Income from Rare Earth materials.
At Durig Capital, we have developed a process to screen, review, select, purchase and monitor high yielding corporate bonds. Each week we screen thousands of corporate bond listings to find what we believe to currently be the best corporate bond for investors needing or seeking higher yields with as minimal risk as possible relative to its projected return. The following is our review process showing why we believe this remarkable Neo Materials Technology (NEMFF.PK) convertible debenture passes the criteria for our clients.
Denominated in U.S. dollars, this Canadian company's 5% Convertible Unsecured Subordinated Bond matures 12/31/17, and is currently indicating a yield to maturity of about 6.3%. Given the possibility of significantly increasing this already high yield through the added capital gains its conversion to stock option allows for, as explained further in this review, we find it timely and appropriate to include the these 59 month Neo Material Technology convertible bonds in our Foreign and World Fixed Income holdings.
NEO Material Technologies
Neo Material Technologies Inc. ("NEM" or the "company") is a Canadian based international company incorporated in 1986, and headquartered in Toronto, Canada, having approximately 1,550 employees in 21 locations, across 10 countries. Through its Magnequench and Performance Materials business divisions, NEM produces, processes and develops neodymium-iron-boron magnetic powders ("Neo Powders"), rare earths and zirconium based engineered materials and rare metals including gallium, indium and rhenium. These innovative products are essential in many of today's high technology applications.
The company's Magnequench division ("Magnequench") is the leading producer of Neo Powders used in the production of high performance, bonded neo (rare earth) permanent magnets and has an estimated global market share in excess of 80%, giving them monopolistic economy of scale advantages. Neo Powders are used in micro motors, precision motors, sensors and other applications requiring high levels of magnetic strength, flexibility, small size and reduced weight. Through a number of manufacturing process and composition patents which expire between now and 2014, the company is effectively the only legal supplier of Neo Powders for bonded neo magnets manufactured or sold in the United States ("U.S."). The company's patent and license position is such that all end-use products containing bonded neo magnets that are sold in the U.S. must use the company's Neo Powders. Magnequench operates wholly owned manufacturing facilities in Tianjin, People's Republic of China ("China") and Korat, Thailand.
The company's Performance Materials division ("Performance Materials") manufactures a product line of oxides and salts of rare earth elements which include cerium, lanthanum, neodymium, yttrium and yttrium-europium co-precipitates, dysprosium and terbium among others. The division also produces zirconium oxides and salts plus a line of mixed rare earth/zirconium oxides. Rare earth and zirconium applications include catalytic converters, computers, television display panels, optical lenses, mobile phones, and electronic chips. Additionally, the division produces, reclaims, refines and markets high value niche metals and their compounds that include gallium, indium and rhenium used in the wireless, light-emitting diode ("LED"), flat panel display, turbine, solar and catalyst applications. Performance Materials operates joint venture and majority owned manufacturing facilities in Jiangsu Province, China; Shandong Province, China; Stade, Germany; Sagard, Germany and Quapaw, Oklahoma. Performance Materials also operates wholly owned manufacturing facilities in Peterborough, Ontario; Napanee, Ontario and Blanding, Utah.
The company sells its products through a direct sales force and exclusive sales agents based in all major markets throughout the world. Third quarter revenues continued to increase for the tenth consecutive quarter, reaching record levels in the three-month period ending September 30, 2011. Revenues were (U.S.) $248 million compared to $216 million during the previous quarter, and $91 million during the corresponding period in 2010. Higher rare earth product pricing and improved margins, driven by Chinese export quota restrictions, as well as price increases for Magnequench's Neo powders, limited direct competition, and increased product demand across both divisions in the first half of 2011, were the main reasons for the 327% improvement in operating income year over year. Earnings before depreciation and amortization, financial expenses and taxes (EBITDA) were $112 million, compared to $22 million for the 3rd quarter of 2010. Their cash balance at Sept 30, 2011, was $316 million and long term debt amounted to $197 million. During the third quarter, the company announced the commencement of a normal course issuer bid, resulting in the repurchase of 2,541,200 common shares for cancellation as at the end of the reported period and the use of $22 million which would have otherwise been reflected in the company's cash balance at quarter-end.
Neo Materials holds several unique competitive advantages among its peers through a combination of its advanced low cost production facilities, its proprietary technology and patents, and its global marketing and long-standing relationships with worldwide clients. Constantine Karayannopoulos, President and CEO, reported that while they were seeing selling prices and volumes moderate off recent peak levels, the overall business remains solid while their balance sheet continued to strengthen and was providing the flexibility to capitalize on strategic opportunities. The company has grown through strategic acquisitions, the most recent being an 80% interest in Gallium Compounds in August of 2011, and their stated aim to become the global supplier of choice in the high quality advanced materials market includes maximizing integration synergies as well as a utilization of their high cash flow to pay down debt.
On June 2, 2011, the company completed a public offering of Convertible Debentures (the "Offering") and raised $230 million through the Offering, net of issuance costs of $9.2 million which will be used to fund future acquisitions and for general corporate purposes. The company maintains access to credit facilities and short term borrowings for its working capital needs, capital expenditures, and general corporate purposes. Management believes that its non-cancellable contractual obligations and other commercial commitments and 2011 capital program will be funded by cash flow from operating activities and by available cash. Occasionally, NEM will enter into short-term foreign exchange forward contracts to sell U.S. dollars in exchange for Canadian dollars. These contracts will effectively hedge a portion of ongoing foreign exchange risk on the company's cash flows as much of its non-U.S. dollar expenses outside of China are incurred in Canadian dollars. The company has not entered into any off-balance sheet arrangements.
There are three primary areas that Durig Capital focuses upon for its bond reviews to help assure the return of our client's capital. After reviewing their most recent 3Q 2011 statements, Neo Material scores breeze pass all three categories with great ease:
- Debt to Equity - about 25%. Very good, shows balance sheet flexibility.
- Cash to Debt ~3:2. Superb, but likely to change if/when more acquisitions are made.
- Cash Flow to Debt obligations - over 20 x's. An astounding coverage ratio.
In addition to the 5% accruing interest (paid semi-annually) that it offers, a very important feature of this bond to consider is the holder's option any time prior to maturity to convert it to common stock at the conversion price of US$ 13.80 (aprox. 72.4638 per US$1000.) This strike price represents a better than 75% rise from the C$7.92 price NEM is currently priced at on the Toronto exchange, yet it is our belief here at Durig Capital that there is very strong upside growth potential remaining within this company that may significantly exceed the 12% average yearly growth that would be required for the stock price to reach par. Although 2011's 9 month EBITDA growth of nearly 280% over 2010's first 9 may prove to be somewhat of an anomaly, solid double digit EBITDA growth averaging over 12% annually appears to have been no problem for them to achieve over the four years between 2006 and 2010. But when 2011's numbers are added to these four much leaner years, the average growth over five years easily exceeds 40% annually. And, while we acknowledge that this bond bypasses the potential equity gains that might be realized should the stock increase from its current level to C$ 13.80, which we think likely, it instead offers a 5% accrued interest payment and significantly more protection from a possible adverse decline in stock value.
The company has not elected to pay dividend distributions, however, it appears instead to have chosen to do stock buybacks. There are very significant barriers to entry in this industry, and it is worth mentioning here that Neo Materials revenues appear to be nearly 2.5x's those of one of this industries few notables, Molycorp Inc. (MCP), a company that has over 2.5x's the market capitalization currently given to Neo Materials. In summary, aside from being extremely undervalued relative to Molycorp and well positioned for growth, Neo Material appears to be a well financed company that has reasonably low debt, ready options for additional funding if necessary, and a prudent use of existing cash flows.
The default risk is Neo Material's ability to perform. Considering their historical and recent performance, their flexible balance sheet, their sound cash position, and the excellent cash flow to service their interest bearing debt, as outlined above, it is our opinion that the default risk for this short to medium term bond, is minimal relative to its more favorable return potential. An option that further reduces the default risk of this convertible bond, should at its maturity the company decide not to pay off or roll over the debt, is a conversion of the principle (at par) to NEM common stock at a 5% discount to stock's valuation at maturity on 12/31/2017.
The company also has execution and market risks as very fast growth company in developing markets, as companies often encounter unforeseen issues. This is a common risk associated with younger, fast growing companies.
We believe that these Neo Material Technology bonds have similar to slightly lower risks, a longer maturity, and a potentially higher yield that the bonds reviewed in Seagate Technologies 2016 Bond Provides Income From the Clouds and American Railcar 2014 Bond.
We think this is an exceptional opportunity for obtaining a very respectable 6.3% yield with significantly lower default risk than is typically associated with an unrated (or low rated) medium term bond, not to mention the additional return potential that its conversion at any time feature allows for. Therefore, we see this less well known debt instrument as a savvy investment risk offering a potentially great return from a company that has a unique position in the world market, a good cash position, very solid interest coverage, and a remarkably strong and flexible balance sheet.
Additional Neo Material Technology news, charts and updates may be found here.
Yield to Maturity: 6.31%
Disclosure: Durig Capital and some clients may currently have a position in Neo Material Technology Bonds. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.