Cameco finished 2019 largely as expected, with an 11% decrease in revenue to CAD 1.9 billion largely due to a 10% and 6% decline in volume and realized price, respectively. It expects further revenue decline in 2020 to roughly CAD 1.5 billion to CAD 1.6 billion, stemming from fewer committed sales. Management has done a good job of cutting costs where it can, helping to preserve cash. Nevertheless, while Cameco waits for demand to recover, near-term results are not representative of future earnings potential.
Our long-term forecasts are largely unchanged, but we’ve updated our near-term outlook to reflect weaker sales volumes and higher costs than previously expected. We aren’t overly concerned, as much of the spending is geared toward maintaining Cameco’s long-term competitive positioning. Further, the company has plenty of liquidity, with nearly CAD 1.1 billion in cash, CAD 2.5 billion in credit lines, and no major debt maturity until 2022.
Our changes lead us to lower our fair value estimates to $15.50 and CAD 20.50 per share, down from $16.50 and CAD 21.50 previously. Cameco’s narrow moat is unchanged. Although its world-class low-cost production is largely offline amid uranium market weakness, we expect the company to return its mines into production when prices recover.
Shares remain vastly undervalued, as we think the market underestimates future prices. However, we reiterate or high uncertainty rating. We continue to believe better prices will be needed to spur mothballed and new mines into production to meet still-rising demand, but the timing of the recovery is uncertain due to the opaqueness of the market. Although we know more uranium will be needed as the global reactor fleet continues to grow and that primary supply has decreased, it’s difficult to estimate when the uranium market will turn without knowing inventory levels.
Business Strategy and Outlook
We think the market is mispricing narrow-moat uranium miner Cameco. Uranium offers a rare growth opportunity in metals and mining. China's structural slowdown portends the end of a decade-long boom for most commodities--but not for uranium.
Uranium prices declined consistently from 2011 to 2017, owing to the supply glut caused by delayed Japanese reactor restarts. However, this situation is unsustainable as much of existing production would be unprofitable at these prices. Yet, because most uranium is transacted through long-term contracts negotiated years in advance, a disconnect between realized and spot prices makes it appear that lower prices are sufficient.
Meanwhile, we expect global uranium demand to rise roughly 40% by 2025, a staggering amount for a commodity that saw next to zero demand growth in the past 10 years. We expect new reactor capacity to drive the strongest uranium demand growth in decades. A quadrupling of China's reactor fleet headlines this growth. China's modest nuclear reactor fleet uses little uranium today. That's set to change in a major way. Beijing is pivoting to nuclear in order to reduce the country's heavy reliance on coal. New reactors in India, South Korea, and Russia as well as eventual restarts in Japan lend additional support.
Years of low spot prices have prevented investment in new mines, while existing mines have entered care and maintenance or near the end of their lives. As such, mined supply of uranium will struggle to keep pace amid rising demand and falling secondary supplies. Low uranium prices since Fukushima have left the project cupboard bare, and we expect a cumulative supply deficit to emerge by 2023. These shortfalls should begin to affect price negotiations in the next couple years, since utilities tend to secure supplies a few years before actual use. We forecast that contract market prices will rise to $65 per pound to encourage enough new supply.
As one of the largest and lowest-cost producers globally with expansion potential, Cameco should benefit meaningfully from higher uranium prices. The company benefits from stellar ore grades, large scale, long life, and an attractive operating cost profile.
Production costs are the primary litmus test for measuring competitive advantage in the highly cyclical mining industry. All producers can generate fat returns on capital when commodity prices are high, but only the lowest-cost producers can be expected to generate excess returns on capital through the cycle. Measured by cash cost of production, Cameco ranks among the lower-cost uranium miners at CAD 15 per pound in 2017 (before royalties) by virtue of an enviable asset base anchored by the extremely high-grade McArthur River mine in Saskatchewan. Generally, this is a recipe for strong returns on capital.
However, owing to long-term contracts struck with utilities before the post-2003 surge in uranium prices, the company has been unable to fully capture the economic benefits due its cost profile. As a result, by our measurements, Cameco hasn't consistently generated returns in excess of its capital cost (about 10% in our model) over the past several years.
We expect this to change in the coming years. We expect that Cameco's price realizations will naturally improve as contracts struck in periods of weaker uranium prices continue to roll off its books. A concurrent improvement in contract prices (toward our $65 midcycle estimate) and new low-cost production from Cigar Lake should help Cameco clear its cost of capital over the long term.
Fair Value and Profit Drivers
Our fair value estimate is $15.50 per share. We use an exchange rate of CAD 1.33 per $1 as of Feb. 7 to convert our fair value estimate. We forecast that real uranium prices will rise to $65 per pound by 2022 in the contract market, as higher prices will be necessary to encourage the new mines needed to meet rising demand and fill the gap left by the continued drawdown of stockpiles.
We expect to see significant earnings growth in the long term because of higher market uranium prices, driven by the expansion of China's reactor fleet, and growth in uranium sales volume driven by higher mine output.
We assume a roughly CAD 700 million charge for the CRA dispute. This is based on two potential outcomes. In an unfavorable outcome, Cameco estimates it would have to pay between CAD 1.95 and 2.15 billion in cash taxes and transfer pricing penalties. We include an additional 75% to represent the potential for material interest and installment penalties. In a favorable outcome, Cameco estimates it would recover more than CAD 300 million in previously paid cash taxes, interest, and penalties. We assume a 25% chance of an unfavorable outcome and 75% chance for a favorable outcome based on the favorable ruling Cameco received in 2018.
We employ a 10-year explicit forecast horizon in our Cameco model. This allows us to capture the significant volume growth that the company is likely to realize in the coming decade and the convergence of realized prices with prevailing market prices as older long-term contracts struck at significantly lower uranium prices roll off the books.
Risk and Uncertainty
The uranium price is the biggest source of uncertainty for Cameco. Over the last several years, prices in the contract market have been as high as $72 per pound (in 2011, immediately before Fukushima) and as low as $29 per pound (early 2018)--volatile, but not especially so by commodity standards. We expect a combination of robust demand and weak supply to push real prices to $65 per pound by 2022, although there is considerable uncertainty around that forecast. For instance, Japanese reactor restarts could be less numerous and slower than we anticipate. Or China could stumble in its ambitious reactor buildout efforts. On the supply side, Kazakh production, always tough to project, could prove stronger than we anticipate. In addition, it's difficult to estimate how much inventory overhand may exist in the market. These excess pounds will need to be consumed before the market reaches balance.
We rate Cameco's stewardship of shareholder capital as Standard.
Cameco had historically been a rather conservative steward of shareholder value but exhibited a willingness to take more risk after a change in leadership. Before 2012, Cameco's largest recent deal was the August 2008 acquisition of the Kintyre uranium exploration project in Australia from Rio Tinto for $347 million, a fairly modest sum relative to Cameco's market capitalization at the time. Under CEO Tim Gitzel, who took over in 2011 from longtime CEO Jerry Grandey, Cameco became more acquisitive, exemplified by three major acquisitions in 2012: the Millennium uranium project ($150 million cash outlay), uranium trader Nukem ($250 million), and the Yeelirrie uranium project ($452 million). Though these projects struggle to provide any return under the current challenging uranium markets, we don't believe Cameco leadership has meaningfully destroyed shareholder capital.
In 2014, Cameco sold its 31.6% stake in Ontario utility Bruce Power for CAD 450 million. The deal made a great deal of strategic sense. For a uranium mining company, the benefits of downstream integration into power generation had always been doubtful, diluting senior management's focus.
Amid the ongoing weakness in uranium markets, we think management has done a good job with the factors it can control by minimizing production and oversupply into the market, cutting costs as it waits for better prices, and maintaining its portfolio's competitiveness. Even as earnings have declined rapidly from low uranium prices, the company has showed significant production discipline, reflecting its commitment to better long-term profitability.
Cameco is one of the world's largest uranium producers. When operating at normal production, the flagship McArthur River mine in Saskatchewan accounts for roughly 50% of output in normal market conditions. Amid years of uranium price weakness, the company has reduced production, instead purchasing from the spot market to meet contracted deliveries. In the long term, Cameco has the ability increase annual uranium production by restarting shut mines and investing in new ones. In addition to its large uranium mining business, Cameco operates uranium conversion and fabrication facilities.