Allana Potash Offers Substantial Potential Rewards Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)
Junior gold miners are common enough and those investors who follow the mining sector closely are probably familiar with other juniors in minerals like copper. Junior potash miners are not nearly so common, though, as potash mining has historically been dominated by the likes of Potash Corp (POT), Uralkali, and Mosaic (MOS). Canada's Allana Potash (OTCPK:ALLRF) (AAA.TO) is looking to shake that up a bit, though, as the company hopes to move forward with a low-cost asset in northeastern Ethiopia.
I suspect that readers are bombarded with enough warnings about risk that they gradually become immune to them. I have to note, though, that Allana is a great deal riskier than average. This company's market cap is just over $100 million and the company is going to need to raise substantial sums of capital to turn its ambitions into reality. Although Allana's ADR shares carry the dreaded "F", the liquidity is actually pretty good (though still less than 20% of the Canadian shares).
Opening A New Source Of Supply
Potash is a popular fertilizer, the third-most used fertilizer in the world, with global demand in the neighborhood of 30 million tonnes today. Most of the world's potash comes from sylvite deposits in Canada and Russia (were about 80% of the world's known reserves are located), and about 70% of the global trade is controlled by Canpotex (a marketing firm owned by Potash, Mosaic and Agrium (AGU)) and Belarusian Potash Company (owned by Uralkali and Belaruskali). There has been turbulence in the market of late due to Uralkali's threat to exit BPC, but that's a topic for another time.
Allana is not looking to shove aside any of the giants of the potash industry, but the company is looking to bring a new mine in Ethiopia into commercial production, a mine that would not only offer low-cost potash deposits, but also good proximity to growing markets like China and India, as well as other Asian and African agricultural markets.
Allana's primary asset is the Danakhil project in northeastern Ethiopia (near Dallol), quite near the border with Eritrea. This area of Ethiopia has been known to have meaningful potash deposits since early in the 20th century, but flooding, economics, its remote location, internal politics, and war with Eritrea have all stood in the way of large-scale commercial development. Now with more stability in the region and Ethiopia's government eager to encourage investment and development in the country, it looks like Allana can play a meaningful role in commercializing some of these assets.
The Project
The Danakhil project includes over 300 square kilometers of land that Allana assembled through a series of transactions. The company has reported about 24 million tonnes of proven and probable sylvinite potash, with another 93M tonnes measured and indicated. I focus on the sylvinite, as that is the best initial target for the mining operations. The deposits are close to the surface, and that means Allana can use solution mining and solar evaporation - basically digging boreholes, pumping water into them, waiting for the water to dissolve the potash, pumping out the resulting brine into evaporation ponds, and then collecting, crushing, and processing the crystals.
Allana has completed a feasibility study that reported potentially strong economic returns from this project. Based on an initial production assumption of 1M tonnes per year, the company believes it could bring this mine into operation at the cost of about $642/mt - well below other potash greenfield projects with per-mt capex estimates of $1,000 to $2,000.
The question now is whether Allana can get the funds it needs and get construction underway. The feasibility study estimated total capex of $642 million, but I would assume the real costs will likely be closer to $700 million based on the typical level of overshoot for mining projects. Given that the company has about $20 million of cash on hand, clearly it will need a lot of financing to bring this project forward.
How Allana goes about raising those funds is now a central question. Raising over $640 million through equity would seem to be a non-starter and it may well prove difficult to raise those funds through debt offerings or bank lending (at least on reasonable terms). Not surprisingly, management is exploring strategic partnerships and off-take agreements, whereby a company/investor would front Allana some or all of the cash to develop the project in exchange for a percentage of the output.
Assuming that Allana can get the funds together, construction could begin in the first half of the this year (2014), and I would expect full-scale commercial production in 2017. Given the expressed interest of parties in China, India, and the Mideast for past potash projects and mining projects in Ethiopia, I think there is a good chance of Allana finding a quality partner with the necessary capital.
So Many Unknowns
Pre-construction mining projects always carry a lot of risk, and there are plenty of unknowns when it comes to Allana. First, there is the question of how much they will need to spend building the facility, the terms they get for those funds, and how quickly construction can be completed. Then there is the cost of production and transportation to consider; the solution mining approach should offer appealing economics, but the company will need to truck the potash to a port in Djibouti.
And that's not all. While Allana's feasibility study focused on 1MT/yr of production (similar to what Yara (OTCPK:YARIY) has reported for its own project in the Dallol region of Ethiopia), I believe it very well may be possible to expand that to closer to 2MT/yr and it likewise may be economical down the road to mine and exploit the kainitite and carnallitite deposits at this project. Keep in mind too, though, that BHP Billiton (BHP) was once looking to develop a potash mine in the same region, but pulled out in 2012 when its studies suggested it wasn't an economical venture.
Suffice it to say, operating in Ethiopia carries ample risks of its own. While the government of Ethiopia seems to be trying to encourage international investment and clean up its image, the country still scores very low on the Index of Economic Freedom (146th in 2013) and issues like corruption, judicial competence, and regulation/bureaucracy still loom large. Perhaps the government now appreciates that it must encourage businesses like mining, but it remains a "show me" story, and the risk of future tensions or hostilities with Eritrea cannot be completely ruled out.
A Wide Range Of Potential Values
Whether Allana produces 1MT of potash a year or 2MT, it will be a drop in the global bucket (roughly 50MT of capacity) or compared to Potash Corp's 9MT of capacity or the nearly 8MT of capacity at Mosaic. Even so, the particular assumptions you make today about production, potash prices, operating costs, and so on have a dramatic impact on the resulting net asset value.
Using the assumptions provided by the company (capex, pricing, production costs, etc.) and adding in some assumptions of my own about capital costs, I come up with a valuation range of about $1.30 to $1.85 per share.
I consider that to be the high end of the range. Potash prices have been exceptionally volatile over the last six years, trading lower than $200/tonne and higher than $850/tonne at various points in time. My preferred price assumption for the long-term is $375/tonne (versus $430/tonne in the feasibility study), which is actually higher than recent spot rates. I also believe that Allana's operating and production costs will be higher than expected initially, before improving with time. Last and perhaps most importantly, I do expect the company to eventually expand its production - leading to better operating synergies and cash flow.
With all of those assumptions (and using a higher discount rate than the 10% that is common in mining NAVs), I come up with a per-share fair value of $1.00. Without the expanded production (but keeping the higher costs), I would see risk down into the $0.20 to $0.30 per share area. At this point I am including no value for the company's potash asset in Argentina (Nequen), as there is too little information to go on at this point.
The Bottom Line
That huge range of potential NAVs highlights a key problem with the NAV approach - a change of just 1% in the discount rate or just $15/tonne in the long-term price of potash has a pretty profound impact on the discounted net present value of those future cash flows. All of that said, I believe even a conservative-to-harsh assessment of capex and production costs points to significant potential value here.
Allana has much work left to do. The company must get its funding together, get the mine up and running, and then actually operate the facility. By no means is this a stock for weak-hearted investors. For those willing to take on some real risks, though, the potential returns from this would-be junior potash miner look quite exciting.
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