Uranium Gets a Catalyst – Cameco is a winner in Japan’s decision to restart its reactors
Welcome news arrived Friday for moribund uranium markets and miner Cameco (CCJ)/ (CCO), as the governor of Kagoshima approved what will be the first restarts of Japan’s dormant reactor fleet: Sendai units 1 and 2. This follows the municipal government’s Oct. 28 approval and sets the stage for restarts next year.
Cameco’s shares rose more than 10% on the news, which is surprising, as we figured the market would have been pricing in the approvals. Despite the bump, we still see upside relative to our $22 and CAD 24 fair value estimates. Better uranium prices (we expect $75 per pound by 2018 versus $36.50 today) along with enviable production growth from moat-worthy assets underpin this view.
Cameco’s shares look particularly attractive relative to a mining sector that we expect will find profit growth painfully hard to come by in the next decade. That’s largely because uranium is one of the few commodities we expect to perform well as China’s fixed-asset investment boom falters.
Biggest and Getting Bigger
Cameco is the world’s largest publicly traded uranium miner and aims to get much bigger. We expect annual output, which was 23.6 million pounds in 2013, to rise roughly 50% through 2019. The new volume will be low cost, with the majority coming from one of the highest-grade deposits in the world. Despite the Fukushima disaster, uranium consumption is set to grow at the highest pace in decades as emerging economies turn to nuclear as a carbon-light source of base-load power. Meanwhile, as decades-old existing stockpiles of uranium are whittled down, we expect to see increased pressure on mined supply to meet that growing demand.
Fulfillment of Cameco’s growth plans will hinge foremost on the successful delivery of Cigar Lake (50% ownership stake), a greenfield project situated close to Cameco’s McArthur River mine in Saskatchewan. Cigar Lake shares McArthur’s attributes: a stellar ore grade, large scale, long life, and an attractive operating cost profile. Production began in 2014, with annual output ramping up to target capacity by 2018.
The biggest variable to Cameco’s long-run earnings power lies beyond its control: the price of uranium. Here we see cause for cautious optimism. The world is running a uranium deficit; the world’s nuclear reactors consume more uranium than the world’s mines produce. Decades-old inventories held by utilities and governments, as well as down-blended highly enriched uranium from dismantled warheads, presently fill the gap between consumption and mine production.
Despite a palpable shift in public sentiment against nuclear power in the wake of Fukushima, we expect respectable uranium demand growth over the next 10 years–about 3% annually, which would be the strongest demand growth the industry has enjoyed since the 1970s. A significant portion of the growth outlook hinges on China. In contrast to other mined commodities, China still punches below its weight in uranium. China is small today, but we expect it to play a central role in any nuclear renaissance as Beijing looks to meet rising electricity demand and reduce the share of demand met by dirty coal-fired generation.
Low-Cost Production Is Advantage
Production costs are the primary litmus test for a measuring competitive advantage in the highly cyclical mining industry. All producers can generate fat returns on capital when commodity prices are high, but only the lowest-cost producers can be expected to generate excess returns on capital through the cycle. Measured by cash cost of production, Cameco ranks among the lower-cost uranium miners at CAD 18 per pound in 2013 (before royalties) by virtue of an enviable asset base anchored by the extremely high-grade McArthur River mine in Saskatchewan. Generally, this is a recipe for strong returns on capital.
But owing to long-term contracts struck with utilities before the post-2003 surge in uranium prices, the company has been unable to fully capture the economic benefits due its cost profile. As a result, by our measurements, Cameco hasn’t consistently generated returns in excess of its capital cost (about 10% in our model) over the past several years.
We expect this to change in the coming years. We expect Cameco’s price realizations will naturally improve as contracts struck in periods of weaker uranium prices continue to roll off its books. This should gradually lift margins and returns on capital, allowing Cameco to clear its cost of capital once price realizations converge on contract prices.
Watching Supply and Demand
The key fundamental risks facing Cameco mostly concern the global supply and demand of uranium and the implications for the firm’s realized uranium prices. On the supply side, while the uranium market has been in deficit since the early 1990s as secondary supplies have filled the output gap, there’s a risk that the situation could change as producers respond to the relatively elevated price levels uranium has enjoyed for the past several years or if anticipated demand growth fails to materialize.
For instance, if Kazakhstan continues its upward growth trajectory or megaminer BHP Billiton pulls the trigger on the massive Olympic Dam expansion, the uranium market might shift from one defined by annual deficits to one defined by a material surplus.
On the demand side, if China’s nuclear fleet buildout program were to fall seriously short of the nation’s very ambitious targets, we might see a similarly unfavorable market imbalance for producers like Cameco.
Notably, however, Cameco’s realized prices will not change one for one with spot prices, as a significant portion of current and future production is tied up in utility contracts with prices established according to factors other than the prevailing spot price.
We assign a high uncertainty rating to our fair value estimate. The rating reflects the sensitivity of our valuation to uranium price assumptions and uncertainty related to the company’s volume growth trajectory, offset by relatively low country risk and moderate balance sheet leverage.