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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.

 

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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.