By Ben Kramer-Miller


Great Lakes Graphite (OTCMKTS:GLKIF) is arguably the best opportunity in the graphite space today given its valuation and its strategy. The company’s NEV is ~$6 million, yet I think the company has one of the most sophisticated teams in the business and it has done a better job of positioning itself to generate near-term cash-flow with a minimal capex outlay than any graphite company that I follow.

Great Lakes Graphite’s approach is completely different from the other major graphite players who are looking to first mine graphite and then sell it. Its Lochaber Project was generating very little interest among investors as an early-stage deposit that only recently has a very small inferred resource at a lower-than-expected grade. In a market that is skeptical of even late-stage projects this situation was clearly unfavorable, and this was reflected in the stock price.

However, on February 26th the company announced that it is going to be leasing a micronization facility–Matheson in Ontario– from Northfil Resources.

(Source: Great Lakes Graphite)

(Source: Ibid)

This micronization plant is virtually unused and requires a minimal capital outlay–~$800,000–to commission. The goal is that by the fourth quarter of this year Great Lakes Graphite will be micronizing and selling graphite. What this means is that Great Lakes Graphite will essentially be “working backwards”–as management has put it to me–as it is focusing on developing its downstream value-added capacity prior to developing its mine.

A Strategy That Makes Sense

This makes an incredible amount of sense in this environment. Not only is the graphite market oversupplied, but there are several companies all trying to bring mines into production, and so there is a threat that we could see continued oversupply even if some of the more optimistic demand scenarios for Li-Bs pan out.

Why, then, should Great Lakes work to bring an expensive mine into production when it can simply buy the graphite it needs and add value to it?

The company was fortunate enough to come across the Northfil micronization facility which Northfil was willing to lease to Great Lakes. This means that with a minimal capital outlay the company will be able to micronize and sell graphite that it buys from a currently undisclosed source (another risk) in Brazil. Meanwhile, the minimal capital outlay minimizes dilution. Great Lakes issued 10 million shares with warrants earlier this year to raise C$500,000. Then last week the company announced a non-dilutive (except for 1.875 million warrants at C$0.10 that expire in 4 years) debt-based financing deal. This not only means that Great Lakes will generate more cash-flow per share within a smaller timeframe, but that it will be positioning itself to finance its Lochaber project and other value-add flowsheets such as high purity, and ultimately shaping and coating for the SPG market.

This cash-flow stream is a luxury other graphite companies don’t have. With a few exceptions, every other company in the space, no matter how great its deposit is or how experienced its management team is, needs to raise a tremendous amount of capital compared with its current market valuation–at least 3-times as much. This differentiating factor has put Great Lakes Graphite in a unique position in the space.

The Innovations Division: the Matheson Micronization Facility

The Matheson Facility has a stated 10,000 tpa capacity which is appropriate given the 80,000 tonne market for micronized graphite ex-batteries. Note, however, that Matheson’s capacity could be 3-times greater should demand for micronized graphite grow to 30,000 or more tonnes per year. The company could also micronize more than this by expanding the facility’s capacity. Great Lakes Graphite doesn’t have to run the Matheson Facility at full capacity. In fact in its first full year of operation CEO Paul Gorman expects 1,500 – 3,000 tonnes of graphite to be micronized. Given that several expenses are flat or not perfectly correlated with production the facility may not be as efficient as it could be at first. Nevertheless, micronization margins should be wide given the facility’s capacity to produce small amounts of specialized products for its clients.

This capacity is unique, and replicating such a business model in order to undercut Great Lakes would require an investment in a similar facility (well over $10 million) with all necessary permits, parallel talent which simply doesn’t exist in this niche industry, and an extensive network of graphite end users that cannot be paralleled. As a result despite the company’s size (and in part because of its size) it has a wide moat.

Great Lakes is going to be buying graphite in order to micronize it at Matheson. It will then sell micronized graphite in various forms designed to the specifications of individual customers. Great Lakes Graphite will be taking generic flake graphite that it can purchase for a little more than $1,000/tonne and manufacturing micronized (ground into smaller flakes) graphite that has the uniformity that makes it ideally suited for industry. This specification and uniformity is a double edged sword from an investor’s standpoint because on the one hand it means that Great Lakes’ product should command a premium price while on the other hand it is difficult to know what this graphite will sell for and future cash-flows are impossible to pinpoint.

So we don’t know Great Lakes’ selling point or its opex definitively, but we do know that it will be providing specialized products to clients who need them, meaning that Great Lakes’ success is essential to all parties involved. Furthermore we have reason to believe that Great Lakes will be able to generate a sizable amount of cash-flow with respect to its current valuation given that high purity custom micronized graphite can sell for well over $2,000/tonne.

The micronization process itself isn’t as complicated or expensive as other processes for making value added graphite products, but at the same time we have seen that there is a barrier to entry, which is promising for the company’s pricing power, especially once it has established itself among end-users of micronized graphite. This in itself is valuable, and given the company’s ambitious yet realistic 10,000 tpa goal we don’t have to see very wide operating margins in order to see a tremendous amount of cash-flow relative to the cost of an investment at today’s valuation.

We don’t know what this cash-flow will look like but we can guess. For instance assuming a graphite price of $1,200/tonne (Great Lakes fixed its price at a higher-than-market price, and it is paying a premium to ensure that its graphite meets its specifications.), opex of $200/tonne and a realized product price of $2,000/tonne Great Lakes Graphite generates $600/tonne in operating cash-flow. At “full” capacity of 10,000/tpa (it can grow beyond this) Great Lakes is generating $6 million in operating cash-flow per year vs. its current NEV of ~$6 million. Now production won’t start off at 10,000 tpa but it can get to this point given the 80,000 tpa micronized graphite market–more than twice that with spherical graphite for Li-Bs. Even at 50% capacity, which management expects to reach in the second year of production (let’s call it Q4 2016-Q3 2017), the company is trading with an NEV/operating cash-flow ratio of ~2. Note that in the graphite space this is a similar valuation to companies that have mine plans which require these companies to raise an enormous amount of money which will inevitably dilute shareholders and increase these companies’ balance sheet risks.

Assuming in year 1 that the company generates 0 cash-flow due to the typical difficulties associated with the commencement of a new operation, and assuming $3 million in operating cash-flow in year 2 and $6 million in years 3-10 with a 12% discount rate we get a post-tax (15% Canada corporate, 11% Ontario corporate, no recovery of sunken costs) valuation of the Innovations Division of $18 million, or 3-times the company’s current NEV. The valuation rises if the company is able to continue the lease or grow its production beyond 10,000 tpa. With 95 million fully diluted shares that comes to $0.18/share or C$0.237/share excluding Lochaber.

The Lochaber Project

Moving beyond the micronization facility’s commissioning Great Lakes Graphite will continue to develop its Lochaber Project, which will ideally have cash-flow support that will limit further shareholder dilution. The Lochaber Project is a past producing mine in Quebec, although any infrastructure remaining is going to be too old and outdated for use today. It has a relatively low ore grade compared with other North American projects but it also has one of the industry’s best flake distributions, second only to Northern’s Bissett Creek.

The company has put this project on the back burner although it recently released a resource estimate which is quite small and only inferred.

I’ve stressed elsewhere that you don’t need a large graphite deposit in order to operate a successful graphite business. Management believes that it will be able to produce ~10-12ktpa and get the project into production for $30-$35 million. That’s a 15-year mine-life assuming the company doesn’t expand the resource.

This is a figure that under normal circumstances wouldn’t be easy to raise for a company valued as low as Great Lakes Graphite. But at the same time it is incredibly low compared with other graphite projects. Most importantly, however, the company will have cash-flow from Matheson in order to finance Lochaber. This cash-flow can be used to service debt (which the company has shown it can issue in a tough environment, and it will also put a floor under the stock price which will make a secondary offering less dilutive to existing shareholders.

Investors in Great Lakes Graphite need to understand that the Lochaber Project is a more uncertain part of the business and I don’t dare to venture a guess as to its valuation on a DCF basis given the knowledge gaps in the resource size, capex and opex. But we’ve seen that Matheson alone offers sufficient value with limited risk so that we can be confident in owning Great Lakes Graphite even in the event that Lochaber never makes it into production and has 0 value. However, since the two biggest barriers to entry in graphite mining are finding financing and finding a client base Great Lakes investors should see Lochaber as having a relatively high probability of getting into production with respect to its North American peers. To reiterate the project is small, the company is already securing a client base through Matheson, and its cash-flow will make financing less risky.

The Bottom Line

Great Lakes Graphite is among the best positioned companies to develop and grow a graphite business of the major start-ups. I still think it is speculative considering that there are so many moving parts in both businesses. But the numbers don’t have to be that great for investors to make money should they buy the stock at today’s prices.

More importantly, Great Lakes has put together an incredible team and has what I believe is the best strategy. Investors should note also the strategic importance of micronizing graphite. Not only is it one of the simpler and higher-margin value-adds a company can make in graphite, but it puts the company in a position in which it is working towards developing spherical graphite. Spherical graphite–the graphite product that is found in Li-Bs–is first micronized. Any company that wants to manufacture spherical graphite and sell it into the Li-B value chain is going to first have to learn how to operate a micronization facility. Since Great Lakes should be able to sell its micronized graphite at a profit, and since micronizing graphite prepares Great Lakes for the spherical graphite market longer term, the focus on micronization at the start seems like the right approach.

Shares are well off their lows but remain depressed considering the relative cash-flow potential that reflects realistic sales goals–something that is lacking in today’s junior graphite market. Not only are the company’s sales goals realistic but the Matheson Project is substantially de-risked. The company has located a source of graphite, micronized samples of it, and distributed these samples to potential customers. Furthermore, Matheson is in low-risk Ontario with the only issue being high electricity costs. Matheson is also financed–shareholder dilution and debt issuance should remain minimal as the company gets ready to bring the facility into production. Finally, the company has put an excellent team in place. I had a chance to interview two new team members: Mike Coscia and Jerry Janik. The level of specificity is incredible and lends credence to the bullish thesis.

While the approach is unorthodox it reflects management’s acute understanding of the industry’s value-chain. The fact is that today mining graphite is a lousy business. The Chinese produce too much of it and there are several companies trying to get into the graphite mining business in an oversupplied market. Meanwhile micronization is a simple way to generate value, but which can only be done if you have people with very specific talents and connections with potential customers for this niche group of products. It is also a way for management to develop part of the skill-set needed to manufacture spherical graphite. This is years away, but the potential demand is there.

Disclosure: I’m long Great Lakes Graphite