Exactly one year and one day ago, we published a research piece sharing our bearish views on Great Western Minerals Group (GWMGF.PK) and the response from both the retail and institutional investor community was overwhelmingly negative. We're happy to point out that since we initially published on Great Western Minerals Group (GWMGF.PK), the stock has declined approximately 50%, but after spending the last two months reviewing our thesis, we conclude that Great Western Minerals offers one of the most compelling investment opportunities in the rare earth sector today. We thereby are upgrading Great Western Minerals Group (GWMGF.PK, GWG) from a SELL to a BUY with a $1.05 price target.
Our analysis has led us to the conclusion that despite the lack of NI 43-101 complaint documents on Steenskampskraal and what is overall just a rather poor level of transparency, there exists a very valuable business in the Great Western Minerals franchise through their Less Common Metals subsidiary based in the Merseyside region of Great Britain. LCM is worth multiples of the current market capitalization of Great Western Minerals Group.
Great Western owns two downstream facilities (Less Common Metals "LCM" & Great Western Technologies "GWTI") plus a majority stake in Steenskampskraal, a formerly producing thorium deposit in South Africa. The company also owns several exploration assets. As we go through this analysis, long time readers will find that our skepticism over Steenskampskraal has not changed so much as we have recognized the value in Less Common Metals.
This research report has four segments
- Macro analysis of REE downstream supply chain segment
- Steenkampskraal, GWTI, Exploration Properties
- Less Common Metals (LCM)
- Valuation & Conclusions
Getting Macro on Rare Earth Downstream Operations
The rare earth element industry segmentation can best be described by the upstream (mining to concentrate), midstream (concentrate to oxides), the downstream (metals, alloys), and finished products (magnets, FCC, polishing powder, lasers, etc.).
With each progressive step downstream, the process becomes relatively less capital intensive with more weight shifting towards intellectual property. For example, our research indicates it costs less than $20 million to purchase, ship, install, and permit a furnace capable of producing 2,000 metric tonnes of NdFeB alloy per annum; David Kennedy of Great Western Minerals said on the April 11th investor call that each 600 tonne NdFeB furnace is costing LCM less than $5 million. Given the margins involved in this portion of the supply chain, the obvious question is why isn't every junior rare earth mining company planning to integrate downstream and leverage this low capital, high return opportunity?
The answer to that question can best be described by the "no inside photos" request Less Common Metals made of our editor when he visited the facility on February 17, 2012. If we desired a photo of something we saw, the management team would send us a photo that did not expose any intellectual property, because the metal, alloy, and magnet segments of the rare earth supply chain involve very complex proprietary processes. While we were there, LCM management informed us that they were currently in the process of testing their new NdFeB alloy strip cast product against customer requirements. Naturally this process takes time, because if the end product is flawed and not up to customer specifications, then a company will find its customer list shrink significantly.
When a rare earth industry executive, consultant, expert, analyst, or insider describes any lack of skilled engineers or knowledge regarding REEs outside of China, (the "intellectual deficit"), they are referring almost entirely to the downstream portion of the supply chain. This plays a key role in our analysis of Great Western Minerals Group. The only two rare earth element supply chain companies we have researched with either the existing intellectual property required to produce rare earth metals & alloys, or the human capital necessary to build such intellectual property are Molycorp (MCP) and Great Western Minerals Group. At Molycorp, the "key man" for the downstream operations is Dr. John Burba. At Great Western Minerals, the "key men" for the downstream operations at Less Common Metals are co-founder David Kennedy and current manager Ian Higgins.
Other then Less Common Metals and Molycorp Tolleson we have not found a neodymium-iron-boron (NdFeB) alloy production facility outside of China or Japan not controlled by Chinese or Japanese interests. We would note tongue-in-cheek that Molycorp acquired Tolleson from Japanese interests with an assurance that the seller would still receive product, (the beauty of having a secure feedstock controlled by the same ownership cannot be overstated given events of the previous few years). In general, when we discuss rare earth elements we talk about China v. ROW. When we talk about the downstream segment of the supply chain, we need to talk about China & Japan v. ROW, because those countries are the sole exceptions to "intellectual deficit".
Given that most downstream operations in Japan, as far as we can tell, are controlled by end consumers, it is difficult to find information on that segment of the market. The same can be said for operations located in China. We also view the China and Japan downstream operations as serving their domestic manufacturing segments on almost an exclusive basis.
We will be touching on rare earth metals, NdFeB alloys, SmCo alloys, and rare earth magnets here in that particular order.
We come away from this research with even a stronger conviction that domestic Chinese prices reflect the new long term rare earth prices due to environmental reforms and consolidation of the Chinese rare earth industry. Environmental issues with Chinese rare earth processing are frequently mentioned in the press, but we think a picture is worth a thousand words on the topic:
The photograph above was taken of a Chinese electrolysis cell in Inner Mongolia producing didymium metal.
What we are looking at is mixed neodymium/praseodymium oxide that is fed into a crucible, which sits in a fluorine bath. This is where it starts to get ugly. Because there is no hood, there is fluorine gas emitting into the atmosphere. Inhaling fluorine gas is, to put it mildly, not healthy. In fact, the Agency for Toxic Substances & Disease Registry in 2003 said, "Exposure to high concentrations of fluorine can cause death to lung damage". Not to overstate the point, but we would also add that this electrolysis cell was charged up to twelve volts according to the individual who provided us with the photo. This is the picture we internally call "the picture of 1,000 horrors". We were informed that the amount of protective gear worn by the workers at this metal-making facility was minimal and would not fly in the western world.
This is part of the discussion about China recognizing the need to implement environmental reforms in their domestic rare earth supply chain. It has not been cheap labor that has enabled China to corner the market on rare earth element supply. It has been the toleration and acceptance of business practices such as those captured in the photo of 1,000 horrors. The long term health costs and impact of these practices on the environment has not been reflected in the price of rare earth products, but now these practices are no longer viewed as acceptable in China.
This photo is a powerful example of why we remain comfortable with our previously published price deck and our view that domestic Chinese prices reflect the new long-term real prices for rare earth oxides. The reality here is that the metal making process exhibited in the photo is absurdly cheap, and in fact, it goes to show that China has in essence been subsidizing the consumption of rare earth elements by the developed world by accepting burdens and costs that have not been reflected in the market price.
When we were at Less Common Metals, we got to see one of the electrolysis cells the company received but has not yet started operating. LCM declined to provide us with a photo of the cell, but our editor saw it with his own eyes. We will not go through the detailed engineering of the metal making process (in part because we are not even 90% sure we have the process down perfectly), except that we saw the cell is built to include a hood to contain the fluorine gas and we were told the company is testing suction methods to pull the metal out of the crucible in accordance with regulations that make it impossible to extract the crucible out of the fluorine bath (which makes sense if you want avoid releasing fluorine gas into an enclosed populated factory setting).
The photo above is a crucible sitting in a furnace we saw at LCM.
Our basic understanding of the metal making process is as follows. The separated rare earth oxide is placed within the crucible and a tungsten tipped piece of metal is dipped into the crucible such that an electric current can pass through the crucible via the tungsten tip and the electric coils around the crucible. This electrolysis forms a molten metal that then needs to be removed and cools into solid metal. Basically, LCM is testing how to use a suction process to extract the molten metal out of the crucible to cool it.
Each one of these electrolysis cells LCM is installing can produce 3 tonnes of metal a month, which translates to over 100 tonnes of potential neodymium iron boron alloy production per annum for each cell feeding metal to a given alloy furnace.
On the metals front, we have identified Molycorp (Silmet) and Less Common Metals as the only companies outside of China and Japan with rare earth metal making capabilities not committed to end products.
Given our conversations with rare earth industry insiders, the general consensus is that 2010 demand for NdFeB alloy was 70,000 metric tonnes with 55,000 metric tonnes within China, 13,000 metric tonnes in Japan, and 2,000 metric tonnes in Europe with zero growth in 2011 due to the significant price increases. We would also add that potentially 10,000 metric tonnes of demand inside of China was going towards "frivolous" applications such as using the magnets in toys, etc.
Working off that 60,000 metric tonnes figure (yes, we are removing frivolous applications, and using a 7% per annum growth rate (below consensus for rare earth magnets through 2020). We estimate there is a need for 24,000 tonnes of incremental NdFeB by the end of 2016 which will require just under 8,000 tonnes of neodymium oxide production. We estimate Molycorp through Phase II capacity has the means to produce just over 16,000 metric tonnes of this incremental NdFeB alloy. When we include the potential NdFeB alloy production from neodymium oxide produced by Lynas and the capacity at Less Common Metals, we are left to conclude that no junior rare earth mining company outside of Great Western Minerals will bring a rare earth primary deposit into production prior to the end of 2015 and prior to the end of 2016 unless its economics are based on its heavy rare earth element content. This does not include the poly-metallic Dubbo project being developed by Alkane Resources which must stand on its zirconium and niobium revenue merits.
We have come to the conclusion that the NdFeB alloy market is the driver of the rare earth element market in general. Cerium as a polishing powder is well and good, and if XSORBX is a success, water filtration looks like a promising demand outlet for cerium. Lanthanum has its role in the energy industry and in nickel metal hydrate batteries, but we do need to acknowledge that at the peak of rare earth price mania in summer 2011, WR Grace announced they had re-done some of their formulas to remove the need for rare earths. Samarium is used in samarium cobalt alloys, but that is pretty much it on that level. Europium is used in lighting as a phosphor (guess where the red in your television comes from). Yttrium is used in light bulbs. Dysprosium is used in lighting. But dysprosium's primary use is in neodymium iron boron magnets that will be used in high temperature environments. Praseodymium has practically no use at all except where it is used in NdFeB alloy. And neodymium of course is used in NdFeB alloy.
Strip Cast Alloy v. Book Mold Alloy
It is great to be able to produce NdFeB alloy, however its production process is critical in determining the quality. There are basically two processes by which NdFeB alloy is produced. The first is the book mold process; in the simplest description of this process, raw materials are basically poured into crucible within a vacuum furnace and then cools into a mold.
The second method is called strip casting, and since we are not engineers we are not going to try to explain to you the difference. But what we can say is that in our discussion with several individuals involved in the rare earth sector, there has been universal agreement that strip casting offers a significantly superior product. The reason is that the strip cast process generates a more consistent grain size which is critical for magnet makers because the first step for turning alloy into magnets involves grinding down the alloy into a powder. If the grain size and distribution of raw materials is not consistent, the alloy is basically worthless to the magnet maker and must be re-cast. As a result, we will find that quality of production process is critical in the rare earth downstream since mistakes will significantly reduce profitability.
Less Common Metals produces 220 tonnes per annum of Samarium Cobalt alloy which represents well over 20% of the market outside of China (market size is 700 tonnes outside of China, 700 tonnes within China). Given the product outlined product mix for LCM in 2016 (4000 metric tonnes NdFeB alloy (3700 tonnes strip cast) and 280 tonnes of SmCo alloy and nonmagnetic alloys), our focus in this piece is primarily on the NdFeB alloy side of the equation.
We would note however that in high temperature environments, rare earth experts have explained to us that SmCo magnets outperform NdFeB magnets. One expert has pointed out to us though that the reason SmCo only represents 10% of the rare earth permanent magnet sector is not because of a lack of samarium or cobalt supply, but because the use of those magnets is specialized.
A Quick Word on Rare Earth Permanent Magnets
The rare earth permanent magnet portion of the supply chain is not in the current plans for Great Western Minerals. The reason for this is simply that they would then be competing with their LCM customer base. But since this is our most extensive public commentary on the downstream component of the rare earth supply chain, we will take the opportunity to discuss the magnet side of things.
The Molycorp-Neo Material Technologies (NEMFF.PK) merger, upon completion, leaves no question that Molycorp will have the vertical integration taken care of. As this report will explain, Great Western Minerals is basically a mine and separation plant away from having a smaller scale version of what Molycorp is constructing minus the magnet component. But beyond Molycorp, we see no mining entity outside of China integrating all the way down to the magnets. And this is practical considering the high costs involved in terms of research and development and the scarcity of personnel. So what we are looking at in Molycorp is one vertically integrated entity.
In Great Western Minerals, we have a provider of NdFeB and SmCo alloy to magnet makers requiring those alloys. There are both end consumers with internalized magnet production and standalone rare earth magnet manufacturers who stand to benefit from the finalization of a second source of alloy outside of China and Japan. The reality here is that while the supply side of the rare earth market is very consolidated, the demand side is very diverse. Unless an end consumer is a major consumer, like say Toyota (who has a tentative JV with Matamec (MHREF.PK) on the Kipawa deposit), it is not economic for the consumer to integrate upstream to secure their rare earth requirements. This is creates a market opportunity for standalone and mine-linked magnet, alloy, and metal producers.
In the United States, there are three of these standalone REPM manufactures which Jack Lifton mentioned in his recent piece following the announcement of the Neo Material Technologies and Molycorp deal and they are Arnold Magnetic Technologies, Thomas and Skinner, and Electron Energy Corp.
These three companies are representative of what remains of the downstream rare earth sector outside of China and Japan that is not currently captive within end consumer businesses other than what Great Western Minerals currently has plus what Molycorp is both expanding and building. These are critical entities because for several end consumers of rare earths, it simply is not pragmatic or economic to construct internal magnet manufacturing capabilities.
We are very pleased that, thanks to the most recent corporate presentation of Compass Diversified Holdings (CODI) who acquired Arnold Magnetic Technologies in early March, Arnold Magnetic generated approximately $18 million in EBITDA in 2011 on $130 million in revenue which is remarkable considering Chinese export quotas.6 We can only wonder what the performance capabilities of this business could be with a secure supply of alloy for its NdFeB and SmCo magnet manufacturing capabilities.
It is for this reason, while acknowledging that Neo-Molycorp is the largest M&A deal in rare earth industry history on a financial basis and is an industry dynamic shifting deal, we consider the takeover of Arnold by CODI to be the REE deal of the quarter. We would point out that in 2009 Molycorp wanted to do a magnet joint venture with Arnold Magnetic Technologies. We do not know why that deal fell through, but it is intriguing why, with obvious synergies and an established global magnetic footprint, Molycorp did not win the auction for Arnold. We do not know who was bidding beside Compass, but it is rather obvious that Molycorp, thanks to synergies, would have been able to offer a superior bid if involved in the process. The deal would have given Molycorp by our estimate, practically what the Neo deal gave them minus the rare earth separation expertise, since Arnold has offices in China, produces SmCo magnets, and according to the company website produces both "fully dense" and "polymer or resin bonded" NdFeB magnets. CODI got all of that for a price tag of less than 10% of what Neo Material Technologies cost Molycorp.
But back from the divergence into reflecting on rare earth M&A, the big questions we see in the rare earth magnet world beyond security of supply are the following: dysprosium and economic breakevens. The first question simply pertains to the fact that the dysprosium content required in some of these NdFeB magnets facing extreme temperature cycles does not sync up with the supply of dysprosium and does not reflect the ratio of neodymium/praseodymium to dysprosium production ratio in the long run. As one industry executive put it to us, "the typical NdFeB alloy is 27% Nd or Nd/Pr and 4% Dy while the typical mine (as in everything not South China ionic adsorption clay) REE distribution worldwide supports a 29% Nd or Nd/Pr and 2% Dy composition."
As it has been explained to us, the key issue with dysprosium is that the dysprosium needs to be placed in certain locations in a permanent rare earth magnet structure. The problem is getting the dysprosium located correctly, and as a result, an excess of dysprosium is used to ensure necessary location (since otherwise the magnet is useless for its intended application). The key to the technology of lower dysprosium requirements is then to improve the ability to apply dysprosium as needed such that it is no longer necessary to use it in excess to ensure it is correctly located within the magnet structure. We know that was probably a painful paragraph for engineers to read, but bear with us here. We will address the dysprosium supply dynamic in depth in the future.
On the issue of economic breakevens, Boulder Wind & Power holds the view that NdFeB is not economic in wind turbines if neodymium oxide is over $100/kg. We are not aware of what sort of dysprosium content is involved in calculating this figure, but this $100/kg Nd oxide breakeven figure for the wind turbine sector appears to have permeated the market sentiment as we have seen almost all analysts and PEA price decks begin using $75-$80/kg Nd oxide.
We would point out that Boulder Wind & Power is working on a new wind turbine design that would operate at low enough temperatures where the inclusion of dysprosium in the permanent magnets would no longer be required. The company anticipates this new design will be commercially available in a 3 MW model in the 2013-2014 timeframe.
As good at this sounds for those bearish on neodymium prices long term, we have to point out that the hybrid/electric car market in 2025 is going to require 2.5 times the amount of neodymium oxide as the wind turbine market will under the high penetration scenario outlined in the DOE Critical Metals Strategy 2011 report. (DOE Critical Metals Strategy 2011 page 88) Under the low penetration scenario in the same report, the hybrid/electric car market will require over five times the amount of neodymium as the wind turbine market in 2025.
Given this dynamic, we must conclude that rare earth permanent magnet usage in vehicles will establish the maximum sustainable price for neodymium oxide from the demand side perspective. In an October piece on the rare earth industry, Jon Hykawy of Byron Capital Markets wrote regarding motor selection in hybrid and electric vehicles, "even at peak Nd prices, the PMSM is the superior choice, assuming that Nd is readily available". (Jon Hykawy, Rare Earths: No Problems, No Shortages?, Byron Capital Markets, 10/24/2011, p.5) Just to put that into context, the peak neodymium oxide price during rare earth mania was over $350/kg outside of China and over $200/kg inside of China versus an April 2012 price of $92/kg inside of China.
The usage of rare earths in wind turbines will be dependent upon whether or not a supply of neodymium can be economically supplied at the economic breakeven price for REPM inclusion in wind turbines. If enough junior rare earth projects can produce attractive returns for investors at the wind turbine economic breakeven for neodymium oxide plus revenue from other rare earth element production while fully satisfying demand in the hybrid/electric vehicle segment, then the long term price of neodymium oxide, and therefore NdFeB alloy and NdFeB magnets will be set at that level. If not, the long term price will reflect the demand for hybrid/electric vehicles versus the supply of neodymium and dysprosium.
As a result, we view future rare earth permanent magnet demand (and specifically NdFeB magnets) to be a function of a secure supply of neodymium and dysprosium far more than a function of rare earth oxide prices. One expert put it to us simply that Toyota will use rare earths in their cars if they are confident they can access supply, and we think that sums it up rather nicely. The future of rare earth permanent magnets in less than ten words, "if there is secure supply, there will be demand".
We cannot emphasize enough our conviction that Mark Smith and Molycorp are going to be proven right about them and Lynas (LYSDY.PK) being the only new mines online by the end of 2015 even though Steenkampskraal may end up being the sole exception (as explained in this report, we remain skeptical). Do note that we may have to include Alkane Resources' (ALKNY.PK) Dubbo project as a potential entry in 2015, but we will not do so until we see definitive off-take agreements in place for the project's HREE and LREE mixed concentrate products. On that mark, and as a sneak peek of what to expect from us in the near future, our trip to PDAC was very helpful in getting a sense of which rare earth juniors can be the "third/fourth/fifth" ROW rare earth mines.
The important thing to remember about the metal, alloy, and magnet making components of the rare earth supply chain is that it is simply a "value add" industry. The input costs are raw materials (rare earth oxides, iron, cobalt, boron), labor, R&D, and capital. The business is simply processing the raw material inputs into the necessary metal, alloy, or magnet product to very specific customer requirements.
The beautiful thing here is that the business of metal, alloy, and magnet production is not affected by variable rare earth oxide prices since the variability can be passed through to the customer. The key risk is a steady supply of rare earth oxides to produce product.
This requires us to think about Great Western Minerals and its flagship Less Common Metals subsidiary differently than we think about other rare earth companies outside of China and Japan.
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Additional disclosure: The facts in this newsletter are 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 account before acting on any advice given in this newsletter. If this concerns you, do not listen to or consider our opinions. 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.