“Asian Profit Play #3:
“A Company About To Smash China’s Monopoly On Rare Earth Minerals. A Probable Triple!”

I don’t know whether there’s something magic about a “triple” that makes Tony Sagami use it as his default promise for stock picks, but for some reason his latest ad that promised three Asian profit plays touted each of them as potential triples (or quadruples really, since it sounds like he actually meant 300% gains) … just the magic of three plays and 300% gains? I dunno, but this last one was the one that he sounded perhaps the most excited about — a rare earths stock poised to cut into China’s market share.

If you haven’t already sat through a few hundred teasers about rare earths stocks, here’s the big picture from the ad:

“What do cell phones, semiconductors, lasers, fiber-optic cables, plasma TVs, hybrid cars, microwave ovens, and even Scud missiles all have in common?

“All of these diverse items — and just about anything electronic — contain some of the 17 elements that the United States Geological Survey (USGS) has identified as rare earth minerals….

“These minerals have very special physical and chemical attributes, such as high degrees of magnetism, luminosity, superconductivity or environmental non-toxicity.

“They are as strategically important as oil, copper, uranium, natural gas, and coal.

“But the fact of the matter is that rare earth minerals are in shorter supply today than just about any commodity on the planet.

“Problem is, China controls 95% of the world’s processing of rare earth minerals and prices are going through the roof.”

And yes, it certainly has been all about “big picture” and “story investing” as we’ve watched the crazy climbs of stocks like Molycorp (MCP) or Rare Element Resources (REE) over the last year — it’s tough to justify a single rare earth explorer or miner based on their earnings … or heck, even their revenues, since most of the stocks we hear touted in this little micro-niche haven’t ever sold an ounce of anything, and won’t for many years even in their own optimistic scenarios (like those Greenland rare earths picks that keep hitting my inbox).

But still, many of these companies have potentially valuable assets, and when a whole bunch of stocks go up 200, 300, 500% or more in a little niche, it catches peoples attention — and now that many of those same stocks have finally come off their speculative highs a little bit, perhaps there’s something worth sampling?

But we’re getting ahead of ourselves — let’s identify the stock first, shall we? And for that, we need a few little snippets of clues from Mr. Sagami:

“The company I just visited in Malaysia … is building the first rare earth metals processing facility outside China in decades!

“The simple truth is that this company is poised to take away 30% of China’s market share in rare earth minerals processing.

“It has a $500 million processing plant near completion … and despite some regulatory hassles, it effectively has the government of Malaysia backing it … the Malaysian Atomic Energy Licensing Board has already approved it.

“The stock is dirt-cheap … the company has ZERO debt and about $288 million in cash in the bank.

“When it’s fully up and running, which should be in four to six months — it’s expected to have annual processing capacity of 22,000 metric tons of rare earth minerals in the first year.

“Figuring an average price of about $151 per metric ton on the sales side, this company should pull in nearly $1.66 million or so in revenue just in its first year, and spin off as much as 91 cents per share in earnings.

“Ninety-one cents may not sound like much but the stock is only trading at just over two times those projected earnings right now. Once the Wall Street crowd catches on to this AMAZING gem of a company, and the P/E ratio expands to just 10 times earnings, its share price could easily triple, or even quintuple. That’s enough to turn every $2,000 you invest into as much as $8,000 and possibly much more!”

So who is it? This, my friends, is our old buddy Lynas (LYSCF on the pinks, LYC in Australia). The stock that gave me my entree into rare earth minerals investing when I first sleuthed it out and wrote about it for you a little over four years ago. It has been through quite a wild life in just a few short years (and I did own it for a while, though I sold years ago), with a boom in “break the China monopoly” interest in 2007 and 2008 and then a “they’ll never raise any more money” or “they’ll get snapped up by the Chinese for pennies” doom and gloom during the market crash … then another boom as they came roaring back to life, with a stock price to prove it, last year.

This is a little Australian miner that has been extracting ore from its large Mount Weld deposit Down Under for quite a while now, but rare earths processing and refining — the part where you take that ore, or concentrated ore, and turn it into the specific rare earth metals that the market wats — is dirty and expensive and difficult. So they chose to ship their ore off to a new Malaysian plant that they’re building rather than try to process and refine it at home (or, as in the “plan B” that was floated when the company was on the verge of going under, ship it to China for refining like most everyone else does).

So yes, there’s a significant Malaysia connection — the rare earths are difficult to find in economic quantities, but they’re not all that super-rare … refining capacity, however, is rarer than hen’s teeth — that’s where China’s monopoly really hits home. China used their cheap labor and abundant rare earths resources to effectively shut down all other rare earth plants and mines in the world by making them uneconomical a decade or more ago, then used their effective monopoly to force manufacturers to do their manufacturing in China if they wanted access to these vital metals — not just a profit-driven move to corner the rare earths market, but a strategic move to boost their own high tech manufacturing sector.

It’s been slow rolling to build up any real competition, since there hasn’t until recently been an economic argument in favor of new rare earths mines — China was still selling the stuff pretty cheap, and big companies and Western governments are never going to be as far-sighted or strategic in their thinking as the Chinese government, so no one was willing to throw billions into building mines and plants that weren’t guaranteed a profit (and were guaranteed to inspire local opposition — rare earths plants have a tendency to be nasty, toxic and radioactive — the stuff is usually found next to uranium or thorium, just to make it all the more challenging).

But now, with Chinese rare earth quotas being cut and cut again in the last year, attention has been strongly focused on all of the rare earths miners — and especially on those who are possibly within a year or a few years of actual production, which is a very short list compared to the many penny stock pretenders to the rare earths throne. Lynas comes out on top of most lists as the company most likely to produce rare earth oxides outside of China, thanks to their stockpile of ore in Australia and this Malaysian refinery that they’re building — they’ve said that they expect the refinery to be online by the end of this year, and that they’ll be delivering end product to customers by early next year.

So it should come as no surprise that recent concern about this Malaysian plant did a number on Lynas’ share price — the New York Times ran either an illuminating investigational piece or a hatchet job (depending on whether you’re a shareholder of Lynas or not) on the Malaysian project back at the end of June, and the shares dipped immediately to A$1.75 … though Lynas responded pretty forcefully and the shares recovered to their current A$2+ (it closed in Australia at A$2.07, which translates to US$2.21 … current trading on the pink sheets is at about $2.17 as I type). Lynas’ latest update on the status of this project, which they call the Lynas Advanced Materials Plant (LAMP), is here. (You can also click here for their latest presentation to media and investors, and here for their last quarterly release which has more numbers).

Assuming that the Malaysian plant does not fall victim to local protests over disposal of waste or handling of radioactive materials, then Lynas still thinks they have a path to final approvals this year (“the pre-operational license for LAMP remains subject to regulatory approvals; however there is a conclusive path forward”), their concentrator plant at Mt. Weld in Australia (which concentrates the mined ore for shipping to Malaysia) is operational and on track, and prices are still rising for rare earths oxides, thanks in part to economic recovery and in part to China’s continuing export quotas that are insufficient for global demand. They also have seven or eight supply contracts in place, including a new strategic alliance with a big Japanese buyer, so there seems to be no doubt that anything they can produce will find a customer.

But, pardon my language, there’s no way in hell Lynas is going to make 91 cents per share in earnings next year.

They do have plenty of cash — they just raised a little over A$300 million in the last quarter in debt and equity, and have A$424 million on hand. Commitments are already in place to spend another A$237 million of that on their continued construction and ramp up in Malaysia and on additional capital needs at the Mt. Weld concentration plant and other capital expenses, along with smaller investments in additional exploration. So even though it seems very likely that all of these projects will go over budget, they ought to have enough cash through the end of the year.

But they’re not going to instantly become rabidly profitable when the year ticks over. Lynas is now, thanks to massive equity fundraisings over the years, a company with at least 1.7 billion shares outstanding (not sure if that includes the last fundraising) and a market cap of around $3.5 billion.

They do have plans to produce 11,000 tons per year of rare earths oxides, with phase II, which I suppose optimistically might proceed by sometime next year, will double that to 22,000 tons. The numbers do sound impressive when you apply that number to the recently spiking spot prices for rare earths — here’s how they figure it:

Lynas calculates the average price for rare earth oxides based on the Mt. Weld composition — the percentage of each of the oxides that occurs in any given kilogram of ore on their site. The average price for that composition has climbed ridiculously, from $10 a kilogram in 2009 to $92/kg in the first quarter and $173/kg in the most recent quarter — and they say it’s still rising. If we calculate that there are 1,000 kilograms in a metric ton, so the current price of a ton is $173,000, and estimate that they will indeed hit their phase II goal of 22,000 tons of oxide produced from Malaysia, then we multiply those and get a number in the neighborhood of $3.8 billion. Sagami must have skipped a step in there somewhere when he says that they are selling oxides for $151/ton, it’s more than 1000X that according to Lynas — and, of course, the idea that a $3 billion company with almost two billion shares would make 91 cents per share on $1.6 million in earnings is laughable, I assume he meant $1.6 billion in earnings — or, with those calculations, a net profit margin of about 50%.

That’s a lot of money, so you might want to check my math. And it would mean that Lynas is trading at about 1X those prospective sales numbers, assuming that prices hold (the spike has been historically ridiculous over the last six months, but demand is rising) and they get production up to their maximum level. I don’t know what the terms are for most of Lynas’ supply contracts, but from a quick check most of them appear to at least be tied somehow to benchmark spot prices, so if prices remain stratospheric I imagine they will indeed have huge sales. If they’re producing that much oxide.

But it’s not going to be without cost, and it’s not going to be in 2012 — Lynas’ optimistic projections are now that they’ll be delivering “some” product to customers in the first half of 2012 (if you had asked then 18 months ago, the projection was that the Malaysia plant would be operating at near capacity by now). But you can read the gazillions of opinion pieces about rare earth miners at Seeking Alpha and elsewhere and decide for yourself.

Rare earths have the supreme advantage of being rare and expensive but also relatively cheap compared to the value added cost of the items in which they’re critical — unlike gold jewelry, where the rising price of gold sends the cost of a necklace soaring, the price of yttrium or of a rare earth magnet hasn’t historically make a huge difference in the overall cost of an iPad or a cruise missile — which means you get an ideal situation for raw materials producers, increasing prices without destroying demand. Strategically critical, but not economically critical to the end user — at least so far. There are a dozen or so relatively active and “real” publicly traded rare earths explorers with a chance of becoming miners, and almost none are as far along as Lynas. I think the most compelling analyst to follow on this topic is Jack Lifton, you can see his most recent articles here, and if you’ve got a favorite, whether it’s Lynas or someone else, feel free to shout it out with a comment below.

There is also an ETF for the rare earths explorers — sort of, it’s the Van Eck Rare Earth/Strategic Metals fund (REMX), which dilutes the impact of the craziest “real” rare earths by including other strategic metals like manganese and tungsten but does include both Lynas and Molycorp (MCP) in its top ten holdings. There’s also sort of an investment fund for the oxides themselves, a non-miner that strategically buys, trades and stockpiles the metals called Dacha Strategic Metals (DSM in Toronto, DCHAF on the pink sheets) — Dacha reports that the shares trade at about half of net asset value of their rare earths oxide stockpiles (they publish the NAV every week), so either someone’s missing a value there or there’s a part of the story that I don’t know.

So yes, I have a hard time envisioning Lynas making 91 cents per share in 2012 … but if their Malaysian plant proceeds without too many further delays they ought to be the first non-Chinese refiner to supply significant quantities of oxide to world markets, which, at current prices, would give them the chance at some very high sales numbers — and since the plans for their refining plant were made back when rare earths traded for 90% less than the current price, one has to assume that there is some potential for windfall profits if things work out as they hope. Maybe I’m being too pessimistic (it’s happened before), but it’s also worth remembering that Chinese strategic moves and a weak economy have been able to scuttle the non-Chinese rare earths market in the past. What do you think? Huge profits in store for Lynas as they proceed in developing their refining capacity, and are the Chinese really cutting back further and keeping prices high? Or is there too much optimism in the rare earths market again now, or more trouble ahead for Lynas in Malaysia? Let us know with a comment below.