Introduction

Cameco (TSX:CCO:CA)(NYSE:CCJ) is a leading supplier of uranium worldwide, thanks to its controlling ownership of the lowest-cost, highest-grade uranium mines in the world. These mines include the McArthur River and Cigar Lake mines, both located in northern Saskatchewan, Canada.

Cameco is not just a uranium miner; it has recently made significant investments across the entire nuclear fuel cycle, through its ownership interests in Westinghouse Electric Company and Global Laser Enrichment.

The nuclear fuel cycle consists of three stages:

• Uranium mining: After uranium ore is extracted from the ground, it is processed into a fine yellowish powder known as ‘yellowcake’, composed of uranium oxide (U3O8).
• Uranium conversion: The mined uranium is converted into a gas, uranium hexafluoride (UF6).
• Uranium enrichment: The portion of the isotope U-235 (the type of uranium that can sustain a nuclear chain reaction) is increased from about 0.7% to between 3% and 5%. The enriched uranium is then ready to be fabricated into fuel assemblies for use in nuclear reactors.

Cameco aims to capture value across all three stages. This diversification is expected to provide more revenue stability. Vertical integration is anticipated to make Cameco the de-facto go-to solution within the nuclear industry in the western world, an important strategic advance given the current geopolitical scenario.

Westinghouse’s Acquisition

On November 7, Cameco completed the acquisition of Westinghouse Electric Company in a strategic partnership with Brookfield Asset Management. Cameco now owns a 49% interest, and Brookfield owns the remaining 51%. Westinghouse is a leading provider of nuclear reactor technology solutions to commercial utilities and government agencies. Its business can be divided into three segments:

• Core business: Westinghouse provides advanced products and services to nuclear plant operators, including plant components, inspections, maintenance, repair, and replacement services. This segment is characterized by recurring revenue streams, most of which are fixed in advance under long-term contracts (3-10 years).
• Energy systems business: Westinghouse is involved in the design, development, engineering, and procurement of equipment for new nuclear reactors based on its AP1000 reactor design.
• Growth business: Westinghouse is also active in the design and development of next-generation nuclear technologies, including its AP300 SMR and eVinci microreactor.

Valuation

The company currently has a market capitalization of around 20 billion and trades at a 70 PE multiple, which may make it seem extremely overvalued. However, without context, this number is rather meaningless. The uranium industry is only now emerging from a prolonged bear market, with earnings just starting to recover. Hence, it’s not surprising that Cameco appears expensive. The real question is how optimistic the expectations about future growth embedded in the current price are. I believe they are quite optimistic.

Firstly, let’s look at the mining business, which remains Cameco’s core business. An often overlooked fact is that uranium miners are not directly exposed to spot prices. Long-term contracts are negotiated with utilities and involve a fixed-price component, in addition to a market-related component. Therefore, even if the uranium spot price were to spike above 100, Cameco’s earnings would not be immediately impacted. This dynamic is significantly different from that of oil producers, for example. The sensitivity of realized prices depends on how the book of forward commitments is structured. Cameco provides the following estimates: even if uranium were to spike to $140 per pound and stay there for the next three years, Cameco would realize prices only between $50 and $73 per pound.

Another issue is that Cameco has forward obligations to deliver contracted volumes that exceed its current production capabilities. As can be seen from the following table, the production cost per pound of uranium during the first nine months of 2023 was CAD 35.5, but the average cost was higher, at CAD 47.1. This is because Cameco had to purchase on the spot market at the worst possible time to meet its obligations. Therefore, high spot prices can be a net negative for Cameco if it can’t ramp up production quickly enough.

Unfortunately, ramping up production is proving more challenging than expected. As stated in its Q3 report:

Inflation, the availability of personnel with the necessary skills and experience, aging infrastructure, and the impact of supply chain challenges on the availability of materials and reagents carry with them the risk that we do not achieve our production plans and/or, experience production delays and increased costs. Additionally, with the extended period of time the McArthur River/Key Lake assets were on care and maintenance, the operational changes that have been made, and commissioning issues that we worked through at the mill in 2022, there is continued uncertainty regarding the timing of a successful ramp up to planned production and the associated costs.

Cameco has already been forced to lower its production guidance for the year:

At the Cigar Lake mine, we now expect to produce up to 16.3 million pounds of uranium concentrate (U3O8) (100% basis) this year, a reduction from the previous forecast of 18 million pounds U3O8 (100% basis). Production from the McArthur River/Key Lake operations for 2023 is anticipated to be 14 million pounds U3O8 (100% basis), down from the previous forecast of 15 million pounds U3O8 (100% basis).

How much money can Cameco make from its uranium segment? This year (and next year), Cameco is guiding for production of below 20 million pounds (on an attributable basis), but it has over 30 million to deliver. Let’s set aside the over 10 million pounds it has to buy at a net loss and assume that, in a few years, it will be successful in ramping up production and will be able to cover its commitments entirely from its mines. Let’s assume production costs of around $35 per pound and realized prices around $70 per pound. Let’s also forget about all other costs and thus assume that Cameco will make around $35 in free cash flow per pound. This is equivalent to around 1 billion in free cash flow, or a 5% free cash flow yield, under the most optimistic assumptions.

What about Cameco’s stake in Westinghouse? It’s very difficult to put a value on its growth business. However, its other two businesses have relatively low EBITDA margins between 10% and 20%. They are, however, expected to grow in the coming years. As per company’s statement:

Revenue and Adjusted EBITDA over the next three years in Westinghouse’s core business are expected to grow at approximately the anticipated average annual growth rate of the nuclear industry, which, based on the World Nuclear Association’s Reference Case, is estimated at 3.6%.

A similar growth rate is expected in the energy systems business. Let’s therefore assume that growth will be, say, 4% per annum over the next 10 years. This means that the business will grow approximately by 50% over 10 years, which isn’t that much. Cameco has disclosed that the outlook for the full year is about $500 million in free cash flow, or around $250 million directly attributable to Cameco from Westinghouse’s operations. Even after 10 years of continuous growth, this would be around $375 million per year, or less than a 2% free cash flow yield relative to current prices.

Adding all this up, we see that under the most optimistic assumptions, Cameco is at best fairly valued (I have neglected its fuel segment, but it is relatively small compared to the other two). Even with oil at $70 per barrel, many oil companies offer significantly higher yields than that; in addition, they are paying it to investors now, and oil demand is still expected to increase over the next 10 years. Therefore, it appears that value investors might be better off investing in E&P companies rather than in Cameco.

Final comments

A new nuclear renaissance is likely on the horizon, as nuclear energy is finally being recognized as the most reliable and low-emission source of baseload power currently available. However, one mistake that many investors often make is conflating industry tailwinds with company-specific ones. Everyone can measure the growth in demand that is coming over the next decade. Everyone can count the number of reactors currently being built in China. Everyone is aware of the restart of the Japanese nuclear fleet and the shift in energy policy of many western countries. Therefore, everyone can quantify the supply gap that will be created. Everyone knows that the uranium price will need to rise even more to incentivize new production and fill the gap. These expectations can be embedded in the price of equities. I believe they already are in the case of Cameco.

The nature of the trade has therefore radically changed. Pre-2020 interest in the sector was non-existent and equities traded at depressed valuations. At that time, it was a genuine value trade. Now, however, expectations are ebullient and the best-case scenario has been priced in. Rather than a purely value play, it has become a sentiment trade.

Cameco’s stock price has almost doubled year-to-date. For long-time value investors, this should be a good moment to take chips off the table and book some profits. Can the stock double again? It could, especially if the uranium price reaches new all-time highs. But it doesn’t have to happen anymore. With multiples already overstretched, the risk-reward ratio has worsened. Better value can be found, for example, in owning Kazatomprom, which trades at a far cheaper valuation. For investors who want a pure play on the uranium price, there is always the option of owning directly physical uranium via investment vehicles like the Sprott Physical Uranium Trust.

In conclusion, I am not suggesting that nobody should be long Cameco at these prices, but that such investors should be aware of the reasons why they are. Cameco is not undervalued. Of course, this doesn’t mean it can’t have great returns over the coming years. However, it does make it significantly less likely.