Valuation of SWC and PAL Compared

Both SWC and PAL are primary PGM metal producers. They are the only major PGM metal producers outside Russia and South Africa. I expect the PGM metals, especially palladium, to be extremely bullish in the near future, due to booming demand from jewelry and fuel cell applications, or even the exotic cold fusion application. Investing in the physical palladium metal is a very good idea. But investing in the stocks of these two PGM producers may bring in much higher leveraged return.

So if you are to buy stocks of PGM producers, which one you would choose at today's price, SWC or PAL? Let me compare the two here.

First, let’s look at SWC. Stillwater mine has a mine grade of as much as 0.55 ounces of PGM metals per ton of ores. That is the highest grade PGM mine in the world. But the SWC mine is mostly palladium, about 3/4 palladium and only 1/4 is the more expensive platinum. So for now it is not as profitable as the platinum mines in South Africa.

The mine grade of PAL is much lower at about 2.5 grams PGM per ton of ores. It contains way much less platinum, too, only 1/10. But PAL does have its advantages. It is mostly an open-pit operation, so the mining cost is way much cheaper than the underground mine of SWC. PAL produces way much more base metals, especially nickel, compared with SWC. Further, PAL has quite a few ongoing exploration and new mine development projects going on, while not much new mine development is going on with SWC.

Now let's look at operating results to compare the two. SWC has a current market cap of $839.72M, compare with PAL's $273.40M (with new shares from secondary offering counted in). For the first nine month of 2007, sales revenue of SWC was $470.50M, among which only $210.877M was from mine production. $247.977M of the sales revenue came from PGM recycling business, which is profitable but really a thin profit margin business due to competition in the recycling business.

Counting only the mining production, SWC has a 9 month price/sales ratio of 3.982. Annualized it is 2.987, a low ratio. But PAL reported $149.426M (in Canadian dollars) sales revenue for the nine months. That's an annualized price/sales ratio of 1.372, way much lower (cheaper) than SWC.

I believe the price/sales ratio is more important than the current P/E ratio, because as metal prices go up, the sales revenue will go up proportionally, while cost of producing the same amount of metals remains about the same. Any increase of sales revenue due to better metal prices will directly go into pre-tax net earnings. With a price/sales ratio less than half of that of SWC, PAL is a much better value to buy here. And I called a PAL bottom last Tursday.

Some folks may like to judgement stocks only based on P/E ratio; I think P/E is less meaningful here. PAL's quarterly results are extremely volatile. In Q1, 2007, PAL reported quarterly earnings of 10 cents per share. In Q2, 2007, it reported quarterly loss of 17 cents. And then in Q3, the loss widens to 25 cents. Some may wonder how PAL could report such increasing loss at a time when PGM metals are moving up.

In reality, the fluctuation of PAL's quarterly results is due to the way how PAL did its accounting. For Q1 through Q3, based on its reported metal productions and realized sales price, the produced metal values are respectively $59.911M, $51.041M and $51.327M. Not a big variation. However the reported sales revenues are respectively $68.439M, $44.495M and $36.492M. That's a gigantic difference. No wonder PAL went from 10 cents a share profit in Q1 to 25 cents a share loss in Q3. The results are really just some temporary aberrations that do NOT reflect the real operating results of PAL from the long term point of view.

What causes those aberrations? For one thing, PAL may not sell all of the metals produced in current quarter. It may decide to hold some metals back for better prices in the future. But the cost of all metals produced in current quarter is nevertheless booked in current quarter regardless when the metal will be sold.

Another reason for the quarterly aberration is PAL records sales revenue in current quarter, using current metal prices, while the metals still need to go through smelters. The actual closing of the sale of the metals will occur about 6 months later at the new spot price, which may be higher or lower than the originally booked sales price, also the sales revenue will be converted back to Canadian dollar at the time of the actual sale, which may be converted at a different USD/CAD foreign exchange rate. Because of this reason, PAL needs to record the commodity price adjustment, as well as foreign exchange adjust, to its quarterly sales revenue. Both adjustments exaggerate the volatility of quarterly results, making one quarter particularly good and the next one particularly bad. Over the long term, both adjustments should NOT have any long lasting effect on PAL's quarterly results.

Two factors pushed PAL from its recent high of $12.65 to recent low of $3.40, the seemingly disappointing Q3 result is one factor, and the recent secondary offering to dilute shares is another factor. Now let's see how bad the secondary offering dilution is.

Before the offering, PAL had 55.23M shares. After the offering, there is 18.67M extra shares, so the new number of shares is 73.9M. 55.23M divided by 73.9M is about 75%. So that's a share value dilution of 25%.

But don't forget that the secondary offering also brings in $74M in cash. That's an increase of book value of about $1 per share. PAL's current price is $3.70. Subtracting the $1 extra cash, the market is pricing PAL at $2.70 a diluted share, or $3.60 per share before dilution. That is a rather ridiculous valuation consider that PAL has been trading between $6 to $12.65 before this secondary offering fiasco!

In summary, I believe PAL is deeply oversold. People should jump right in and buy as much as they can afford at current price level.

Disclosure: The author owns a lot of long positions in PAL and some long positions in SWC.