LYC - Love is Rare at the moment

We know the story. Battery metals are on the nose and Toilet Paper commands more of a premium than Lithium Spodumene (at least here in Victoria.)

The rise of potential solid-state batteries, with solid electrodes and electrolytes instead of the liquid or polymer gel electrolytes found in lithium-ion or lithium polymer batteries, has spooked many, shutdown nation building mines and is being keenly watched by a government who like want the royalty payments.

Along with Lithium and Nickel we have seen Rare Earths Elements (REE) mixed into the discussion. This is a little unfair as I have read a number of scientific journals that suggest rare-earth elements are still required in all solid-state batteries. Beyond the hype, we are not here to argue the benefits and possible application of solid vs liquid batteries (both have their positives and negatives….pardon the pun.)

So assuming demand for REE's will not disappear overnight, the question we should be asking ourselves is whether there are any opportunities that warrant another look at? This is nigh on impossible to do from a momentum perspective as every stock from A - Z in the space is down. So we can only look to their current operations, and notwithstanding the challenges the sector is facing, there is clearly one stock on the move operationally. The good news is we don’t have to look too much further than its largest constituent Lynas Rare Earths (ASX:LYC)

Lynas has a convoluted operational profile that requires its own article. But at its simplest, Lynas is underpinned by its world class Mt Weld project in WA, recognised as the largest rare earths deposits outside China. Its largest customer is Japan, and it is prized for its independence and transparency.

As at the end of last year, the company has two processing facilities. Lynas Malaysia is the more established and recognised site (the largest outside China), whereas the recently commissioned Kalgoorlie site will take Naturally Occurring Radioactive material (NORM) produced in Kalgoorlie to be further processed at Lynas Malaysia more advanced facility. In time it will also send material to the proposed Rare Earths separation facility in the United States funded in large part by the US Department of Defense.

Lynas 101

So starting with Rare Earths 101 - As many will attest, Rare Earth Elements (REE) are actually not that rare. There is quite a lot of it, just generally not in commercial sizes and quantities, nor can it be mined profitably. There is more of it than Gold and Silver and as the website says, Cerium (which is one of the products they extract) is as abundant as copper. Rare Earths are made up of 15 elements from the Periodic Table (many sources quote up to 17... both are correct). I am not going to bore you to snores with the different elements, their uses and the scientific reasoning behind each. Suffice to say that these minerals can be altered to suit a particular outcome.

China has a dominant position currently producing 60% - 70% (I have even read up to 80%) of the world’s REE supply. Australia is only a minnow (circa 4%) with Vietnam a distant second to China. This stranglehold and risk to the supply chain is a clear risk and major manufactures like the US have only really identified this as a key risk relatively recently. 

In fact during a select committee late last year it said, “Congress should incentivize the production of rare earth element magnets, which are the principal end-use for rare earth elements and used in electric vehicles, wind turbines, wireless technology, and countless other products.” Defense was also left out of this description but of the risks, they are acutely aware. In fact since 2020 the US Department of Defense, through the Defense Production Act has issued hundreds of millions to external providers to ease processing restrictions and create an internal value chain operation (particularly in Heavy Rare Earths. At present China separates 99.9% of heavy rare earths globally. They refine about 85%-90% of all global REE output.)

LYC has been one of the key beneficiaries of this seismic shift. LYC is the biggest supplier of rare earths outside of China. Coincidently an other major player is MP Materials, which we will discuss further in the Outlook section.

The biggest news recently to impact the sector was delivered four days before Christmas when China banned the export of technology to make rare earth magnets. This added to a ban already in place on technology to extract and separate the critical materials. This is the latest salvo in an escalating battle with the West over control of critical minerals but to be honest doesn’t change the playing field all that much, though it supports current incumbents.

Dealing with REE can be risky business. In the US for example there is only one operating mine, the Mountain Pass Mine operated by MP Materials in California. Now from time to time, MP Materials has had to stop its operations because of regulatory issues. An issue that LYC shareholders will appreciate very well. LYC has a refinery currently in Malaysia, and it has had a long-running battle (since I first looked at the company and Dr. Mahathir Mohamad was in power) with the government over all aspects of the cycle. Be it importing, production, refining, exporting - you name it, LYC has been in a Malay Court over it. 

Most recently it was the Malaysian government banning LYC from importing and processing a crucial substance which generates low-level radioactive residue at its refinery in Kuantan. That was lifted to March 2026 allowing it to import and process lanthanide concentrate from Lynas’ Mt Weld mine in Western Australia at the facility. We will discuss more of these in the Risk section below.

Stock Rank and the numbers

The company currently has a stock rank of 66, this is not unusual for a miner who is often priced for future events. On historic numbers the stock is holding up OK.But it must be said the future numbers look to be challenged.

LYC StockRank as at 07 Feb 24

Quality is currently  the strongest element when it comes to this business, particularly as Bankruptcy risk is very low and Return on Equity and Capital are both reasonable despite what has been a challenging period for the business (more under Risks)

Value is dragging on the overall score, however this is consistent with producing miners. Also as things have started to turnaround, the Value score has been actually improving (no doubt helped by the price decline).

This is a good lead into the weakest factor which is Momentum. At 47 it is nothing to sing about. Given the 52 week high was above $9.20, it is not unsurprising to see many of the relative price measures challenged.

So too when we look at analyst expectations, despite the maintained buy rating, EPS forecasts for FY24 and FY25 have been headed South-East (ie not good)

But, I can't help it, I do like to look at big businesses that has halved from their highs as possibly there is an opportunity there.

LYC has done that from the high of April 2022. Coincidentally the overall score is worse than where it was back then, however at that point it was Momentum driving things (as you would expect). The Malaysian challenges and price decline of REE's have since impacted the make up of the score significantly.

LYC StockRank as at 02 Apr 22

An obvious risk that comes to mind, is covering a stock like this, before it reports.

Like most mining stocks, LYC issues both an Activities Statement and Cash Flow Statement. While these are not a full set of accounts, we can get a sense of what the next report will look like, and in the case of LYC it ain’t going to be pretty. Sales revenue were half of what it was the same time last year and less than the previous quarter which likewise was a reduction. Cash was also down with Capital Expenditure up as well. 

In my eye, this latest quarter will be as bad as it gets given the issue in Malaysia and the fall in NdPr production. We will cover these risks in a moment, however while I think the company will turn the corner, the numbers don’t lie. and it will be interesting to see if the company maintains its high Quality rating when it next reports. I don’t have high hopes for the result. For the record, the company said it withheld supply as prices had fallen due to. “...softer demand for permanent magnets in Japan, and to oversupply in rival producer, China.”

Outlook

It's back to the narrative. And while I say the worst seems to be behind it, I say that because I feel there are operational plus’ that can’t be ignored by long term investors. For those that could look past the numbers in the latest quarterlies there were some green shoots.

The very first thing is Rare Earth Elements are not Lithium. I am not going to get into a debate over the vagaries. And yes, it is true that REE are used in the construction of batteries (about 20% - 25% of all REE mined), however there are many alternative uses for the elements including combustion motors, metal alloys, electronic and computing equipment, catalytic converters, petroleum refining, medical imaging, colouring agents in glass and ceramics, phosphors, lasers and special glass. Without becoming more specific, there is underlying demand beyond one major use which helps. The Chinese ban on exporting technology to extract and separate the critical materials makes what LYC have even rarer. Especially as the shutdown in Malaysia gave them a chance to do further work on this and improve its reliability.

Second is feed material from Mt Weld now being introduced into the Kalgoorlie Rare Earths Processing Facility. This was a major milestone in expanding their operational footprint in Australia, making it the first value-added rare earths processing facility in Australia. The Mixed Rare Earth Carbonate (MREC) produced from the facility will be introduced to the Lynas Malaysia plant. Its anticipated the output from Kalgoorlie will be upped to 200,000 tonnes by the end of 2025. Long story short, the company says this expands the company’s production profile.

At the time of their quarterly report they told the market that further Mt Weld exploration had been going well with drilling confirming fresh carbonatite below the current Mt Weld Rare Earth Elements (REE) open pit mine. This enhances the resource with the drilling program being used to update the resource model later in the calendar year 2024. The schedule for the approval of the site’s expansion continues to be ontrack receiving the approvals it needed from the Environment Protection Authority (EPA) last month.

Almost included as an after thought was the announcement that detailed planning and approvals continued for the U.S. Rare Earths Project. I was interested to learn in January that LYC had made a submission to a DoD for a new Prototype OTA process for the development of an additional source for the domestic Light Rare Earth Elements (LREE) industrial base. Either way the agreement for the US$60M project continues (50:50 cost share). Future developments here I will be interested to see.

Recently though there was some mini excitement created by the retracement in REE prices. Talk had started to emerge of a possible merger between LYC and the second largest producer of REE outside China is MP Materials operating out of the US. But we got official word from the company on the 5th February that whilst discussion had been had, they were not going to progress any further. To be honest, I wonder how both sides would agree on a value give the current price of REE and their respective prospects. However, being parochial, and given the still experimental nature of MP’s hard rock product, I believe LYC brought more to the table anyway…. Much more

Risks

Given I have spent a bit of time on the “gonna” tasks - it would be remiss of me not to mention the clear and obvious risks. (LYC has them by the container full!) Risks that have seen the share price fall from a high well above $10 to where it is right now. I would also go so far as to say the decline is deserved and has been evident in the regular reduction in EPS forecasts from analyst.

One of the obvious risks is the current Financials. As I said, LYC is not a poster boy fundamental stock. Though the Quality score is OK for now, I expect it to get worse when the company releases its full result. Of not was the significant cash burn over the quarter on account of continued investment and the issues in Malaysia. As mentioned, for now I feel the worst is behind it, however ignoring it altogether would be folly..

Another clear and present risk is the separating facility in Malaysia. Notwithstanding Lynas Malaysia is domiciled there and employs a significant workforce, the issues with the nation’s regulators have been ongoing. The latest crisis was not wasted as the company chose to close from mid-November to upgrade the facilities to not only upgrade the facility further, but also allow some workers to assist in establishing the Kalgoorlie facility. The market waited with baited breath as since 1 July 2023 the company had been banned from importing Lanthanide from Mt Weld for processing at the site. The ultimate end of the deal was Jan 1 2024. They have since won a reprieve until March 2026 (some may say kick the can down the road) with the only impost I can see being that LYC has to invest 1 per cent (previously 0.5 per cent) of its gross sales in Malaysia each year to undertake research with the Malaysian nuclear authorities to reduce radioactive waste.

This brings up another risk, REE ain’t clean. As alluded to before, the process of separating REE is not easy and it can be nasty business. Reports regularly surface from China on the emergence of toxic lakes created from the process being discussed. Fortunately LYC has had multiple years in the corporate spotlight and has learnt to manage this somewhat, but what can’t be denied is that it is nasty stuff. Therefore how LYC manage it, particularly with their Malaysian and in time their US partners will be important.

Financially the price of REE, in particular their most major product NdPr. Like the other risks it is also an unknown. In appreciation of the weakness in the price of the commodity, LYC has curbed production somewhat and sold stockpiles to the market (never waste a good crisis). Though as the company says. “Improvement to the rare earths market price continues to be dependent on China’s economic recovery.” As I attest though, I see REE being more than just batteries, so the underlying demand for their services will remain., though it doesn’t change the fact that they are a “price taker” and need to be treated as such.

Conclusion

To be frank, to explain the current situation with LYC would require me to prepare a dissertation and I do not have the time to cover the current situation or the history in greater depth. 

Suffice to say that it has been tough and the price has shown it. We can't sugar coat the financials, and they will get worse. The ranks suggest as much, But for investors who don't mind risk, I can't ignore a big stock that has fallen this much, so I took some. If you believe that prices can be cyclical, we are are closer to the bottom of REE and Battery pricing than what we once were.  Operationally I get the sense things are moving for LYC, though their risks are present and live. But with a better runway in front of them perhaps we could ignore this fundamental blip and watch the rubber hit the road when they next report.

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