The Market's Mispricing This Miner

We think the market is mispricing narrow-moat uranium miner Cameco CCJ. Uranium offers a rare growth opportunity in metals and mining. China’s structural slowdown portends the end of a decade-long boom for most commodities--but not for uranium.

Uranium prices fell each year from 2011 to 2017, owing to the supply glut caused by delayed Japanese reactor restarts. This situation shouldn’t last much longer, with prices beginning to recover in 2018. We expect global uranium demand to rise roughly 40% by 2025, a staggering amount for a commodity that saw next to zero demand growth in the past 10 years. We expect new reactor capacity to drive the strongest uranium demand growth in decades. A quadrupling of China’s reactor fleet headlines this growth. China’s modest nuclear reactor fleet uses little uranium today. That’s set to change in a major way. Beijing is pivoting to nuclear in order to reduce the country’s heavy reliance on coal. New reactors in India, South Korea, and Russia as well as restarts in Japan lend additional support.

The mined supply of uranium will struggle to keep pace amid rising demand and falling secondary supplies. Low uranium prices since Fukushima have left the project cupboard bare, and we expect a cumulative supply deficit to emerge by 2023. These shortfalls should begin to affect price negotiations in 2019, since utilities tend to secure supplies three to four years before actual use. We forecast that contract market prices will rise to $65 per pound to encourage enough new supply.

As one of the largest and lowest-cost producers globally with expansion potential, Cameco should benefit meaningfully from higher uranium prices. The company benefits from stellar ore grades, large scale, long life, and an attractive operating cost profile.

Among the Lowest-Cost Uranium Miners Production costs are the primary litmus test for 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 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.

However, 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 that Cameco’s price realizations will naturally improve as contracts struck in periods of weaker uranium prices continue to roll off its books. A concurrent improvement in contract prices (toward our $65 midcycle estimate) and new low-cost production from Cigar Lake should help Cameco clear its cost of capital over the long term.

We assign Cameco a positive moat trend rating, reflecting expectations of an improved relative cost position that should accompany the ramp-up of production at the high-grade, long-lived, and low-cost Cigar Lake project in Saskatchewan. We also view the expiration of the Megatons to Megawatts program at the end of 2013 and, more broadly, the continued drawdown of secondary supplies as favorable for Cameco’s competitive position, as it will put increased onus on mine supplies to meet worldwide reactor demand, effectively improving the cost position for all uranium miners.

Uranium Prices Are Biggest Source of Uncertainty Over the last several years, uranium prices in the contract market have been as high as $72 per pound (in 2011, immediately before Fukushima) and as low as $29 per pound (early 2018)--volatile, but not especially so by commodity standards. We expect a combination of robust demand and weak supply to push prices to $65 per pound (real 2016 dollars) by 2021, although there is considerable uncertainty around that forecast. For instance, Japanese reactor restarts could be less numerous and slower than we anticipate. Or China could stumble in its ambitious reactor buildout efforts. On the supply side, Kazakh production, always tough to project, could prove stronger than we anticipate.

Cameco reported a gross debt balance of roughly CAD 1.5 billion at the end of the second quarter of 2019, more than 3.5 times EBITDA over the trailing 12 months. While leverage appears high, this reflects the current challenging state of uranium markets rather than a company that has taken on too much leverage. Debt/book capital was 23%, within the company’s target of 25% or lower.

Cameco distributes cash to shareholders primarily through dividends, currently at CAD 0.08 per share on an annual basis, which is roughly equivalent to a CAD 30 million annual outflow. The dividend was reduced at the end of 2017 due to weak uranium prices, but we expect it to be restored and even increased when prices improve.

Amid the ongoing weakness in uranium markets, we think management has done a good job with the factors it can control by minimizing production and oversupply into the market and cutting costs as it waits for better prices. Even as earnings have declined rapidly from low uranium prices, the company has showed significant production discipline, reflecting its commitment to better long-term profitability.