Yellow Cake Takes Advantage of Historically High Discount

I’ve been writing on the uranium theme for a couple of years now and even though the price of uranium (U3O8) is up from $22/lb when I started writing to now $33/lb the share prices have not performed in that period.

In my mind it makes some sense that the junior miners have come down as the price of uranium is still lower than their cost of production so obviously they cannot sell their goods at these levels (they need $50/lb+) and are instead forced to dilute shareholders to keep the lights on while they wait for higher prices.

So fair value for the miners can be debated but what makes less sense to me is that those companies whose business it is to simply buy and store uranium rather than mine it are also not performing.

In fact both Yellow Cake and Uranium Participation are trading at historically high discounts to their net asset value at a time when uranium fundamentals are clearly improving with uranium inventories being drawn down at a rapid pace not seen for years, in part, but not solely, due to Covid 19 (which I will get back to) and also because psychology is shifting in favor of nuclear energy due to climate change.

For Yellow Cake especially the discount is kind of astounding: 30% here and now (upside to NAV = 43%). And for Uranium Participation it is at 21% currently (upside to NAV = 27%).

Screenshot 2020-06-30 at 14.51.27

A Brief History of YCA/UPC Trading Patterns

Here is a graph of how the latter has traded in relation to NAV since 2007. The orange line represents the price of uranium and the green one the NAV the company trades at. Whenever the green line is above the orange line it means the shares trade at a premium (and vice versa).

Screenshot 2020-06-30 at 14.22.55

And here is the same graph zoomed in on the last three years:

Screenshot 2020-06-30 at 14.41.55

As can be seen it is not the natural state of affairs that these companies trade at a deep discount. In fact for long stretches of time they have traded at a premium.

And as can be seen in the graphs Uranium Participation currently trades as if the price of uranium was below $26/lb. For Yellow Cake that figure is $22.50/lb currently(!). Since my view is that the longer term trajectory of the price of uranium is quite clearly pointing upwards from the current $33/lb I view the current situation as one where my margin of safety is so large that I can comfortably make a big bet and sleep well knowing that if I’m wrong I likely won’t take much of a hit. A protected downside along with a leveraged upside is my idea of fun in the markets and for that reason Yellow Cake is my biggest uranium position currently.

Since Yellow Cake’s inception in July of 2018 it usually traded around NAV (except for a brief tantrum in December 2018 along with the rest of the market). In that same period Uranium Participation has usually been priced 2-3% higher (perhaps due to a combo of a longer history in the markets along with more liquidity since it is listed in Canada along with most other uranium equities while Yellow Cake is listed in ”uranium poor” London). Now the gap between the two is 9%. A few weeks ago it was even higher. (Edit after posting: The derivative liability does not explain the discount gap because the maximum cost of this vs what is in the books is slightly more than 1% of market cap ($6.5M vs $2.6M in the books, see disussion in the comment section below).

Covid19 – A Temporary Situation?

”But wait”, you might say, ”the boost in the uranium price is all about Covid19 shutting down a large percentage of mines temporarily and thus the boost in the uranium price is articifial. This is a situation that goes away!”

Screenshot 2020-06-30 at 13.59.28

And this is indeed what I suspect the wild discount is all about: The market seeing this as a short term thing that will ”revert to normal” (ie. a uranium market that is soundly asleep!) once the Covid restrictions are lifted.

You might also say: ”Look at the predictive powers of the high discount in the 2015 period. At that time the spot price went down when the discount was high. That will likely happen again!”

Screenshot 2020-06-30 at 14.01.05

While that viewpoint may prove to be correct in the very short term here is why I personally believe this time is different:

  • A large amount of pounds of U3O8, at least 20 million, have in fact been taken out of the market bringing inventory levels down further. Kazatomprom have announced that these pounds are not coming back by increased production at the other side of this. That means that the bull will arrive sooner than if Covid hadn’t happened.
  • Spikes in commodity prices, such as what we saw in uranium in March and April, are almost always signals of underlying tightness between supply and demand even if the immediate trigger that sets it off is a supply shock caused by outside events that are temporary in nature (such as Covid now, and such as the Cigar Lake flooding in 2006). If there was a lot of available supply ready to be sold the price would likely not have responded as it has. Sellers would have been more willing to offload uranium into the market to take advantage of the situation.
  • But perhaps the most significant part of the equation is the longer term significance: When the cost of shutting down a nuclear power plant is much greater than the cost of the fuel (ie. uranium) security of supply becomes an issue that increases in importance for uranium buyers and the focus on price becomes less important. Covid19 has exposed the “just in time” supply chain thinking to be a dangerous one. For that reason I would think the utilities will likely want higher levels of inventories than they wanted pre Covid19 and that they will start to come into the market in the not too distant future.
  • Last, but not least. Say the doubters are proven correct: The cushion is very soft when buying a commodity as if the price is $22.50/lb when it is currently selling at $32.60/lb.

Yellow Cake Changes Course – Selling Uranium No Longer Off Limits!

Apparently Yellow Cake also thinks the current discount is unsustainable because today came the announcement I have been waiting for for some time: https://otp.tools.investis.com/clients/uk/yellow_cake/rns/regulatory-story.aspx?cid=2392&newsid=1399401. Yellow Cake announced that they have sold 300,000 lb of uranium, correesponding to 3% of their holding, at $33.20/lb (which is slightly above the current spot price) and that they will be using the proceeds, $10 million, to repurchase their own shares thereby increasing the value of that $10 million by 43% (upside to NAV at current share price) to $14.3 million. The current market capitalization of the company is roughly $220 million so 2% of value was created out of thin air with a shrewd shareholder friendly decision. Capital allocation at its finest because value was increased without taking ANY risk! Like picking up free cash from the street…

And importantly, it carries with it the possibility that if the discount persists Yellow Cake could, now that the door has been opened, decide to sell all of their uranium and distribute the resulting cash to shareholders. That would mean a 43% increase in the share price overnight and if the market starts pricing in such a scenario as a possibility we will obviously see the discount gap narrow leading to a higher share price all other things being equal.

Go For the Easy Stuff!

As an investor this is why you chase value even when it has been sleeping for a long time rather than chase the next hot thing for fear of missing out (which was the subject of my most viewed post to date: God Damnit, I Missed the Boat!).

Value has periods where it underperforms – but it is there! It is no illusion. And it isn’t dependant on being smarter than or outmanuvering other market participants. And the great thing for someone with an IQ below average, such as myself, is that no brilliancy or deep insights into the market is needed.

We all know we overestimate our own abillities. It is in our nature. And it is what pushes us to perform in all other areas of life. But in investing it usually is a liability because you want accuracy of judgement above all else. Inflated egos crash and burn all the time due to perceived prowess because 90% of investors aren’t better than the average investor and so ought to opt for prudence over excessive risk-taking. Just like 90% of drivers aren’t better than the average driver. But we all think we are the exception to the rule. This benefits society but necks are being broken in the process. So take advantage of this human glitch. Go for the easy stuff and outperformance over time becomes almost a given even though there will be prolonged stretches of underperformance along the way.

For inspiration of such an investment philosophy here is a clip from the humble and dignified human being who first inspired me to look towards the deep value approach, John Templeton:

John Templeton on deep value investing

By the way, somewhere in this post I have dared to contradict this greatest of deep value legends. Can you spot where?

 

Disclaimer: I own shares in Yellow Cake  at the time of this blog post’s publication. Nothing herein should be considered investment advice. The post is to be considered a starting point for further investigation. Please perform your own due diligence before making any investment decision.

18 thoughts on “Yellow Cake Takes Advantage of Historically High Discount

  1. Thanks a lot for the write up. Echoes my thoughts incredibly well! Great to know others’ thinking is so well aligned with my own.

    I certainly agree the latest news release is what investors have been waiting for, hopefully we see a sustained closing of the discount now.

    Thanks again for sharing your well written thoughts.

    Liked by 2 people

  2. Hi , thanks and good Points. If you were to impose the TSE:u discount on yca and check The usd Delta of mkt cap. Divide that Delta by one fourth of the lb yca owns,i.e. the derivative liability (put sold to kazatomprom) and you’ll find the market implied put premium around 9usd/lb…seems fair! Excluding this put premium they are priced identical. Everything else equal I prefer TSE because of liquidity, bigger

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    1. Thanks for your comments, TC. Thanks for reminding my of the derivative liability because I forgot to mention that point in the text. The language isn’t all that clear to me in the agreement so I checked with the CFO of Yellow Cake a while back and the response was that the maximum cost of this is $6.5M (vs $3M or so in the books) so an impact of slightly more than 1% of market cap and of course that is only IF it is ever exercised (ie. if the U spot price goes above $37.50/lb for two weeks). So this does not explain the large 9% gap in the discount.

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      1. Thanks again for that CEO comment.. I’m a bit confused know but very interesting.. Given this is a call option, any knowledge as to why the loss would be capped is greatly appreciated, thanks!

        Liked by 1 person

      2. Thank you for your great post. Regarding the liability, shouldn’t we be considering the full $6,5M just to stay on the safe side? If one is long uranium, it’s not that hard to picture a scenario where the U price will go above $37,5 for two weeks.

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      3. If you want to be conservative you could do that. It would lower the discount by 0.8%. Still the weighted value is closer to $3M and this investment for me is not only about catching upside but also protecting my downside and if the U3O8 price never reaches the $37.50/lb threshold that then the liability is $0. Therefore in my view the most correct view is the weighted figure of approximately $3M or so which is calculated using the current U3O8 price.

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  3. Thanks for a great write-up.

    Apologies for beating what may be a dead horse, but I still don’t quite understand the derivative liability. You already referenced Note 7, which reveals that Kazatomprom has a repurchase option “at the prevailing uranium spot price less an aggregate discount of USD6,525,000”. It seems to me that the USD 6.5m is a discount to the (theoretically infinite) liability, not a cap. Do you have any other information to support the notion that the liability is capped (as opposed to simply being rebated)?

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      1. Alright, I finally get it. I initially missed that there’s a second option at play; if Kazatomprom exercises their option, YCA has the option to repurchase the same volumes at the same price, thus capping their loss at USD6.5m.

        Considering this would only happen in a scenario where the remainder of YCA’s uranium has also appreciated beyond USD37.5/lb, this derivative arrangement will not keep me awake at night.

        Liked by 1 person

  4. Yeah, definitely a marginal thing and the fair value of the arrangement is already accounted for in the books so the discount cannot possibly justify the discount. And if $37.50/lb never sees the light of day you could say the liability is actually an asset worth $2.6M.

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  5. Well. I agree it’s marginal and already reflected in the net asset estimates. But so is the premium received for writing this call. Until expiry the call remains a liability, and while it may expire worthless it will never be an asset.

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      1. Agree. For what it is worth, I have my money on us happily paying the full USD6.5 million, because come 2027 uranium is going to be a whole lot more than USD37.5/lb.

        Liked by 1 person

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