Rare Earth Metals – Invest in the future

This week, I want to look at Rare Earth Metals (REM). It’s a nice segway from my previous post on Electric Vehicles, as these metals are a crucial building block of not just electrification technology, but most technologies we rely on today (Consumer Electronics, Medical Research, Defense…).

What are they?

The term Rare Earth Metals (REM’s) refers to 17 Metallic elements found in the Earth’s crust. The issue with mining REM’s are that they are widely dispersed, so mining them profitably is difficult as it requires multiple mines operating at small scale.

The quality that makes REM’s special is how they react with other elements; particularly the resulting magnetic, phosphorescent and heat resistant properties[1]. The first two are the most important and explain almost 50% of their total demand in the Glass and Magnetics industries. As our desire for strong, faster and better continues, REM’s will be essential in the production process and there’s no known alternative to date. Even the most conservative forecasts have demand growth at 8%pa for the most critical REM’s [2].

State of play

Whereas the demand for REM’s is global, their supply is certainly not. 85% of the worlds total supply of REM’s is produced in China. This hasn’t always been the case, but the Chinese govt has made a concerted effort to increase its production through lax regulation on the handling of radioactive waste (as a result of REM mining operations), predatory pricing/import quotas and large government subsidies. In second place for total production share, is Malaysia at 10%. The third biggest suppliers are France, Vietnam and Estonia with around 3% collectively, speaking to how concentrated global production remains for this commodity group.

This concentration of production has made for a wild ride on prices. In 2010, China imposed export quotas sending prices rocketing. The US spearheaded a successful dispute at the WTO but in response, China dropped the prices of REM’s, ultimately making it harder for US entrants to raise cash to compete, and resultingly increasing China’s market share further.

Tensions have been high since and there have been major policy announcements to try to decrease US dependence on China for REM’s. In March 2020, Senator Ted Cruz introduced a “Rare Earths Funding Bill”, which if approved would allow US companies to deduct from their tax bill, the cost for building mines, processing facilities, equipment purchases. Other initiatives have included the US signing deals directly with competing REM refiners (such as Lynas) and providing funding directly to US companies as MP Materials.

What’s the trade?

Given the extremely high Chinese market share, the investment opportunities in REM’s outside of China, are limited. To date, there are currently only two REM producers outside of China; Lynas and MP Materials.

MP Materials

MP Materials owns the Mountain Pass mine in California (producing around 50kt/year of concentrates). However, ironically, MP Materials still relies on China for almost all of its $100m in revenues[1]. The reason for this is that MP Materials is not integrated down the value chain. They produce REM Concentrates but don’t refine or produce magnets. So their current business model relies on sending their Concentrates to China for further processing; being subject to Chinese import taxes and ultimately Chinese surplus of processing capacity relative to the size of domestic production. There are plans for MP Materials to establish a Processing plant in the US in 2022 (2 years later than planned), but there are currently no projects planned for integrating further down the value chain into magnetics, which means for at least the next decade, MP Materials will continue be dependent on Chinese cooperation.

Lynas – a more interesting proposition

The only other non-Chinese producer is Lynas. They are an Australian company, publically traded, and have a stronger foothold in the REM industry than MP Materials. Lynas mines REM’s in Australia and then sends these to Malaysia for processing. This diversified business model allows Lynas to operate (almost) independently from China, relying on Chinese customers for only 10% of revenues (in the last qtr).

Lynas & COVID

Unsurprisingly, Lynas has not been spared by COVID. Their mines are operating at 75% capacity and the company stated in their Annual Report (June 20) that they do not expect rates to pick up “until COVID uncertainty is resolved”. Meanwhile, NdPr prices (their highest margin REM used in the automobile sector), are down 22% in the last year, led by a 15% decline in the global automobile market this year (which the company says translated into a 3% decline in global demand for NdPr). This double whammy is reflected in the companies recent filing where they reported their first NPAT loss since 2017.

That being said, Lynas will remain an active player in the REM market. This year, they renewed their license with Malaysian govt out till 2023 (for $12m) and have received direct US government funding to ship REM’s to a proposed Processing facility in Texas.

Lynas production volumes decline due to mine closures

Lynas – time to get long?

Lynas stock (LYSDY) has risen 55% YTD despite a slowdown in revenues and a net loss for the most recent reporting. That being said, there are a couple reasons to still like the stock.

Cash flows still positive

In 2019, the company reporting CFFO (Cash Flow From Operations) of $104m. Including net capex spending, they still had over $63m in Free Cash Flow. In 2020, those numbers dropped but were still $32m and $10m, respectively. Maintaining positive cash flow is a strong sign and has allowed this company to maintain investment spending required to cement its position in the industry; more recently, allowing them to renew their operating license with Malaysian authorities.

Strong balance sheet

Lynas has a very strong balance sheet with Current Assets being close to 2x their Current Liabilities (1.88 in 2020, 2.36 in 2019). Current liabilities as a proportion of Total Liabilities remain in a very healthy range of 20%.

Future growth

Despite the above, the stock is clearly pricing in future growth in the REM market. Lynas trades at 6x book value, 10x 2020 sales, 30x total cash and 300x their FCF. This time last year, the stock was cheaper on all accounts (4.6x book, 7x sales, 27x cash and 39x FCF). Without future growth to at least meet investor expectations, the stock cannot sustain these valuations.

Conclusion

It is rare to find a sector which is undoubtedly going to grow at higher than global GDP growth, has a very supportive regulatory environment and has very limited entrants. This is definitely an industry I want exposure to and for me, Lynas is the best way to play this. They are the only real alternative to investing directly in China, are furthest along with building an independent supply chain and ultimately, have been able to maintain operations and positive FCF in a very difficult year. If you can handle the short term price swings in REM prices, this is a resilient business in a growing market and a lot of government support.