Sierra Rutile (SRX)

Mostly upside......but who wants to own a mine in Sierra Leone?

Hello all! Before jumping in, I’d like to highlight that Sierra Rutile’s shares are traded in AUD but all financial reporting is in USD. To keep things simple I’ve used USD throughout, employing the conversion 1 USD = 1.5 AUD when required. Right, let’s get to it….

In July 2022, Sierra Rutile was listed on the Australian Stock Exchange. This new company wasn’t created in the usual way, by an Initial Public Offering (IPO), but instead was demerged (or spun-off) from a much larger public company, called Iluka Resources. The specifics of the spin-off meant that all shareholders in Iluka Resources received shares in this tiny micro-cap company.

Iluka Resources has a market valuation of a few billions dollars and is held by many institutional investors and index funds. Yet, Sierra Rutile is too small for any indexes and its shares are too illiquid for most institutional investors. Therefore, when they receive Sierra Rutile shares, they are forced to sell. This selling is further exacerbated by retail shareholders. Many are comfortable owning Iluka Resources, a large and diversified mining company. But that doesn’t mean they like the idea of Sierra Rutile, which owns a single mine in Sierra Leone. Those who don’t, also sell.

Importantly, these sales are made without any regard for valuation, thereby flooding the market with an excess supply of shares and ultimately driving down the price. Remember, a spinoff in not an IPO - there is no roadshow, no fanfare, no marketing. Buyers are scarce.

In July 2022, shares in Sierra Rutile began trading at over $0.3. However, the price quickly slumped and today it sits around ~$0.15, giving us a Market Capitalisation of ~$60mm. With no debt, and cash of $57mm, Sierra Rutile has an Enterprise Value approaching zero. Put another way, the current price assumes the underlying business is worthless! This made me want to learn more…..

Sierra Rutile has a 60 year history operating a mine within Sierra Leone. Called Area 1, this mine produces around a third of the worlds supply of Natural Rutile. It is cash generative, has no debt, mature infrastructure, and access to its own dedicated port facility. But it is close to the end of its useful life with 3-4 years remaining at current production rates.

Rutile is the natural form of Titanium Dioxide, a valuable feedstock used in paint products to decorate and protect surfaces. Consequently, Sierra Rutile’s main customers are large North American and European pigment producers such as Tronox, Kronos and Chemours. A minority of sales (around 20%) are for producing welding wire and titanium metal. These end uses, in construction and Aerospace, require higher grade feedstock and command premium prices.

I’ll keep this short and refrain from embarrassing myself further with my spurious geological knowledge. Instead, if you want to learn more I’d recommend starting with this report.

Sierra Rutile plans to replace Area 1 with another mine called Semberhun, located just 30km away. Semberhun is an early stage and speculative exploration project. The Pre Feasibility Study (PFS) estimates a pre-production cost of over $300mm - more than five times the current market capitalisation of the company!

To date, the management team have been undeterred and still intend to develop the Semberhun mine. The CEO, Theuns de Bruyn, joined in late 2019 and both the Chair, Greg Martin and the Finance Director, Martin Alciaturi joined at around the time of the Spinoff. Together, they own very few shares and are mainly incentivised through Performance Rights amounting to 2-3 times their base salaries.

In recent months, Samual Terry Asset Management (STAM) has emerged as the largest shareholder with ~18% of shares outstanding. STAM is an activist investor who I’ve followed for many years due to an impressive track record of forcing shareholder friendly changes.

STAM’s large (and recently increasing) ownership gives me confidence that a strategic shift is highly likely. Realistically, I cannot see STAM, or many other shareholders, supporting a speculative and expensive exploration project in Africa. The cost of financing is simply too high for such a small company and the payback too uncertain.

Especially, when the alternative looks much more attractive. A multi year liquidation - running down Area 1, returning all capital to shareholders, and selling the Semberhun project. In this case, shareholders would receive:

1. The Net Cash of ~$57mm (as of 31st March 2023).

2. The remaining free cash flow from Area 1, potentially another ~$60mm over 3-4 years (assuming stable Rutile prices of ~$1,400 per tonne and cash costs of ~$1,000 per tonne).

3. Proceeds from the sale of Semberhun, which has a book value of ~$30mm (~10% of the project’s Net Present Value.)

Adding these together, I think this could be worth in excess of $150mm, a pretty good outcome, given the current market capitalisation of ~$60mm.

Hold up one second - for Area 1 you’ve assumed stable Rutile prices and stable costs. But surely prices fluctuate with supply and demand?

Mining is a commodity business and so yes, supply and demand matters. The industry (who are clearly biased) will tell you there is a structural deficit and prices will continue to rise over the coming years. But, to be honest, I’ve not worked very hard at becoming a Rutile analyst.

It’s true that a sharp drop in the Rutile price, or increasing costs, would indeed make Area 1 un-economic. Thereby, forcing an early shutdown of the mine. However, in this scenario most of the costs are covered by a segregated and independently run Rehabilitation Trust containing ~$40mm. Shareholders would still be entitled to the remaining cash and working capital, currently worth ~$80mm as well as the sale proceeds for the Semberhun project. Still not a bad outcome!

Another obvious risk is political. The government of Sierra Leone is trying to re-negotiate its third agreement with Sierra Rutile and there’s always a chance that political relations could sour. Yet, even in the unlikely scenario that every asset in Sierra Leone is requisitioned, I think my downside is still well protected! Almost all cash is held in an Australian bank account and most of the working capital comes from outside of the country.

Clearly, for those looking for a quality compounder, this is not it! Mining is a dirty, cyclical, commodity driven business with volatile outcomes. Understandably, for the majority of generalist investors the entire sector presents an immediate no. Yet, in the case of Sierra Rutile, I think the probability of permanent capital loss is actually very low, which for me makes this a low risk investment.

But wait….is there such a thing as a low risk African mining stock?…………I think I’ll let you be the judge of that! Enjoy!

Disclaimer. This article is for informational purposes only, and should not be seen as investment advice. Please do your own research before investing in any company mentioned.