Frontier Rare Earths (OTC:FREFF) went public in November 2010 raising approximately $55m net of fees with the sale of approximately 20% of the company or 17.6m shares at $3.40/share. The IPO included approximately 9m warrants priced at $4.60/share which will expire out of the money. Despite completing several key milestones since the IPO such as completing a PEA which valued the mine at $3.65bn with a basket price 16.5% below current levels and securing a strategic partner which committed capital at extremely favorable terms and off-take arrangements, Frontier is currently trading at $0.66/share, down 80% from its IPO price. I think the current share price is extremely undervalued and represents a rare opportunity for significant risk adjusted returns.
This table illustrates just how cheap Frontier is. The market is basically dictating that the value of the mine is 3% of its value at the time of the IPO. This is despite management adding value to the mine with a PEA, a soon to be released PFS (by March 31, 2012), and the signing of a strategic partnership with funds received to validate it.
Before getting into the fundamentals of the mine and business I want to cut straight to tangible valuation metrics. The management of Frontier has proven to be very skilled negotiators and the arrangements they have made so far have been terrific. If all the options are excised, 71% of Frontier will be bought out within a year and a half at significantly higher prices then today. With the completion of the Bankable Feasibility Study, the Black Economic Empowerment Shareholders are required to buy 21% of the asset for its then 3rd party valuation, which will be considerably higher then today (the PEA valued the mine at $3.65bn). In addition, once KORES (the Korean partners) helps secure the project finance after the Bankable Feasibility Study, which must be approved and acceptable to the Frontier board, KORES will have the option to buy 40% at the then market price. There are several reasons these arrangements are so important beyond money committed at much higher prices.
If you compare Frontier to any other rare earth in the space it is simply extremely undervalued. With the recent payment by KORES, who paid 400% above market price for their 10% interest Frontier has $52m in cash, no debt, and a $58m market cap. The Frontier mine has a more favorable TREO grade then the other junior players (FREFF.PK-3.12%, QRM-0.90%, AVL-1.43%, ALKF.PK-0.89%, OTCQB:HREEF-0.26%), a very low operating cost of $13/kilogram, low radiation levels, infrastructure, etc. They have a fantastic management team, have used only the best consultants and have a top strategic partner. So what gives? I think the two issues are that investors get sticker shock when they see Frontier will need to get almost $1bn of financing together to make this project happen, secondly I think investors have been burned by the sector and need time to heal and rotate back in, and finally I think investors are generally risk averse at present and the thought of a foreign mine in Africa concerns them.
Let's start with the country risk. Getting back to the commitments that have already been made, investors will really only have to take country risk for a year and half. After that Frontier will have effectively been bought out at much higher prices. The general consensus view seems to be that Zuma will be re-elected next year and it will be more of the same. The point is that South Africa is not going to become a Zimbabwe next year. Unemployment is bad and politicians are abusing their people but we are not close to some kind of a Tunisia event. With the global economy starting to show signs of renewed life it's going to be slightly above global growth in South Africa but more of the same. Regardless it won't matter, with the elections around the corner Zuma just bought 4 more years and Frontier will be effectively sold within two.
With regards to investors getting burned, this is the world of commodities. With cash operating cost of $13/kilogram Frontier will make money hand over fist regardless of the price. Is the NPV $2bn or is the NPV $6bn, who knows, but the point is that the intrinsic value is so far above current prices that it really does not matter. There is so much written by ignorant western journalists with a bias against China who haven't touched a chemistry book about substitutes and other nonsense. Anyone who understands anything about physics and chemistry understands that these are elements, the basic building blocks of nature. There are only 118 known elements, nature's most pure substances, and they all have unique properties. The substitute argument is simply ignorant. Even if it was true, there is a natural hedge because as elements they will always have superior performance. If substitutes brought the price of rare earths down then manufacturers would use more of them, because they have better performance, and drive demand right back up. It's a dumb argument overall.
The second thing investors have wrong about rare earths is the China angle. The Chinese are not as ignorant as many people think. They hoard rare earths and restrict exports not because they want to stiff Japan and flex their muscles. They hoard rare earths because it gives their companies a global competitive advantage and because they know rare earths are running out. The story of western textile manufacturers moving production to China because they can hire 30 people for every one is over. The labor gap has dramatically closed. One way to attract and keep western companies as well as support their own is to sell them rare earths at 60% of the international price. The other way to protect their competitive advantage is to stockpile a rare resource to use for themselves. Shutting off exports and driving up the price has spurred international production and the Chinese know enough economics to know this would happen. At some point in the future, when the market realizes that this was not some geopolitical power play but an economic and limited resource reality I expect the commodity price will eventually reflect that reality. Follow the money. Why would the Koreans pay 400% above market for an asset if their national companies to which they will be selling the off-take don't need it?
It's also important to note that not all rare earth stocks are created equal. Just because different companies are mining the same commodity does not mean that all their problems are sector specific. MCP and OTCPK:LYSCF are the big fish in the sector but it's safe to say a lot of their problems are company specific. Unfortunately during the bad times asset management involves thinking about money flows, and money coming out of MCP and LYSCF.PK is not likely to flow into better rare earth stocks but out of the sector. Frontier is being penalized for the faults of others. That's not to say that Frontier has done everything perfectly but they have largely kept to the time table so far and have proven they know how to get a deal done.
And finally, how is it that a junior mining company is going to raise $937m dollars next year? Well let's start off by saying that they don't have to raise that much, they could raise less and not separate the elements but that's not going to happen. So how are they going to do it? Simple, they have the backing of the government of Korea and might not even have to tap the equity markets. We can only speculate, but if the stock gets to a more reasonable multiple of its intrinsic value, which I think it will when they announce bank commitments, 30% of the equity could easily cost KORES more then a couple hundred million. The rest could be financed with the help of KORES nudging banks and others. Interest rates in Korea are 2.75%. Sure, maybe the government of KOREA has done two years of due diligence and spent $24.4m because they wanted to give their employees a chance to vacation in Cape Town, but I think that perhaps they really are serious about getting this thing done.
My conclusion, the rare earth sector has caught a serious cold but eventually people's wits will return to them and they won't continue lumping everyone together and valuing an asset that could supply 10% of the world's production for the next 20 years for $6m ($58m FRO market cap - $52m cash). It's actually absurd. KORES just paid $24m for 10% of the asset and the market is valuing the remaining 90% for $6m, which probably explains why the company has authorized a 1m share buyback when they could be putting the cash into their 50%+ IRR project. The returns on the market look more attractive. Since the announcement of the KORES transaction closing the stock has traded a whopping $120K worth of shares. I don't know many people regardless of how rich they are that would not pick up a dollar on the floor if they saw one but it certainly feels like there are plenty of people walking past. At some point people will wake up and realize its sheer nonsense and Frontier will get the credit it deserves. Until then I will remain long and restudy the efficient market hypothesis.
Important! Please note that Frontier Rare Earths is a small cap stock. Investors should only consider investments in small cap stocks as part of a diversified portfolio. Risks involved investing in small cap stocks like Frontier include low liquidity, increased volatility, and other unique risks. I do not recommend this stock for investors with low risk tolerance.
Disclosure: I am long OTC:FREFF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Do not invest in this stock or allocate more to this stock if you cannot afford to lose your entire entire investment.