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Company: Largo Resources
Ticker: LGO (U.S. OTC ticker is LGORF)
Exchange: Toronto Stock Exchange
Sector: Basic Materials
Industry: Industrial Metals Mining
Priced for a Vanadium Bear Market
Canadian-based Largo Resources operates the Maracas Menchen vanadium mine in the Bahia State of Brazil. Maracas Menchen is the highest grade vanadium mine in the world in production and one of only 3 primary vanadium mines in the world that is currently in operation. By “primary,” I mean vanadium is the main metal mined and not a by-product metal of some other primary metal. Largo derives 100% of its revenue from selling vanadium pentoxide (V2O5 )at the European quoted price.
The following 2 charts are (1) the weekly price chart of LGO.TO and (2) the Chinese and European price charts of Vanadium Pentoxide Flake per lb.:
I put these 2 charts next to each other so that you could see that Largo is clearly trading in correlation with the price of V2O5.
When I plug a $10 per lb. V2O5 price into my financial model for Largo this is what I get for 2019:
$101 million of free cash flow at a 43.9% margin
Price to Free Cash Flow Multiple of 8.9
Debt to EBITDA Ratio of a modest .8 (average is typically 1 to 2)
Hypothetical dividend yield of 3.8% if 1/3 of net income is paid out (the company will announce their capital allocation policy soon)
Keep in mind that $10 per lb. is 42.5% below the current price. At $10 per lb. Largo would thus be a highly profitable miner with a modest amount of debt trading for a low valuation. The company would also have $171 million in cash after the hypothetical dividend, some of which it could put toward share repurchases. Last but not least, it is also set to increase production by 14% from 2019 to 2020.
As you can see from the second chart above, the price of V2O5 in China is again on the upswing and currently trading for $17.40 lb. This tells me a few things:
Largo is priced for a collapse in the price of vanadium and a total bear market.
General mining investor sentiment is still very subdued, given that vanadium has the strongest fundamental story of any metal that I know of right now.
Largo is trading on investor sentiment and not fundamentals.
Largo’s downward price action is entirely divorced from the fundamentals which I will now demonstrate.
Vanadiums Fundamental Pillars
The fundamental bull case for vanadium rests on the following 3 pillars:
(1) 2019 vanadium mine supply is about 88,000 tonnes and I am projecting demand will be roughly 96,000 tonnes. Only 17% of mine supply is from primary vanadium mines with the remainder coming as a by-product of mostly Chinese and Russian iron ore mining (ferrovanadium) for steel production. Only the primary mines can increase production materially and this takes time (i.e., several years). The integrated Chinese and Russian steel companies are not going to mine more iron ore just to get vanadium. For example, Russian integrated steel producer Evraz is the largest vanadium producer—responsible for 16,000 tonnes in 2018. Doing everything they can over the next 3 years, they can only add 1,200 tonnes of production and this entirely by focusing on increasing efficiencies in extracting vanadium slag as a by-product.
(2) Increased demand is primarily being driven by the Chinese implementing a higher rebar standard in November 2018. There have been some high profile incidents in China of buildings collapsing and killing school children due to poor building standards. Chinese authorities are cracking down hard on this. This is expected to add at least15,000 tonnes of annual demand from 2019 to 2021. My 2019 demand projection assumes an initial 5,000 tonnes of new demand hits this year (91,000+ 5,000 = 96,000). In their October 2018 Investor Day presentation, EVRAZ provided similar guidance as shown here:
(3) Bushveld Minerals and Largo are increasing production, however, absent a global recession, the deficit has no chance of being erased until at least 2021 and this remains suspect. Let me give you the specifics on the projects that have the potential to bring new supply to market:
Bushveld’s ramp-up from 2,560 tonnes in 2018 to 5,000 tonnes in 2021 will likely be pushed back 1 year as they continue to work out the kinks from restarting their Vametco plant in South Africa.
Ferro-Alloy Resources is trying to get Balasausqandiq in Kazakhstan up and running to produce from carbonaceous ore but this has been slow going. They will not likely be able to produce a material amount until 2021 and this is not guaranteed.
Atlantic Ltd., owned by the Indonesian Salim Group, is trying to restart the Windimurra mine in Australia to potentially produce 4,350 tonnes per annum in 2021.
Australian Vanadium wants to produce 5,655 tonnes per annum from their Gabanintha project in Western Australia starting in 2021. The company has a market capitalization of $40 million and they need $354 million of upfront capital to develop the project.
Technology Metals Australia also has a project called Gabanintha which is a few kilometers away from Australian Vanadium’s Gabanintha project. They are targeting 7,283 tonnes per annum of production starting around 2021. Technology Metals has a market capitalization of less than $20 million and they need $380 million of upfront capital to develop their project.
If all 4 of these new projects come online in 2021, then there could be a surplus of about 6,000 tonnes in 2022, but over $1 billion of investment is still needed to make this happen. The 2 Gabanintha projects are where the largest potential supply increase could come from, however, their stock charts show that a major change in sentiment will have to come first for either of these projects to get financed. The following daily chart of Australian Vanadium (green) and Technology Metals Australia (blue) shows that both of these stocks have bombed out:
If one or both of the Gabanintha projects do get funded, the most likely scenario is that they do not start producing until at least 2022.
Because of the potential supply that these Gabanintha projects could bring to the vanadium market, their cascading stock charts are actually very bullish for Largo longer-term.
Vanadium Price Action
Chinese steel producers stocked up on vanadium in 2019 to be able to begin implementing the new rebar standard and this sent the price of V2O5 screaming above $30 per lb. Some producers stepped back from the market late last year to see how strict the new rebar standard would be enforced and this was the catalyst for the sell-off. They quickly found out that the authorities are serious about the new standard after inspections began to heat up. With the New Year holiday behind them, they are now starting to return to the market and this is reflected in the price chart beginning to turn higher.
It is important to keep in mind that even without the implementation of the new Chinese rebar standard, the market would still be in a deficit. It is the implementation of the new standard that is set to propel vanadium prices higher again.
Putting this all together, it is my view that the price of vanadium is going to go to a new all-time high this year. More importantly, the price of vanadium is going to stay very elevated for at least several more years and this is going to fuel a cash flow bonanza for Largo Resources. My 12-month price target for Largo is CAD $3.37 or USD $2.55 per share. This reflects a multi-year elevated vanadium price environment which would enable Largo to continually reduce its share count through buybacks and/or invest to grow production. Ultimately, when the vanadium price normalizes to what I think will be a price of around $8 per lb., Largo may be worth more than CAD $6.00 or USD $4.55 per share. My 12-month price target reflects a 38% compound annual growth rate from CAD $2.44 to where I think the stock could ultimately settle a few years from now ($2.44 x 1.38 = $3.37). All this being said, if the price of vanadium moves as high as I think it will in 2019, shares of Largo could go much higher than CAD $3.37 or USD $2.55 per share.
This is really a play-it-by-ear situation. I have to see what Largo’s capital allocation plans are and what their strategic direction is. Are they going to repurchase stock? If so, how much? Are they going to initiate a new plan to grow production? If so, when and by how much? I will weigh all these factors in my financial model which includes my longer-term price outlook to continually adjust my price target. For now, I see 40% upside and this could materialize very quickly. I am not yet settled on Largo as a long-term hold—I think Bushveld Minerals has more longer-term potential—but it is now significantly more undervalued than Bushveld. This is at least a good multi-month trade opportunity right now.
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Joshua Hall, ChFC
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The True Vine Letter is a publication of True Vine Investments, the investment advisory business of Joshua S. Hall, ChFC, and a Registered Investment Advisor in the U.S.A. The information presented is for educational purposes only and should not be regarded as specific financial or investment advice nor a recommendation to buy or sell securities or other investments. It does not have regard to the investment objectives, financial situation, and the particular needs of any person who may read this Letter. In no way should it be construed as personalized investment advice. True Vine Investments will not be held responsible for the independent financial or investment actions taken by readers. All data presented by the author is regarded as factual, however, its accuracy is not guaranteed. Investors are encouraged to conduct their own comprehensive evaluation of financial strategies or specific investments and consult a professional before making any decisions. Positive comments made regarding this Letter should not be construed by readers to be an endorsement of Joshua Hall’s abilities to act as an investment advisor.
Bushveld Minerals and Largo Resources are holdings in some client and family portfolios that I manage. I have an economic interest in both of these stocks.