On Wednesday December 7th, Hudson Resources issued a press release announcing the results of the Preliminary Economic Assessment that Wardrop completed on its Sarfartoq rare earth deposit in Greenland. In the press release the company highlights its impressive net present value, internal rate of return, and all the typical measures we have become accustomed to seeing when junior mining companies complete this milestone.
However, when digging beneath the headline numbers, we think investors should walk away from this report concerned as to whether many of the deposits currently being developed by publicly traded junior rare earth mining companies are economically viable. When we refer to economically viable in this sense, we are speaking more to the all important question with junior miners: will the proposed project generate high enough returns to attract the funds necessary to fund mine and facility development CAPEX?
As many of our subscribers would note, our newsletter is very bullish on rare earth element prices in the long term, given that we see new applications for rare earth elements being developed in the next decade. But when investors are putting money into a company with no cash flow producing assets in order to develop a mine and accompanying facilities, they are going to be conservative in their demand assumptions. Better to be suprised positively (and look like a genius) than surprised to the downside (and have angry investors).
For that reason, the Hudson Resources Preliminary Economic Assessment [PEA] raises concerns that rare earth element investors should be watching out for in the coming months. This was the first document in an upcoming wave of milestone reports for junior rare earth mining companies, which will provide significant clarity as to which projects will become producing mines (if any) and which will not be developed. These include: Matamec Exploration PEA on Zeus property (we estimate early January 2012), Ucore Rare Metals PEA on Bokan-Dotson (1Q2012), Tasman Metals PEA on Norra Karr (1Q2012), Rare Element Resources pre-feasibility study on Bear Lodge (1Q2012), Quest Rare Minerals pre-feasibility study on Strange Lake B-Zone (1Q2012).
When looking at the figures in the Hudson Resources PEA, five things stand out immediately:
1) The discount to the basket price of 43% is signifcantly smaller than the 75% discount we hear from industry insiders that concentrate sells for in China . In our discussions with individuals involved in the re-development of the rare earth supply chain outside of China, we have been told that the separation facilities in China purchase concentrate for 25% or less of the end value of the separated oxides. It is possible that given the supply crunch outside of China, concentrate only mining operations will be able to negotiate a smaller discount. Given the current decision by Hudson Resources, just as Matamec Exploration and Tasman Metals are expected (in their upcoming PEA) to only operate in the mining and concentration portion of the rare earth supply chain, we will be carefully observing which reports assign a steep discount when generating the headline results.
2) Despite being primarily presented as a deposit with a very high relative distribution of neodymium, the combined revenue contribution from cerium and lanthanum make up 50.4% of the total revenue. In our opinion, this creates increased financing risk. We do not think investors will attribute any value to cerium and lanthanum revenue for the "third and potentially fourth mine" (or at best, a minimal amount) to be developed outside of China this decade after Mountain Pass and Mt. Weld. In the medium term (2012-2015), the rest of world (ROW) demand for cerium and lanthanum will be primarily supplied by dwindling Chinese exports, and production from Mountain Pass and Mt. Weld. There are even some estimates-- cited all too often by Molycorp (NYSE:MCP) bears-- that these elements, in particular cerium, could even be in surplus. As a result, incremental cerium or lanthanum production would potentially result in a flooded market, which would cause prices to crash for those respective elements given the current demand projections.
Junior rare earth mining companies raising mine development CAPEX will need to show their projects can generate significant returns for investors putting up the mine development CAPEX with only a minimal or zero revenue contribution from cerium or lanthanum, given current demand projections for those elements and the supply coming online from Mt. Weld and Mountain Pass.
3) When we used domestic Chinese prices from late November (resulting in a 10.31% discount to the basket price), we calculated that the cerium and lanthanum contribution to revenue was only 26.61% of total revenue with neodymium contributing 40.95% of total revenue. Hudson's Sarfartoq resource gets some points in our book for this. In fact, if we only assume revenue from Neodymium, Praseodymium, and Europium at domestic Chinese prices, Hudson would receive 62.4% of the total revenue it receives when we apply current domestic Chinese rare earth oxide prices for all rare earth elements in the Sarfartoq deposit. However, the problem is that-- whether we take that crazy Nd, Pr, and Eu only scenario, or the scenario where we only take out cerium and lanthanum-- the internal rate of return will be significantly impaired.
4) Using the basket price in the PEA, the project has a pre-tax IRR of only 31.17%. Once we take out cerium and lanthanum revenue-- either from the price deck used in the PEA, or domestic Chinese prices-- and adjust for the difference in basket price, we are looking at either a 34% or 50% revenue impairment. We don't yet have access to the full PEA, it will be on SEDAR within 45 days of the press release. As a result, we cannot do a formal sensitivity analysis. However, a back of the envelope analysis using the operating cost per tonne highlighted in the press release tells us that operating income could be impaired by 39-57% if investors do not assign any value to the cerium and lanthanum revenue potential. Assuming a similar degree of impairment to the cash flows, both net present value (pre-tax & pre-finance) and pre-tax IRR are significantly impaired.
5) When Molycorp went public, its business model for Phase I production at Mountain Pass included an after-tax internal rate of return of over 34% (page 75 of S-1). The investing community in the United States knew practically nothing about rare earth elements during the roadshow, as evidenced by the fact that Molycorp priced at $14/share, below the indicated $16-$18/share range. Given that this project went through the ringer that severely-- with an after-tax IRR of over 34% using trailing 3 year average prices ending prior to the second half 2010 export quotas were announced, we see no reason to believe investors will be more forgiving and accept lower returns for rare earth projects with higher cost structures, less downstream integration (Molycorp's business plan incorporated metals and alloys in addition to oxides), assumes higher rare earth prices, and the potential that the project's production will push the market for some specific elements into surplus.
As we look ahead, there are clearly rare earth element specific deficits that still exist, even after Phase I & II of Mt. Weld and Project Phoenix come online. The question we then think investors should ask of each junior rare earth company is this:
If cerium and lanthanum (the two most prevalent rare earth element in every deposit with a potential start date before 2018 and TREO ore grade exceeding 2%) are removed from the revenue stream, can this project provide to investors returns similar or superior to those Molycorp Project Phoenix Phase I offered to investors in its initial public offering?
In the Molycorp IPO, assuming the remainder of Phase I CAPEX was raised at the same share price as the initial public offering, Molycorp raised capital at $14/share, which would have resulted in a net present value of $16.30/share (34% after-tax project IRR) using 3 year trailing average prices at the time of the IPO or $22.54/share (43% after-tax project IRR) using the June 15, 2010 prices (both net present values involved an 8% discount rate). This also did not take into account the potential for the company to scale the Mountain Pass project up to Phase II production if it raised additional capital.
As this wave of NI 43-101 compliant reports are released in the junior rare earth mining sector over the coming months, investors should look past the headlines numbers and ask whether the project can attract the significant capital necessary to fund mine development if investors assign zero value to any revenue contribution from cerium or lanthanum.
The key figures we will be looking for are:
1) The potential for a 30% after-tax IRR at a conservative price deck assuming zero revenue contribution from cerium or lanthanum.
2) Net present value per share greater than the offering price following mine development CAPEX capital raise.
There is a very decent possiblity that none of the publicly traded junior rare earth miners will meet those high standards in the milestone reports scheduled to come out between now and the spring of 2012. We will discuss the consequences of that potential outcome in a future missive.
Additional disclosure: The facts in this newsletter is believed by The Strategist to be accurate, but The Strategist cannot guarantee that they are. Nothing in this newsletter should be taken as a solicitation to purchase or sell securities. These are Mr. Evensen’s opinions and he may be wrong. Principals, Editors, Writers, and Associates of The Strategist may have positions in securities mentioned in this newsletter. You should take this into consideration before acting on any advice given in this newsletter. Investing includes certain risks including potential loss of principal. The commentary of The Strategist does not take into consideration individual investment objectives, consult your own financial adviser before making investment decisions.