Value Investors Club / MP Materials (FVAC)

Description

Does anyone remember Molycorp, Inc.(“Molycorp”)? I have fond memories of the rare earth euphoria a

decade ago; its parabolic rise followed by the complete collapse of the stock and its eventual

bankruptcy. That flash in a pan mining company has been restructured and is currently in the process of

consummating a merger with a SPAC - Fortress Value Acquisition Corp. (FVAC). The company, upon deal

closure, will be called MP Materials and will focus predominately on the manufacturing of NdPr, a rare

earth element that is very different from the focus of the company a decade ago. We believe, MP

Materials is a play on the enormous secular growth of EV vehicles and is the only asset in North America

with scale. If you believe the long-term penetration of electric vehicles is north of 25% then the demand in rare

earth materials provides an attractive way to gain exposure to this trend without having to choose the winner.

Here are the key tenants of our thesis:

1. Rare earth demand is directly tied to electric vehicle (EV) penetration, with 90% share of

permanent magnet motors.

2. Secular growth in EVs, wind turbines, and e-transport (25% of demand for rare earths) will result

in a substantial shortage of supply in the years to come which could lead to a significant increase

in pricing.

3. MP Materials is currently valued at approximately the cost to replace the asset (based on actual

cap ex incurred to develop its mine a decade ago).

4. Rare earths are deemed a “critical” material for the US government. Given that 83% of supply is

in China and rare earth materials are used for the production of missiles and drones, it is

understandable that there is currently considerable pressure from the US government to

insource rare earth supply. MP Materials operates the only mine of scale in the US and has

recently been awarded a contract with the DoD.

5. $1.15 in FCF @20x suggests this is a $22-$23 stock. However, upside to pricing could

meaningfully increase this value (i.e. an extra $100/kg of pricing could drive an extra ~$3.30/sh

in FCF per year).

6. Reputable investors in the deal include the Omega Family office and Chamath Palihapitiya.

MP Materials checks the box on many of the core investment themes that are attractive today. It stands

to benefit from 1) Chinese tensions (i.e. there is a Rubio Bill that was submitted that provides an

enormous tax deduction for domestic rare earth materials) 2) ESG increased capital allocation, 3) EV and

wind turbine growth, and 4) inflation/USD devaluation.

NdPr Supply/Demand Dynamics:

Amongst the 17 elements defined as rare earths, NdPr is expected to drive the market over time. The

entire market today is approximately $4.0B, but is expected to grow to $12.7B by 2030 as demand from

wind and electric vehicles accelerates. To illustrate the coming wave of demand, VW alone has targeted

cumulative EV production of 28mm cars by 2028. Given the company only produced 80k hybrid- and

battery electric vehicles last year, it suggests the growth rate in the industry is parabolic. In fact,

applying this kind of penetration and growth rate would effectively double the global demand for NdPr

just from the auto industry alone over the next eight years.Growth rates such as this require

substantial new capacity which would only be incentivized by higher pricing.

Source: Hedgeye

It is for this reason that the CRU (Consultant) expects pricing to move from ~$40/kg to ~$140/kg by 2025

(note: pricing has already moved up materially in recent months suggesting an already tightening

market). While one does not need to underwrite this level of pricing to justify an investment, it does

suggest FVAC can generate ~$3.50/share in FCF.

What is the right penetration for EV Vehicles over time?

I believe the implied demand from CRU assumes approximately ~8% penetration of EV vehicles in 2025. This appears to be a conservative number relative to many of the public statements out there. VW has noted they expect to see 20% penetration in 2025 growing to over 50% by 2028 (my estimate of their public commentary of 28mm cumulative units). If one believes the penetration is closer to 20%, demand for the global NdPr market expands by an incremental 16% (Note: This equals almost 50% growth in global demand from 2020 levels). .

Why hasn’t this theme been appropriately recognized?

There are no US-listed companies that operate rare earth mines and the only public comp is in

Australia. It is a smaller cap, has limited coverage, and the company does not do public

conference calls. Further, most of the production today is in China and there is simply very

little information available. Rare earth pricing has not improved in almost a decade because

the market was structurally oversupplied and focused on a different rare earth called cerium.

Currently, EV’s only represent 9% of the total demand for the market, which explains why this

has not yet received the appropriate attention. However, the growth rate of this end market is

so strong that it is likely to soak up all available supply. If you dig into the growth of these

markets, approximately 25% of the demand today could be classified as secularly growing. We

believe by 2025, the 25% exposure to growth markets will grow to 45% of the market, thereby

leading to accelerating growth for NdPr demand and higher pricing.

Mountain Pass Asset:

The company has a single location in Mountain Pass, CA which is approximately 50 miles south of Las

Vegas, NV just over the state line. Mountain Pass mine has been in production for ~70 years and its rare

earth ore grade is approximately ~8%. To put this into context, most mines are not commercial if the

ore grade is below 3.5% and according to the USGS, Mountain Pass is the only proven and probable

reserves in the United States. Molycorp spent ~$1.7B in cap ex trying to develop the rare earth market

for approximately the current enterprise value today.

Source: https://mpmaterials.com/uploads/2020.07%20MP%20Materials%20Transaction%20Deck.PDF

While Molycorp focused on developing its production capabilities in the rare earth market, the company

was very poorly managed and exposed to a part of the market that was a commodity with excess supply

(cerium). Today, NdPr is expected to represent ~90% of revenues and has an entirely different demand

profile. While there are plenty of businesses that have exposure to electric vehicles, there is some

significant supply constraints in the NdPr market. Firstly, there are very few locations to add capacity

economically. The process generally takes 3-4 years and most of the global reserves are in China, which

has sought out to control the global supply for this market. Even if you have a world class site, pricing

would have to increase materially from current levels to get a return on your investment. If you assume

most of the projects in the pipeline do succeed in adding capacity, the market is still materially short of

supply by 2025.

MP Materials Strategy:

The company currently mines the concentrate of rare earths and then sends the product to China for

solvent extraction at which point it is further processed downstream into NdPr magnets. Because the

company is not vertically integrated, they are not benefitting from the substantial margin uplift from

further processing NdPr downstream. Therefore, the company has targeted a stage two project to

further process the product downstream, targeting $252mm of EBITDA in 2023 once online at $70/kg

pricing (the project is not predicated on growing capacity). The capital required is modest ($170mm)

compared to its current net cash balance of ~$500mm and the company is FCF positive today at trough

pricing. There is likely additional value in further processing the NdPr into magnets and selling directly

to EV customers, but the company has yet to quantify this benefit.

Valuation:

I think the value of the lithium players provides a good framework on relative valuation. Albermarle

Corp and Livent Corp operate in an oversupplied market where low-cost brownfield capacity additions

are abundant. They are both in the materials sector and tied to the growth in EV vehicles. Both of the

companies trade between 20-24x P/E and 13-15x EBITDA on 2022 estimates, which assume a substantial

recovery in the end market. I have inserted below a quick sensitivity table on the earnings power, but I

think using a 20x P/E at $70/kg is an appropriate framework for fundamental value. However, this does

not incorporate the probability that it could trade at a premium to the lithium players or that pricing is

higher. The efficiency of a NdPr magnet is substantially more attractive than alternatives such that the

substitution does not economically make sense until pricing hits $200/kg. It is worth noting that MP

Materials can easily free cash flow its entire enterprise value if pricing hits that level for a few years

before auto players reengineer their products or new capacity comes online. While one does not need

to bet on this to underwrite the investment, the inelastic nature of the product provides explosive

upside in the event pricing increases further.

Government Supply and National Security Issues:

Rare earth elements are used in the most important national security components of our defense

department. They are essential to drone production, F-35 fighter jets, Virginia-class submarines,

smart bombs, tomahawk cruise missiles, etc. As a result of the increasing tensions with China coupled

with the fact that 83% of production is in China (Source: CRU), the US has named all rare earths as

critical materials for the US government. On July 10, 2020, MP Materials received a contract with the

DoD (See press release below) and there is substantial additional upside to the extent many of the

currently proposed bills make it through Congress. If you look at the detail of recently proposed bills,

there are some interesting bipartisan efforts ranging from allowing the DoD to substantially increase the

ability to fund rare earth development (similar to Kodak) to giving buyers of US rare earth materials up

to a 200% tax deduction. While the intent of these bills is clearly to accelerate domestic production, it

could be a substantial catalyst for the shares in 2021.

“In April 2020, we were selected by the U.S. Department of Defense (the “DoD”) for a preliminary contract to

support the initial phase of a DoD effort to restore domestic heavy rare earths production and separation

capabilities to the United States. The construction of a heavy rare earths separation facility at Mountain Pass would

be independent of, but complementary to, our Stage II optimization project. The heavy rare earths award contract

was formally issued to us on July 10, 2020, and is now underway, though there is no guarantee that we will proceed

with any contract for subsequent phases of the DoD’s heavy rare earths efforts, or receive any additional U.S.

government funding.”

While the reason for the government’s concern is apparent, there is also a precedent for China

restricting supply of rare earth materials. In early 2011, China pulled global supply from the market in a

retaliation towards Japan over a disputed territory. This action sent pricing up ~500% in a matter of six

months, underscoring the concentration risk the Chinese have on the global market. While there has

not been much out of China that would suggest they do this again, it could be used if trade tensions rise

significantly.

Environmental Angle:

While MP Materials operates one of the lowest cost mines in the world, its cost structure would be even

more advantaged if China operated with stronger environmental restrictions. There have been articles

suggesting that the wet tailings process in China requires significant ground water usage and has been

noted to create “cancer villages” in the areas surrounding production. The hypocrisy of buying rare

earth materials in this manner to put it into an EV vehicle is obvious and could change over time. It is

possible that buyers of rare earth magnets such as Tesla would pay a premium for sustainably produced

materials.

Catalyst:

The company has already filed its S-4, will de-SPAC in October and made its first public appearance at

the Morgan Stanley Laguna Conference yesterday. I believe as investors better understand the secular

exposure and the scarcity of rare earth assets, it is likely to rerate substantially higher.

Disclosure: At the time of publication, the author of this article holds a position in FVAC. This

article expresses the opinions of the author. The author has no business relationship with any

company whose stock is mentioned in this article.

The author of this article, has a long position in the company covered herein and stands to realize

gains in the event that the price of the stock increases. Following publication, the author may

transact in the securities of the company, and may be long, short or neutral at any time. The author

of this report has obtained all information contained herein from sources believed to be accurate

and reliable. The author of this report makes no representation, express or implied, as to the

accuracy, timeliness or completeness of any such information or with regard to the results to be

obtained from its use. All expressions of opinion are subject to change without notice, and the

author does not undertake to update or supplement this article or any of the information contained

herein. This is not an offer to sell or a solicitation of an offer to buy any security.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

The company has already filed its S-4, will de-SPAC in October and made its first public appearance at

the Morgan Stanley Laguna Conference yesterday. I believe as investors better understand the secular

exposure and the scarcity of rare earth assets, it is likely to rerate substantially higher.

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			2020	2021
Price:	14.50	EPS	0	0
Shares Out. (in M):	150	P/E	0	0
Market Cap (in $M):	2,140	P/FCF	0	0
Net Debt (in $M):	-430	EBIT	0	0
TEV (in $M):	1,700	TEV/EBIT	0	0