Chris Berry on Dislocations in Graphite Company Valuations

Chris Berry, president of House Mountain Partners and co-editor of the Disruptive Discoveries Journal, co-authored an article on the graphite market with Jonathan Lee, an institutional mining analyst and president of JGL Partners.

In it, Berry and Lee look at the valuations of various graphite companies, noting that there are interesting discrepancies between producers and companies in the earlier stages of their work. For instance, they state:

The point of this note is not to pick winners or make companies look bad, but rather to point out some of the inexplicable dislocations in the graphite space. How can FDR, a graphite producer, have the lowest market capitalization and enterprise value of its peers? Regardless of the industry, shouldn’t a company generating revenues be more valuable than one that isn’t? Even an established graphite producer such as AMG Advanced Metallurgical Group NV (AMG:AMS) has a market capitalization of €226M – much larger than all but one in the emerging graphite producer group. Additionally, the margins are not as wide as are those predicted in the economics studies for the junior mining aspirants – AMG’s 2014 gross margin in its mining business was 20.1%. Further to this, late last year, AMG announced the sale of a 40% equity stake in its graphite business and a 10.33% stake in Bogala Graphite (which AMG owns 80% of) for $38 million. We believe the inference here is that even established commodity producers are repositioning for higher margin activities going forward.

To be fair, these are diversified businesses, making an apples-to-apples comparison challenging, but the yawning gap in valuation is so far apart that clearly the market mechanisms for determining fair value have malfunctioned.

All in all, Berry and Lee believe their observations raise a number of questions, such as:

Is FDR cheap, or are its peers overvalued?

Or perhaps a better question is why is FDR cheap relative to its peers?

Why have the Australian-listed graphite plays been more successful in procuring off-take agreements than their Canadian counterparts?

The production numbers are higher and cap ex numbers slightly lower for ASX-listed companies. Why? Were there any different assumptions made by various engineering firms?

How much do we know about the Chinese off-take partners? What does their capacity profile look like? How about the debt load (if applicable) on their balance sheets?

What are the true production costs in China? After all, these junior graphite companies aren’t competing against each other, they’re competing against Chinese producers.

Are Chinese graphite off-take partners using the juniors as a hedge in case they run out of stock or get shut down in an environmental cleanup effort in China?

Are these valuation disparities telling us something about the state of the global economy or perhaps steel demand? It’s no secret that steel demand in China continues to fall. Could this, coupled with sluggish global growth, be telegraphing lower graphite prices and lower valuations across the graphite sector?

Click here to read the full note from Berry and Lee and to learn their conclusions.