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Investing in Rare Earth Mining Companies – It’s All About the People

Apr. 07, 2011 8:49 AM ETNEMFF, GWMGF, ARAFF, REE-OLD5 Comments
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Mike Holt's Blog
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My research into rare earth elements began as part of an ongoing effort to identify potential risks that could negatively impact my clients’ portfolios. I saw China’s stranglehold on this vital resource as a significant threat. It then occurred to me that one of the best ways to mitigate this risk is to invest in companies engaged in the development of this vital resource and the downstream products that support so many important technologies. These technologies, in turn, hold the key to the economic growth that we are so desperately seeking.
The first step, of course, is to select worthy investment candidates from the growing list of rare earth mining companies and companies involved in the equally important downstream industries. If we were to reacquaint ourselves with the concept of investing as a means of allocating capital, and then sought to allocate our capital as effectively as the Communist Chinese government, these investments would ideally be made by companies that are dependent upon access to raw materials derived from rare earth elements. Although the market for rare earth elements is relatively small and profits have likewise been insignificant given the artificially low prices that resulted from China’s growing influence over this industry since the early 1990’s, such investments should make sense if companies developed business models that focus on the long-term sustainability of profits from their higher margin final products, rather than the short-term profitability of each intermediate process. Unfortunately, most companies outside China have not implemented such vertical integration strategies, and are now extremely vulnerable to the risk that they will not be able to access these vital raw materials without jeopardizing their intellectual property and business franchises. But, this has created investment opportunities for individual investors who can appreciate the importance of these relationships.
Of course, individual investors should not be expected to make such investments purely for altruistic reasons. In order for the capital allocation process to be effective, it should be based upon the long-term profitability of these investments. In other words, the activities being funded should make sense after taking into consideration their true costs and benefits. It may be helpful to conceptualize this as Chinese capital allocation with American characteristics. Within this more rational framework, this article will seek to provide investors with helpful guidance on how to invest in rare earth mining companies. In particular, I will focus upon how they should be valued, and the important but often overlooked role that a company’s board and management team are likely to play in determining a company’s failure or success.
What’s the value in owning rare earth mining stocks?
To begin, investors should bear in mind that their objective for investing in a rare earth mining company should be to acquire an interest in the future earnings derived from the development of these natural resources, rather than simply acquiring an interest in a rare earths deposit in a static sense. Toward this end, investors must, therefore, take it upon themselves to project what these future earnings are likely to be, and to compare their valuation estimate with the value that the market is currently assigning to the rare earth mining company. As evidenced by the bursting of previous price bubbles for many types of assets, failing to do so can have adverse consequences for investors and society at large. Conversely, overlooking attractive opportunities until it is too late can also be detrimental to investors and society.
Toward this end, for the rare earth mining stocks that I own, I have used various discount rates to calculate a range of discounted net present values of their future earnings based upon conservative estimates of the weighted average price of the rare earth oxides that they are expected to produce over the projected life of their deposits. (Current and historical prices are posted weekly on the Lynas Corporation website, among other sources.) In some cases, ongoing operating costs are mere “guesstimates.” The resulting present values should be reduced, of course, by the projected up-front costs required to achieve a state of production. My previous post includes an example of this methodology under the heading, “Before you pay the price, ask yourself what is ‘the China price’?”
If current rare earth prices are sustainable, the results are very attractive. Otherwise, the benefit of owning rare earth mining stocks becomes more strategic in nature, based in part upon global security concerns whose value is less tangible and therefore difficult to quantify. Under those scenarios, governments and companies whose profits are dependent upon reliable access to rare earths-based raw materials would seem to be the more natural investors. However, such strategic considerations so far have gone unnoticed. In my opinion, this means that the prices that must be paid to gain access to rare earth elements outside of China are more likely to remain at elevated levels. Consequently, those willing to commit a portion of their capital toward the development of resources outside China could possibly be rewarded with high returns commensurate with the high risks being taken.
For a detailed description of the principal rare earth elements deposits of the United States, this 2010 Scientific Investigations Report by the USGS may be helpful.
But, while evaluating certain characteristics of deposits already owned by a particular company is obviously important, investors should be aware that there are other important considerations. Unfortunately, judging by the comments shared on the message boards for investors in these companies, undue emphasis is apparently being placed only upon such characteristics. In other words, too little thought is being given to each company’s business plan and the ability of their management to execute that business plan against the backdrop of a very challenging economic and market environment. Of critical importance to investors is not only whether a company’s management will be able to succeed in the execution of its business plan, but whether management will be able to do so in a manner that will be beneficial to existing investors.
How the value in rare earth mining stocks is unearthed over time
As indicated in my previous post, early investors in a particular company that has just gained access to a rare earths deposit may benefit if that company or certain of its assets are acquired shortly thereafter. But, absent such an acquisition, early investors who remain committed to the successful conversion of a deposit into a productive, profitable enterprise must be prepared to endure a multi-year development process in which the cycle of a mine life goes through several stages: exploration, discovery, evaluation, development, and operation (which may ultimately be followed by closure). Although they may not always think of it in these terms, such investors stand to gain from an increase in the discounted present value of the company’s future earnings, which may result from:
  • A decrease in the discount rate used to value future earnings as various development milestones are achieved. (In the example included in my previous post, using a discount rate of 15%, the discounted PV of annual earnings of $1.54 billion was calculated to equal $10.236 billion. All else being equal, if a discount rate of 30% was applied at an earlier stage of development to reflect the higher levels of uncertainty that existed before certain milestones were reached, the discounted PV of those same annual earnings would equal only $5.133 billion.);
  • An increase in the projected resource base that can be profitably developed;
  • An increase in the market price for such resources;
  • A decrease in the cost of developing such resources; and/or
  • An increase in projected future earnings stemming from synergistic horizontal and/or vertical integration strategies.
Lynas Corporation – The “down under” company that has risen to the lead
The pattern within which these return drivers unfold is consistent with the development process that I described in my previous post. Page 15 of a February 2011 Investor Presentation by Lynas Corporation which compares the size and progress of various global rare earths projects should also put this into better perspective. From this it can be seen that the price per tonne of ore at Lynas Corporation’s relatively large Mount Weld deposit in Western Australia is quite high relative to that of the other projects listed, and that Lynas is also expected to be the first of these non-Chinese rare earth mining companies to start production. Several years ago, the discounted present value of projected earnings from such production was less than it is today since:
  • Uncertainty whether Lynas Corporation would successfully achieve each of the milestones listed on the x axis of the illustration warranted use of a much higher discount rate than whatever discount rate an investor would deem suitable today;
  • The size of the projected resource that could be profitably developed has increased as development of the resource has progressed; and
Despite the fact that certain projected operating costs have increased recently, from a projected $7/kilogram to $10/kilogram, these costs continue to be quite low relative to Lynas’ competitors. Furthermore, Lynas has already fully secured financing for the first stage of its two-stage construction plan, and financing that is not anticipated to be significantly dilutive to existing stockholders is expected to become available soon at terms that may be more attractive than those previously anticipated.
I should have known it was going to get complicated
However, a number of additional factors that investors should consider when evaluating the investment merits of various rare earth mining companies are not captured by the illustration on page 15 of the Lynas Corporation February 2011 Investor Presentation referenced above. These include:
  • The current market capitalization for the various companies;
  • The projected future costs to develop the resource and the amount of cash on hand or access to non-dilutive financing available to fund such future costs;
  • The existence of any “trap door financing,” such as warrants or convertible preferred securities, which can sometimes catch unwary investors by surprise;
  • Certain characteristics about a company’s resource(s) such as their composition (light REEs vs. heavy REEs), grade, concentration, metallurgy (which can impact processing costs), the presence of other elements that may represent additional assets or liabilities – such as radioactive elements that often accompany certain types of rare earth deposits, location (which can be further broken down into political risk and geographic risk, the latter including topographical and climatic conditions that may determine what type of mining operation is required – surface mining vs. tunnel mining – as well as whether mining activity will be possible throughout the entire year), proximity to a skilled local labor pool, and access to transportation routes and important infrastructure;
  • Certain characteristics about the company’s processing facilities, or other downstream operations. (The higher the cost of production, the greater the fluctuations in profits, and thus share price – and investors generally frown upon higher levels of volatility.);
  • The terms and conditions of any marketing agreements that the company may have in place to ensure sales of the products on attractive terms;
  • The company’s business plan; and
  • Last but not least, the background and skills of the company’s board and management team.
The attribution of many of these factors to a number of rare earth mining companies was summarized in an October 10, 2010 Seeking Alpha article titled “Rare Earth Elements Part 2: Companies with REE Assets.” As such, a repetition of that detailed discussion is not likely to add much value here. However, in order to evaluate and compare the merits of investing in one or more rare earth mining companies, a matrix that takes all of these factors into consideration could be helpful. That may be an undertaking worth pursuing in a future article, but for now I would simply like to focus upon what I believe to be the most important of these factors, namely the quality of a company’s management. As indicated earlier, this is rarely mentioned in message board discussions among investors, nor is it often cited in the numerous reports, articles, and studies concerning the rare earths mining industry. For example, in response to a question on one of the message boards for investors in rare earth mining stocks asking whether anyone knew anything about a company’s management team, I recall one investor expressing his supposed belief that the company’s only other asset beside the rare earths deposit was “two guys and a pickup truck!”
A skilled management team to the rescue – It’s all about the people
Yet, management’s ability to meaningfully act upon all of the other characteristics of a rare earths mining company is likely to be far more important than the level of knowledge that an investor may be capable of accumulating regarding a company’s resource. Even if a relatively unskilled management team was successful in acquiring a substantial project, it should not be taken for granted that they will be sufficiently talented to develop that resource in a manner that will ultimately be beneficial to that company’s investors. In fact, the quality of a company’s board and management team is likely to be the most significant determinant of whether a company fails or succeeds.
The four most important skills to be possessed by those who manage and direct a rare earths mining company are:
  1. the ability to raise capital. (Mining is a capital intensive business, so if a company can’t access capital, it can’t advance its projects much less its share price.);
  1. the ability to identify and acquire attractive projects;
  1. the ability to guide the project through the various stages identified on page 15 of the February 2011 Lynas Investor Presentation referenced above. (Rare earth mining companies are somewhat unique in that the process required to separate the ore into individual rare earth oxides after it has been beneficiated, crushed, and concentrated, is extremely complex and can be subject to extreme environmental scrutiny and regulations. Moreover, the separated oxides require further processing before they can be useful in the numerous technological applications for which they are so critical.); and
  1. the ability to make the investment community aware of management’s successful development of the company in order to boost its share price to a level that is consistent with the increased value of the company that results from their efforts.
This is a balancing act. In their effort to acquire sufficient capital to advance their projects, management must avoid issuing too many shares at low prices, while still providing an attractive level of remaining upside potential for investors.
So, how should investors go about evaluating whether a management team possesses these skills? The best indicator is management’s prior success – not necessarily for themselves, but for investors. And, their prior management expertise must be relevant. Individuals who have attained success in a particular field are often capable of attracting capital and exceptional staff members, and this may also enable them to gain access to an attractive project. But, without relevant expertise, they may prove to be unable to capitalize upon these competitive strengths within a new and unfamiliar environment.

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