Spec Value Hunter Comment - May 14, 2013: Verde Potash BFS needs 200 tpd demonstration plant for critical performance guarantees
Verde Potash plc took a hit on May 14, 2013 (down $0.86 to $1.30) after reporting on May 13 that several key people are leaving the company, it would not be able to complete its bankable feasibility study in Q2 of 2013, and that it was unable to secure a performance guarantee from FLSmidth for a 12,000 tpd rotary kiln whose scale is critical to the feasibility of the Cerrado Verde project. The departure of certain people is unfortunate, but likely of no major consequence as Verde Potash shifts to a greater reliance on Brazilians as I discuss later on. The delay of the feasibility study and associated cost, however, is a significant setback for Verde Potash, which is the subject of a Good Absolute Spec Value Buy at $6.90 made on January 31, 2012 and whose basis was outlined in Spec Value Hunter Comment - March 27, 2012 which projected a target price of $15-$20 by the end of 2012 when the feasibility study was initially supposed to be finished. Unless there is a miraculous decision by potential lenders to waive the requirement of equipment performance guarantees, Verde Potash will likely need to raise another $20-$30 million to conduct a 200 tpd demonstration plant study whose timeline pushes completion of a bankable feasibility study into Q3 of 2014. The need to raise additional capital during the next few months during a bad raw materials bear market, in the context of deep disappointment that management failed to anticipate the performance guarantee problem, may undermine the significant upside offered by NPK's low 41.2 million fully diluted capitalization implied by the modeled outcome of the PEA assumptions. Although a number of large potash developments and expansions have been shelved during the past couple years, and the outlook for near term potash demand growth is diminished, the Verde Potash story remains very relevant to Brazil from a strategic security of supply perspective. I cannot predict at what price and when the stock will stabilize - much will depend on the need of institutional shareholders to bail out and the desire of longer term Brazilian investors to acquire a position, but it will be several months before Verde Potash can and needs to address financing of the 200 tpd demonstration project. This could be a window to accumulate a position with H2 of 2014 in mind, but unless one is eager to acquire a large position, it would be wise to let the smoke clear.
I have updated the PEA base case financial model I presented in my March 27, 2012 analysis by boosting capital and operating costs by 10% and adjusting the current FoB Vancouver KCl price to $391 from $483 just over a year ago, which still generates an after-tax net present value of $944 million or $24.11 per fully diluted share using a 10% discount rate, though the internal rate of return has shrunk to 17%. As the sensitivity chart above shows, the economics at the PEA base case cost and recovery assumptions is very sensitive to FoB Vancouver KCl prices. In my model the price NPK is deemed to receive for its KCl output is the FoB Vancouver KCl price plus a delivery charge from the Vancouver port to the Uberaba blender district that ranges from $105-$116/t KCl based on the FoB Vancouver price. A $15-$20 price target is still conceivable, especially if NPK were to be valued with the upside case in mind where the five year output ramp-up is from 1 million tonnes KCl per year to 4 million tonnes instead of 600,000 tonnes to 3 million tonnes. However, if we were to see a collapse of FoB Vancouver KCL prices to $300 without a rise in delivery costs, the NPV at 10% is negative, with breakeven occurring at $325/t. Given the downside risk related to global potash prices, and the high processing cost which works out to $306/t KCl in Brazil, it is understandable that potential CapEx lenders want a performance guarantee from equipment suppliers for the Cerrado Verde facility. Assuming that the need for a 200 tpd demonstration plant is more to mitigate FLSmidth's balance sheet risk than to resolve underlying technical issues, and that potash prices have bottomed at the current level (the 8 year trailing average is $380/t KCl), the main question for the moment is how much equity dilution NPK will need to incur in order to fund the 200 tpd demonstration plant over the next year. Spec Value Hunters can expect the price of NPK stock to be volatile until the answers to the cost and funding method questions have been provided. Given this uncertainty I am converting Verde Potash Inc to a Fair Absolute Value Spec Cycle Hold at $1.30.
A performance guarantee is something that bankers insist on from equipment suppliers for large capital projects such as Cerrado Verde, whose stage one 600,000 tpa KCl output capacity was projected to cost $598 million, with expansion to 3,000,000 tpa costing $2.3 billion. NPK's Cris Veloso has indicated that during the past year cost inflation of 6% has been observed, with further cost increases to be expected as the engineering details of the Cerrado Verde project are worked out. For those of you new to the Verde Potash story, NPK owns several hundred million tonnes of an unconventional potash source rock, potassium silicate, which grades 7%-10% K2O compared to 20%-30% K2O for sylvenite, the conventional potash source rock which contains potassium in the chloride form used by the fertilizer industry. Unlike the sylvenite deposits in Canada, Russia, Belarus and Germany, all of which are mined as deep underground beds, NPK's verdete slate deposits are at surface in Brazil's fertilizer hungry agricultural heartland. NPK's goal is to become a major baseload potash supplier in Brazil whose profitability will be a function of the difference between the delivered cost of imported KCl and NPK's domestic production cost. The key is a new process developed by NPK and Cambridge Professor Derek Fray which deploys a flowsheet of pyrometallurgy, evaporation and crystallization to convert finely ground potassium silicate into a potassium chloride product that can be shipped directly to Brazilian fertilizer blenders. Because of the comparatively high processing cost NPK needs a long term delivered potash price of at least $425/tonne to be profitable, which means that with FoB Vancouver KCl currently at $391/tonne, or $499/t delivered, there is little room for technical errors in KCl recoveries and associated costs. Verde Potash has secured a full performance guarantee from Veolia Water Solutions & Technologies for the evaporation and crystallization stage of the Cerrado Verde KCl process, but FLSmidth would only guarantee rotary kiln units with a 3,000 tpd capacity for the pyrometallurgical stage.
That guarantee is useless to NPK because the 600,000 tonnes KCl output per year for stage one of the development plan requires rotary kiln capacity of 24,000 tpd, which includes the salt and limestone additives needed to produce KCl. Installing eight 3,000 tpd kilns instead of two 12,000 tpd kilns not only implies a higher capital cost, but also a higher operating cost in terms of maintenance. Although he did not quantify the difference, Cris Veloso made it clear in the Monday conference call that Cerrado Verde based on 3,000 tpd kilns is not commercially feasible. Since the comparatively higher installation and operating costs of 3,000 tpd kilns would have been obvious from day one, the sudden revelation in March of 2013 that FLSmidth would only be able to guarantee a 3,000 tpd kiln has put into question the competence of NPK management, both current and outgoing members, and also raises questions about NPK's chosen equipment supplier.
During the Monday afternoon conference call it was stated that any scale-up beyond 100 times the pilot plant demonstration scale is considered non-standard by the equipment industry. The pilot plants at NPK's Belo Horizonte facility and FLSmidth's Allentown facility operated at only 4 tpd using a kiln with a 1 metre diameter. That FLSmidth was willing to guarantee a scale-up of 750 times to 3,000 tpd is impressive, and shows a fair degree of confidence in the process. However, in order to achieve the stage one output capacity of 600,000 tonnes KCl per year envisioned by the PEA, NPK needs 24,000 tpd rotary kiln capacity. This would require 8 kilns with 3,000 tpd capacity versus 2 units with 12,000 tpd capacity. FLSmidth has sold hundreds of 3,000 tpd kilns, but only ten 12,000 tpd kilns, all of them for cement production. The 12,000 tpd kiln represents a scale-up of 3,000 times for a material that has never been commercially processed before, namely a potassium silicate. That FLSmidth would not warn NPK right from the start that a 4 tpd pilot plant would never be sufficient to allow it to provide a guarantee that makes the feasibility study "bankable", seems very odd. Did they delude themselves into thinking NPK would buy the smaller units? Why would FLSmidth with its sales and marketing experience not alert NPK about the inadequacy of the 4 tpd plants? The fact that no current or departing management members knew enough to ask about performance guarantees until it was brought to their attention in March 2013 is apparently due to ignorance for which shareholders are now paying a painful price.
One of the issues with rotary kilns is that the larger kilns rotate at a slower speed than the smaller kilns, which can affect the degree that the material sticks to the kiln walls and builds up until the entire kiln is clogged. The 3,000 tpd kilns have a diameter of 4 metres, while the 12,000 tpd kilns have a 7 metre diameter. FLSmidth has proposed that it would be able to provide a performance guarantee for the 12,000 tpd unit if NPK conducted a 200 tpd pilot plant demonstration, which involves a kiln with a 2 metre diameter. Veolia was able to guarantee the evaporation/crystallization stage because this is a conventional process already in widespread use. Grinding potassium silicate into a powder and mixing it with salt and limestone in a rotary kiln fired by petroleum coke has never been done before on a commercial scale.
NPK has not yet determined what a 200 tpd demonstration plant would cost, but it is likely in excess of $20 million, more than NPK's current $17 million working capital which is burning up at $500,000 per month. FLSmidth has indicated that the demonstration plant must operate for at least six months. It would have to be set up at the mine site, which to do will require receipt of an environmental license which NPK hopes to have in hand by July. It would take 3-4 months to prepare the site and install the demonstration plant, followed by 6-9 months of testing, which means that the earliest NPK would be in a position to produce a bankable feasibility study is early Q3 of 2014, just over a year from now. This assumes that the 200 tpd pilot plant does not reveal unsolvable problems. An alternative would be to see if other rotary kiln makers would be willing to provide a performance guarantee for 12,000 tpd kilns, though this would require testing their slightly different technology and also incur delays.
There may, however, be a silver lining to this expensive delay, provided NPK can obtain much of the funding for the demonstration plant from non-equity sources. Normally a demonstration plant's post demo value is that of scrap, but in this case the plant could continue to be used to produce ThermoPotash, the slow-release "whole rock" product which was NPK's focus in 2010 before the Cambridge Process breakthrough was achieved in late 2010. Agronomic studies initiated in 2009 are still underway and according to Cris Veloso are demonstrating that ThermoPotash is effective as a supplement to traditional fertilizer blends of nitrogen-phosphorus-potassium. The potential economic value of producing ThermoPotash pales against that of producing potassium chloride, but this cash flow business could represent a downside limit for NPK shareholders in the event that completion of the 200 tpd demonstration plant and feasibility study result in a conclusion of marginal economics at prevailing KCl prices. And if the study proves positive setting the stage for a takeover by a deep-pockted entity such as Vale, NPK would already be a year ahead with its plan to spin-off ThermoPotash as a separate business that keeps a small corner of its verdete slate deposit. During 2010 NPK produced a positive PEA for the ThermoPotash business. So this performance guarantee setback may in fact have furnished NPK shareholders with a hedge against a possibly catastrophic outcome for the feasibility study. NPK indicates that it will be a couple months before it is in a position to provide clarity on the cost of the 200 tpd demonstration plant and the subsequent utilization of it as a ThermoPotash production unit.
The departure of chairman Peter Gundy and Jed Richardson as directors is due to a breakdown of their personal relationship with the CEO Cris Veloso rather than a loss of confidence in the viability of the company's proposal to convert its Brazilian unconventional potash deposit into conventional potassium chloride sold to the agriculture industry in Brazil's Cerrado region. This is based on public comments made by Cris Veloso and an email Jed Richardson sent to his contacts. The relationship breakdown has its roots in the $28.75 million underwriting arranged at $6.45 on March 1, 2012 through a brokerage firm with a history of accommodating short-selling hedge funds. Verde Potash, which was trading in the $8-$9 range when it published its PEA on January 31, 2012, came under attack from a short seller after management signaled its intent to finance the company, something easy to do in the absence of the uptick rule, but also helped by the complexity of the PEA which relied on transportation cost differentials to offset a high processing cost compared to conventional sylvenite derived potash. Because this selling helped depress the eventual financing price, Veloso did not want the hedge fund to cover through the financing, something the brokerage firm, whose principals were close to Gundy and Richardson, insisted on. Ironically, as we now know, the hedge fund left quite a bit of money on the table, but the strained relationship between Veloso and Gundy/Richardson never recovered. I suspect there is probably more to the "misalignment of communications", possibly linked to why it took everybody until March 2013 to figure out that the pilot plant study was impossibly small to support a bankable feasibility study with the required scale of 12,000 tpd rotary kilns. But that is now water under the bridge, and I am optimistic that in due course Peter Gundy and Jed Richardson will be celebrated for the important contributions they made with regard to Brazil's evolution of partial self-sufficiency in potash supply. Verde Potash has indicated that Gundy and Richardson will soon be replaced by individuals with strong Brazilian credentials, signaling a further shift away from Canada. The departure of Milson Mundim, who was appointed as CFO on August 22, 2012, apparently was due to him accepting a substantially better pay package from an oil services company. The challenge for Verde Potash going forward is for Cris Veloso to pull together a team the market trusts will allow no further screwups on the road to producing a BFS during H2 of 2014.
*JK owns shares in Verde Potash PLC