Thesis
SprottResource has done it again, almost doubling their book value withanother fantastic investment. And once again investors are not payingattention. Due to a well-timed investment in a distressed energycompany, Sprott is now worth around C$6 per share thanks to the newlypublic Orion Oil & Gas (Toronto: OIP: C$1.50). Investors aren’tpaying attention to the fact that Sprott’s stake in Orion alone isworth around $340 million. With further catalysts coming later thisyear including another Sprott investment going public, Sprott Resourceis offering investors an opportunity to make an easy 50% plus returnsthis year even after last year’s impressive gains.
Eric Sprott, the Chairman, is one of the best resource investors around
EricSprott, the Chairman of Sprott Resource, is also the chairman of SprottAsset Management, which has nearly $5 billion in assets undermanagement in Canada. He is also the founder of Sprott Securities,which is now called Cormark Securities, a mid-size Canadian brokeragefirm. He founded Sprott Securities in 1981 and split off from it in2002 to focus on money management.
His main hedge fund,Sprott Hedge Fund, was only down 2.8% in 2008 (a year when mostcommodity stocks plunged over 50%) and is up over 22% annually sinceinception in 2000. In November 2008, due primarily to superiorperformance, Hedge Fund Intelligence nominated Sprott Asset Managementin the “Management Firm Of The Year” category at the 2008 AbsoluteReturn Awards.
Check out the Sprott website for more information on this impressive firm with great long-term results: https://www.sprott.com.
So what exactly is Sprott Resource?
Sprott Resource is a public company that is managed like a hedge fund or private equity fund, without the use of any leverage.
Theadvantages that Sprott Resource has as a corporate entity over mutualor hedge funds is that by having a captive pool of capital, they havethe flexibility to invest in private companies or in long term deals,without the worry of clients pulling money out.
Furtherbecause of Sprott’s expertise and connections to management teams andresources all through Canada, management has access to a wide breadthof deals and opportunities that most investors never get to see.
Anddue to their non-levered structure and long-term capital, SprottResource is a very attractive partner to other companies; Eric Sprott’spositive reputation in Canada is a bonus as well.
Hedge Fund’s Style of Pay
Theway Sprott Resource management gets paid is very unique for a publiccorporation. Management is paid like a hedge fund with a management feeof 2% of the assets and 20% of the profits at the end of every year.
The20% incentive paid is based on pre-tax earnings (i.e. realized gains),so unrealized gains that flow through other-comprehensive income do notcount. Further, Sprott values privately held securities in which theyown less than 20% of, at cost. Management evaluates valuations eachquarter and writes down the carrying value if necessary.
Finally, there is a hurdle to the incentive payment being paid. Theprofit has to be over the average rate for the year of the 30-yearCanadian generic bond index. A copy of the Management ServicesAgreement can be found on their website, which outlines the incentivefee calculation in greater detail.
This is a unique way toget paid and some people may not like this at all. I will point outthat there are no salaries or options or bonuses. What is veryattractive about this set-up is that all compensation is verystraightforward and there are no hidden expenses or dilution as is thecase with most companies.
There is another example of acorporate entity being compensated as if it were a hedge fund and thatis Greenlight Capital RE (NASDAQ: GLRE). GLRE is a reinsurer, whichcompensates, pays management 2% and 20% on its investment returns. Forthose who think that this type of payment structure deserves adiscount, GLRE trades for about a 20% premium to book value.
Track Record with PBS Coals is quite compelling
SinceSprott Resource was formed, their track record has been quite good. Infact, they hit a home run with PBS Coals in 2008. Sprott had investedUS$55 million in December 2007 through April 2008 and sold it inNovember for US$200 million to OAO Severstal, one of Russia’s largeststeel companies.
PBS Coals is a low cost producer of privatemetallurgical coal in Pennsylvania that needed funding to expandproduction and also to buy out existing investors. This is an excellentexample of what to look for in the future, since financing is harderfor resource companies now.
Just hit another home run with Orion Oil & Gas
Justlike with PBS Coals, Sprott took advantage of a tight financingenvironment to invest a little over $100 million into Orion Oil &Gas (Toronto: OIP), which is now public. That stake is now worth around$340 million, as Sprott owns 229 million shares of OIP.
Orionis a fast growing exploration and production, energy company focused onAlberta, Canada and has 2,650 boe/d of production on its way to 7,000boe/d of production by year’s end. Orion has 18.0857 million barrels ofoil equivalent (MBoe) in proven and probable reserves and is about 45%light oil and 55% natural gas.
There are number of ways totry and value OIP, which is important since it is the biggest piece ofthe valuation of Sprott. The two I am focused on is on a multiple ofdebt-adjusted cash flow for 2010 and on an enterprise value toreserves.
Orion currently trades for around 7 times cashflow for 2010. On a multiple of cash flow it appears a bit expensivecompared to many other Canadian juniors, which trade for 4-5 timesmultiples to cash flow, but Orion, is growing really fast, much fasterthan comps. It should grow its production this year 180% from beginningof the year to year-end. Further, it has little or no debt and it has awell-capitalized partner in Sprott that removes financing risk.
Onan enterprise valuation to reserves it comes out cheaper than compswith a valuation of about US$19 per barrel per barrel. Most comps tradeon average for over $20 per barrel equivalent.
Here is thebottom line for investors in Sprott, OIP has to trade below
.50 pershare versus its current price of around $1.50 for Sprott to be worthless than its current stock price. Before getting to the valuation,let’s check out some of the other big Sprott investments.
Stonegate Agricom
StonegateAgricom Ltd. is an approximately 79% owned subsidiary of SprottResource Corp., which indirectly owns and is working on exploring anddeveloping the Mantaro Phosphate Deposit located in Peru. StonegateAgricom is independently managed.
Stonegate potentially has avery large phosphate mine in Peru and a recent report estimated thatthe inferred mineral resource on the Philip concession of the MantaroPhosphate Deposit is 45.17 million tonnes grading at 15.4% P2O5.Phosphate prices have soared in recent years due tremendous demand foruse as a fertilizer in agriculture, and a shortage of supply.
Thisis worth about $32 million (63.6 million shares at a recent financingprice of
.50), but a new resource estimate due out soon, could makeit worth much more.
Waseca Energy
Waseca EnergyLtd. is a private oil and gas company and another subsidiary of SprottResource Corp. In October 2008, Sprott Resource Corp. funded over $27million to acquire over 79% of Waseca. Sprott recently participated ina follow on offering of $20 million and increased their stake to 81.3%.
Waseca’sprimary focus is heavy oil production from the Lloydminster area on theborder of central Alberta and Saskatchewan. Waseca currently owns fourprospective petroleum and natural gas leases, has started drilling, andwill continue to drill on its existing leases as well as pursuingadditional acquisitions.
The independent management team atWaseca has an average 33 years of technical and managerial experiencein the oil and gas sector. Prior to founding Waseca, managementgenerated significant production growth in the Lloydminster area whileemployed at a major independent oil and gas company.
Managementhopes to bring Waseco public by year-end just like Orion. Sprott owns73.64 million shares of Waseco at a recent valuation of
.60 per shareindicating a value of $44.2 million. In IPO, this would garner a muchhigher multiple.
One Earth Farms Represents a Huge Opportunity
InMarch of 2009, Sprott Resource announced that it was launching OneEarth Farms, a large-scale farm in the First Nations’ farmland of thePrairie Provinces in Canada. Sprott invested $27.5 million to establishoperations, fund working capital and support its initial growth.
Theplan for One Earth Farms is to start with an initial 50,000 acres andgrow to possibly one of the largest farms or the largest contiguousfarm in North America on untapped First Nation land (First Nationstribes are similar to Native Americans in the US).
I am hugebull on agriculture, the prospects for agriculture companies and forgrain prices in general and think this could be an absolute home run.There are very few ways to invest in agriculture and One Earth Farmscould be quite an attractive stock to many investors, especiallyconsidering it is in such a stable country as Canada.
The company has been an Active Buyer of its Stock
Thecompany has bought back over 3.1 million shares at prices as high as$4.10 in the last year. The aggressive buyback should serve as aprotection for investors on the downside. As the stock has continuouslysold below book value the company has bought back over 15% of the stockin the last two years. If the stock continues to languish below bookvalue, expect management to once again begin buying back shares.
Valuation
Thereis some work involved in getting to the cash balances and goldbalances. Since the last quarterly report (9/30), the company has putmoney to work and bought some gold and sold some silver. Here is myanalysis of what Sprott is worth today:
$/CAD# of units$ per unitTotal
Cash$41,364,405
Gold (oz)1.0673,971$1,100.00$86,250,186
Public Equites$25,989,024
Minority int.Private Cos$18,978,480
Waseca73,640,000
.60$44,184,000
Stonegate Agricom63,600,000
.50$31,800,000
One Earth Farms30,000,000$1.00$30,000,000
Orion Oil & Gas (OIP)229,000,000$1.50$343,500,000
Cash From Warrants16,594,284$4.25$70,525,707
Fully Diluted S/O113,953,284$6.08
If OIP is at
.50 $4.07
$1 $5.07
$1.50 $6.08
$1.75 $6.58
$2.00 $7.08
Thereare some caveats and important points to note. First, Sprott managementgets paid a percentage of the profit, so there is an incentive fee thatI have not taken out. The incentive fee should be about $25 to as highas $40 million, which would lower the valuation by
.22 to
.35 pershare. Second, this lists the value of One Earth Farms, Stonegate andWaseca at their last financing as a valuation. They could be worth muchmore than what is listed above. Finally, this assumes that the warrantsthat convert at $4.25 actually convert. The fully diluted share countincludes the exercise of the warrants.
Optionality of investing with Sprott should be worth something
Ithink that at a minimum, the stock should be trading around $5.50 pershare (net asset value minus incentive fees). Even more, the stockreally should be trading at a premium to book value of 1.1 to 1.2times. Why? I think there is tremendous optionality and value toSprott’s access to deal flow, management teams and insider typeopportunities. The examples of the private equity investments in PBSand now Orion are an excellent example of how much value this team iscreating. Further, One Earth Farms is exactly the type of investmentthat we as ordinary investors have no access to.
Finally, Iwill point out that when Sprott Resource went public, investors were soexcited that they bid the stock up to over 2 times book value, whichwas initially C$1.50 per share. For this reason, my initial pricetarget for Sprott is C$6.60 a share (1.2 times NAV), 57% higher thancurrent prices. Twelve to eighteen months from now, Sprott could betrading as high as $8 based on a premium to NAV and a Waseco IPO.
Pleasenote that I wrote this stock up in April 2009 at $2.65 per share,arguing that its then book value of $3.50 was worth $4 per share. Thatrecommendation has proven to be conservative.
Summary
Insummary, I think Sprott Resource is an opportunity to buy $1 worth ofassets at
.75, and the value of these assets are growing. With shrewdmanagement, who has access to deals normal investors don’t with ahistory of creating value, there is no reason why Sprott should betrading for Benjamin Graham type prices. Once investors realize howmuch larger Sprott’s net asset value is, the discount is likely todisappear. With little downside, due to its incredible balance sheetstrength, Sprott Resource offers investors an incredible risk/rewardsituation.