After a successful second bid for OZ Minerals (OZL) at $28.25/share on Friday 18 November 2022, we have decided to remove OZL (-2%) from the Focus Portfolio in order to lock in profits.
We have used the proceeds from OZL to add Lynas Rare Earths (LYC) to the portfolio at 2%.
| Company | Ticker | Sector | Old Weighting | New Weighting | Change |
| OZ Minerals | OZL | Resources | 2.0% | 0.0% | -2% |
| Lynas Rare Earths | LYC | Resources | 0.0% | 2.0% | 2% |
Source: Refinitiv, Wilsons.
Focus Portfolio Underweight Miners, Overweight EV Minerals
The Focus Portfolio is underweight resources at a headline level, mainly due to our underweight to iron ore. We are overweight EV minerals with our weighting at 8% versus the market at 4%. The positive growth outlook of rare earths and other EV minerals is in contrast to the outlook for the traditional ASX miners, such as iron ore, where we expect earnings to fall over the next 2-3 years. This is a key rationale for our overweight to EV minerals and our underweight to iron ore.
Rare Earths: Magnetic Appeal
Rare earth elements (REEs) are a family of 17 elements. On the basis of atomic weight, among the lanthanides group, the lighter 6 elements are classified as the light rare earth elements (LREEs) and the other 9 elements as the heavy rare earth elements (HREEs).
We will predominantly focus on light rare earths (LREE), namely neodymium/praseodymium (NdPR), as these are the most highly valued and applicable to LYC. These elements have significant applications in permanent magnets (the key material for producing NdFeB permanent magnets), which are vital to the energy transition thematic.
These magnets should see a surge in demand from clean energy technologies. NdFeB magnets are currently used in the drive mechanism for Electric Vehicles (EVs) and wind turbines, and this is expected to drive a 2-3x increase in demand by 2030.
It is estimated that a standard model EV will require around 5x the rare earth magnets that a traditional petrol vehicle requires. We expect electric vehicle uptake to grow faster than the market, which should provide upside for NdPr demand versus consensus.
Constrained Supply
Demand is expected to outrun supply. Primary and secondary supply sources are limited over the next decade, and many producers can't increase production at their existing mines due to lack of new resources.
We expect the market to be in a supply deficit in 2025, which is forecast to expand by 2030.
Upside Risk to Prices
We believe there is upside risk to consensus price expectations for NdPR over the medium-term. The mismatch between demand and supply should worsen in coming years as supply cannot keep pace with surging demand, leading to upward pressure on prices.
There is also a near-term upside scenario that China further eases its COVID policies, which should also support NdPr demand and price.
Cyclical Headwinds Short-Term
In addition to the demand from the decarbonization trend, rare earth elements like NdPr also have a range of ‘traditional’ uses such as appliances, air conditioning, elevators and electronics. Therefore, we think rare earth minerals have an inherent degree of cyclicality to broader macroeconomic conditions in the short-term (much like copper and nickel), despite a strong structural demand story over the medium to long-term (driven by more EVs and wind turbines).
We think this could weigh on rare earth prices over the next 12 months, given the potential softening economic backdrop.
However, we believe the shift to renewables and EVs will be a key driver of NdPR demand over the medium-term and this period of soft demand presents an opportunity to buy into weakness.
Geopolitical Opportunity
A list of 35 critical minerals identified by the US Department of Interior in 2018 included 17 rare earth elements (REEs). As a result of underinvestment for more than a decade, the US government highlighted the need for investment to open or reopen rare earth mines and processing facilities in Europe and the US.
In light of the Russian/Ukraine crisis, resource security concerns have emerged regarding the REE supply chain and its overreliance on Chinese suppliers.
The primary supply and refining capacity of the rare earth market are dominated by China, accounting for 60% and 90% of global capacity, respectively. However, bipartisan government support (in the US and Australia) is emerging for building out the domestic rare earths market.
US, EU, and Australia governments are investing heavily in rare earths production. Exploration and processing of the elements (outside of China) are becoming more advanced.
There is upside risk for rare earth miners that governments help fund growth projects, which would support miners cash flows. We have already seen this for Lynas (LYC) and Iluka (ILU) this year.
LYC received US$150m for 2 funding grants from the US government to develop a light and heavy rare earths separation plant in the US.
ILU, an Australian mineral sands miner, plans to spend $1.2b building a rare earth oxide refinery at its Eneabba operation north of Perth; $1.05b of this spend will be funded by federal government support.
China’s Dominance to Fade
China’s dominance of the rare earths supply chain from mining to production presents both opportunities and risks for non-Chinese producers. China’s ability to dictate supply via its quota system can have a large influence on rare earth prices, which was evidenced by the country’s 25% increase to its rare earth quota for 2022.
This is a significant medium-term risk to earnings; however, over the longer-term we believe China’s influence over rare earths will fade as Western nations have invested heavily into increasingly ‘onshoring’ the rare earths supply chain. Ex-China supply should increase enough to dampen the dominance of China on supply.
Substitution Risk Minimal
Some rare earth elements have a degree of substitution risk for certain applications, however, in these cases the necessary trade-offs involved around weight/performance/ongoing maintenance costs typically outweigh the benefits. For major future uses like permanent magnets in EVs, rare earths have no clear, viable alternatives at this stage.
Adding Lynas Rare Earths (2%)
Lynas Rare Earths is a leading rare earths producer. Mt Weld Central Lanthanide Deposit, inside a collapsed ancient volcano, in Western Australia is one of the highest-grade rare earth deposits (tier 1) in the world and is the largest rare earths mine outside China. The majority of the value comes from NdPr.
Lynas also operates the world’s largest single rare earths processing plant in Malaysia, where it produces high-quality separated rare earth materials for export to manufacturing markets in Asia, Europe and the US.
As part of the “Lynas 2025” growth plan, LYC is building a rare earth processing facility in Kalgoorlie (WA) to process the rare earths concentrate from the Mt Weld mine. LYC is also planning to build a rare earths separation facility in Texas to supply the US Defense industrial base and commercial manufacturers.
Why we like LYC
Production growth
LYC plans to increase its NdPr production capacity from ~5.5ktpa to 12ktpa by 2025, which will be a key driver of the company’s earnings growth over the medium-term. Currently the market is expecting a lower production level than guidance in FY25, potentially providing an upside to earnings if management can execute.
CAPEX covered by balance sheet strength
In our view, LYC remains adequately funded for its growth projects. Projects are expected to cost ~A$1.25b over FY23 and FY24, which is not insignificant. However, current cash levels are ~A$1b and the remainder should be covered by its operating cash flow.
Ex-China supply receiving government support
A key upside risk for LYC is that further funding could be provided to support growth. As discussed earlier, the US, Europe and Australia are all looking for ways to support the rare earth supply chain outside of China. Government funding could be provided for growth projects providing upside to LYC's consensus cash flow forecasts.
Challenges remain but look priced in
There is only a relatively tight timeline for LYC to replace its existing Malaysian cracking and leaching facility – which will lose its license to operate in March 2023 – with its new plant in Kalgoorlie that is mooted to be opened to fill the void by July 2023.
The September quarter update saw Kalgoorlie plant costs increase 15% from initial budget estimates to $575m and there was a continuation of water issues in relation to its processing plant in Malaysia.
These issues present short-term risks, but we believe they are largely now priced into consensus (capex cost upgrades and lower production downgrades) and provide a good opportunity to buy into short-term weakness.
Valuations at reasonable levels
The LYC price may have got ahead of itself in 2020 and 2021. However, there is now the potential to buy LYC at a PE of below 15x for a company that is expected to offer 16% EPS CAGR (FY22-FY25) and leveraged to what, we think, is a strong multi-decade thematic in terms of EV penetration and renewables.
The growth outlook of rare earths and other EV minerals is in contrast to the outlook for the traditional ASX miners, such as iron ore, where we expect earnings to fall over the next 2-3 years. This is a key rationale for our overweight to EV minerals and our underweight to iron ore.
Consensus commodity price upgrades should provide considerable EBITDA upside
Higher commodity prices should lead to even bigger increases in LYC EBITDA due to operating leverage. A 10% increase in NdPr prices, according to our calculations, should lead to a ~16% upside to FY24 EBITDA.
| Consensus | 10% increase in NdPr price | 20% increase in NdPr price | ||||
| FY24 EV/EBITDA | EBITDA | FY24 EV/EBITDA | EBITDA upside | FY24 EV/EBITDA | EBITDA upside | |
| LYC | 8.74 | 783.3 | 7.56 | 16% | 6.8 | 28% |
Source: Refinitiv, Wilsons.
Written by
Rob Crookston, Equity Strategist
Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.
About Wilsons Advisory: Wilsons Advisory is a financial advisory firm focused on delivering strategic and investment advice for people with ambition – whether they be a private investor, corporate, fund manager or global institution. Its client-first, whole of firm approach allows Wilsons Advisory to partner with clients for the long-term and provide the wide range of financial and advisory services they may require throughout their financial future. Wilsons Advisory is staff-owned and has offices across Australia.
Disclaimer: This communication has been prepared by Wilsons Advisory and Stockbroking Limited (ACN 010 529 665; AFSL 238375) and/or Wilsons Corporate Finance Limited (ACN 057 547 323; AFSL 238383) (collectively “Wilsons Advisory”). It is being supplied to you solely for your information and no action should be taken on the basis of or in reliance on this communication. To the extent that any information prepared by Wilsons Advisory contains a financial product advice, it is general advice only and has been prepared by Wilsons Advisory without reference to your objectives, financial situation or needs. You should consider the appropriateness of the advice in light of your own objectives, financial situation and needs before following or relying on the advice. You should also obtain a copy of, and consider, any relevant disclosure document before making any decision to acquire or dispose of a financial product. Wilsons Advisory's Financial Services Guide is available at wilsonsadvisory.com.au/disclosures.
All investments carry risk. Different investment strategies can carry different levels of risk, depending on the assets that make up that strategy. The value of investments and the level of returns will vary. Future returns may differ from past returns and past performance is not a reliable guide to future performance. On that basis, any advice should not be relied on to make any investment decisions without first consulting with your financial adviser. If you do not currently have an adviser, please contact us and we would be happy to connect you with a Wilsons Advisory representative.
To the extent that any specific documents or products are referred to, please also ensure that you obtain the relevant disclosure documents such as Product Disclosure Statement(s), Prospectus(es) and Investment Program(s) before considering any related investments.
Wilsons Advisory and their associates may have received and may continue to receive fees from any company or companies referred to in this communication (the “Companies”) in relation to corporate advisory, underwriting or other professional investment services. Please see relevant Wilsons Advisory disclosures at www.wilsonsadvisory.com.au/disclosures.