Formation Capital Offers a Rare Opportunity: a Cobalt Play

Instead of my usual discussions on gold, silver and the banking sector, I want to talk about a different subject and company this time. It is about cobalt and a cobalt producer in North America. I usually pay more attention to the precious metal area, but cobalt and cobalt producers are very uniquely situated in the metal industry, which offers good diversification outside the typical precious metal miners in my portfolio.

Last Thursday (6/12) in New York City, I attended a corporate presentation given by Formation Capital (FCO) CEO Mari-Ann Green and President Scott Bending. FCO is a Canadian cobalt producing company headquartered in Vancouver with their cobalt mining operations in Idaho. I purchased FCO shares last August, when the whole mining sector including FCO got hammered by the subprime sector and credit crisis. I thought I bought them at the right time, but FCO along with the whole junior mining sector have been range bound since then for almost a year now, with FCO now not a lot higher than my purchase price.

Cobalt is a chemical element with symbol Co. About 36% of cobalt is for industrial and medical usage such as inks, paints, drill bits, ball bearings, and 33% for environmental such as solar panels, fuel cells, re-chargeable batteries, and 22% for strategic and national defense including jet engines and turbine blades, and 9% for electronics including propulsion systems, cell phones, memory chips and hard disk drives. As you can see, cobalt is a key material with multiple uses for the US.

For the last several years, and foreseeable future years, the global consumption has exceeded and is expected to exceed global production. Cobalt price has also gone from around $10/lb in 2001 to over $40 today. The major cobalt producing country is Congo in Africa, but now the Congo has placed restrictions on exporting cobalt-bearing ores, requesting that the ores must be refined there first. This has forced large cobalt importing countries such as China to make large capital investments to build plants in Congo in order to secure their future cobalt resources.

FCO owns North America's sole primary cobalt mine in production, a unique position to be in, considering cobalt is the key element with many industrial uses, including strategic national defense discussed above. FCO started the purchase of the Idaho properties back in 1995 in installments, which are located in central Idaho west of the old mining town of Salmon.

In 2001, FCO began the legal and regulatory process to get its cobalt rich claims in Idaho's Lemhi Pass district approved for mining. FCO has spent a lot of capital on obtaining regulatory approvals for the last 7 years, more than on exploration, geological studies, and process developments combined, which is the way mining business is conducted here in the US. It is very different than, say Mexico, if you read my previous write-up on Endeavour Silver, which managed to produce silver only half year after the purchase of the Guanacevi mine.

The good news is that this permit process is finally coming to the end. FCO is expected to receive its last permit in July, so they can begin their start-up and construction phase, which will take a little over 1 year. The production is expected to begin in the 4th quarter of 2009 or the 1st quarter of 2010. Due to the need for large capital expenditure in this phase, FCO is expected to do a major round of financing this summer, about $150M.

FCO is pursuing various options, probably a majority from a large high-yield notes combined with some equities. FCO will also try to avoid hedging during the potential issuance of these high-yield notes. This cobalt mine life in Idaho is currently at 10 years, with potential to even double it to 20 years. The average operating cost of cobalt is only about $8 per lb. If the current cobalt price is sustainable for the next 10 years, conservatively say $28 instead of $48 of the price today, it represents a $20 per lb net cashflow for FCO.

The average production per year is about 2.6 million lb, with $20 operating profit per lb, resulting $52M net operating cashflow per year for the next 10-20 years. This is a very large profit considering FCO's market cap is only at $120M now. With fully diluted shares of 233M, it represents $0.22 per share ($52M / 233M), about one third of its current stock price at $0.60 per share.

If we use today's cobalt price at $48, the net operating cashflow becomes two thirds of the current stock price. Even if we include the potential dilution from future equity financing, it still represents a low ratio of net operating cashflow to its current stock price. I think that the current depressed stock price reflects the uncertainty of its upcoming major financing for capital investment in order to start production next year.

As is very typical in the case of financing, the stock price could go even lower. However, once this cloud is cleared, if financing is done successfully and aligned with shareholder's interest, both institutions and retail investors will realize FCO's unique value of owning a scarce strategic resources in a low geopolitical area. In addition, I have totally ignored the value of other uranium/gold/silver projects in FCO's portfolio. I won't be surprised to see its stock price double from the current level in the next 12-18 months, which was over $0.90 per share at one point last year