db report misreads recent price implications

Finally had time to plough through the 100+ pages of the recent Deutsche Bank report on Lynas.

The basic premise behind their sell recommendation is that they are predicting a US$20/kg basket price for the next 3 years, until 2016. Post 2016 they are actually quite bullish on Lynas and the RE industry in general. They think that supply will outstrip demand until 2016, at which time, demand will suddenly outstrip supply and RE prices will take off again. So they are more or less telling investors to avoid LYC until 2016, at which point the stock will suddenly become a strong buy.

They also reckon that for FY14 'all-in cash cost' of production will be $33/kg, $24 for FY15, and around $20 for FY16 and beyond.

As a consequence of the above assumptions, they don't think LYC will have positive EPS until FY17.

While their conservative estimations re Lynas' 'all-in cash costs' over the next few years look reasonable in my view, I think the report has a number of serious failings:

(1) It makes no mention of the fact that Baotou Steel are halting production for the next 6 months (despite the DB report being published 2 weeks after Baotou initially made that announcement), nor does it place sufficient emphasis on the huge efforts Chinese authorities are now making to end the black-market trade in REE (which DB acknowledges has been a major contributor to price falls over the last couple of years). These clean up efforts are already starting to bear fruit in terms of modest price rises – a point completely ignored by DB. As a consequence, since the report was published some heavy RE have achieved prices that DB weren't predicting to occur until 2016.

(2) the fact that Baotou steel decided to halt production on the basis of the spot prices of a few weeks ago (roughly $20 FOB/$16 internal Chinese prices), tells us that they were not making money at those prices. Evidently, with new environmental controls now in place, legitimate/regulated Chinese 'all-in' costs (inclusive of production costs, corporate costs, interest payments etc) must be getting close to the $20 mark. On this basis, if DB's $20 FOB price becomes a reality over the next three years, then NO LEGITIMATE RE PRODUCERS (including Chinese producers) will be making money over the next 3 years.

So the logical extension of the DB $20 prediction is that the entire legitimate global RE production industry will operate at a loss for the next 3 years. This seems to contradict basic micro-economics and defy common sense.

(3) Reading between the lines a bit – and this an important point I think the DB analysts completely missed – what is really interesting about recent comments from Lynas, Baotou, and Moly, is that the recent $20/$16 prices represented a kind of industry threshold; basically, these companies are saying to the market if RE prices fall much further, these companies will have to close up shop, and there will be no legitimate RE industry; RE buyers will then be dependent 100% on the dodgy black market for supply. Given that this scenario is in no one's long term interests (other than chinese black market producers), economic fundamentals and common sense suggest that RE prices must continue to rise to a point the permits legitimate producers to make money over the medium term.

In other words, the LYC sell off to 36c was predicated on the fact that only LYC was losing money at the spot prices of a couple of weeks ago; what I think we can now legitimately infer is that every legitimate producer was losing money at those prices – and this fact should give LYC shareholders some comfort.

(4) What is a minimum price point in order to ensure a viable, environmentally sound RE industry over the long term? Keeping in mind that the basket price is only a crude indicator as to the prices that Lynas or anyone else is in fact getting for individual REE, the industry seems to be telling the market and buyers that sooner rather than later it needs prices in the region of $35 FOB/$27 domestic in order to be viable over the long term. I think recent price action indicates that a structural transition to a more sustainable price point has begun. I expect the LYC sp to slowly rise accordingly.