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Oct 30

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.

Oct 24

3 Comments

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

Oct 18

1 Comment

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:

Snam Rete analyzer current order
Engie biomethane skids (analyzer and RTU)
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:

CUI has over $100 million of NOLs so they won’t be paying taxes for a long time
G&A is expected to decline $1.5 million annualized after a small restructuring in the first half of 2017
The power business is doing well. I’m projecting 5% growth for the Power segment over the next year compared to TTM numbers
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.

Oct 10

10 Comments

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 30^th.

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.