NOPMF - Neo Performance Materials: In The Right Part Of The Value Chain

2023-05-16 13:02:28 ET

Summary

• Neo Performance Materials seems to me to be in that right and usefully profitable part of the rare earth value chain.
• They're not mining rare earths - where prices can be horribly volatile - they're adding value to them.
• More than that, declining prices would lead to greater take up of rare earth magnets, meaning more opportunity to add value.

This isn't going to be a complete overview of the company

Neo Performance Materials (NOPMF) ( NEO:CA ) has several different business lines. I recognize some of them from my past life as a metals wholesaler and I have indeed done business with their Estonian operation (back when it was a newly privatized Soviet enterprise) but that was long enough ago that I'm sure I'm over any partiality. It's also true that their indium, hafnium and so on businesses aren't going to be all that volatile and therefore shouldn't move equity prices that much. That hafnium tends to be a byproduct of making nuclear-grade zirconium is interesting to me and about perhaps 3 other people - only one or two of whom work at Neo Performance.

The driving force of any changes in the NEO share price is going to be the rare earths business. Which comes in two parts. As a result of that old Soviet linkage, they have a lanthanides (i.e., rare earths) purification and distribution business. But note that they don't mine them. They've also picked up the Magnequench business and are therefore in the business of making rare earth magnets.

This also isn't going to be a detailed look through the finances. Instead, a discussion of the base business drivers - plus a trick about when to buy into NEO stock.

The structure of the rare earths business

So there are miners - they produce a rare earths concentrate. Then there are concentrate processors - they separate out the individual elements from that concentrate. This is the major cost center in the production of the individual oxides (or chlorides, etc.). Lynas does both , MP Materials mines and ships off to separate but is intending to build a separation plant. Then there's the process of making these now separated metals into something useful.

This can be an odd business. It used to be a Siemens plant in TX which used 90% of the world's lutetium, for example - making the crystals which make MRI machines work. A substantial portion of the world's terbium went through a plant in the Midwest to make charges for compact fluorescent lightbulbs. Lanthanum went off to Japanese camera lens makers, cerium to firelighters - it pretty rapidly became not the rare earth business that is, once the separated elements were, well, separated.

These days, the part of the business everyone is interested in is the permanent magnets. Neodymium, Praseodymium, Dysprosium, and Terbium, in varied combinations, make up the FeNdB magnets that so much of the electrification revolution depends upon.

OK. But outside the big Chinese companies, there's pretty much no one - other than Neo Performance - making these magnets. Sure, that's going to change, there are all sorts of plans about doing that outside China and some of them will even succeed.

Competition in rare earths

The recent rise in rare earths prices has meant many people charging into the business. Most are in mining, producing those concentrates. In some other work elsewhere I've seen some 10 different announcements of ionic clay finds in the past couple of months in Australia alone ( OD6 , Australian Rare Earths , just as examples and no, they're microcaps, don't). I explained the point about ionic clays for you here . They're a markedly lower-cost way of gaining the magnet metals, that's all we need here.

My read on this is that rare earth prices are going to decline substantially over time. They're already well down off their peaks, but we could write that down to market cycles. I - in the medium term - think we're going to see a structural decline in the magnet metals prices.

OK, well, that's a prediction. But this doesn't damage Neo Materials, right? Well, that's the bit we're going to get to.

The permanent magnet market

There are many - Tesla (TSLA) just one - saying that rare earth magnets are now so expensive that they're going to stop using them. Ferrites perhaps - larger, less efficient, but markedly cheaper. OK, that could happen.

My read is that it's going to work the other way. Rare earths are going to become markedly cheaper, and so substitution away from RE magnets will cease or even reverse.

This is hugely beneficial to a magnet maker who does not produce their own rare earths. Which is where Neo Performance is. The drop in Nd pricing - just as one example - feeds through into a drop the processor pays for the concentrate. That means that NEO pays less for inputs. But the lower price of the finished magnets doesn't deteriorate the manufacturing margin of turning the rare earths into those magnets.

I'm also not so worried about competition in the magnet making itself. I've had some dealings with this (again, decades back, so no partiality) and the real issue is learning by doing. It's not patents (most of which have run out anyway) or cool machinery. It's the simple fact of making magnets makes you better at making magnets. You're trying to turn out a complex material that needs to be just right in both large volume (the total throughput) and also in each individual piece (tens of grammes at a time). This is just something that those doing have an advantage over those trying to learn how to do.

So, the setup here

Permanent magnets containing rare earths are going to continue to be important. I expect rare earth prices to fall over time. There might be a cyclical upturn soon enough but medium term a fall. This should all benefit a producer of rare earth magnets who does not mine their own rare earths.

Which is a class of just one, Neo Performance Materials.

And now the trick

From NEO's recent results chat :

Though we speak of the four consecutive quarters of rare earth price declines, the current price is still higher than the prices from three to four years ago back, and you will see that Neo's margins were quite healthy in that time frame. It underlies the same point Neo's position as a value added supplier will generate margins at higher or lower rare earth prices. However, any short-term period has this continuing reporting dynamic of lead lag. It's a touch odd that we had six consecutive quarters of rare earth price increases, followed now by four consecutive quarters of rare earth price declines. So we appreciate that it's hard for folks to clearly see through this lead lag dynamic over this rather extended period of time.

That's a bit, well, not entirely clear, actually. It's this:

We've discussed the lead lag effect on these calls in the past that we are processing higher cost past inventory purchases than the current replacement cost, and this is the main driver of lower margins.

NEO accounts for raw materials - and thus margins - on a first in first out basis. That means that in a world of falling rare earth prices, they report losing money - they bought raw materials at the old, higher, prices but report margins and profits on the new, lower, sales prices.

Well, you've got to use one method or another, FIFO or LIFO, and it's often the mark of a scam that folks change their method dependent upon which way the market is working. But it's worth noting that oil companies do tend to report on a replacement cost basis, taking the hit of price changes on the balance sheet instead of necessarily through the P&L. The method doesn't, in fact, matter, as long as it's consistent.

To note this, NEO is consistent about this.

And now the trick again

I roughly enough agree with that earnings report. That rare earth prices are off their peaks - 50% down in fact - and this depresses NEO results as a function of their accounting policies. I'm also willing to believe that there's another rally to come - before what I think is the inevitable fall back to production cost of rare earths (so, Nd at $30 and $40 per kg).

But this very accounting policy means that rising rare earth prices will flatter NEO results while they rise. The market, I think, doesn't incorporate that in the valuation. So, when rare earth prices rise, then buy into NEO to benefit from the rise in profits due solely to the accounting policies.

Why I could be wrong

It's possible that by the time the next RE price rise comes that raw material costs just won't be, umm, material to NEO. I think that's unlikely, but it could happen. It's also true that believing a CEO when he lists reasons for bad performance can be a wealth diminishing activity. But I think he's right here.

The investor view

The strategy here is quite simple. NEO's a good enough business. But it is heavily influenced, in its reported profits, by the price of the raw rare earths. This is simply a function of using first in first out accounting policies. So, the stock will cycle along with the rare earths price - with a lag. As we see - if they do - rare earth prices rising, then profits at NEO will improve the following quarter and two.

So, buy on rising rare earth prices, sell on falling.

Of course, if everyone does this, then the effect happens at the same time as the raw material price changes. But as long as we keep this just among ourselves, it'll work.

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