Ideas Lab: Lynas Corporation

When Wesfarmers announced the demerger of Coles, investors cheered. Those jubilations went mute, however, when the same company - renowned for its investment and capital allocation nous - turned around to make a bid for Lynas Corporation, a miner of rare earth metals.

The market's shock was palpable and its disapproval clear - Wesfarmers' market value fell by more than $1bn the day the bid was announced. Yet when a smart investor makes an unexpected move, we should take notice. 

Lynas's share price has shot up 35% but still trails the $2.25 bid price, perhaps because Lynas management has stridently rejected the bid and Wesfarmers shareholders haven't offered the strongest support. 

The bid has, however, sparked endless speculation. Who else might make a move? Why is Wesfarmers interested? How might China react?

So is Lynas really worth all the fuss?

Not so rare

We begin by correcting a widespread misnomer: rare earth metals, despite their name, aren't all that rare. They were given that name because, in mining's early days, similar chemical properties prevented individual elements from being separated. Today's technology has removed that constraint.

On the surface, the production of rare earths looks like conventional mining. A fleet of big machines is used to mine and transport ore that contains the metals. That, however, is the extent of the mining operation. 

From that ore, complex processing is required to extract individual elements. The processing task is hard, expensive and dirty. Two-thirds of the cost of producing rare earths - and all the risk and the difficulty - comes from the processing of ore. This is chemistry masquerading as mining. 

Even after rare earths are successfully separated, the process tends to leave a vast trail of radioactive waste. Dealing with that waste is another problem.

It's best to think of the business not as a mining business but as a chemical manufacturing one that happens to use mined ore as a raw material. The economics and risks of rare earths production are therefore rather different from traditional mining.

It makes money

The economics of each rare earths project differ, and their profitability depends on the proportion of individual elements present in the ore. Lynas is already decently profitable and returns will climb as it scales up output and perfects its processing.

Lynas mines ore from Western Australia and ships it to Malaysia where it undergoes extensive processing. Production is characterised by a high proportion of neodymium/praseodymium (NdPr), a pair of high-value elements which are vital in the production of high-powered magnets used, amongst other things, in electric motors and generators, including those in wind turbines and electric cars. 

The high-value nature of the output makes Lynas particularly attractive. Since processing, which accounts for the bulk of cost, is a fixed expense, higher value output increases margins. 

The strategic importance of Lynas's production also shouldn't be underestimated. This is the world's second-largest producer of vital NdPr and demand for the product is increasing. China overwhelmingly dominates the supply of rare earths, contributing about 95% of global supply.

Japanese firms are Lynas's largest customers and, for them, NdPr is a small cost in a large value chain. Japan is on record, along with the US, in expressing discomfort about Chinese dominance of the market.

China has been uniquely willing to bear high waste and environmental costs and Lynas is now the only source of supply outside China. This is unquestionably a strategic asset that could be immensely profitable if everything goes to plan.

What needs to happen?

The range of outcomes from here is wide. Lynas today is burdened by regulatory obligations to deal with its waste. 

Under its current Malaysian operating licence, waste must be recycled or stored but regulators have suggested that will change. A renewal of the licence, due in September this year, will depend on meeting stricter waste disposal obligations. Lynas is currently investigating ways to comply with the stricter rules.

Wesfarmers bid has put Lynas in play and there are potentially many suitors for an asset that is both strategic and potentially profitable.

China and Japan are both logical buyers. Japanese firms have already signed up as contracted customers to take Lynas output and have an interest in preserving a source of supply outside of China. There is every chance that Japanese firms might pay a high price to control the resource directly. China, for the same reasons, has an incentive to pay to prevent its grip on supply from faltering.

Wesfarmers would make a sensible owner for Lynas. It has a huge balance sheet to deploy which will aid in comforting regulators who worry about another miner making a mess and walking away. Wesfarmers also has some chemical expertise and could even move the entire processing chain back to Australia to maintain long-term production. That would be expensive but it would secure supplies and remove the political risk that has long hung over the business.

Worth buying?

Despite the market's general misgivings, we're impressed by Wesfarmers choice of target. Colleague James Greenhalgh will say more about Wesfarmers in due course, but we can say this of Lynas: it could become a hugely profitable business and the current share price, even after rising following the bid, values the business at less than $1.5bn. 

To justify that market capitalisation, it would need to make, on average, about $100m a year in net profit. Last year it made $53m but that was with historically low commodity prices and while operating below full capacity. At full capacity, Lynas could easily generate over $200m in net profit and more if commodity prices kick higher.

The high degree of risk here - the business has already earned a warning from its auditors - prevents us from recommending it at this stage. There is still a possibility of the company going broke. But the more likely outcome is that another buyer emerges - or at least another bid. 

The poor history of rare earths miners, and of Lynas itself, has meant few have taken this business seriously. Put it on your watchlist. We have.