Weak Prices Have Lynas Fighting An Undertow

| About: Lynas Corp. (LYSDY)
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Continuing a theme here of late, Australia's Lynas (OTCPK:LYSDY) is yet another mining company that has been laid low by significant price declines in their core addressed markets. As falling copper, iron, and uranium prices have brought the long-term value of First Quantum (OTCPK:FQVLF), Fortescue (OTCQX:FSUGY), and Paladin Energy (OTCPK:PALAY) into question, the dramatic fall in rare earth oxide prices has likewise crushed Lynas and brought the very viability of the model into question.

A huge (and likely unnecessary) supply squeeze a couple of years ago sent REO prices rocketing, and while investors responded by throwing money at REO mining companies, customers responded equally predictably by increasing recycling and finding alternative materials. Matters are not helped by the fact that the REO market is the murkiest, least transparent segment of metal mining, nor by Lynas's various glitches with production. The significant spread in bear/bull outlooks for Lynas tells me that there could be huge upside to these shares if prices firm and management stays on course, but it also tells me that there's a real risk that Lynas fades away and ultimately sees its assets bought for pennies on the dollar.

Rare Earth Oxides Have Lost Their Luster

Call them whatever you like - rare earth elements, rare earth metals, or rare earth oxides - the fact remains that this sector has seen a massive boom-bust cycle play out over the last three or four years. Due to a combination of a sudden acceleration in demand for advanced batteries, catalysts, and magnets, and tight supply due export restrictions in China and shuttered mines outside of China, prices for REOs skyrocketed in 2011.

That spike in prices, coupled with giddy forecasts for long-term demand growth fueled by renewable energy, electric/hybrid vehicles, advanced alloys, and so on, led to a flood of investor capital hitting the REO space. What it also led to, though, was responses from REO customers. Rhodia and Umicore stepped up with new battery recycling technology, and other consumers like Panasonic and Siemens likewise improved their recycling and reclamation capabilities, while also developing substitutes and alternatives.

As bubbles typically do, this one collapsed and prices have dropped from 80% to 90% for many REOs. With that, former speculative high-fliers have retreated deep into penny stock territory, while Molycorp (MCP) and Lynas have struggled to realign their operating plans.

Quality Assets, Albeit With Some Glitches

Lynas does have legitimate REO assets. The company's open pit Mt. Weld mine in Australia can be profitable at mining volumes that would be unsustainable for large base metal miners like BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO), and Australia is a generally well-regarded operating environment.

Mt. Weld boasts almost 10Mt of rare earth reserves and another 15Mt or so in resources, enough to supply Lynas's production plans for more than 20 years. While the largest component of Lynas's resource base is the over-supplied REO of cerium oxide (more than 40%) and lanthanum oxide is also a significant constituent (more than 20%), the site does boast a respectable content of neodymium oxide and praseodymium - two of the most attractive REOs.

Lynas mines in Australia, and operates a concentration facility there, and then sends the concentrate to its LAMP (Lynas Advanced Materials Plant) facility in Malaysia for further refinement and extraction. There have been some challenges in getting the LAMP facility operational, as it hasn't been universally popular with the Malaysian people (smelting/processing facilities rarely are) and has been a political football. More recently, the company has also had to deal with some production glitches that have required repairs to the cracking and leaching units.

Lynas also boasts a high-quality list of customers, as companies like BASF, Rhodia, and Siemens have signed agreements covering about 75% of Lynas's expected Phase 1/2 output.

Finding That Profitable Sweet Spot

While REOs are often talked about as though they were one monolithic "thing", that's not the case. About 90% of the demand for REOs is covered by four elements - cerium (around one-third), lanthanum (around one-quarter), neodymium (around 20%), and praseodymium (around 10%). Within that, cerium is no particular short supply (and unlikely to run short) and while Nd and Pr make up about 30% of REO demand volume, they make up more than 50% of value. With that, the challenge for companies like Lynas and Molycorp is to maximize the amount of Nd and Pr they produce and minimize the cost of producing Ce and La.

I expect demand will continue to shift within the REO space. Demand for REOs to be used in magnets and batteries for wind turbines, electric vehicles, and so on is likely to lead to above-average growth for Nd and Pr, while the demand for Ce in applications like glass polishing and phosphors is unlikely to keep pace.

The real question for Lynas is the same as any miner - controlling production costs and hoping for better metal prices. Pricing did improve sequentially in the September quarter, helped by a mix shift, but that basket price of $23.60/kg isn't good enough for Lynas to reach its goals. Management believes they can achieve production costs of $14 to $15/kg once they're running at a 22Ktpa volume, but production volumes were only 9% of rated capacity in September and less than 5% of that stated target volume. With that, the former consensus forecast for fiscal 2013 EBITDA of $191 million (back in 2011) vastly overshot the mark, as FY2013 EBITDA came in well in the red.

The Bottom Line

Lynas management has tried to make the right moves as REO prices bottom out, including deferring and slowing the Phase 2 production ramp. Lynas had over A$100 million in cash at the end of September and its debt repayment schedule for the next few years isn't particularly onerous. I believe Lynas can reach cash flow breakeven in FY 2015/16 with an average realized basket price in the mid-$20s/kg, and be quite cash flow positive with prices in the $30s.

If and when that happens is the big unknown. I've seen EBITDA estimates for FY2015 ranging from A$20 million to $160 million, and FY2016 estimates ranging from A$90 million to $365 million. That's a tremendous range of uncertainty, and that tells you something about the challenges and opacity of the REO market. It also means opportunity for real price action, both good and bad.

If REO prices move into the mid-to-high $20s over the next couple of years, a net asset value of $0.40 to $0.60 per ADR is reasonable, and that estimate can move quickly into the $0.80 to $1.00 level with prices in the $30s. As an aside, a 10x multiple to FY2015 EBITDA suggests a fair value of about $0.35 today, highlighting the big difference in near-term and long-range outlooks.

Lynas is quite speculative, though I believe the balance sheet is in good enough shape to get the company through to cash flow breakeven unless the bottom falls out of REO prices or the company sees major glitches in its LAMP processes. There are a lot of cheap-looking mining stocks out there today, though, and investors considering Lynas need to be well aware of the fact that the murky nature of the REO market (both supply and demand) significantly ups the risk here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.