good article...................... Jan 9, 2015 3:00 PM | about stocks:
EORBFThis article deals with a stock with a price under $1. As such, it will not get published as a regular article. I figured some people may be legitimately interested in the company, so decided to publish it as a blog post.
Every so often you stumble upon a stock with an exciting story, a story so promising that the risk-taking side of you wants to throw money into without further due diligence. This is the investor I used to be and is a behaviour that I am trying to avoid. As such, when I ran across Orbite Alumina (OTCQX:EORBF) I decided to take a closer look before making an investment decision.
Background
Headquartered in Quebec, Canada, the company has developed proprietary technology that is an alternative to the Bayer process, which is used to produce alumina, an input to the aluminum industry. The Bayer process was invented in 1887 and, more or less, hasn't changed since. It is inefficient and generates a toxic by-product called Red Mud, which currently has no use and is left to sit in tailing ponds.
Orbite estimates that 3 billion tonnes of Red Mud are sitting at various sites throughout the world, with an additional 120 million tonnes produced annually. Orbite's process extracts the necessary inputs for alumina, as well as most of the remaining valuable materials from the feedstock, such as magnesium, gallium, scandium, Rare Earth Elements (REEs) and Rare Earth Metals (RMs). The by-product from the process is an inert residue. Not only that, but one feedstock for the Orbite process is Red Mud, which the company estimates contains up to 25% alumina concentration, as well as various other materials that can be extracted. Essentially, Orbite can feed Red Mud into its process and convert waste into valuable materials, again leaving an inert by-product.
HPA commercialization
Currently, the company is focused on commercializing its High-Purity Alumina (HPA) plant located in Quebec that will produce 3 tonnes per day (tpd) of HPA, with commercial production scheduled for Q3 2015 (as of December 4, 2014). HPA can be used as an input in the production of LED displays (TVs and smartphones) and lithium-ion batteries.
HPA is somewhat of a niche industry and, according to the company, is currently in oversupply. However, this is forecasted to change, with supply and demand projected to come into balance by 2016. Market prices for HPA are generally difficult to determine because many purchase contracts include confidentiality agreements. The price also heavily depends on the grade of HPA produced. Regardless, a better supply/demand balance should be bullish for prices.
It should be noted that the HPA facility is the company's first commercialization effort and was originally scheduled to be operational in 2013. I believe the current management team is a little more transparent that the previous team and have no reason to doubt the new timeline.
It should also be noted that the plant that is currently under construction is not able to use Red Mud as an input; however, the company has indicated it aims to modify the plant to its chloride process (which can treat Red Mud) by early 2016. It will also make a decision in early 2015 on whether to expand the plant to a 5 tpd capacity.
Future priorities
The HPA plant is the first priority for the company. The second priority is waste monetization (e.g. Red Mud remediation). Another potential feedstock in the Orbite process is fly ash, which is a by-product of coal-fired power plants. At this time it is unclear whether the company is aiming to license its technology or build and operate future plants itself. My opinion is that a licensing deal would make the most sense at this time since I feel the company may encounter financing problems (discussed more below).
The company's third priority is a smelter-grade alumina (NYSEMKT:SGA) plant, to be located in Quebec. The company owns a number of mineral claims as well as a mining lease on a site in Quebec, the material from which would be used as an input for the proposed SGA plant. I have not found a concrete timeline on this project other than a statement in the 2013 AIF that says Orbite intends to begin negotiations with potential partners during 2014-2015.
It is worth noting that the company has a binding offtake agreement with Glencore International AG for the purchase of 100% of the SGA produced at the proposed SGA plant for the first 10 years after commencement of commercial production.
From what I have read Orbite's cost of producing SGA will be at the low end of the cost curve (USD 210/tonne vs. industry estimates of USD 265/tonne). In addition, a plant located in Quebec will be next door to the Quebec aluminum industry - the third largest in the world, with a limited supply of alumina - giving Orbite's product lower transportation costs.
Valuation
I must stress that there is a lot of guesswork associated with my analysis. As a pre-revenue company there is no comparable operating history to project into the commercialization phase. Also, I was not able to find any projections from the company itself, other than production targets and some capex numbers. I was able to find market prices for the materials that the company expects to produce. The company has indicated its cost to produce SGA will be in the USD 210/tonne range. I was unable to find a cost estimate for HPA and am using a value of USD 15,000/tonne, which is based on various gross margin estimates I have seen in other research reports and an average market price of USD 25,000/tonne.
I have valued the company three different ways. One is simply tangible book value as of Q3 2014, which is CAD 0.26.
The other two methods involve projecting financials going forward 10 years and discounting back free cash flow (NYSE:FCF) and net income (NYSE:NI).
Assumptions
- HPA production begins in 2016 at a rate of 2.5 tpd over a 365-day year. Capacity is 3 tpd and this estimate gives room for some downtime.
- SGA production begins in 2020. I have nothing to base this date on other than the SGA plant is the third priority and will take some time to finance and build. The SGA plant will produce the following products (in tonnes per year): 540,000 SGA, 189,000 hematite, and 1,200,000 silica. These are estimates provided in the 2013 AIF.
- Market prices are as follows (in USD/tonne): HPA 25,000; SGA 330; hematite 90; silica 10. I have assumed prices remain the same for my 10-year timeframe, which I have done to be conservative.
- Operating costs are as follows (in USD/tonne): HPA 15,000; SGA 210; hematite 70; silica 5. I have also assumed these costs remain flat over my 10-year horizon.
- Capex as outlined by the company. I have not included capex for the proposed SGA plant, which I estimate at CAD 600 million. Obviously, including all or part of this will greatly reduce my share price estimates.
- 20% discount rate, to reflect the risk of the investment.
- Long-term growth rates for both FCF and NI of 4%.
FCF estimate
Share price: CAD 0.21.
As I mentioned, this estimate does not include any capex related to the proposed SGA plant. I have done this because at this time I don't believe the company has access to this kind of money. Therefore, I believe a partnership/JV or a licensing deal would be necessary and I do not know the form or financial impact of such a deal. Essentially, the FCF estimate is well below the current market price without accounting for a large chunk of capex being spent.
NI estimate
Share price: CAD 0.18.
Again, this does not include the capex related to the proposed SGA plant. Including the capex will alter debt levels and depreciation amounts, which impacts NI.
Further thoughts
The biggest takeaway for me after reviewing my projected financial statements is that the commencement of commercial production at the HPA facility will not push the company to profitability. (Because there is no commercial operating history, I have simply extended current costs into the future. I have added a depreciation and amortization estimate as well as revenue and COGS based on estimated production and prices from above. I slowly increase SG&A as commercialization begins. All in all, I think my cost estimates are on the conservative side and I can see them being higher than my estimates once commercialization begins. Again, there is a lot of guesswork that went into these numbers.)
When I began my analysis I was hopeful that the HPA plant would generate profits and reduce the company's need for debt and/or equity financing. Based on my projections, this is not the case. I see profits starting with the commercialization of the SGA plant, which is at an undetermined future date. It is possible that licensing deals could materialize that could change this; however, I have no insight into what such a deal would look like.
The gist is I see the need for financing to continue well into the future. Based on what I have read, I get the impression that these financings are becoming more difficult to come by and, when they do, the investors offering the money are squeezing more and more out of the company, which in turn turns the screws on current equity holders.
Another red flag for me is that in all of the reading I did the same story seemed to be repeated year after year: commercialization of the HPA plant has been delayed and no concrete developments on its other initiatives. I feel that what I read in the Q3 2014 report is the same thing that I read in the 2013 annual report; basically, things just don't seem to be moving along for the company. It's purely anecdotal on my part, but it doesn't make me feel great as a potential investor.
Conclusion
I love the story of this company. It has engineered a new process that could theoretically replace another that has been used for over 100 years. Not only that, but it's an environmentally-friendly process and has the potential to clean up 100 years of toxic by-product.
However, one issue for me is technology adoption. In my view, current producers will only switch for economic reasons or due to legislation. I like to think there is an economic reason because it seems like a doing-good-and-making-money scenario. Who doesn't like that? However, that comes down to whether adopting Orbite's technology and selling by-products is more profitable (or less costly) than paying to contain Red Mud in tailing ponds. I have not been able to find enough information to convince myself of this case. The other option is government legislation, which I do not want to use as a basis for this investment.
I want to like Orbite as an investment; however, I am trying to be a more rational investor and my numbers just don't make a strong case. I am only on the fence because if the company does take off I can see this investment being a huge winner (I know it's a poor reason); in my mind, the potential upside is far larger than the downside. I'm still young enough to be able to take risks like this.
I have two strategies to play this stock, one of which is riskier than the other. Please note that this is what I would do if I were to buy shares; it is not a recommendation for what you should do. You are welcome to consider both strategies for yourself and determine how it fits in your portfolio and risk appetite.
- Buy the stock sooner rather than later (well before commencement of commercial operation of the HPA plant). I believe commercial operation of the HPA plant will cause the stock price to jump up significantly. At this time I would sell all of my shares on the assumption that a funding crunch will come and the stock price will dive again. Then, follow #2.
- Wait until more is known about the proposed SGA plant and any licensing deals and re-evaluate at that time.
To me, option #1 seems too much like market timing. The possibility of doubling (which I think is plausible) my money is enticing, but it's risky. I would only speculate with a very small percentage of my portfolio. Because I am trying to be a more disciplined investor, I do not see myself taking option #1.
I view option #2 as being the smartest way to deal with Orbite. My projections show the company becoming profitable with the commercialization of the SGA plant. At that time, the company would have a few years of operating history under its belt and more concrete estimates regarding SGA plant operations. With any luck, the company would still be flying under the radar and shares could still be picked up on the cheap.
Please note that this is a pre-revenue company and is a very risky investment. I am not publishing this article as investment advice or a recommendation to buy or sell; rather, it should be used as an opinion amongst many. Ultimately, you are responsible for your own investment decisions.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: This article is not meant as investment advice or a recommendation to buy or sell. You are responsible for determining if an investment is appropriate for your portfolio.