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A few more thoughts on Overstock

My biggest position right now is Overstock.  I’ve already written two posts about the stock (here and here). I actually added to the position some more today as it dipped back into the $40s.  I’ve been spending most of my time on the name.  Here are a few new thoughts on it.

What is the lending platform worth?

I am constantly re-evaluating the lending platform.  The industry is really opaque and its been a lot of work getting numbers that I have some comfort in.

I have found two sources that seem credible.  The first is this paper from Beneish, Lee and Nichols.  The second is this lawsuit from the pension funds against the prime brokers.

In what follows I am considering the US stock market only.  I believe that once this market is proved out, tZero should be able to expand the platform to other market.  But we’ll leave that for the future.  Right now the big question is whether tZero can make this work in the US.  The news on the call that there is indeed $100 billion of inventory and that they had been offered another $6 billion of hard to borrow that very day (as I’ll describe, the vast majority of revenue from stock lending comes from a few hard to borrow securities), is reassuring.

The US lending market generates $4-$4.5 billion of revenue to prime brokers.  According to the lawsuit documentation, and also described by Bryne a number of times, the prime broker cut is supposed to be around 60%.  But most assume the actual cut is higher because of inter-broker transactions that reduce the cut for the lender.  So let’s say its actually 75%.  That pegs industry revenue from US equities, including what is going to the lender, at $6 billion.

You can get to a very similar number by using the data from the Beneish paper and this article from the securities lending times, which was referenced in the lawsuit document.  The Beneish paper uses IHS Markit data on stock lending rates and volumes.  Global equities on loan are $851 billion and the US makes up 55% of the lending market.  Therefore total US equities on loan are $472 billion.  The average borrowing rate for US equities on loan is about 1.5% (its actually a bit higher but roughly).  So that gives a market size of $7 billion.  So its in the ballpark of the first number.

You often hear a much smaller average borrowing rate quoted, something around 45-50 basis points.  I believe this is because the number quoted is referring to the volume averaged borrowing rate.  In fact the number is usually is described as just that: a volume weighted average.  The reality of the stock lending business is that 80% of equities are easy to borrow and fetch a very small rate (33 basis points).  So most of the volume generates very little revenue.  The majority of revenue comes from a few hard to borrow stocks.  To give perspective, and its a rough calculation because all the data isn’t there, but I calculated that around 50% of revenue from stock lending comes from the 5% most hard to borrow stocks when I used the tables and data from the Beneish paper.

So I’m going to assume it’s a $6 billion market.  Byrne has said that they want to cut fees by 50%.  He has also said the tZero/lender split will be 20/80.  That gives a total addressable market of $600 million for tZero.  I expect that to be very high margin revenue, though Overstock hasn’t given us any numbers to put to margins yet.

One consideration that I haven’t accounted for is the impact of collateral on the prime brokers numbers.  I’m still fuzzy on how this will work.  I believe that the prime broker revenues quoted are fee only revenue.  However the prime brokers also makes some money from holding collateral of the borrower.  Some of this collateral return is passed back to the borrower as a rebate, but the rest is profit to the prime broker.  I don’t know how the collateral will be considered with tZero, but if the lenders are now going to participate directly in the interest generated, that may be included in that 20/80 split, which would make my above estimates low.

Even ignoring the collateral, the opportunity is considerable.  At 10-20% market share, which should be a reasonable objective if the platform is successful, tZero stands to generate $60-$120 million of high margin revenue.  An 8x revenue multiple on $120 million puts you at $1 billion valuation.

Of course there are plenty of folks that don’t think tZero will succeed in capturing any of the market.  I guess that’s what the next few months will prove out.  For what its worth they’ve gone from $0 to $100 billion in two months.  And they’ve brought on board Quantum Fund and Passport, who presumably aren’t making their investments in Overstock because of their desire to make a play in e-commerce.  But we’ll see.

What is e-commerce worth?

The second element I’ve spent time on is e-commerce.  To be honest, for the longest time I was scratching my head about the e-commerce numbers I was hearing.  Marc Cohodes estimated in his Grants presentation that the business could fetch $70+ in a sale.  D.A Davidson valued e-commerce at $58.

When I was stepping through the valuation, I had trouble coming up with those numbers.

Starting with the existing business, I calculated that EBITDA from e-commerce (after eliminating the losses from Medici) for 2015, 2016 and 2017 were $33 million, $31 million and around $18 million for this year.

Byrne said on the third quarter call that there would be “hundreds of basis points of synergies” if they got together with a “bricks” retailer.  I assumed 200 basis points.  Presumably there would also be sales growth from the membership base of the “bricks” acquirer being directed to Overstock to shop.  I assumed 20%.

With all these assumptions the best I could come up with was about $80 million of EBITDA including all the synergies.  That made it hard to justify where the big buy-out numbers were coming from ($70 per share is about $1.75 billion before considering the Soros and Passport dilution, or more than 20x EBITDA including all the synergies).

But then I found something I missed the first time on the conference call.  @teamonfuego, who has been working on Overstock valuations as well, pointed to this passage late in the call.  My underline:

Yes, so this synergy goes both ways. So for example, if we were combined with a large chain, these large chains have similar logistical footprint. They typically have a dozen or so mega distribution centers, each of which are feeding a couple dozen distribution centers, each of which are feeding 10 to 15 stores. If we were integrated with such a company, we could overnight I mean, you would have a system that was competitive with Amazon, fulfillment by Amazon or even nicer than fulfillment by Amazon in several ways. We built, this thing, Saum and Stormy, actually, built some years ago, SOFS. This thing we called SOFS is a software logistics system for an agile network supply chain. We’ve only had it hooked up to our 3 distribution centers, but it could be hooked up to thousands, and it was actually built to be hooked up to as many as we wanted, you don’t need thousand, you need a dozen. So just by, for example, if we were part of a large brick-and-mortar chain, that itself was like $200 million, $250 million of various logistics cost, all right to the bottom line.

I’ve actually talked to a couple of people now that acknowledge that e-commerce logistics are a problem for many of the bricks retailers, and a solution to that problem could be quite coveted.

So who has thousands of distribution centers?  Well this article from Forbes is interesting.  So I’m not at all saying that Walmart is a potential acquirer, but more generally the article talks about how Walmart specifically but also other bricks retailers are embracing what is called omni-channel commerce.  Omni-channel commerce is essentially the process of turning each store into a distribution center.   A number of the chains mentioned, along with plenty of others, would have the 1000’s of stores that would make the logistic cost reduction realized.  The concept aligns pretty well with what Byrne is talking about above.  Needless to say this can change the e-commerce valuation substantially.

Curious Transaction

One of the first things that caught my eye the day of the third quarter earnings release was this disclosure in one of the 8-K’s.

I found it very curious.  Why would Overstock terminate an existing loan and lease agreement in order to make a similar loan with Patrick Byrne’s family?

Indeed I was not surprised when I saw that this transaction was picked up by a few of the shorts on twitter a couple days later.  They pointed to it as an example of a questionable related party transaction.  I can’t disagree, it’s certainly odd. But I wonder if it’s missing the point.

I dug into exactly what the master lease agreement was for.  As it turns out, Overstock entered into the MLA on November 25th 2015.  The lease is to “finance certain software and/or software licenses(s) (“Licensed Software”), software components, including but not limited to, software maintenance and/or support“.

The lease and debt agreement occurred close to the time of the closing of the acquisition of SpeedRoute.  The purchase was initiated in August 2015 and it closed some time before the beginning of 2016.  In fact the day before, on November 24th, Overstock issued an S-3 amendment for potential selling stockholders from SpeedRoute of Overstock stock.

The timing makes me think there’s a pretty good chance these are Speedroute’s assets that Overstock is doing the MLA for.  Reading through the MLA, those assets were secured by Overstock’s land and building.  So you had tZero software secured by Overstock.com assets.

I have to wonder if Overstock cancelled the loan and MLA in order to disentangle the two entities.  Byrne decided to take on the loan and MLA himself (via his family) as a short term plug.  Keep in mind there was no reason to end the relationship with US Bank.  The agreement extended to 2020.  Also, the terms of the loan to Byrne’s family was at a higher interest rate, so this couldn’t be construed as an economic .  Obviously the optics of leasing out from your own family are unfavorable, and I can’t see doing that unless you had another motive.

I may be totally off base about this, but I just have to think you don’t make this change unless you are pretty far down the road to some sort of separation.

Bitt

While all the focus is (rightly) on tZero, Byrne did point to Bitt as his second most promising investment.  I knew Medici owned 11% of Bitt but didn’t know they could own up to 35% with warrants.

Bitt is in the business of digitizing currency to the blockchain for governments.  they are “creating digital wallets for citizens, for people, essentially frictionless payment system, including remittances, which incidentally are a $500 billion industry globally, remittances alone, on which the vig is about 15%.”

Bitt is close to completing their first use case in Barbados.  Catlin Long (from Symbiont) commented on this on her blog back in 2016:

More central banks in small countries will follow the lead of the central bank of Barbados, which green-lighted a blockchain start-up called Bitt to create a digital Barbados dollar that uses Bitcoin’s blockchain as an alternative method for settling foreign exchange. Small central banks are searching for alternatives because local banks are losing access to US financial system, owing to the retreat of American correspondent banks from small countries — a trend called “de-risking.” This is choking off trade, which is the lifeblood of most small economies.  Folks, this an unintended consequence of laws requiring U.S. banks to comply with strict anti-money laundering and know-your-customer regulations. These laws are hurting the developing world — and, ironically, boosting Bitcoin as a valuable alternative payment system. Kudos to Barbados for its creative solution!

Byrne said on the call that Bitt’s development in Barbados is undergoing 4 weeks of testing.  So its pretty close to coming to fruition.

I mean, this thing has a global application, and what I think the first to market with the kind of wallet we’re bringing to market, I just saw, I mean, it’s all in testing. It’s all done. It’s all being tested for another 4 weeks, it’s really slick. It’s really better than anything I’ve seen in the market, that’s a potential enormous business.

While I don’t really have a sense of what the addressable market is for a digital currency, I suspect if the blockchain really does snowball and become the preferred method of recording transactions, it would be pretty big.  If Bitt can be first to market with a successful launch in Barbados, I think that the company is probably worth quite a bit (pun intended).

A few other random thoughts

1. On the conference call Byrne said that “the market” wanted Overstock to get their ownership in tZero down to below 50%.  I think that makes sense for optics.  It makes me wonder if we get some sort of divestiture announcement before the ICO.  Maybe selling a 20% stake to a strategic investor, which along with the ICO would take the overall stake down to 50%?  Purely speculating here but it would seem to make sense to do that before the ICO.  I didn’t really understand the whole “bitcoin fork” reason for the 15 day delay.

2. The securities purchase agreement for the Quantum Fund is lacking the normal disclosure that no non-public information has been exchanged (h/t 20slots for this).  Note that in the Passport agreement, the statement is present (any information that constitutes or could reasonably be expected to constitute material non-public information…)

3. Who was the man in the next room?

4. There was some insider selling over the last few days.  At a glance it appears like they were selling out, but after closer inspection its clear that each of these insiders own significant amounts of restricted stock.  For example Sam Noursalehi, President of Retail, sold 5,000 shares.  He owns 48,000 shares of restricted stock in addition to the remaining 11,000 shares he owned.  I’m not too worked up about these sales.

5. The shorts have been out in full force on Overstock.  Lots of tweets and articles.  I’m actually somewhat comforted that so far, while I can see that the shorts are digging through IP addresses, looking for backdoors to tZero platforms and searching through the Linkedin connections, I haven’t really seen anything that scares me that much.  Of course that could change tomorrow. I’m sure there will be another article.

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My thoughts on the Overstock/tZero ICO

This is a follow-up on my original post on Overstock and blockchain.  There are likely be more to come as I learn more (and come up with more questions).

Up until I got interested in Overstock.com I had not given a lot of thought to initial coin offerings (ICOs).  I knew they were a way of raising money, I knew a few fellow investors were making a killing on them, I knew that the details were often murky and that the holders rights were not all that clear.  But I didn’t really delve into the concept too much.

As I explained in my last post, I have yet to make a serious investment in crypto-currencies.  I was running into stumbling blocks being Canadian, and it appeared that there were going to be more stumbling blocks with ICOs.  So I didn’t look too closely.

But when I started looking at Overstock, I started thinking about ICOs.   Overstock’s subsidiary tZero is going to start the pre-sale of their ICO on November 15th (there is a countdown on their website).  tZero is 83% owned by Overstock.  This is, in essence, the first ICO for a publicly traded company.

After spending some time on it, what I’m kinda thinking now is that an ICO is a pretty neat way for a public company to raise money.  Particularly if it’s a company trying to fund a new venture that needs scale from the customer to succeed.

What are the details?

From what I can tell, we don’t know all the details.

Overstock announced some details about the upcoming t0 ICO on October 24th, so about a week ago.  As I pointed out in my last post, of these details I thought the key ones were the following:

  • The tZERO token will be tradable on tZERO’s U.S.-regulated ATS.
  • The tZERO token will incorporate profit-sharing features of a security as well as utility features of an app token, including:
    • Token holders will be able to use the tZERO token to pay for fees on the ATS and payment of such fees using tZERO tokens will grant up to a 25% discount as compared to payments made using U.S. dollars. The tZERO token is expected to have additional functionality and token holder benefits to be announced at a later to date and will be included in the offering memorandum; and
    • tZERO believes its token will be the first to offer a percentage of tZERO’s profits, distributed as a quarterly distribution paid into tZERO token holders’ digital wallets.

The benefits of token holding are: A. discounts when using the platform, B. quarterly distributions and C. additional functionality to be announced at a later date.

The one thing that I’m not clear on is whether the discount is referring to the token exchange, the share lending exchange or both?  I am assuming its referring to both, but that might be wrong.

The most important distinction is that this ICO does not convey ownership, at least not in any traditional liquidation/acquisition sort of sense.  While the strict definition of Simple Agreement for Future Token (SAFT) considers this offering a “security token”, and that is how Overstock refers to it in their press release, it is not a security in the way we usually think of it.  Byrnes himself has referred to the token as a “utility token” on other occasions.

When the ICO is complete Overstock expects tZero will get somewhere between $200 – $500 million of capital (based on comments made by Byrnes a couple of weeks ago).  This will be used to further develop their various platforms: their security lending platform, their token exchange, potentially other exchanges that have yet to be revealed.

What I think is pretty cool

The way the token is set up has some pretty interesting consequences.  Unlike a share offering or debt offering, the capital provider doesn’t just give his money and sit passively. The token holder has an active interest in seeing the platform succeed.

This is because one of the two key features of the token is a discount on usage.  This means the value of the token is best realized by a consumer of the platform.  Maybe a speculator can make some money buying a token and watching it appreciate but the token holder who is also lending stock or buying tokens on the exchanges (so using the platform) is going to be benefiting more from holding the token then the speculator.  Moreover, once a consumer of the platform is a token holder, they have an interest in making that platform succeed because the value of their token will increase based on its success.

In this scenario the consumer of the platform is the natural lender.  I think that’s the key point here.

The lynch pin to the whole process is having a platform that is valuable.  If you have that, then the token offering becomes a virtuous circle of on-boarding consumers and giving them a stake in its success, which in turn will help lead to its success.

In the case of tZero, if a pension fund decides they like the idea of the alternative security lending exchange, they can buy tokens.  This will give them a discount on transactions when using that exchange.  Furthermore, once they have tokens they can benefit from the dividend and benefit from the rise in value of their token.  So it becomes in their best interests to drive business to the exchange and get others involved.

The same reasoning can be used for the other tZero platform, with a consumer of the ICO trading platform.

As for the benefits to Overstock, I’ve already pointed out that tZero gets a capital injection they can use to facilitate the growth of the business.  If allocated properly, this presumably will lead to more value creation for the token. And I imagine, though I don’t know this for sure, haven’t seen it detailed, that Overstock will keep a significant percentage of the tokens so they participate in the increase in value of the token as the platform grows.  The less obvious benefit, but the one that I think is the most interesting and should be underestimated: in many ways Overstock acquires partners in the business with an interest in seeing it succeed but without giving away ownership.

What they are really giving up is a portion of future revenues determined by the discount on usage. But again, this benefit only accrues to consumers of the platform.  And Overstock/tZero needs those consumers to buy into the platform anyways for it to be successful.  Giving away a portion of that future value to prospective consumers in return for improving the chances that this future value is realized seems like a pretty reasonable trade-off to me.

The other way to think I was thinking about these benefits was to try to frame it as a very unique debt offering with unusual attributes.  First, the principle will never have to be repaid.  Instead of payment of principle you give payment of discount.  Second, the “interest” that is paid (I’m framing the dividend as being an interest of a sort) is a function of the platform success (in terms of lost revenue from the discounts and from dividends paid).  And third, you give some sort of stake in future developments yet to come.

I’ll be honest. I have thought about this in maybe half a dozen different ways in the last few days.  Its kinda like debt, kinda like equity, kinda like a membership, kinda like a co-operative, but not really exactly like any of those things.  None of the analogies fit perfectly.  This is different.  And It’s a pretty cool way to raise money.

One other thing…

The last thing I wanted to mention is that @teamonfuego found a great bit of due diligence.  A little over a week ago Byrnes made three announcements at the Money 20/20 conference.  One of these announcements was with respect to the digital locate receipt technology they are using in the tZero stock lending platform.

Brynes said that the platform is now live in an alpha stage and has about $8 billion of inventory.  If you remember from my last post, there was about $100 million of inventory as of the second quarter earnings call.

But even more impressive, Byrnes said that by November 1st the platform will go live with more than $120 billion of inventory.

He also said they were integrating with a couple platforms (so far unnamed), have about 8,000 users, active traders involved, and he reiterated that he thinks they can disrupt the prime broker desk which is 75% of revenue of prime brokerage industry.

When I wrote my original post on Overstock, my thought was I would add once we have confirmation of buy-in on the security lending platform.   I doubled and then tripled up on my position on hearing this news.

My bets on Blockchain

This is going to be a quick and dirty “here are my thoughts” post because I want to get the idea out there and solicit feedback.  I want to talk about what I have done with blockchain, where I think it might be going, and why I am (cautiously) optimistic that blockchain technology isn’t the bubble that many fear.

Back in May I decided that bitcoin just might be the real deal. I started to look for ways of investing in it.  It was a tough go.

I found that putting money into bitcoin in Canada was somewhat more difficult than the United States.  I cringed at the idea of providing a bunch of personal information to some exchange site, including drivers license and a credit card. I’m a dinosaur in some respects and I get nervous about transferring personal information over the internet.

I also found very few ways of playing the trend via the stock market.  There were basically zero publicly traded company’s that I could find.

I ended up taking only a small position in bitcoin and ethereum (really small).  But I also did another, much smarter thing.  I took a tiny position in Overstock.com.

The size of the position was inconsequential.  I’m not going to pretend I got in before the move or even that I understood what Overstock was doing.  I did it simply so I would have a placeholder in my portfolio and I would be aware of it if something happened.

In mid-September something happened and the stock started to go.

Now fortunately but unfortunately, I was really caught up in the Helios and Matheson story at the time, and so I didn’t pay a lot of attention to Overstock.  My mind doesn’t multitask all that well, and delving into blockchain while I was trying to decipher Moviepass just wasn’t within my capacities.  Its too bad, because if I had I am sure I would have seen what I see now and gotten in about $10-$15 earlier.

Nevertheless, I did get around to looking at both Overstock.com and at other crypto ideas over the last couple of weeks.

A few things have struck me.

Blockchain not Currencies

First, I feel like the real play here is with blockchain, not bitcoin. Getting into crypto-currencies has been a money maker, no question.  But going forward I am of the mind that the winners are going to be companies that have figured out ways to use blockchain technology to eliminate inefficiencies, in particular those associated with the middle man of particular transaction classes.

The most common description I hear of blockchain is that it is a decentralized platform.  That has never really resonated with me.  Maybe the word decentralized is too vague.  After doing much reading and listening on the subject, I have found that the definition that makes more sense to me is to say that blockchain is simply a very effective way of eliminating the middle man.

I know if I was to use that definition publicly I would get a lot of push back: its too narrow, it doesn’t describe all the functionality or possibilities that blockchain can encompass, etc.  But to me, looking for near-term disrupting investment ideas, that is the definition that sticks.

Our world is full of transactions that individuals and companies perform with each other every day.  Each transaction requires a level of trust between the buyer and seller.  In many cases the level of trust required to complete a transaction directly between buyer and seller is not possible.  Maybe its distance, logistics, complexity, could be any number of things.   Whenever we run into this “trust gap” the solution has always been to employ an intermediary that embodies a greater level of trust and through which the transaction can flow.

Of course this middle man takes a cut.  In some cases, especially if its an opaque market, they take a big cut.

The way I look at blockchain is it’s a way of dis-embodying that trust into technology.  The middle man disappears.  The skim shrinks.  Everyone (other then the middle man) benefits.

This makes so much sense to me.  It seems inevitable. It makes me want to go all in.

Overstock

Overstock is the obvious way to play this.  I finally got into Overstock in a more meaningful way in the mid-$30s.  I have added since then.  The stock is parabolic which is frightening and I can just as easily see it going to $35 as $55 in the short run.  I mean who knows when a chart looks like this and is clearly being run around by traders.

In the longer run, I think that what Overstock is doing is fascinating and if it works, the stock will go much higher.

The thing that really jump-started Overstock was their initiative, via their subsidiary tZero, to launch a trading systems for tokens.  That seems to have coincided with when the stock took off.  They also announced their own initial coin offering (ICO) for tZero, which will take place over the next couple of months.

I think these are both great initiatives and are movements in the right direction.   But the most interesting development to me is the blockchain securities lending platform that Overstock’s tZero subsidiary has developed.  Byrnes does a really good job of describing how the platform works on the second quarter conference call.  Start listening at a little after the 20 minute mark.

In this case, the middle man that Overstock is trying to eliminate is the prime broker.  The cut that the prime broker appears to be taking in security lending seems to be abnormally large.  If you want the details of how it works, just listen to the call and do a few google searches.  Its clear that A. this is a very large market and B. there is a lot of waste to be eliminated if the middle man can be removed.

What I also find so interesting about the opportunity, other than that it makes sense, is that even by taking a much smaller piece of the pie than prime brokers currently do Overstock/tZero can make a lot of money because the transaction base is so large.  IHS Markit says that security lending is a $9 billion market.  If this platform can begin by taking even a smidgeon of that, its going to be very significant to the stock.  If the platform goes viral, well then things would get silly.

On the second quarter call Byrnes noted the following about the platform (my underline):

I’ll mention we have about 700 symbols in inventory now. 100 of them are hard to borrow, we have over $100 million in inventory. Another reason I’m in New York is talking to people who have billions or tens of billions of dollars that they want to integrate, they want to provide as inventory. So, we’ll see how this goes, but I’m really quite proud of this system.

So its just starting to scale.  I think it was only 5 weeks old at the time.

I admit I am fuzzy about the economics.  Clearly the play here is to make this advantageous to funds and short sellers by lowering transaction fees and taking a smaller skim than what prime brokers take, and by performing the task with complete transparency.  Byrnes goes on in the call to define the following economics of the platform net to tZero:

This is the best use of blockchain I’ve ever seen, because it addresses exactly the issues that regulators have, that short sellers have, that prime brokers have. I don’t want to be sued if this turns out to be wrong, I think the capacity is 1% of x, if we theoretically got somebody putting in $1 billion, I think we should be generating $10 million through, essentially the bottom line of tZERO, and I think there may be possibilities well beyond that.

None of this is to say that it’s a sure thing that the security lending platform, the ICO platform or any of the other initiatives that Medici (the Overstock subsidiary that owns tZero) has a stake in, are going to pan out.  But I am of the mind that some of them will.

One last thing about Overstock that I think is worth mentioning.  The ICO seems like a really interesting way to raise money to me.  According to the press release that I linked to above, the ICO will give participants a tZero token that has the following attributes:

  • The tZERO token will be tradable on tZERO’s U.S.-regulated ATS.
  • The tZERO token will incorporate profit-sharing features of a security as well as utility features of an app token, including:
    • Token holders will be able to use the tZERO token to pay for fees on the ATS and payment of such fees using tZERO tokens will grant up to a 25% discount as compared to payments made using U.S. dollars. The tZERO token is expected to have additional functionality and token holder benefits to be announced at a later to date and will be included in the offering memorandum; and
    • tZERO believes its token will be the first to offer a percentage of tZERO’s profits, distributed as a quarterly distribution paid into tZERO token holders’ digital wallets.

My take on this (tell me if you think I am wrong) is that the value intrinsic to the token is not based on ownership.  The beauty of it is that its not really an ownership stake.  In fact I am pretty sure you can’t do a US based ICO right now that generates out right ownership in a company (the SEC hasn’t laid down any structure for this yet but again tell me if I am wrong about this).

Instead the token is more like the right to participate in the success of the platform.  I almost want to say that its like an Amazon Prime membership for blockchain technologies but maybe that’s too cheeky and a bit of a stretch.   Nevertheless, the value of the token is a function of the success of the platforms created by tZero, realized via the discounts and dividends that are derived from their success.  So the benefits are most easily realized by participants in the platforms, in this case those who participate in the ICO exchange and the securities lending exchange (maybe others?).

To use a word I hate to use, it all seems very synergistic.

Think about it.  These tokens, while not offering ownership in tZero, are going to give holders a significant discount on transactions on the platforms and are going to give a dividend based on the success of the platforms.  So the bigger the tZero platforms get, the more valuable the tokens are.  And if you are a fund that is thinking about how it would be nice to lend securities without having to have a prime broker take a big chunk of the interest, it probably makes sense to take on some token exposure so you can make your transactions even more cheaply and even get a dividend kick-back that is a function of your own volume to some degree.

Its easy to see how if this works, it could snowball.

Other ideas

Overstock is my favorite blockchain idea hands down and the only one I have a truly meaningful position in.  But I also took small positions in a few others.

I own two Canadian venture stocks, LeoNovus and Posera, which both made JV’s with the company DLT labs.  I will be the first to admit that the details on what comes of the JV’s are murky but I did some work into DLT Labs and they seemed like a legitimate blockchain development company so I figured each was worth a small stab.  LeoNovus also has a proof of concept agreement with a Canadian bank and was interviewed on Capital Ideas TV here.  Both of these stocks are actually up quite significantly today, and I’ll admit that I have questioned whether their growing market capitalizations are justified on multiple occasions today.

I also took small positions in a couple of Chinese related ideas, Xunlei Limited and Xinyuan Real Estate.

Xinjuan has somewhat of a peripheral blockchain idea.  My original impetus to buy the stock was that it appeared cheap compare to other Chinese real estate developers and we seem to be in a bit of a China bull market at the moment.  But its also had a blockchain platform for property financing live for over a year now and that gave me some added reason to take a small spec.  I came across the stock from this youtube video.

Xunlei has a blockchain based product called OneCloud and has recently had an ICO, which is not easy to do for a Chinese company.  The company also has over $5 in cash and investments per ADS, so it appears relatively cheap and thus I figured it was worth a tiny punt.

Again none of these four stocks are significant in size for me. Way less than 1%.  Overstock is the only one I have any real conviction in so far.

Conclusions

I am not going to pretend I have some amazing insights that project the success of any of these companies.  I’ll be clear about this, and I include Overstock in the statement.  This is to a large degree a speculation.  The technology makes sense to me, and in the case of Overstock the applications they have identified make sense to me, but I don’t really know if it pans out in the end.

It is a bit like Helios and Matheson in the sense that while I don’t know how it all plays out, my thinking is this:  I suspect that for foreseeable future the money wanting into blockchain technology assets is going to far exceed the number of available avenues to invest in.  This happens all the time and when it does it floats a bunch of little companies along with it.  A few of these companies turn out to be winners.  Many turn out to be flops.  But getting from here to there can make you a lot of money if you are agile.  So for the time being, picking the eventual winners kind of takes a back seat.  That’s why I was willing to take some bets on the smaller basket outside of Overstock.

And like I said, I don’t even know if Overstock will be a winner here.  Maybe no one will adopt their initiatives and tZero will crash and burn.  I’m certainly no expert in the field.  What I do know is that while Byrnes seems to be more than mildly hated by many, which I think is great, when I listen to what he has to say (for example as the 2014 key note at this Bitcoin conference) I think he makes a lot of sense.  He clearly has thought this through and made his bet after much consideration for underlying conditions.  I am of the mind that the underlying conditions he describes are accurate, and that the direction he projects is correct.

So I’m going along for the ride.  And I will tell you what I want to do.  I want to take a really big position in Overstock.  I think the upside is so big if these ideas pan out.

But its really hard to jump heavily into a stock up as much as Overstock is. My position size right now is a relatively modest, but not insignificant, 3.5%.

I am in part writing this post as a request for comment.  Please send me emails with opinions of whether you think this makes as much sense to you as it does to me.  Or not.  And whether you think Overstocks initiatives or any of the other company’s I’ve taken a spec position in, will pan out or not.

Its so new and uncertain, but also seems to make sense.  So I am open minded.

Waiting on my position in Bearing Lithium

I took a position in Bearing Lithium a little over a month ago.  It was one of a number of positions I took when I realized the significance and inevitability of the electric vehicle.  But since then it hasn’t done much. It has probably been the worst performer of the bunch.

When I compare the performance of Bearing to other lithium stocks that have risen significantly I am disappointed.  Nevertheless the stock is cheap and I think over time the valuation discount will be closed.  So I plan to wait on it a while longer.  Here is the story.

Maricunga Deposit

Bearing owns a 17.7% interest in a lithium brine deposit in Chile called Maricunga.  Maricunga is one of the highest grade deposits in the world with a measured and indicated (M&I) resource of 1,143mg/L. The Ni 43-101 report outlines a deposit contains 1,720,000 tonnes of lithium carbonate equivalent (LCE) M&I resource.

The deposit is co-owned by Lithium Power, Bearing Lithium and a Chilean JV Partner.  Lithium Power has an earn-in to 50% ownership by advancing the project to feasibility.  Because of the earn-in Bearing has their costs covered until roughly mid-2018 when a feasibility study is produced.

Here is the Australian firm Independent Investment Research, who covers Lithium Power, giving their thoughts on Maricunga (note that this was before the recent resource estimate that more than doubled the size of Maricunga):

Bearing Lithium acquired its stake in the project via a merger with a US OTC company called Li3.  Li3 had a 49% stake in the project until July 2016 when they entered into the agreement with Lithium Power and the Chilean JV Partner to create a JV to hold the assets.

As part of the JV agreement Li3 had their stake reduced (to the current 17%). In return Lithium Power agreed to contribute $27.5 million in cash to the Maricunga JV to cover exploration and development until feasibility.

Being an OTC junior strapped for cash, Li3 took the deal.

Still being short of cash and stuck in relative obscurity as a penny stock on the OTC, Li3 agreed to be merged with Bearing in January of this year.  The merger wasn’t met with universal glee by all shareholders.  As a number of posts on the investorhub board suggest, some shareholders questioned why they were diluting their stake in Maricunga.

It’s a good question.  I am guessing that it came down to a lack of options for raising capital, and the hope that a listing on the TSX Venture would lead to promotion and a re-rating of the deposit.

Unfortunately that hasn’t happened so far.

Peer Comparison

I would argue that Bearing Lithium is undervalued.  Below is a comparison with a number of other lithium explorers, some with a defined deposit and some without.  Even companies with no firm resource hold much higher valuations than Bearing.

Why the discount to peers?  There are reasons, but I don’t think any of them justifies the discount.

First, the majority of the lithium resource exists in the Litio 1-6 concessions (I provide a map that outlines the concessions below).  These concessions do not have a mining permit yet and are not grandfathered like Cocina 19-27 concessions. In their current state they can be explored, but not mined.  There may be some concern about getting a permit.

Mitigating this concern are comments from the mining minister in Chile, who came out and was in favor of maricunga (according to this interview):

If I was to choose anywhere in Latin America, one, two and three, it would be Chile, Chile, Chile. But saying this, moving forward, Aurora Williams, who is the mining minister of Chile, announced at PDAC only last week that Chile’s main goal is to find foreign capital to develop the Maricunga.

While permitting, at least with the current government, will require negotiations, when it comes time to go to the table I don’t expect that Bearing Lithium and Lithium Power will be the one’s to take the deposit to production.  I think Maricunga gets picked up by a bigger player.  The map below shows how the concessions are surrounded by neighbouring concessions owned by Codelco and SQM.

Consolidation into a single large operation makes sense.  When that occurs, I suspect that the larger company will be able to negotiate permits for the entire district.

The second reason for the discount might be that Maricunga is in Chile.  Chile has a far more left leaning government than Argentina.  The government has feuded with SQM over the company’s leases in Chile.  They have been renegotiating terms of Albemarle’s royalties where they have asked for a 60% royalty if lithium prices rise over $12,000/t USD.

There is an election in Chile in November so a change of government is possible.  Early polls suggest a change in government might occur.

The third reason is ownership structure.  The ownership was a problem before the merger because Li3 was listed on the OTC, was a penny stock (like literally a 1c stock!) and thus it received zero exposure.  It’s a bit better now that Bearing holds that stake, but I wonder how many investors are dissuaded by the relatively small minority interest Bearing has.

It doesn’t help that Lithium Power trades on the ASX.  I don’t think there are many lithium-brine plays on the Australian exchange.  Australia is all about hard rock lithium mining.  I don’t know of another that is primarily a brine-only play (please tell me if I’m wrong?).  Lithium Power is a bit of a fish out of water.

As well, Lithium Power has a huge warrant overhang of 72 million shares at 55c.  Because Bearing Lithium and Lithium Power trade to a similar valuation, the ceiling on Lithium Power impacts Bearing as well.

The fourth reason is promotion.  Whether or not you think all these tiny little lithium explorers are going to turn out golden in the end, you have to admit that their stock movements lately have had more to do with speculation than anything fundamental to the individual names.  So far there isn’t a lot of promotion around Bearing and the Maricunga deposit.  For example, if you go through the Seeking Alpha articles on lithium you will find all kinds of tiny juniors referenced, some with only some hectres of land and no resource, but there has been nothing written about any of the Maricunga players.

So there are some reasons.  None of them are particularly compelling to me.  None make me want to sell my position.

Conclusion

Its been a disappointing investment so far.  I’ve watched a couple of other tiny positions I have in lithium juniors (International Lithium and Nemaska Lithium) give me more profits than my larger position in Bearing (I’m down on my position in Bearing so far).

Nevertheless I am going to stay the course.  The Maricunga deposit is world class, its higher grade than almost all its peers, its relatively advanced and has not shown any features that would handicap it.  I think eventually the superiority of the deposit will win out and I’ll hold on for that to happen

CUI Global – what to do now?

CUI Global is a total gong-show.

When I bought stock a couple months ago I thought I was buying a lottery ticket on news that the Snam Rete tariff issue would be resolved and there would be a nice pop in the share price.

I was wrong.

I wouldn’t have thought it possible but the company managed to announce the news I had been waiting for and implode the share price in the process.

For the love of…

They pulled off this feat by announcing an a extremely large share offering at the same time. The company is offering $15 million worth of stock.  There is no pricing on the stock, but if they wait a few more days maybe it will be a 99c special <rolls eyes and shakes head>.

In all seriousness, I’m underwater, the news I was waiting for is out, and the stock didn’t do what I thought it would do.  So what do I do now?

I have to admit my temptation was to sell.  Especially given that this event does not shine a positive light on management.  I don’t know if the selling is related to the offering (Craig Hallum often seems to be associated with these sort of crazy stock moves coinciding with a placement that they facilitate) or if its just a pissed off institutional holder that wants out, but at the end of the day its on management for making a decision that led to a full collapse in the price of the stock (it was a $4 stock like 5 days ago!).

Anyways I decided to stick it out.  I also added to my position yesterday and today.  Here’s why.

GasPT Opportunities

First the opportunity presented by GasPT is legitimate.  And the opportunities on the radar are extensive.  The following table outlines what CUI Global has talked about on conference calls and during presentations at investment conferences that I have listened to:

Potential Near-term Revenue from these Opportunities

Of these opportunities, the one’s that are most likely to be near term, or accretive to 2018 or 2019 numbers, are:

  1. Snam Rete analyzer current order
  2. Engie biomethane skids (analyzer and RTU)
  3. Snam Rete first stage of odorizer order

The quarterly revenue from these 3 products are in the table below.  I made assumptions about monthly units based on managements (admittedly vague) comments about delivery time frames on conference calls for each project.

Of these projects, we now know that the Snam Rete analyzers will start being delivered in “early 2018”.   My quote is from news that was supposed to move the stock up but didn’t.

Energy and GasPT Gross Margins

I needed to get a better handle on GasPT gross margins.  Energy gross margins have fluctuated over time depending on how much engineering work CUI is doing and how much product (ie. analyzers) they are selling. Product revenues have higher margins so more GasPT sales are going to raise energy margins as a whole.

There have been enough quarters where energy revenue has been all engineering work to know that this work has margins of about 35%.  Based on known Snam Rete shipments over the first 3 quarters of 2016 I backed out what gross margins are (at least roughly) for GasPT analyzers.  It turns out to be 59%. I came up with  this by comparing the quarters where CUI Global saw Snam Rete revenue and the quarters where they didn’t in the table below:

Earnings

Once I had an idea of GasPT margins and volumes, coming up with how this plays out into earnings is pretty straight forward.  I made the following assumptions:

  1. CUI has over $100 million of NOLs so they won’t be paying taxes for a long time
  2. G&A is expected to decline $1.5 million annualized after a small restructuring in the first half of 2017
  3. The power business is doing well. I’m projecting 5% growth for the Power segment over the next year compared to TTM numbers
  4. I assume the Energy (ex GasPT) and Power segments to operate at 35% margins, which should be conservative against historical comps. The company guided to 40% Power margins in the second quarter.

I looked at two scenarios.  The one that I illustrate in the table below assumes GasPT revenue is only from the Snam Rete analyzer order.  This is 300 units per quarter or 1,200 units per year.

The numbers are annualized.  I’m doing my per share calculation before the offering, so I am using the 20.9 million shares outstanding right now.  And the trailing twelve months (TTM) are ending with the second quarter.

Conclusion

In my opinion, my biggest risk is that I don’t understand why the company is issuing stock.  It doesn’t make sense.  Its possible that when the reason comes out I will get to do another face plant.

At the very least we know there is going to be dilution.  Its going to be significant (maybe 30% if the placement is done around the current price?).  However there is also going to be a lot of cash on the balance sheet and the company will be debt free.

Its hard for me to ignore the earnings potential.   The numbers I ran through in the scenario above only assume the Snam Rete order. When I looked at a second scenario that assumes all 4 of the potential near term opportunities come to fruition, I get earnings of $1 per share pre-dilution.

There is also the future billing project from the UK to consider.  The company announced last week that the project was progressing into a second stage.  While revenue is still a couple years off the number of potential GasPT units for this project (45,000) are staggering.  I didn’t bother to work out a scenario for this one because the number would just sound stupid.

So there you go. I doubled down my bet.  Sometimes that works and sometimes it blows up in my face.  I put the work in to justify my decision, at least to my own satisfaction.  We will see where the chips fall.

 

My REE Bet: Lynas Corp

When I was looking for ways to play the price rise in rare earth elements (in particular neodymium and praseodymium, or NdPr) I almost skipped by Lynas Corp.  It traded on the Australian market (where I cannot buy stock) and the OTC market in the United States (where I don’t like to buy stock).  It was a penny stock.  And when I dug into the story I found there were over 4 billion shares outstanding!

It didn’t strike me as an ideal vehicle.

But after scouring through the REE universe, I came back for another look.  I had to.  The thing is, the company is pretty much the only miner of rare earths outside of China.  I found some companies with deposits, and some with technologies for better extraction, but there aren’t really any other options if you want a company that is going to see direct upside from the price rise of NdPr in the near term.

Background

I mentioned in my last post that mining rare earths is difficult.  The history of Lynas is an example of that.  The company started mining at its Mt. Weld mine in 2013.  It was immediately plagued with operational problems.  This wasn’t helped by collapsing prices for rare earths.  The stock, which peaked at over $2 during the rare earth boom of 2011, collapsed into its current penny stock status:

As I read about the company’s history the theme that came across was that they were an operating disaster until the current CEO, Amanda Lacaze, came on board and began to turn things around.  Since that time she has slashed production costs and restructured a crippling debt burden.

“When I joined, production was unstable. We had high costs and were very cash consumptive. We had to reset our cost base and improve our operating performance while dealing with a market that was significantly less profitable than before.”

The company started to see better results in 2016.   Then, in October 2016, they restructured their debt and reduced interest significantly.

Unfortunately, along with the restructuring came dilution. The strike price on the existing convertible debt of $225 million USD was reduced to 10c AUD.  This meant that full conversion of the debentures would result in 2.67 billion shares being created.

But that’s what you get when you are trying to survive.  The important thing is that they did survive.  Now are the company best positioned to thrive as the REE market recovers.

Capitalization

Fully diluted Lynas has 7.1 billion shares.  Once the convertible debt is gone (it undoubtedly will be converted into the stock) $200 million in long term debt will remain.  The fully diluted market capitalization when I bought the stock (at 16c) was about 1.1 billion USD.  They have $67 million ASD of cash.

Operations

The company has a single operating mine, Mt Weld. The mine produces material via the Central Lanthanide deposit.  Reserves at Central Lanthanide are 9.7Mt of rock at a 10.8% rare earth oxide (REO) grade (from this report).  Below is a table of reserves at Central Lanthanide:

In addition to reserves there is another 15Mt of resource at Central Lanthanide at 8.8%.  A second, underground deposit called Duncan has 8.2Mt at 4.7% REO grade.

The deposits host a fairly typical distribution of REOs:

Ore is mined from the Central Lanthanide deposit and taken through a flotation circuit on-site to get a rare earth oxide concentrate.

The concentrate is shipped to Malaysia for processing.  The company has an advanced materials plant in Kuantan, Malaysia where the concentrate goes through chemical processes like cracking and leaching and solvent extraction to separate the individual REEs from solution and create an end product oxide.

The plant in Malaysia has been controversial. Some locals in Kuantan don’t want an REE processing plant in their back yard.  At the time it was built, maybe in part because of the REE mania that was in full force, it became a media story.  The protests held up development.  As this report points out:

The campaign managed to attract a lot of international media attention and stopped bigger contracts being pursued by major buyer. Lynas share values plummeted due to negative publicity and financial risks and because prices of rare earth elements dropped.

I can’t be sure of course, but it seems like some of the conflict has died down.  I can only judge that the media stories I have read (which admittedly are in English and so may not be representing the entire picture) are more balanced and less common in the last few years.  However I did see a comment that the upcoming Malaysian election this year could refuel some of the protest

Production

As Lynas has gotten the levers of production under control, volumes have improved.  At the same time direct mining costs have dropped by about one-third since 2015.

The Mt Weld mine produces 2kg of other REEs for every 1kg of Nd.  In Fiscal 2017 the mine produced 5,200t of NdPr.

While NdPr accounts for one-third of the production from Mt. Weld, it is the source of most of the revenue.  Sales in 2017 were $257 million AUD.  Sales of NdPr were around $225 million.

What’s the Upside?

The upside here is leverage to NdPr price increases.  Below are NdPr quarterly prices from the Lynas full year report ending June 30th.

There was a slow but steady uptrend in prices.  Since June, however, prices have jumped significantly.  I talked about reasons for the jump in prices in my last post.

FOB prices excluding VAT reached $65 USD/kg over the summer.

What’s really fun about mining companies is that their costs are essentially fixed with volume.  So when a company sees a step change in price, the incremental revenue goes straight to the bottom line (less any taxes of course).

Every $10/kg change in price with 5,200 tpy production is about $50 million USD of extra operating cash (before tax) beyond what they currently generate.  Lynas is hinting that they can get to 6,000 tpy of production, which would add another $8 million USD per $10/kg on top of that.

Here was an estimate I found from one analyst that gives a picture of sensitivity of net asset value to changing NdPr prices.

A second analyst, Newgate Capital, forecasts $230 million of free cash flow using  $70/kg for NdPr prices.

Worth noting is that in the Newgate estimate assumes a 30% tax rate.  In note 12.2 of the year end financial statement the company notes the very large unrecognized deferred tax assets that are carried ($785 million ASD, from years of losses).  I am not positive how efficiently these can be utilized, but they should represent significant tax credits.  So I think (and I might be wrong) that most of the operating cash flow will go straight to the bottom line for at least a few years.

Buying the stock on the OTC

There are two symbols for the stock, LYSDY and LYSCF.  The former is an ADR and the latter is an OTC traded share.  I don’t think there is any real difference between the two; they are both 1:1 Lynas share equivalents.  But the ADR is typically more expensive.  I think this is because it’s more liquid.  I haven’t had much luck buying the OTC traded share, even when I put in a bid above current it often gets ignored.  Maybe its my brokerage?  While I have a few shares of LYSCF, I have mostly paid up for the ADR.

Conclusion

There are risks here.  One risk is that Lynas Malaysian plant has not been without controversy.  There is always the chance that Lynas becomes a political football in Malaysia, especially given any upcoming election.

A second risk is that REE mining and extraction is hard.  It’s the bull case and the bear case.  Just as I think its going to be difficult to see much of a supply response, there is always the potential that Mt Weld has a hiccup.

There is also the potential for technological advances that limit the use of permanent magnets in the growing electric vehicle or wind turbine applications.

A fourth risk, maybe the biggest, is that the whole story depends on China.  There’s no question that China can derail the REE rally if they decide to loosen the reins on illegal mining or flood the market with stockpiles.

But as I pointed out in my previous post, there are reasons to believe that won’t happen.  I’m coming around to the idea that the price of NdPr has, over the last few months, not so much as spiked as it has started to re-establish a supply/demand equilibrium that will encourage investment that is not illegal and not environmentally toxic.  If that’s the case, then its sustainable, and there is a lot of upside in Lynas in my opinion.

Keep in mind that even with the jump in prices, NdPr is still below what it was at a few years ago and not even close to the bubble levels it reached in 2011.

I don’t want those bubble levels to return.  That wouldn’t be in the best interests of anyone, as demand would be destroyed.  But I would be fine with a consistent rise on the back of rising magnet demand.

As well, given that Lynas is the only producer outside of China, and given that in the past various governments have raised the issue of REE dependency.  There was this 60 minutes segment from 2015 (as an aside, sort of, I would highly recommend tuning into this documentary, in particular to check out the horrible scenes of the landscape around Chinese REE mines and description of the “relocation of entire villages” around the 6 minute mark.  It gives me resolve in my thesis that China will be firm about ending this sort of mining).

More recently the DOD looked for ways to manage the “national security risk” posed by the REE supply chain.  The collapse in price has mostly alleviated these concerns.  But with prices rising again, it would see to me that a company like Lynas, with operations outside of China, should command some sort of a “rareness” premium (pun intended).

Look, I could be wrong about this.  Lots of things could go sideways.  I’ve tried to outline a few.  But if they go right I think the stock has significant upside.  So I’m willing to make a bet.

REEs: Another way to play the EV Ramp

There are a lot of ways to play the boom in electric vehicles.  There is lithium.  There is graphite.  There is cobalt.  And there is nickel.

I have invested in a number of companies levered to these EV minerals.

  • Bearing Lithium, Albemarle and Orocobre for lithium
  • Sherritt for nickel and cobalt
  • Leading Edge Minerals which has a graphite operation they are trying to get qualified for battery grade graphite
  • A bit of a takeoff on the battery idea with a Vanadium producer called Largo Resources
  • A zinc play, Acendent Resources, where the electric vehicle ramp could have an impact but its not core to the investment thesis

In addition, there is one other play I have on the electric vehicle theme: Rare earth elements.  I have taken a position in a company that produces them, Lynas Corp.

I’m breaking my discussion up into a couple blog posts.  In this post I’m not going to talk too much about Lynas Corp.  I’m going to focus on the rare earth market. I will talk about Lynas later.

But Lynas is core to the thesis.  In fact the EV story for rare earths is probably not as strong as the story for lithium or cobalt. But Lynas is in a unique position and trades reasonably, and that makes up for it.  So I’ll mention a few points about Lynas before I start talking about the rare earth market:

  1. With a single mine in Australia (Mt. Weld) Lynas is the only rare earth producer outside of China right now – seriously…the only one
  2. Lynas looks incredibly expensive on backward looking metrics that use average prices over the past few years
  3. Lynas will generate a lot of free cash if the price of Neodymium oxide and Praseodymium oxide stay at the level they are at right now.  If prices rise further the numbers get very large

With that brief introduction to Lynas, lets talk about the rare earth market.

Rare Earth Elements

I’m not going to spend a bunch of time talking about what rare earths are, how they are classified and all that stuff.  You can look it up on Wikipedia if you are interested.

What is important to know is this:

There are a few rare earth elements that can be used to make magnets.  In particular neodymium, when combined with iron and boron, can be used to make a Neodymium-Iron-Boron (NdFeB) permanent magnet.  In addition praseodymium (Pr) and to a lessor extent dysprosium are used in permanent magnets. Praseodymium can be substituted for neodymium up to about 25% of content in the NdFeB magnet.  This is done if the neodymium price gets too far ahead of the praseodymium price.  It also improves corrosion resistance.  Combined neodymium and praseodymium supply is often described as NdPr, given their linked nature.

While there are other metals you can put together to create a permanent magnet, the NdFeB magnet is superior because A. it is stronger and B. it is primarily made from iron, which makes it relatively cheap.

Rare Earths and EVs

REEs are not the highest intensity way of playing the EV growth story.  The demand numbers aren’t going to “wow” you like they do for lithium or cobalt.  The introduction of electric vehicles is an important part of the rare earth bull case, but its not the only element of it.

The chart on the right from UBS demonstrates the impact of a full EV world on rare earth demand:

While the rare earth content doesn’t show up on the chart on the left, that is because rare earths are used in relatively small amounts in all applications.  A Chevy Bolt will have about 1kg of Neodymium in its engine due to the use of a permanent magnet in the electric traction motor.

The NdFeB magnet is used in the electric traction motor of almost electric vehicles.  In 2016 89% of EV’s and hybrids sold used a permanent magnet motor.  The motors are “unbeatable in delivering torque and overall power by weight, and suffer less electric and mechanical losses, and have a simpler rotor/stator configuration” (from this report).

In fact, every EV manufacturer is using a permanent magnet in the engine other than Tesla.  Tesla has been using an AC induction motor.  However, recently Tesla announced they would be switching to a permanent magnet on their Tesla 3 long range model and I have read anecdotes that the change could be made globally to all Model 3’s.

In addition to the larger electric traction motor, there are about 20 other motors in an EV that use an NdFeB permanent magnet.  In total an EV will use about 1.5kg-2kg of NdPr, with about 1kg of that being in the engine.  This is an incremental of 1kg-1.5kg over an internal combustion engine (internal combustion engines still uses about 0.5kg of NdPr throughout the vehicle for various smaller motors).

Wind Turbine Demand

Electric Vehicles are one piece of the demand story.  The other piece is wind turbines.

Global installed wind capacity has been growing significantly over the past decade.

Given that wind is now cheaper than gas turbines in many locations wind installation is forecast to continue to grow, at 11.5% CAGR, over the next 30 years.   The following is a near term capacity growth estimate from the Global Wind Energy Council:

Hybrid drive (HD) and direct drive (DD) wind turbines use permanent magnets to convert the wind energy into electrical power.  They are an improvement over traditional gear box systems because they are lighter, quieter, more efficient and require less maintenance.

A hybrid drive requires about 70 kg of Neodymium.  A direct drive requires about 210 kg.  I get these estimates from this report, which provides an extremely good dive into the entire sector.

Adding up demand

To come up with a rough idea of where NdPr demand is going, I used the consensus uptake of electric vehicles, growth in wind turbine capacity and an underlying growth in demand from other applications of NdPr of 2.5%.  With these assumptions I see demand going from about 37,500 tonnes in 2016 to 54,000 tonnes in 2021.

Global consumption of NdPr is 2015 was 37,300 tonnes.  2016 was likely in the area of 39,000 tonnes.  But note that the number seems to vary depending on the source.  I saw one set of numbers for 2016 that were a little above 40,000 tonnes and another that was below 30,000 tonnes (thought I suspect this one was really referring to Neodymium demand only, even though the referenced it as NdPr).  Its an opaque market.

UBS recently estimated that they expect 3.1 million EVs by 2021 and 14.3 million EV’s by 2025.  Assuming 75% of those cars use permanent magnet motors that translates into about 3,000 tonnes of NdPr.  14.2 million EV’s, the estimate for 2025, would translate to 12,500 tonnes of NdPr (assuming the mass/unit declines from an incremental 1kg down to 0.88kg by the time this happens).

At 35% market share for HD/DD turbines of cumulative capacity growth, rising to 50% by 2020, an additional 2,344 rising to 5,591 tonnes of NdPr will be required to support incremental turbine demand.  If HD/DD market share rises further (some expect these turbines to eventually reach 75% market share) that number will grow.  At a 75% market share in 2020, over 8,500 tonnes of NdPr would be required.

While a move from 37,000 tonnes to 54,000 tonnes is significant, the demand growth pales in comparison to some of the other EV materials.  Lithium demand, for example, is expected to go from 189 Kt LCE (lithium carbonate equivalent) in 2016 to 329 Kt LCE in 2021.  Almost twice as much growth.

What differentiates the rare earth bull case from the lithium bull is that its not all that certain where additional supply is going to come from.

Looking at Supply

What I like about the REE story is that its more two sided then lithium and cobalt.  Lithium and cobalt are seeing a supply response that is most definitely occurring.  You can argue whether that supply response is going to be sufficient (I am of the mind it won’t as I think the demand numbers will end up too low and the supply will be delayed) but there is no question lithium and cobalt supplies are going to increase substantially in the coming years.

With REEs, that is not so clear.  First, there is a complete lack of mine development outside of China.  There is Lynas, which operates the Mt. Weld mine in Australia.  And there is one small development in Burundi, run by a company called Rainbow Rare Earths, that is trying to get into production by the end of this year.  But I think that’s it.

Rare earth mining is very difficult.  Processing the rare earths and separating the constituent elements can take many cycles and can be toxic to the environment if not done carefully.  Lynas took almost 5 years of fits and starts before they have finally been able to produce at a consistent level and with decent costs.

Second, rare earth have, for some time, relied on a single source of supply, China.  China supplies about 95% of rare earths. There are 6 state owned enterprises (SOEs) that legally produce REEs in the country.  These companies are given a quota by the country that they can produce 105,000 tonnes of REEs (note that this includes all rare earths, not just NdPr).

But China has been producing far above that amount for years.  They produced around 150,000 tonnes in 2016.  The difference between the official tonnage and actual production is due to illegal miners.

Illegal mining of rare earths is profitable because it is polluting and harmful to the environment.  As part of the governments efforts to stem pollution, China is cracking down on illegal mines.  The following is from this Adamis Intel note:

Adamis concludes that tightening the reins on illegal mining has lead to stockpile draw downs in 2017.   Its also led to a huge jump in the price of both Neodymium and Praseodymium (from slide 8).

With the moves taken by China, particularly given that they are part of a larger effort to reign in pollution, there seems to be more chance that REE supply from China falls then rises in the medium term.

Interestingly, Chinese companies have been buying up or taking stakes in a number of rare earth deposits outside of the country.  Here is a list of projects that have recently become affiliated with or owned by Chinese interests:

  • Shenghe Resources takes a 12.5% stake in ASX listed Greenland Minerals and Energy which owns the Kvanefjeld rare-earth-uranium project
  • Shenghe Resources and JHL Capital place winning bid for Mt. Pass rare earth mine in the United States (was the last mine to operate in the US and used to be part of Molycorp)
  • Huatai Mining invests Northern Minerals and its Browns Range dysprosium project
  • Northern Minerals sales agreement with Guangdong Raising Asset Management
  • Mkango Resources on the TSX has done two financings with Noble Resources

Its possible these are just opportunistic Chinese speculations.  But it could also be an understanding within China that soon their rare earth dominance must be tapered.  Adamis Intelligence was quoted as saying that they expected China to be a net importer of NdPr by 2025, and that demand from magets within China will significantly exceed their internal supply by that time.

Conclusion

I missed out on the first spike in REEs.  To be honest I never really bought into the thesis.  That didn’t turn out to be wrong.  The boom in rare earths in 2011-2012 was driven entirely by Chinese trade dispute with Japan, which led them to pull back on exports, which led to price spikes in a number of the minerals. When that ended so did the spike.

It wasn’t really based on demand in any significant way.

Now, however, is different.  There is both a demand story and a supply story.  Both are coming to a head at the same time.  Both have legs in my opinion.

But this is not without its risks.  The biggest risk is China.  We can’t be sure what the government is thinking and how they will direct the SOE’s to act.  We can’t be sure they will continue the hard line against illegal mining.

Maybe most importantly, we can’t be sure what impact price rises will have.  Will they cause China to back-off? China has strategic stockpiles.  These are being worked down but so far its been orderly.  Also, further price rises will, at some point, encourage substitution.  NdFeB is not the only permanent magnet and eventually if it gets too expensive, alternatives will be considered.

I’m of the mind that the spike we saw in NdPr over the summer was off of an unsustainable low.  Prices needed to rise to encourage some investment in new mines outside of China.  But I’m not sure a further spike would be constructive.  The best case scenario would be a slow rise over time. As I will talk about in a later post, that would be more than enough for Lynas.

I’ll end with this comment from an article quoting Adamis Intelligence:

The outlook for rare earth demand from 2020 through 2025, and beyond, is exceptionally promising. This period reveals that for many of today’s most highly publicized rare earth end-uses, such as electric vehicles, wind turbines, and many others, the rate of annual demand growth is poised to accelerate between 2020 and 2025, steering global rare earth demand to unfathomable new heights in the years thereafter.