Zenyatta Ventures—Not All Graphite is Created Equal

I’m excited to finally break down my thoughts on Zenyatta Ventures (ZEN.V/ZENYF) after digesting their recent PEA (Preliminary Economic Assessment) and absorbing various feedback and questions from investors. Before I dive into that let’s recap some history for those hearing about ZEN for the first time. At $1.60 per share currently, the stock is up over 800% from when GIL made it our top recommendation in summer 2012 at 18 cents. The ensuing 11 months from August 2012 to July 2013 literally made many of our subscribers rich as the share price skyrocketed to a high of $5. That wasn’t without serious volatility along the way and to this day ZEN’s stock is still quite the rollercoaster ride. Certainly many newsletter writers would have bailed at a double or triple and moved onto the next sexy story. Why have I stuck around so long?

The answer is because I believe that Zenyatta found something very unique, special, and valuable at their Albany deposit in Ontario, Canada. There are simply a ton of misgivings and false information circulating the graphite sector. Admittedly, I have experienced quite a learning curve to absorb this seemingly complex form of carbon that nature gave us. Today, I want to dig more into the economics and new information ZEN’s PEA gave us to put fresh analysis on the company and share price. But before we do that, let’s spend some time clarifying the similarities and differences between the types of graphite out there and compare it to what Zenyatta has at Albany. This is a very important exercise.

If you don’t like Zenyatta that is more than fine, but after reading my analysis, none of my readers should be heavily invested (or better yet-invested AT ALL) in flake graphite companies….period. As you’ll see, not only is flake graphite plentiful throughout the earth, the supply coming into the market will likely crush prices. Luckily, Zenyatta will be competing exclusively in the high purity synthetic graphite market, which is 15 times larger than the flake market, and is not correlated with flake graphite prices. Did you hear that? Synthetic/hydrothermal graphite and flake graphite markets and pricing are different and not highly correlated whatsoever. Minimally, people need to stop comparing flake graphite companies to Zenyatta! It is like comparing economics of a Lead mine to a Gold mine. Yes, they are that different! How many flake graphite (regardless of the end purity %!) PEA’s do you see modeling anywhere near a $7,500 per tonne selling price? Rightly so, virtually all flake graphite companies model selling prices from under $1K per tonne to a MAX $1,800 or so.

Here is how GMP Securities describes Zenyatta’s graphite:

“Zenyatta is focused on developing the largest known hydrothermal graphite deposit in the world. The Albany deposit is a unique hydrothermally derived graphite deposit; the purest naturally occurring form of graphite. Indications are that Zenyatta’s graphite could compete with the highest purity type of graphite, synthetic graphite, resulting in revenue per tonne at the highest end of the graphite price range.”

Zenyatta Ventures describes itself as having the world’s “largest and only high purity hydrothermal graphite deposit being developed in the world”.

Types of Graphite

Somewhat simplified, there are three (3) different processes leading to the formation of graphite deposits. Natural graphite material has varying levels of quality depending on the type (amorphous, flake or hydrothermal). The degree of purity can vary greatly, which heavily influences the use of the material in applications and its pricing:

1. Amorphous (Sedimentary) graphite is derived from the metamorphism of coal deposits. Graphite formed under these conditions is characterized by incomplete structural ordering, abundant impurities and low crystallization, resulting in low value “amorphous” graphite with its main market in foundry applications. Amorphous applications include old school pencils. Prices for amorphous graphite are quite low at around $500 per tonne.

2. Flake (Sedimentary) graphite is the metamorphism of organic material and is very common. The formation of these deposits involves sedimentation and then alteration of carbonaceous organic matter to graphite during regional metamorphism. This graphite contains abundant impurities. Upgrading of graphite from this deposit type is complex and costly as a result of processing using aggressive acids and/or thermal treatment.

3. Hydrothermal (volcanic) graphite deposits are very rare. The formation of these deposits is associated with migrating supercritical carbon-bearing (C-O-H) fluids or fluid-rich magmas associated with volcanic activity. The formation of the carbon-bearing fluids is most often a consequence of high temperature metamorphism, but magmatic degassing can also produce graphite. Fluid precipitated graphite is well-ordered and can be a source of highly valued crystalline or vein-type graphite.

The Albany graphite deposit is a unique example of a hydrothermal graphite deposit in which a large volume of highly crystalline, fluid-deposited graphite occurs within a volcanic host rock. Says Dr. Andrew Conly from Lakehead University: “Evidence has shown that Zenyatta has discovered a unique sub-class of a hydrothermal graphite deposit unlike any other. Igneous breccia-hosted graphite deposits like Albany are very rare, and to the best of my knowledge, none are currently being mined or even in an advanced stage of exploration globally. Our on-going research of the Albany deposit will establish the first genetic model for this distinctive type of graphite.”

“In contrast to more commonly occurring flake and amorphous graphite deposits, the unusual hydrothermal style in the Albany deposit can be processed, at a cost advantage, to yield high purity, crystalline graphite ideally suited for advanced high-tech applications. The world trend is to develop products for technological applications that need extraordinary performance using ultra-high purity graphite powder at an affordable cost. High purity is gaining prominence at a time when Zenyatta discovered a very rare, (hydrothermal) graphite deposit, which can be upgraded to >99.9% carbon (‘C’) with very good crystallinity without the use of aggressive acids and high thermal treatment. The development of this deposit would place Zenyatta in a strong position to compete in specialised markets such as those currently supplied by high-cost synthetic graphite. When combined with a large, discrete ultra-high purity graphite deposit and the growth potential of these markets, the substantial potential of the Albany graphite deposit becomes quite evident.”

Flake Graphite Pricing

Flake and amorphous graphite deposits are abundant globally as witnessed by the many companies that own flake graphite deposits. These types of graphite deposits are located on every continent and are huge. Flake Graphite prices have been under pressure lately with 94 – 97%C +80 mesh dropping 21% from $1227/tonne in Q4 2014 to $967/tonne today FOB Qingdao China. This decline is a result of weak demand out of China and Europe and the strength of the American dollar. The decline has occurred in spite of reduced supply out of China stemming from the Chinese government’s effort to clean up archaic and dirty mining operations.

The price decline seen recently has taken the pricing deck of flake graphite down 32% to 4 year lows. Clearly there is no shortage of supply of flake graphite in today’s market, and the potential for declining prices in the future is very significant. This is because of the avalanche of new supply that is planned by the many flake companies with mines in development.

The current (and VERY well supplied) global flake graphite market is about 500,000 tonnes of consumption per year. If you take the flake graphite mining operations that have advanced to the engineered economic evaluation stage (that we know of) the total planned production from these mines is over 1 million tonnes per year. I doubt all will make it into production but even one new mine will have a very significant negative effect on flake graphite pricing. Syrah alone (one of the most advanced mines in development) is modeling sales of 356,000 tonnes per year (tpy) into a market of 500,000 tpy. Clearly this won’t happen without a severe decline in flake graphite pricing from current levels. This will be very problematic for planned producers. Many have current models that assume $1500/ tonne pricing for 94 – 97% C.

It is important to understand that there is no shortage of flake graphite deposits in the world. The geological zone hosting graphite in Mozambique, Tanzania, and Madagascar is massive. There are literally billions of tonnes of flake graphite available for development. Lastly, the entire market size in terms of dollars for most flake graphite applications is only $1 Billion annually versus high purity synthetic graphite which is nearly $15 Billion and growing.

Synthetic and Hydrothermal Graphite

Zenyatta’s hydrothermal high-purity graphite will almost exclusively compete in the synthetic graphite market. It is indeed true that flake graphite can be purified to 99.9% plus, but the cost is the main issue. Most graphite can be purified to 3N levels but also at what cost to quality? Many high tech applications simply will not use these end products if too many acids were used in the purification process, creating inferior brittleness amongst other attributes.

One major coup that got my attention in late 2013 was Zenyatta’s hiring of Dr. Bharat Chahar.

Bharat’s CV is very impressive as it pertains to high purity carbon applications and the synthetic graphite market. I encourage you to take a moment to read the press release above detailing his experience. Dr. Bharat Chahar stated “Having carefully reviewed the Albany graphite data available, I am convinced that Zenyatta has a resource with excellent potential for high value carbon applications. It is a special natural graphite deposit unlike any other that I’ve seen in the industry. I am thrilled and excited to be part of a top-notch ZEN team to help bring this unique graphite product to the market. In my experience, if you offer a better product with an obvious advantage, the world will beat a path to your door.”
Dr. Chahar in his recent talk about technology and marketing of high purity graphite, gives us some distinct tidbits to absorb (my highlights in bold):

“Graphite is one of the most versatile materials on the planet and is used widely for many industrial applications due to its high conductivity, low coefficient of thermal expansion, extremely high melting point, inertness and high lubricity. Graphite is either mined from deposits in many parts of the globe (Natural Graphite or NG) or it is synthetically produced from petroleum or other cokes (Synthetic Graphite or SG). Although the basic structure of the graphite is relatively simple,graphite from different sources can have huge variations in many properties of the material. Consequently, the value of graphite is highly dependent on the purity, degree of alignment and size of crystals, particle shape and size, and surface characteristics. The purity of graphite plays a critical role in determining the suitable applications for a given graphite grade. As the purity of graphite increases from commonly available NG of 90% carbon purity to highly pure 99.999% SG produced for highly specialized and niche needs, the value of the material also increases exponentially. The processes used to clean up NG can have significant impact on the final properties of the material and its value.Similarly, the raw material and processes used to produce SG determine the applicability and final value of the product.

So why is Zenyatta going to have any advantage when trying to sell their end product up against other synthetic graphite, even if the quality is similar? Cost and environmental advantage. I can guarantee you that no synthetic graphite producer can make their end product at a cost below or even near $2,046 per tonne as was reported in the recent PEA. And, ZEN’s actual cost could drop towards $1,700 per tonne as we get to feasibility stage. Environmental advantage as outlined by GMP: “The complete environmental footprint of the Albany Deposit benefits from its hydrothermal graphite which can be concentrated using conventional methods and purified using a caustic bake process flow sheet which has much less environmental impact than the alternatives. Other types of graphite are upgraded using hydrofluoric acid or very high temperature roasting. The use of conventional and environmentally friendly processing at Albany would be attractive for end users who are increasingly demanding full environmental product stewardship” (this is increasingly becoming a big deal to end users).

Before we get into the PEA and economics of the mine, I want to make a few comments, which are based on my experience and due diligence. First, we’ve heard that Zenyatta has over 30 NDA’s signed with potential customers, which is a lot. Many of these companies approached Zenyatta, not the other way around. Not only are many of these companies enormous in size but I am 100% confident that at least a handful will end up buying product from ZEN or whomever owns the mine when in production. In my diligence I have surmised that at least several of the companies testing ZEN’s graphite are not only pleased with the results but are elated with the quality. Graphite is a unique animal because you can’t just produce it like gold and sell it into the liquid global market. No, you actually have to court customers that test the product to see if it meets their unique needs in terms of properties.

To me, the 30,000 annual tonnes sold that are modeled into the PEA is likely going to end up being conservative. It doesn’t take more than potentially 4-6 customers to absorb that amount on an annual basis and we are going to be selling into high growth markets like lithium ion batteries, fuel cells, powdered applications, nuclear, and future dynamic markets that are just beginning to surface like sintered metals. This is important because I believe the bar has been set low by Zenyatta and RPA in the PEA and the economics will improve substantially into the pre-feasibility stage. Into feasibility, the true economics will likely improve even further and the estimates in all key areas have been conservative up to this point. In contrast, there is a near term flake producer listed in Australia with a $500 Million market value that modeled selling over 350,000 tonnes into a 500,000 tonne global annual market in year one. I’ll let you draw your own conclusions as to whether or not that is realistic.

So, I do not think Zenyatta will have any trouble selling their product at a minimum of $7,500 per tonne at 30,000 tonnes per year. In fact, we may see the average selling price climb in addition to the tonnage. Even though the profit margins are substantial as is, we should see them expand into pre-feasibility, which should be finished by the end of Q1 2016. The pre-feasibility study should kick off quite soon and due to the exhaustive amount of work done for the PEA, will be completed in approximately 6 months (I call it 8 months to be safe). If the PEA is taken at face value (Again, RPA I believe, was incredibly conservative in virtually all areas of study), Albany will surely become a mine, and a very profitable one at that. For those that haven’t seen it, you can review the numbers here.

It can be argued but it is my opinion that the NPV (Net Present Value) at this stage should be at an 8% discount versus 10%. Even so, we will definitely look at the 8% discount numbers upon pre-feasibility in 6-8 months which gives us an almost $600 Million net present value (this is US dollars so that is over $700 Million CDN). There are a few other key factors to keep in mind as the company gets thru pre-feasibility. Two areas that RPA were too conservative on were that they did not use the underground resource, which reduced the life of mine to 22 years from what is well over 30 years using the entire proven resource (this should add close to $100 million plus to the NPV at an 8% discount rate). Additionally, they padded contingencies of 24%, which is quite high, leaving room for a $30MM reduction, or in essence another addition to the NPV. So, keep in mind that by the end of Q1 2016, Zenyatta’s Albany deposit will very likely see an after tax Net Present Value of nearly $730,000,000 US (just moving the discount rate to 8% versus 10% alone brings us to nearly $600MM). Keep in mind this should also take the internal rate of return (IRR) to nearly 40-45%.

I zero in on this because at that stage, Zenyatta’s share price should be trading at minimally 1/3 of its NPV. Let’s use just $700MM US or $875,000,000 at today’s conversion rate. That gives us a $291,000,000 market cap for ZEN.V. Today, we are trading at less than one third that value! Tack on 5 million to the shares outstanding to cushion for a capital raise of approximately $5MM and we should have a stock trading near $4.50 per share by early 2016….minimum. And remember, as the company moves forward from pre-feasibility to feasibility stage, the discount rate drops even further, eventually to zero once in production. At feasibility stage, a 5% discount will be appropriate and trading value near 50% of NPV means we have a low double digit stock in Zenyatta Ventures.

If there is any one negative that sticks out to people from the PEA it is that capital costs (CAPEX) came in higher than we all expected. However, I am very confident that just a more reasonable contingency percentage brings the number into the high $300’s. Additionally, once more accurate numbers are sourced on supplies, etc my work shows the pre-feasibility stage CAPEX should decline to the $300-$340MM range. This is not very high when you consider that this is a project that will likely show cash flow of over $120MM after taxes for over 30 years, probably higher and longer.

In summary, Zenyatta is extremely undervalued at current prices. The Albany project has been de-risked tremendously since we initially got involved in 2012 and since the stock hit $5 in 2013. There is no better way to invest in and own exposure in the growing high purity graphite marketplace. Economics will only improve not decline going forward into the pre-feasibility stage of development.

The share price is oversold and could bounce 10-20% based solely on technical action. I expect a financing at some point to fund the pre-feasibility work, yet the dilution factor will be minimal, considering the company only needs $5-6 million to complete the pre-feasibility study. That said, buying half now then half after any placement is announced in the future could be a solid entry strategy for long term investors. Zenyatta is one of the few natural resources companies that has a clear path for investors to potentially triple their money in the next 12 months.

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Disclaimer: Eric owns shares in Zenyatta Ventures and may buy or sell at any time without prompt notice.

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