in this business, and honestly goes along way towards neutralizing the negative effects associated with the cyclicality of met coal or commodity pricing generally. I don’t say that lightly, but the reality is that we are talking about an asset (1) with well covered economics given its low cost operations which, almost by definition, should allow the asset in question to generate consistently positive cash flows over a full cycle. If you toss in long-term contracts into that equation, the assets vulnerability to external shock is lessoned materially (2) that is owned by a producer that is – and should continue to be – well financed thanks to the financial fortress that is SND.
In commodity investing I think owning marginal (i.e. assets that aren’t low cost) is a really bad idea generally and – at least in my experience – one of the best ways on the planet I’m aware of to both (A) lose money and (B) suffer sleepless nights. Not my cup of tea. Again, as someone that’s learned the hard way (twice no less!), I think its critical to insist on only owning assets that are low cost in nature and possess balance sheets that are strong enough to safely withstand a long period of low commodity prices – otherwise the company in question may be forced to liquidate assets or raise equity at the absolute worst possible moment. It’s just not worth it. Ever. That, and if your trying to get leverage to commodity x, there are much better ways to go about it than owning the equity of some high cost producer that’s loaded with debt. So what I’m saying is that we have the best of all worlds with these streams as the presence of low cost deposits, long-term contracts and a strong financing partner augment the MOS to a level that’s usually not possible in resource assets and for that I’m thankful. And it’s also no small point that SND’s fortress like financial strength and win-win partnership approach provides NDX with both the financial flexibility and firm financial footing necessary succeed long-term as it allows them to both better deal with the occasional “out of left field” kick in the balls (that is part and parcel of all capital intensive commodity businesses) as well as a healthy amount of negotiating leverage when negotiating contracts with customers. All in all, the odds of success seem highly skewed in our favor.
Thoughts on NovaDx Ventures: More Than Meets The Eye
Before we dig in to the assets, I wanted to do a quick overview of Sandstorm’s partner NovaDx Ventures. For those who aren’t familiar with NDX yet, they are a Vancouver based mining investment company that owns the Rosa & Rex No. 1 mines and the companies primary focus is to acquire and develop companies with active or near production high quality coal reserves within the US Appalachian coal region. NovaDx’s goal over time is to continue growing its “specialty” coal business through expanding production organically at its existing mines as well as through the opportunistic pursuit of value accretive acquisitions.
Per the company’s website…
“In October, 2006 new management lead by Neil MacDonald, Novadx’s CEO took over Novadx and the company began operations as a merchant bank with an investment focus in mineral exploration. The company structured, made investments as a principal and provided management and other related services to companies and projects that it believed had an above average opportunity to provide a high return on investment. During this time the company acquired and expanded the Canadian Small Cap Resource Funds, a family of flow through funds, which was subsequently sold in June 2009.
In October 2008, Novadx changed its investment focus to concentrate on acquiring and developing high quality coal reserves and operations in the Appalachia coal region of the USA and incorporated its wholly owned subsidiary MCoal Corporation to commence the property acquisition, permitting and development of the Company’s flagship Rosa Mine in Blount County, Alabama. Novadx commenced production of high quality metallurgical coal at the Rosa Mine in April 2010. In November 2010, Novadx arranged up to $38 million in funding by way of a coal stream financing with Sandstorm Metals & Energy of Vancouver, BC”
So, we have a CEO who is a former financier who used to run a merchant bank, but decided that the Rex and Rosa opportunities were worth effectively winding down his merchant bank business in order to focus solely on the development of those assets. Interesting to say the least. Of course as a focused opportunist myself that sees what he sees (just do the math), I can certainly relate.
Now I’ve never spoken to Mr. McDonald personally, but from what I can gather he seems to be about as non-promotional as it gets given the minimal publicly available information on both his previous firms history, and more importantly on NDX and its assets generally (as the company doesn’t even have a presentation on its website or an IR representative – at least the last time I checked) – so its hard to size him as I normally would. That said, from the few things I do know I’ve been impressed, and I trust Nolan’s instincts and overall process thoroughly anyhow, so intuitively I think we’re in good hands here.
As far as what specifically impressed me, it was the way McDonald went about building the business from the start. In particular, how he patiently poached various top local executives in order to build a deep bench that appears to possess both (1) a distinguished track record and (2) a truly intimate familiarity with what it takes to successfully operate within both the Appalachian coal belt (and Tennessee and Alabama in particular).
Another salient signpost in my mind has been his strategic decision to focus on specialty coals – or put differently – on only higher margin subsets of the coal industry with structural supply/demand imbalances (nice and double nice!). So while I withhold a definitive opinion for now, I think its fair to say that clearly this isn’t your typical early stage natural resource management team. I mean it’s been built by a guy that for all intents and purposes did it through the acquisition of local all-stars (genius) and with a focus only on stable, higher margin niches with attractive long-term pricing dynamics (common sense). Two very savvy moves no doubt.
All in all then, given his history as an investor and financier, and taking into account his execution so far at Rosa and Rex, not to mention the way he built his team and shaped its strategy, again, it appears things are quite good in respect to the individuals leading the charge. At the very least he appears to be a capable leader that understands how to intelligently build and operate this type of business as well as capital allocation and competitive strategy – a convergence of characteristics that – lets be honest – is exceedingly rare in the industry (we are, after all, talking about an industry dominated by C-level execs and geologists that historically has proven adept, no freaky good actually, at the fine art of shareholder wealth immolation). That, and I seriously doubt Nolan wouldn’t be extremely picky about the team he chose to back the development of Sandstorms flagship (and originally only) asset. Again, I think we’re in good hands and that’s a critical point.
The Rex No. 1 Mine: Underground Mine located in Campbell County, TN
With the backdrop out of the way, lets switch gears and turn our attention to the actual assets underlying Sandstorms coal streams and in particular, its crown Jewel, the Rex No. 1 mine located in Campbell county, TN. This is where it starts to get good.
As I alluded to earlier, the Rex seam is known for its high quality metallurgical coal; a high volatile A bituminous coal with very low ash, very low sulphur, and high British Thermal Units content that is often used in the production of silicon metal. The Rex deposit is located in one of the most attractive coal mining districts in NA and notably sits on one of the largest single continuous resources of metallurgical coal located in the Central Appalachian coal belt. Historically, high quality metallurgical coal has been mined in the area surrounding the Rex No. 1 deposit since the early 1900′s and was traditionally sold as metallurgical “coking” coal. Since 2004, the Rex coal has been sold primarily for the production of silicon metal due to its high quality and low iron and titanium content.
What we have here then is more of that Watson’s family special sauce we observed in Part 1 with Sandstorms Gordon Creek natural gas stream. Like Gordon Creek, the Rex deposit is indisputably high quality, long-lived, and currently under development in a premier location with (A) consistent and well known regional geology and (B) substantial infrastructure (and access to ports) already in place. Also like the Gordon Creek stream, this asset is (1) run by a seasoned, locally connected management team with (in this case) over 100 years of cumulative experience in both the coal and capital markets (2) low cost operations and (3) a “high impact” opportunity to expand the resource base with a simple and well known playbook. The similarities don’t stop there either, as it’s also entirely reasonable to assume that management is capable, and will ultimately succeed in their goal of ramping Rex’s normalized production volumes to a level vastly higher than the initial run-rate. And again, were talking about basic blocking and tacking here (i.e. a combination of increased drilling and increasing the lease area in the immediate vicinity). Basically it’s just more of the same, and why my mess around with a perfect recipe anyway? “Perfect” may be a little strong but clearly the odds are stacked in our favor, and let’s be honest, that’s what its all about is it not?
Anyhow, the Rex No. 1 Mine is still undergoing development and is expected to begin production during the third quarter of 2013. As you would expect, managements got lots of wood to chop between now and then. Which, now that I think about it, is probably why they don’t have a presentation or why they don’t appear to have a scintilla of interest in promoting the stock at this point. Frankly, now is not the time in my opinion and honestly view it as another sign we’re dealing with capable individuals here. So ongoing construction at the mine is considerable at this point, including surface infrastructure, development of additional mains to support future operations, rehabilitation of access ramps and preparation of underground mining equipment. Think of it like a bunch of bees preparing the hive in order to ensure that it will hum in perfect harmony.
So what’s it worth? Well, I’ll break it down in the valuation section below but lets just say there’s a decent chance that Rex is Sandstorms most valuable asset, in which just like Gordon Creek, the NPV of all future cash flows is likely worth more than the current enterprise value of Sandstorm as a whole. With an initial production run rate of 450-500k tons per year and a 2p reserve value of ~39m tons, this thing has the potential to become a cash producing monster once it grows up. Think about it like this, barring a substantial increase in annual production, current reserves dictate a LOM ~78 years!!” Call it the “super long lived, long-lived asset” if you will. From a cash flow perspective, assuming a flat silicon coal price (so a ~115 cash margin/ton) and zero increase in mine resources (both ridiculous assumptions), Rex would generate ~$14.3m to SND every year for the next several DECADES. Read that twice.
Remember, you can theoretically purchase the whole enterprise today for ~100m. Lets take a moment to think about how crazy this is, as even if we assume flat prices, no resource expansion, a conservative recovery rate and in one last fit of insanity decide to zero out the entire rest of SND’s current – and hugely valuable – existing streaming portfolio and assume they never do another deal – even then – we would be purchasing what I think is intellectually valid to characterize as a fully covered, 40+ year senior secured bond with an implied ~15% annual yield, where that yield is highly probably to grow substantially over time. Now if that doesn’t put it into perspective for you, you should probably just stop reading now. Not to beat a dead horse, but this business at this price is a GIFT.
The Rose Mine: Auger & Strip Met Coal mine in Alabama:
The Rosa Mine in Alabama is a currently producing auger mine and is expanding its strip mining operations in addition to increased auger mining operations. Construction of the Rosa wash plant was recently completed and is now entering the commissioning phase, increasing its recoverable coal yield to 90%. Notably, NovaDx had previously stockpiled a portion of its coal production, in anticipation of the wash plant becoming operational, and has recently begun processing this coal through the new facility for sale to market.
I’ve chosen to keep the analysis light on Rosa given its value is a secondary consideration in the context of Rex. Readers should feel free to ask any questions about the Rosa mine in the comments section below. That said, annual expected production is approx 150k tons/yr with on-going cash costs of $75. At 150k oz of production, Rosa’s current LOM sits @ ~3.5 years but is expected to reach ~12 years after Rosa is fully proved up and developed. SND’s streams cover the first two phases.
Now to the valuation…
Terms of the Transaction
Sandstorm has agreed to purchase 25% of the first 3,800,000 tons of metallurgical equivalent coal produced and 16% of the life of mine metallurgical equivalent coal produced thereafter from the Rosa and the Rex No. 1 Mine for an upfront payment of US$30 million plus ongoing per ton payments of US$75 for metallurgical coal. NovaDx has provided Sandstorm with a guarantee that Sandstorm will receive minimum cash flows of $5.0 million in 2012, $6.0 million in 2013, and $8.0 million in each of 2014 and 2015.
For our purposes here, lets ignore the potential measured and indicated reserves and just use the 39m Tons of proved and probable currently on the books. Let’s also be ridiculously conservative simply for conservatisms sake, and assume that only 55% of this number is recoverable, so the amount of total recoverable reserves at Rex is ~20m Tons. Now depending on how well you think management will execute, normalized production volumes should fall somewhere between the 500k ton “kitchen sink” estimate used to manage expectations and lets say 1m tons at full utilization upon maturity.
Either way you slice it then, were looking at a wonderfully long-lived asset. With conservative recovery estimates on 2P reserves of ~39m tons and a range on steady state production between 500k to 1m tons a year, the Rex No. 1 LOM is somewhere between 20 & 40 Years. So let’s split the difference and say the LOM is 30 years. So, our senior secured high margin annuity has a duration of ~3 DECADES.
If management reaches a steady state production level of 1m tons at some point within the next ~5 years (which to a generalist at least, seems like a reasonably plausible outcome), then at 1m tons per year in production Sandstorms 16% interest would equal ~160k tons per year. Assuming ~160k tons and a reasonable after-tax cash margin/ton of $115 (met coal price of $190/ton – $75/ton fixed cost), SND would earn ~$18.4m in a normal year. Not bad.
Again this is conservative because SND will receive a 25% interest of the first 3.8m tons produced or for about the first 6-7 years of the life of the assets and 16% thereafter. Just for fun, 25% of first 3.8m tons equals 950k tons to SND. So 950k in annualized production x $115 cash margin/ton = $109,250,000 in total undiscounted gross profit attributable to SND over the first 6.3 years of production (3.8m /600k in normalized production – 450k Rex, 150 Rosa). SND’s total current EV today is roughly ~100m.
What’s a reasonable multiple to pay for a growing, high margin ~30 year bond-like annuity with a normalized/inflation protected coupon of ~$18.4m and a “AAA” credit profile (capital at risk is fully covered and then some)? What’s that worth when a return free 10yr treasury is ~2%? Let’s be borderline insane and say it’s only worth 12x. In that case, the Rex stream is worth ~$220m our over 2x the implied enterprise value of SND today.
The fact that Watson was able to purchase this wonderful asset for only $30m is yet another example of his demonstrated ability to literally crush the ball. The man sees his pitches clearly, and clearly knows when its time to really swing. And not that I’m counting my chickens before they hatch either, its just that under any reasonable future scenario this asset should make a lot of money for a very long time. That, and given the embedded value of the reserves, in place infrastructure, etc its almost inconceivable that they would permanently lose money here. Once again, the asymmetry here is stunning.
For more of the same Jedi Knight style value creation, take a look at the IRR’s on these streams and the embedded and highly visible, multi-decade runway of high return reinvestment opportunity that they provide.
Note: In thinking about the IRR I’ve decided to capitalize the cost of the asset and write it down over its life on a straight line basis (annual costs). I conservatively assume a ~20 year LOM. Feel free to front load the initial investment over 5 or 10 years instead of 20 if you wish, either way its still a phenomenally good use of capital.
Normalized Economics: The Rex No. 1 Mine
Annual Investment: $10,625,000
Unit Cost Breakdown:
Annual cost/Ton $10/Ton
Normalized Op Cost/Ton $85
Normalized Production 125,000
Normalized Met Coal Price $190
Normalized Op Cost/ton $84
Steady State Free Cash Flow $13,125,000
Normalized Economics: The Rosa Mine
Annual Investment: $2,936,250
Unit Cost Breakdown:
Annual cost/Ton $13.3/Ton
Normalized Op Cost/Ton $78.3
Normalized Production 37,500
Normalized Met Coal Price $170
Normalized Op Cost/ton $78
Steady State Free Cash Flow $3,438,750
Rex No. 1: Base Case
Notes: FCF assumes SND caps out at 125M tons in annualized production at maturity. A multiple of 12x seems unjustifiably conservative given Rex’s recoverable reserve value of 20m+ tons of silicon based metallurgical coal. Remember SND pays no taxes and is debt free so gross profit pretty much approximates FCF.
Normalized Revenue $23,750,000
Normalized operating costs $9,687,500
Steady State Free Cash Flow $14,062,500
Implied Per Share value of SND’s interest at 12x SS FCF $168,750,000
Implied Value Per Share $0.53/share
Implied Per Share value of SND’s interest at 15x SS FCF $210,937,500
Implied Value Per Share $0.66/share
Rex No. 1: Best Case
Notes: FCF assumes SND caps out at 250M tons in annualized production at maturity.
Normalized Revenue $47,500,000
Normalized operating costs $19,375,000
Steady State Free Cash Flow $28,125,000
Implied Per Share value of SND’s interest at 12x SS FCF $337,500,000
Implied Value Per Share $1.06/share
Rosa Mine: Base Case
Notes: FCF assumes SND caps out at 37.5k tons in annualized production at maturity. A multiple of 5x seems unjustifiably low given management expectations of a fully developed Rosa LOM of 10-12 years.
Normalized Revenue $6,375,000
Normalized operating costs $2,936,250
Steady State Free Cash Flow $3,438,750
Implied Per Share value of SND’s interest at 5x SS FCF $17,193,750
Implied Value Per Share $0.05/share
Royal Coal: Victory in Defeat
As an aside, let me publicly proclaim that Royal Coal be damned – it was a good decision and a bad outcome, it will by necessity happen from time to time, and shareholders should get their money back under a reorganization anyway. Eventually. That, and I couldn’t help but find it delightful to hear on last week’s inaugural conference call that Watson was able to emerge victorious even in in the jaws of defeat. Specifically, shareholders learned that by doing the deal, the company earned a tax shelter with an NPV worth more than the entire amount of the Royal Coal investment. Good form!! In all seriousness, that’s exactly the type of hidden revelation that warms a value investor’s heart. Makes you want to make a T-shirt with a picture of Watson with RULE #1 in bold above it doesn’t it not?
So to conclude…
Watson has made a stunningly asymmetric bet on high quality, silicon based metallurgical coal that should eventually pay off many multiples of his invested capital over time. This initial investment of $30m comes with a put option in the form of a 5yr guaranteed payback and a low-risk, highly visible runway of high return reinvestment opportunity that should last for many decades to come.
Initial Production come 2013 should approach an initial run-rate of 125m tons a year or ~ $14.3m in profit to SND’s bottom line (500m tons * .25 = 125m tons to SND or ~$14.3m in annualized gross profit assuming a 2013/14 price of $190 per ton. And as I’ve outlined above, this annual run-rate of ~$14.3m in gross profit could easily double as NovaDx’s management continues to tackle the abundance of low hanging fruit on its properties in the fullness of time.
Last but not least, the Rex No. 1 mine possesses the potential to be a low-cost mid tier silicon based coal producer for the next several decades and is hence a scarce, hugely valuable high quality coal asset given its low cost operations, consistent regional geology, long-term contracts and huge 2P reserve value, not to mention in place infrastructure and access to ports.
So while I put together an overview of the next significant stream that SND investors are currently getting for free, let me ask, what’s not to love here?
March 2012 Novadx Presentation (H/T to Joel Kitsul, NDX’s new IR!!)
The New World Economy and the Global Met Coal Market (H/T Alex)
July 2010 NovaDx Private Placement Presentation
Inaugural Conference Call
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