Spec Value Hunter Comment - December 3, 2013: Recommendation Strategy for Verde Potash plc
Verde Potash plc is heading into a yearend round of tax-loss selling and redemption driven fund liquidation that Spec Value Hunters should exploit as an opportunity to acquire a position in a story that underwent a tremendous run starting in late 2008 and which, despite the steep market price decline since the Q1 2011 peak, remains intact as a security of supply play on potash. After closely covering Verde Potash from its start as a $0.20-$0.29 bottom-fish at the end of 2008 I finally bought the stock close to the top in early 2012 when the junior published its PEA for the KCl process. I have ridden this position down to current levels for a massive 97% loss because the core reasons for liking this story have never changed, namely Verde Potash's potential to revolutionize the way at least part of Brazil's farmlands get fertilized. I remain convinced that the "verdete slate" is a very important "security of supply" story, and, because Verde Potash has not blown up its share structure nor its balance sheet, and the Brazilian CEO Cris Veloso remains in charge with an unflinching vision still intact, despite a management split earlier this year that saw Peter Gundy and Jed Richardson depart, I am closing out the old Spec Value Hunter recommendation cycle and launching a new recommendation cycle to enable KRO members and myself to take advantage of weak end of year prices ahead of the resumption of a strong story development cycle in 2014 that hopefully culminates in 2018 with a positive BFS for the large scale KCL project and a profitable sideline business in the form of ThermoPotash production. Verde Potash plc is a Good Relative Spec Value Buy at $0.21.
The current KRO recommendation cycle began with a Good Relative Spec Value Buy at $7.00 on December 31, 2011 premised on expectations for a positive PEA regarding the new KCl from potassium silicate process invented by Verde Potash in conjuction with Cambridge's Derek Frey, which I converted into a Good Absolute Spec Value Buy at $6.90 on January 31, 2012 when a positive PEA was indeed delivered. As the junior went to work on a BFS for a large scale KCl production facility its stock got caught in the resource sector bear market downtrend that became manifest in Q2 of 2011. The security of supply aspect of the potash conversion story unique to Brazil's circumstance as having the most undeveloped arable land in the world and a heavy potash import dependency should have enabled Verde Potash to survive the resource sector downturn as a process technology innovation laurels story. But in Q2 of 2013 when the BFS was due Verde Potash shocked the market with the announcement that its economic study could not be published as "bankable" without first conducting a 200 tpd pilot plant study that would cost $40 million and another year of work. The problem was that the rotary kiln manufacturer was unwilling to provide a performance guarantee for the 12,000 tpd units required for the KCl production facility to be feasible on the terms of the BFS. The junior's failure to anticipate this problem cost it the market's confidence and I downgraded the buy recommendation to a Fair Absolute Spec Value Hold at $1.30 on May 14, 2013 as I awaited a new game plan. Verde Potash subsequently came up with a new strategy whereby it would revive the original ThermoPotash business plan by building a 1,000 tpd facility for the production of ThermoPotash as a slow release fertilizer supplement for Brazilian agriculture. In October 2010 Verde Potash published a PEA that envisioned ThermoPotash production at a rate of 1-2 million tpa at CapEX ranging $180-$250 million. The smaller scale "Flex Plant" would only produce 300,000-400,000 tonnes of ThermoPotash per year and cost only in the order of $100 million. Most importantly, it would also double as a test facility for the production of KCl from potassium silicate at the scale needed to attract a performance guarantee. Rather than spend $40 million on a pilot plant that ends up as scrap, Verde Potash has chosen to develop ThermoPotash as a separate business venture that need not be acquired and operated by a major interested in the large scale KCl production concept. Unfortunately the market has been unsympathetic towards the new game plan because of skepticism Verde Potash will be able to raise the $100 million likely needed for the ThermoPotash facility, and concern about the future of potash prices in the wake of Uralkali's July withdrawal from its cartel relationship with Belaruskali.
A potash price war is in fact good news for Verde Potash because it effectively kills export oriented greenfield potash projects and stalls most of the brownfields expansion projects that threatened to glut the potash market by 2021 (see Analysis of the Verde Potash PEA - March 27, 2012). An interim price war will create future potash supply shortages to which Brazil and its agricultural expansion plans are particularly vulnerable unless Brazil decides to risk destroying its Amazon Basin by developing the underlying KCl evaporite beds. If anything the potash cartel breakdown enhances the strategic urgency of developing a long term domestic potash supply from an environmentally benign source such as the Cerrado Verde potassium silicate deposits controlled by Verde Potash. Potash prices have not yet sunk to the $200/t KCl level where the viability of the 2012 PEA disappears, but the perception is that projects which require $300/t KCl plus pricing will be shunned during the next couple years while the price war plays out. However, global fertilizer consumption growth coupled with non-development of new supply will have brought the potash price war to an end by the time Verde Potash is in a position to supply the Brazilian market with 3-4 million tonnes of KCl annually as proposed in the 2012 PEA, and it is this strategic dimension as it pertains to Brazil's long term goals that Spec Value Hunters must keep in mind with regard to Verde Potash. Government officials no doubt had these considerations in mind when Inova Agro, a special financing program focused on innovation, selected Verde Potash as one of many potential recipients for $5 million grants whose decision is due in February 2014. Winning a $5 million grant from Inova Agro does not itself solve Verde Potash's CapEx funding problem, but the grant would make Verde Potash eligible to negotiate with the Brazilian Development Bank for low interest debt and equity financing. The BDB will loan up to 65% debt and provide equity up to 90% of CapEx. If the Flex Plant will cost $100 million to build, $65 million could come from a BDB loan, leaving Verde Potash to seek credit for the remaining $35 million from other lenders or, if the stock price is no longer in the gutter, raise it through an equity issue.
Verde Potash plans to divide its Cerrado Verde property into two parts, one allocated to the Phase 1 Flex Plant that will produce ThermoPotash at a rate of 1,000 tpd and in between batches test run the KCl flowsheet, and the other will be allocated to a Phase 2 future large scale KCl production facility such as envisioned in the 2012 PEA. The verdete slate potassium silicate resource running 9%-11% K2O is so large relative to proposed production rates that subdivision of the property into two projects has no economic implications with regard to the value of the in situ resource. The junior hopes to publish a PFS for the Phase I Flex Plant by February of 2014, followed several weeks later by a PFS for Phase 2. The Phase I Flex Plant PFS will be an important milestone because it will give us the first understanding of the economics of a scaled down version of the 2010 ThermoPotash PEA. The technical report will be a key document in negotiations with the BDB for project financing if the Phase I Flex Plant clears the important milestone of securing the $5 million grant from Inova Agro. The Phase I PFS will also allow the market to judge to what extent the KCl pilot plant study required for the Phase II BFS will be paid for by ThermoPotash cash flow. The Phase II PFS will in effect be the KCl production feasibility study Verde Potash was supposed to publish in Q2 of 2013, except that it will not be "bankable". However, it will present an optimized and more heavily engineered version of the KCl production plan outlined in the 2012 PEA, and it will be the basis by which the market and potential partners or acquisitors judge the viability of Verde Potash's large scale KCl production plan. It will also no doubt play a role in helping government officials judge the wisdom of helping out with project financing for the Phase I Flex Plant, the success of which would bring Brazil closer to solving its long term potash import dependency problem.
Publication of the two prefeasibility studies during Q1 of 2014 will allow the market to rethink its valuation of Verde Potash plc, which at the moment it seems to see as heading to zero. As of September 30, 2013 the junior had about $11.3 million working capital left, and burned $1.8 million during the third quarter. According to CEO Cris Veloso the company has reduced its burn rate to $200,000 per month, which suggests that Verde Potash may still have $7 million working capital by the end of 2014. Based on 41.2 million shares fully diluted, and a current estimate of $10 million working capital, Verde Potash would appear to have a cash breakup value of $0.24 per share, sinking to $0.17 per share by the end of 2014. Given the current stock price of $0.21 per share and sinking under tax loss selling pressure, the market is saying that the Cerrado Verde project is an all out bust, and that to me represents Good Speculative Value. Although Verde Potash has not disclosed any details about the content of the aborted BFS, reading between the lines I think one has good reason to believe that it was positive, and that the Phase II PFS will also be positive when published. The big risk factor with Phase II is the technical one of whether or not the KCl process flowsheet would operate at a commercial scale according to design parameters. That question will only be answered after Verde Potash has built the Phase I Flex Plant, which is contingent on receipt of an environmental license, which is the biggest obstacle for the Verde Potash story moving forward in a timely manner.
By the end of Q1 of 2014 we may have good news in the form of two positive PFS studies and a grant from Inova Agro that represents a ticket to securing Phase I Flex Plant financing. But we will not know how long it will take to get an environmental license that is a precondition to securing project financing from the BDB and other sources. Cris Veloso is blunt when he says that in Brazil the timing of an environmental license for excavating a pit and constructing an industrial processing facility is not predictable. He does state that it would take 18 months to construct and commission the ThermoPotash facility. So assuming best case that Verde Potash has an environmental license in hand by the end of 2014, we can assume another 6 months to nail down project financing, with construction starting in mid 2015 and completing at the end of 2016. By mid 2017 we would know how well the ThermoPotash production is doing, and by then we could expect the plant to switch to testing the KCl flowsheet. The minimum 200 tpd continuous pilot plant study that FLSmidth has identified as necessary to provide a performance guarantee for the 12,000 tpd rotary kilns required by the aborted BFS will be done by the end of 2017, with a BFS then expected in mid 2018. Based on this timeline the earliest Brazil could expect large scale domestic KCl production from a potassium silicate source rock would be 2020, which is about when one might expect potash supplies to have become tight again. The time horizon relevant to Spec Value Hunters is between now and the receipt of Phase I Flex Plant project financing, namely mid 2015. Most of the gains from "bottom-fish" levels, however, will have been achieved by Q2 of 2014, which gives my new Good Relative Spec Value Buy at $0.21 a fairly short time horizon. I do not have a specific price target, other than the expectation that it will be several times higher than the current stock price which is less than cash breakup value. The $5-$8 range we saw during the post 2008 crash resource sector boom is unlikely to be revisited. A specific price target based on cash flow analysis scenarios will have await publication of the two prefeasibility studies in Q1 of 2014.
As described so far the Verde Potash story comes across as a somewhat tedious resource feasibility demonstration process that will not exhibit the excitement of the 2009-2011 period during which management unfolded the ThermoPotash plan and then escalated it into the KCl conversion plan with the help of some innovative process engineering. It will very much be about numbers, politics and bureaucracy. However, there is a potential twist which could inject a much higher level of urgency and excitement into the Cerrado Verde project. On September 12, 2013 Verde Potash reported that a 30 month field test on coffee crops had demonstrated that ThermoPotash fertilizer containing 36% of the K2O equivalent in potassium chloride (KCl) applied to the control plots had achieved equivalent crop yields. Interestingly, the slow-release multi-nutrient ThermoPotash fertilizer was applied only once at the start of the trial, while the KCl had to be applied 4 times to reflect the actual seasonal application requirement due to the high leach rate of Brazilian soils. This outcome is consistent with the junior's original argument as to why domestic ThermoPotash could help reduce Brazil's consumption of imported KCl. But the real test still underway which has far reaching implications is whether or not the ThermoPotash fed coffee trees produced higher quality beans than the KCl fed trees. Brazil is by far the world's largest coffee producer, but when was the last time you saw Brazilian coffee beans for sale in a Peets or Starbucks? Brazil does not produce premium coffees because its soil lacks the natural potash of the volcanic soils in which the world's top coffee brands are grown. Brazil has to add KCl to its coffee plantations, and the chlorine has a negative impact on the taste of coffee. Furthermore, any crop fertilized with KCl cannot qualify as organic. Because of the simple manner in which ThermoPotash is produced from whole rock, it does not fail the "organic" test which prohibits chemically processed inputs. Independent quality tests are now underway to determine if coffee made from the ThermoPotash fertilized coffee beans tastes better than coffee made from standard chlorine tainted Brazilian coffee beans. If the answer is a definitive yes, Brazilian farmers will be able to cultivate specialty coffees and market them as premium and even organic coffees. If coffee growers pursue this avenue, Verde Potash would have an instant after-market for its ThermoPotash output, and the junior would probably attract financial support from the coffee industry. Such a development would inject excitement into Verde Potash's story; we should hear a preliminary verdict by the end of December 2013. It is not critical to the junior's game plan, but good coffee news would really give Verde Potash an espresso shot on the upside.
*JK owns shares in Verde Potash PLC