Why the world's largest graphite mine is on our radar

SG Hiscock & Company
Andrew Gillies
Andrew Gillies
SG Hiscock Analyst
0
Syrah Resources is a stock we look at as an exposure to emerging companies.

These are smaller-mid market cap stocks that are developing strategic assets in new markets, innovative business models and/or disrupting incumbents. As a consequence, they are smaller positions and are designed to provide optionality to the portfolio.

We take an ‘up or out’ view where we increase position size as conviction builds, or we exit.  

It is fair to say Syrah’s performance has been more volatile than we initially expected. At this point, it is disappointing relative to expectations. However, we feel it is necessary to talk about our ideas and explain our thinking even when the stock price doesn’t yet reflect the value we see in a business.

By way of background, the company owns a large graphite mine in Mozambique called Balama (picture courtesy of Mozambique Mining Post). This is built and is now in the process of ramping up to supply the industrial steel refractory and battery anode material (BAM) markets. 

This is particularly interesting when one thinks of this as an exposure to the electric vehicle megatrend. As part of its strategy, it is also building a BAM processing plant in Louisiana in the US. This will service large battery ‘megafactories’ such as the Gigafactory built by Tesla. 

Whilst the development of the mine facility came in broadly on time and budget, the positive underlying progress in building the plant, establishing the supply chain and obtaining initial offtake agreements with customers has been overshadowed by production ramp up issues.  This has seen delay in cash flow, need to raise capital and the stock under perform significantly.

This has been disappointing, but we must ask ourselves if our investment thesis changed.  In considering this we ask: 
- is the thematic still something we want exposure to? and;
- is the exposure we have the best way to play the trend?

More specifically, in considering whether we continue to hold a stock there are three broad questions we consider:  
- Can the risk/return profile be improved,
- Has there been an impairment to earnings power of the business,
- Is management still capable of building value?

Let’s consider the first part of the question.

During the quarter we attended the Benchmark Minerals Intelligence (BMI) World Tour in Melbourne. BMI are a London-based battery metals & technology consultancy firm. They provide market research, dynamics and insights, as well as pricing data for battery metals and chemicals. 

The conference reaffirmed the key tenets of our views on the demand for batteries and added to our confidence around the potential in the medium to longer term for Lithium-ion batteries to serve as stationary storage; building blocks in an energy network solution, as well as electric vehicles. 

Generally, energy systems are built to peak demand. This is inefficient in terms of greenhouse gas emissions and in cost. 

Efforts to assuage these peak power pressures and build a more efficient system are beginning to gain real traction. Batteries provide a solution for this. 

We can see this in our own backyard; South Australia’s state government, collaborating with Tesla, has built the world’s largest lithium-ion battery. It is powered by a nearby windfarm at Hornsdale in off-peak times, and energy is released back to the grid to meet peak demand. 

Although it is a specific example, it is synecdoche of a greater trend: lithium-ion batteries are, and will remain, the incumbent technology. BMI contend it will be the most commercially viable battery technology for the next 7-10 years. 

Further confirmation can be seen in battery producers’ allocation of capital to battery ‘megafactories’. 

In turn, with increased capacity, automakers are showing their hand. Auto manufacturers with household brand names like VW, Tesla, BMW, Daimler & GM have all made hard commitments to making EVs. 

Chinese manufacturers are also committing to EVs with 96% of the 711,000 EVs built and sold in China in the last year made by Chinese brands, and most of the new battery capacity coming online in China.  This is increasingly dependent on natural graphite rather than synthetic graphite given the high cost and pollutive energy intensity that comes with synthetic graphite production. 

Given we continue to see strong end market growth for graphite; we turn to the second part of our original question: is Syrah the best way to play this trend, and are we still confident there is value in the business and it can be realised?

As a general rule, we think over the long-term that resource companies do not have pricing power. The world is well endowed with most resources and, if the incentive price is high enough, supply will respond.  It is therefore vital in investing in resource stocks to identify companies that:

- Have a large, high quality resource: Balama mine in Mozambique will be the largest natural graphite mine globally from 2018. It is a long-life asset that will be at the bottom of cost curve in the first year of production, with optionality to expand.

- Are well capitalised: Syrah has no debt and $100m in cash which should be sufficient to fund to cash flow breakeven in the first half of FY19. 

- Are led by experienced and focused management: Management changes over the last 12-18 months (including the appointment of Shaun Verner as CEO) have given us greater confidence in Syrah’s operational capabilities and focus. Strategically, we also view the collaborative relationship for battery testing and product development with Cadenza Innovation, a leading innovator in downstream battery technology.

To reiterate, we see the ramp up and commissioning issues as largely temporary and not structural. It is not uncommon for start-up mines to experience teething problems. Fortescue’s development and commissioning of its Port Hedland and rail facilities in 2008 and Oil Search’s start-up in PNG LNG in 2014 are two examples where initial teething issues were rectified and free cash flow was realised. Beyond this, there was a material re-rating in the company’s share price. 

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We believe in buying great companies at good prices. We are firm believers in co-investment, demonstrated by our significant investment in our own funds. Our confidence in our investment approach means we always seed new funds with our own money. We have made the decision to cap our Funds Under Management at modest levels, to ensure that the funds retain greater flexibility to generate strong investment returns across varying market conditions. In order to identify the best opportunities for our clients, we undertake a broad fundamental research program which incorporates an extensive company visitation schedule. With an experienced team of investment professionals, our approach to analysing companies is designed to ensure no stone remains unturned.

We engage with a hand-picked team of external research providers to complement our insights in the macroeconomic landscape (both locally and abroad) and general investment trends. We also have an exclusive joint advisory arrangement with one of the world’s largest commercial real estate investors; LaSalle Investment Management Securities, LLC is a subsidiary of global property giant, Jones Lang LaSalle. This provides our property team access to LaSalle’s research capabilities.

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SG Hiscock & Company has a formal board-endorsed environmental, social and governance (ESG) policy. This incorporates the key principles of the Australian Council of Superannuation Investors, as well as the framework provided under the United Nations’ Principles for Responsible Investment. SG Hiscock & Company is a responsible investor and we take an active approach to integrating ESG considerations into our investment decision-making process. We believe that the effective governance and management of business risks has a direct impact on a company’s intrinsic value over the long term and helps to reduce investment risk. In order to identify the best opportunities for our clients, we undertake a broad fundamental research program which incorporates an extensive company visitation schedule. With an experienced team of investment professionals, our approach to analysing companies is designed to ensure no stone remains unturned.

We engage with a hand-picked team of external research providers to complement our insights in the macroeconomic landscape (both locally and abroad) and general investment trends. We also have an exclusive joint advisory arrangement with one of the world’s largest commercial real estate investors; LaSalle Investment Management Securities, LLC is a subsidiary of global property giant, Jones Lang LaSalle. This provides our property team access to LaSalle’s research capabilities.