CORRECTION: Lamp Going Out For Lynas?

This story features LYNAS RARE EARTHS LIMITED. For more info SHARE ANALYSIS: LYC

Note from the Editor: Due to an error, a story was yesterday published on the FNArena website, titled "Lamp Going Out For Lynas?". The story in question was at that time still a work in progress and should have not been published as it was. FNArena apologizes for the error made and for any inconvenience or confusion caused by it.

Today, we publish the story as was intended, though we feel compelled following the error made yesterday, to add the label "Correction" to it, including this editorial note to explain what happened. We will review our internal processes to avoid such errors from happening again.

On the other hand, anyone with a personal interest in Lynas should bear in mind the views expressed in this story are derived from a research report released by New York based mining researchers Hallgarten & Co. As an independent media company, FNArena does not by definition (or by association) share the views and opinions expressed by the experts that feature in FNArena stories and reports. This applies to specific reports such as The Australian Broker Call, as well as to other regular and spontaneous stories, analyses and reports published by FNArena.

 

By Greg Peel

As recent FNArena articles on the subject of the rare earth metals space have noted, the global race to compete with China on rare earth element (REE) production has now come down to a mere handful of names including two stand-outs, and a big chunk of daylight to third. (See, for example: Rare Earths Done And Dusted? No, It's Xeno-Time). Those two companies are Molycorp in the US and Australia's own Lynas Corp ((LYC)). A year ago, it looked like Lynas had moved ahead of Molycorp.

According to research and opinion from REE specialist Hallgarten & Company, that is certainly no longer the case. Indeed, Lynas shareholders may be in some trouble.

Lynas' Mt Weld mine in Western Australia ranks as one of the richest major light REE deposits in the world. Light REEs such as lanthanum, cerium and neodymium are not as valuable as heavy REEs such as dysprosium but with an advanced project and significant scale, Lynas looked set to be a prominent player in the global REE market, with a big jump on the field outside of Molycorp. A few years ago Lynas became somewhat of a test case for sovereign investment in Australia's mining industry when the federal government ruled a Chinese enterprise could not acquire a stake in the company, thus setting the guidelines for future Chinese investment. Not being able to source funds from China was not an issue for Lynas. REE prices began to accelerate into space and funding was thus easy to secure outside of China. Says Hallgarten:

“If there is one thing on which one cannot fault Lynas it is the size and attractiveness of its deposit. The Australian government was very right in ensuring that it didn't fall into Chinese hands.”

Source: Hallgarten & Company

Having a REE deposit is one thing, but the real money to be made from REEs is in the processing – a complex and highly costly business. Lynas could have chosen to build its processing plant in Western Australia, thus providing tax income and jobs and possibly attracting some incentives from the state and/or federal government. But Lynas decided to go offshore to find a cheaper alternative. One alternative would have been to build the plant in low-wage China, but given China controls the global REE market there would be a certain risk. Instead, Lynas chose to build its plant in low-wage Malaysia, where from 1982-1994 Mitsubishi Asian Rare Earths had processed REEs as a by-product of tin mining.

As former prime minister Paul Keating will recall, Australia and Malaysia do not have the rosiest of friendships. And we seem to run into problems when it comes to “offshore processing”.

The Lynas Advanced Materials Plant (LAMP) has been under construction in Kuantan, Malaysia, for over two years and is all but completed, with the testing phase having reached 85% completion by the end of the March quarter. It is not clear just how much money Lynas saved by choosing Malaysia over Western Australia, but whatever it was, Hallgarten suggests that benefit has now been more than wiped out by the fall in the LYC share price. Lynas has had to suffer along with all REE hopefuls from the recent bursting of the REE price bubble, but investor ill-will generated when Lynas executive chairman Nick Curtis attempted to sell off a prospective niobium asset owned by the company to Forge Resources ((FRG)) of which Curtis is also (non-executive) chairman, for a great deal less than Lynas had valued the deposit back in 2007, also impacted heavily on sentiment.

Both of these issues have helped sink the Lynas share price (from $2.60 in April to around 75c now), but weakness is also reflective of the Malaysian government's delay in granting approval for the LAMP start-up.

Was Lynas being too cavalier? Or did the company underestimate Malaysia's famous “recalcitrance”. 

Either way, Lynas did not seek to draw on past experience. REE deposits most often include levels of radioactive elements in the mix, such as uranium and thorium, which need to be separated and dealt with as waste. In 1982, the aforementioned Misubishi Asian Rare Earth began operations in Malaysia with a plan that the local state government would keep the waste as a potential source of nuclear energy. However both parties were subject to strident protest from local villagers, opposition politicians and non-government organisations when the tailings began to pile up in a field, emitting 88 times the safe level of radioactivity. The company initially began a clean-up, but by 1994 had decided it was all too hard and shut down the plant.

The ore from Mt Weld contain traces of thorium, which by all accounts are not significantly dangerous within the processing operation. However they still provide waste which needs to be dealt with, and that's why LAMP approval has stalled. Last July, the Malaysian Atomic Energy Licensing Board (AELB) required Lynas to satisfy eleven conditions before the LAMP could proceed, including a long-term solution for the radioactive waste. In its first proposals to the AELB, Lynas failed to meet any of the conditions. By September the Malaysian government had called on a review from the International Atomic Energy Agency and put the plant on ice.

When Lynas was first looking for a location for its processing plant, the Malaysian government offered a 12-year tax exemption as part of the enticement. With an established history of REE processing, Malaysia seemed the best choice to Lynas. Whether or not Lynas gave much thought to the reasons the earlier plant had closed down is not clear, but Hallgarten suspects management assumed it could just talk its way through the issues with the government, NGOs and other interested parties. Meanwhile countries such as Vietnam and probably the Philippines would have cried out to take the LAMP on board, Hallgarten suggests.

Lynas had the opportunity to halt construction on the LAMP at a very early stage once local protest initially stalled the approval process. It would also have been sensible at that point, Hallgarten suggests, to play off other interested parties such as Vietnam against the Malaysian government. But Lynas pressed on with construction, and the LAMP is all but ready. The Malaysian government has been the big winner – no Malaysian job has been lost but the government is seen to be playing a responsible role with regard to the waste. Lynas has spent a good deal of money.

The company kept on building even as, in the September quarter last year, Dutch company AkzoNobel pulled its contract to supply resins for LAMP construction. The resins, Hallgarten notes, were needed to coat the walls of concrete tanks in which hundreds of tonnes of REEs with low levels of radiation were to be mixed with corrosive acids at more than 93C degrees. Akzo apparently cited “safety issues”.

Lynas won a reprieve in February, nevertheless, when the AELB granted a temporary operating licence (TOL). The AELB will monitor the plant over the next two years in which time Lynas must show it can limit radiation to the safe levels the company originally claimed it would. Assuming this can be done, it might seem like Lynas is of the hook. Except for a certain conundrum.

Lynas can only satisfy the AELB by detailing all aspects of a permanent disposal facility, whether or not the company is able to reprocess low level radiation waste into a commercial product. The radioactive residue produced is the responsibility of the company and if necessary, it will be returned to its place of origin.

And what might be the place of origin's attitude?

“National legislation stipulates,” the WA minister for mines and petroleum has stated, “that Australia will not accept responsibility for any waste product produced from offshore processing of resources purchased in Australia such as from iron ore, mineral sands, and the rare earths produced by Lynas Corporation”.

And fair enough too, suggests Hallgarten. Analyst Christopher Ecclestone lays it on the table:

“The Malaysian finding that Lynas must take the radioactive waste back to Australia may be the straw that breaks the camel’s back with the Lynas effort. This slight detail requires the governments of both Australia and the state of Western Australia to acquiesce in taking the waste from a plant that should have been built in Australia in the first place but wasn’t because Lynas wanted to make jobs elsewhere (and in a country that has been proven to be anything but friendly). We will need quite a lot of convincing as to why the Australians should cave in on this one. As we have often said in the past the value added in REE is in the processing not in the mining. Thus we might also ask the question as to where the real profits of the value chain are dropping off? If they are falling off in Malaysia and the government there is getting the tax windfall then how much is in the equation for the Australian economy or its taxpayers? 

“It is hard to see why such a limited job generator as Lynas, which quite clearly snubbed an onshore processing option, should get a free pass and we do not believe that it will.”

So what happens now?

As is the case with most major mining projects, Lynas' effort in recent years has seen a one-way flow of money out of the coffers, first to finance the Mt Weld mine and then the LAMP. However one usually has more to show for it, Hallgarten offers, than a very large plant which may be worth little more than its scrap value. Lynas signed a “strategic alliance” in March 2011 with Sojitz Corporation to supply REE products to the Japanese, which included a loan facility to Lynas of US$225m. On top of earlier funding, Lynas still has US$215m sitting on the books but the company's cash burn, as Hallgarten notes, is pretty hefty. Yet there is not much more needed to be spent on the LAMP.

It would appear, however, that Lynas has hit a Catch-22. Or maybe a Catch-90 (thorium's atomic number). Malaysia may not let Lynas process REEs unless it sends the radioactive waste back to Australia and Australia will not accept radioactive waste, as a matter of policy, from Australian mineral processing conducted offshore. Both the Federal government and WA government are nevertheless happy to deal with the waste if the processing plant is onshore.

Hallgarten suggests there is a very real possibility Lynas will have to bring its LAMP to Australia. That will mean starting again from scratch and something in the order of US$400m, Hallgarten estimates, net of what, if anything, one can get for a disused and possibly unusable REE processing plan in Malaysia. And, importantly, in a race in which “first to market” status could definitively determine who wins in the light REE production stakes, Lynas would be set back significantly, allowing Molycorp to bolt ahead. 

Take that a step further, Hallgarten suggests, and other hopefuls around the world who had given up due to costs, the plunge in price in light REEs, and the level of advance of major aspirant Lynas, might just see a reason to get back on board and offer up potential competition once more.

In the meantime, Lynas must deal with the small matter of its earlier US$225m convertible bond issue to Mount Kellet Capital Management. On the assumption the Malaysian government does not suddenly soften its stance, which would presumably require popular protest to go away, if Lynas defaults on its loan from Mt Kellet then the Mt Kellet could do a debt equity swap with Lynas, Hallgarten theorises. This means Sojitz and Mt Kellet could well end up owning the company. Under such a scenario (pure speculation at this stage), existing Lynas shareholders would either get nothing, or at best, a little of the remnant equity. Hallgarten doesn't know what that equity would be given there will be no revenues no matter how advanced Mt Weld becomes.

“If Lynas does end up having to retreat from Malaysia,” says Ecclestone, “it will largely be game over (or at least postponed) for a good three years until it can reconfigure itself in a different context with existing shareholders largely wiped out and management ousted”.

Hallgarten believes wiser international investors have already seen the writing on the wall, and begun switching out of Lynas and into Molycorp – the new definitive front runner. Oddly enough, the analysts note, Molycorp's share price has still underperformed that of Lynas over the past twelve months of REE price shake-out. Hallgarten is thus recommending a pairs trade – shorting Lynas and buying Molycorp. A 12-month target price of US$28 has been set for Molycorp.

A 12-month target of (A$) 20 cents has been set for Lynas.

The risks of shorting Lynas, Hallgarten suggests, are such: Australian federal and WA governments overturn a long-held policy (unlikely); the Malaysian government allows Lynas to stockpile waste without a disposal solution (unlikely with an election approaching); China accepts Mt Weld concentrate and makes the LAMP redundant (perhaps this the plan from China all along); Lynas is taken over by Molycorp, or perhaps by Europeans Rhodia/Solvay (international competition issues, China would protest); or local Malaysian protest against the LAMP runs its course and fades away.

Investors can weigh up the odds. Of the five leading stockbrokers in the FNArena database covering Lynas, all have Buy or equivalent ratings on the stock for a consensus target of $1.49.

Last month an appeal against the issuance of the TOL was dismissed and Lynas submitted its plans to address two additional conditions imposed by the AELB at the end of June. Lynas provided a quarterly production report last week but no new news on the TOL was provided. LAMP construction is completed and the plant is 64% commissioned, with analysts assuming commissioning is currently stalled pending TOL approval. No timeline has been provided.

Analysts suggest the stock will continue to trade at a discount until TOL approval is granted, after which the discount gap should quickly close to reflect operating value. The issue is nevertheless whether Lynas' cash burn will cause balance sheet difficulties in the interim. The company has sufficient funds to survive for some time but it is unclear just as to how long some time will be.

Deutsche Bank had previously pencilled in approval this month has now extended that expectation. The bank's Malaysian strategy team is expecting the next election to be called possibly as early as November. Deutsche's base case is for the incumbent government to remain in power with a 60% majority and that on that basis approval for the LAMP would be ultimately granted, with January next year the broker's new target. The analysts nevertheless remain cautious given the uncertainty, given the funding implication from further delays an given the general risk of ramping up such a complex facility.

Macquarie notes that as well as dismissing an appeal under Malaysia's Atomic Energy Licencing Act after the new conditions were imposed, the government also denied application for a judicial review of the AELB's decision on the TOL. This decision is also expected to be appealed.

The question thus is to how long effective opposition to the LAMP can be maintained and whether the government sees it as an impediment to an election victory. Meanwhile brokers in the FNArena database are content to assume ultimate approval at this stage in maintaining Buy ratings, albeit on reduced target prices.

Hallgarten & Company is less confident, as evidenced by its pairs trade recommendation. Mitsubishi's experience a couple of decades ago is clearly important to the analysts' view along with a poor opinion of Lynas' decision to build it's plant offshore, and in Malaysia in particular.
 

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