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NORILSK NICKEL: WORLD’S LARGEST NICKEL AND PALLADIUM PRODUCER SIGNIFICANTLY UNDERVALUEDSUMMARYNorilsk Nickel (NILSY), the world’s largest nickel and palladium producer, is being significantly undervalued as a result of the 2015 market flight from the mining industry as virtually all metals prices declined and the geopolitical risks associated with Russia.Despite nickel prices reaching recent lows not seen since 2003, Norilsk Nickel’s superior operations and EBITDA margins allow the company to still generate significant earnings, cash flow, and returns to shareholders.Entering 2016, the nickel market has swung from being in a surplus to a deficit and once investor hysteria abates, nickel prices should begin to rebound allowing for Norilsk to generate even greater returns for shareholders.Since 2013, Norilsk Nickel has returned over US$6 billion to shareholders in the form of dividends. Additionally, the company started a $500 million share buyback program in 2015 as a result of depressed stock prices. In 2016 and thereafter, the company plans to distribute 50% of annual EBITDA to shareholders in the form of PANY OVERVIEW AND CORPORATE STRATEGYNorilsk Nickel (NILSY) is the world’s largest producer of both nickel and palladium. Headquartered in Russia, Norilsk also produces significant quantities of both platinum and palladium. The company also owns a small amount of natural gas assets as well as significant logistics operations. Major shareholders include Interros which owns 30%, UC Rusal which owns 28%, Crispian Investments which owns 6%, and Metalloinvest which owns 3%, leaving a free float of 33%.Under a new corporate strategy, which was first implemented in mid-2013, Norilsk is now focused on expanding and improving efficiency at its “Tier 1” Russian operations. This resulted in the sale of mining assets considered “Non-Tier 1” in Australia and Africa, with the last African operation being completed in the second half of 2015. “Tier 1” operations, as judged by the company, must meet three criteria 1) >US$1 billion in annual revenue, 2) greater than 40% EBITDA margin, and 3) have a mine life greater than 20 years. Norilsk has identified its two major operations in Russia, the Polar division located on the Taimyr Peninsula and the Kola division located in the Murmansk region as “Tier 1” assets, which have remained profitable despite the steep decline in nickel prices during 2015. Norilsk is focused on maximizing efficiency, further defining resources, and exploration in these two divisions as well as the development of another potential “Tier 1” asset in the Chita region near China.While focusing on its downstream operations, Norilsk also has upstream optionality and can produce finished products should economics demand. However, the company follows the first marketable product doctrine when it comes to moving upstream. Norilsk has sales agreements with over 500 different commercial customers in over 40 countries worldwide. Only roughly 10% of its customers are located in North America.NICKEL MARKET OVERVIEWDuring the majority of early 2016, London Metal Exchange nickel prices have fallen below US$4/lb. Such low prices have been realized as a result of 1) the surplus in the nickel market driven by excess supply and 2) poor market sentiment during most of 2015. The excess market supply resulted from Chinese stockpile liquidation in 2014 and early 2015. Additionally, many producers continued to run at full output during that time due to anticipation of Chinese Smelter declines and the anticipated benefit from the Indonesian mining ban.Despite the recent low spot prices, the World Bureau of Metal Statistics (WBMS) issued a press release on February 17th 2016 with full year nickel production and consumption statistics showing the nickel market has now entered into a small deficit with demand outstripping supply. During 2015, the WBMS reported refined nickel production of 1920.6 thousand tonnes and refined nickel consumption of 1934 thousand tonnes, a 14 thousand tonne deficit. Mine production for 2015 was 1772.9 thousand tonnes, 130 thousand tonnes lower than 2014. Apparent demand of 1934 thousand tonnes in 2015 was 234 thousand tonnes higher than 2014.Nickel mine production for 2015 was lower as a result of higher cost producers being forced to shut due to declining LME spot prices. Nickel consumption/apparent demand for 2015 increased as a result of Chinese smelter declines and inventory exhaustion, strong production in the stainless steel market, and the increase of nickel use via substitution as nickel prices below $6/lb make it more economical for companies to produce more nickel intensive alloys.I estimate LME nickel prices rebound from sub US$4.00/lb to average $4.50/lb for 2016. I estimate due to the growing deficit in the nickel market prices surge to $6.00/lb in 2017 and conservatively estimate a flat price level thereafter.Norilsk Nickel faces competition in the nickel market from Vale (VALE) and Glencore (GLCNF), with Norilsk being the largest producer. Similarly, in the palladium market Norilsk enjoys being the largest producer while facing competition from Anglo American (AAUKY) and Impala Platinum (IMPUY). In the platinum market, Norilsk again faces competition from Anglo and Impala with Anglo American holding the top spot. Lastly, in the copper market Norilsk faces competition from Codelco, Freeport McMoRan (FCX), and BHP Billiton (BHP).CURRENT PRODUCTION LEVELS AND FUTURE PROJECTSNorilsk Nickel reported total nickel sales of 266 thousand tonnes, total copper sales of 369 thousand tonnes, total palladium sales of 2689 thousand ounces, and total platinum sales of 656 thousand ounces in 2015. I estimate 2016 sales of 255 thousand tonnes of copper, 365 thousand tonnes of nickel, 2392 thousand ounces of palladium, and 586 thousand ounces of platinum. There is a slight decrease in estimated sales during 2016 as a result of a one-time reclassification of material as work in progress inventory and a temporary slowdown at the Polar division due to operational restructuring which should increase future efficiency. I estimate sales rebound in 2017 to 278 thousand tonnes of nickel, 413 thousand tonnes of copper, 2689 thousand ounces of palladium, and 656 thousand ounces of platinum. Copper sales estimates grow even more in 2018 to 458 thousand tonnes, with the addition of the Bystrinsky project, which I discuss in the following paragraphs.Norilsk Nickel has several brownfield projects at the Polar division which should enable production to remain at 2017 levels for another five years without any further expansions. These projects are at the Taimyrskiy Mine, the Oktyabrskiy Mine, and the Komsomolskiy Mine. A major addition to potential future production out of the Polar division is the Maslovskoe deposit. This greenfield project is currently in the exploration and pre-feasibility phase with production targeted for after 2020, with ore reserves over 200 million tonnes and the potential for annual production of 1.3 million ounces of Platinum Group Metals.The Bystrinsky Project, located in the Chita region in Russia near the Chinese border, is Norilsk Nickel’s next large project. Development of the project is already underway with an estimated US$1 billion in capital expenditures remaining and first production targeted in late 2017. Once fully operational, Bystrinksy will be capable of producing 66 thousand tonnes of copper concentrate and 219 thousand ounces of gold annually. Norilsk estimates annual EBITDA from the project to be between US$400-$500 million by 2019. SIGNIFICANT EBIT MARGINS PRODUCE POSITIVE CASH FLOW EVEN IN HARSH MACROECONOMIC CLIMATEIn 2014, Norilsk realized an EBIT margin of 40%; this margin expanded to 49% during the first half of 2015. As one of the few metals producers who can generate healthy operating margins during down pricing periods, Norilsk has a superior competitive advantage. During the first half of 2015, margins expanded due to the strengthening USD relative to Russian Ruble. Since the majority of Norilsk’s operations are in Russia, operating costs are significantly reduced when the Russian ruble depreciates.Since Norilsk has focused its efforts on the Polar and Kola divisions, both “Tier 1” assets with EBITDA margins well over 40%, I estimate EBIT margins of 45% for 2015 onward. In my opinion, this is a conservative assumption as Norilsk is targeting an additional US$350-$400 million per annum EBITDA uplift beginning in 2018 as a result of the expansion and modernization of key smelters and refineries in the Kola and Polar divisions. Should nickel prices rebound from the current unsustainable low levels, I estimate Norilsk will produce operating income of over $3.3 billion in 2016 and over $4.3 billion in 2017 assuming 45% margins. SUSTAINABLE DIVIDEND LEVELS PROVIDE SIGNIFICANT VALUE TO SHAREHOLDERSSince 2013, Norilsk has returned over US$6 billion to shareholders in the form of dividends, with a mandate to return up to US$7 billion by the end of 2015. Such extraordinary dividends in the face of horrible market conditions were the result of operational cash flows, the sale of non-core assets, and a one-time liquidation of inventory. While the extremely high levels of dividends paid out to shareholder during the past 3 years is not sustainable indefinitely, it does show the company’s commitment to returning cash to shareholders. A US$500 million share repurchase program was also enacted during 2015 as the stock price fell.Beginning in 2016, management has decided to return to shareholders approximately 50% of EBITDA annually in the form of dividends. Using my production, margin, and pricing assumptions this implies dividend payments totaling US$2.16 billion in2016, US$2.755 billion in 2017, US$2.954 billion in 2018, and US$3.014 billion in 2018. Which assuming the current ADR price of $11.50 implies a dividend yield of 12.3% in 2016, 15.7% in 2017, 16.8% in 2018, and 17.2% in 2018. Given the operating margins enjoyed by Norilsk’s “Tier 1” assets, it is my opinion that even if LME Nickel prices were to remain below $4/lb, Norislk shareholders would still be able to reap the benefits of a >10% dividend yield.VALUTATION USING DICOUNTED CASH FLOW METHOD INCLUDING A STRESS TEST AT CURRENT SPOT PRICESIn order to determine a price target I used a discounted cash flow analysis, assuming a 12% discount rate which is a conservative assumption given Norilsk’s market capitalization, asset base, and competitive position. I assumed a 1% growth rate to account for potential growth of the Chita division and overall production given the large reserve base of the company. After subtracting US$3.564 billion in current net debt from the present value of total cash flows, I arrive at an NPV of US$24.158 billion or US$15.81/ADR implying a 35% upside over current stock prices.I performed a stress test analysis assuming current spot prices of US$3.88/lb nickel, US$2.16/lb copper, US$486/oz palladium, and US$924/oz platinum continue indefinitely. Even under such extreme circumstances, I estimate Norilsk would still be able to produce annual earnings >US$1/ADR, have free cash flow >US$1billion annually approaching US$2 billion annually by 2020, maintain healthy cash accounts on its balance sheet, and have a discounted cash flow valuation of $11/ADR implying only a 6% downside over current stock prices. POTENTIAL RISKS FOR SHAREHOLDERSShareholders in Norilsk Nickel face operational risks including metals price risk and exchange rate risk. However, Norilsk has already demonstrated that it can be profitable despite significant deterioration in the spot prices of nickel, copper, platinum, and palladium. While the weakened Russian ruble has helped maintain operating margins in the current low price environment, a stronger Russian ruble would increase operational costs for the company. Additionally, since almost all of the company’s operations are located in Russia there is not much diversity of exchange rate risk.Shareholders in Norilsk Nickel also face geopolitical risks given the current state of acrimony between the Russian government and Western nations. Additionally, roughly 67% of outstanding shares in the company are controlled by several key Russian billionaires. These include Vladimir Potanin, Norilsk’s CEO and founder of Interros, Oleg Deripaska (UC RUSAL), and Roman Abramovich, commonly known as the owner of the Chelsea F.C. However, vastly improved corporate governance has been a major initiative within the company, which has a Board of Directors with an Independent Chairman, and 13 seats, five of which are occupied by independent directors. Additionally, the company has stepped up its investor relations efforts, regularly giving updates concerning company progress. ................
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