Description

Neo Performance Materials

This short post is dedicated to an interesting opportunity opening up recently in NPM – a Canada headquartered advanced industrial materials manufacturer.

NPM is one of the global leaders in the production of magnetic powers and magnets, but also different specialty chemicals/alloys/metals. The company itself divides its’ business across three business lines/segments –

1. Magnequench -- the production of magnetic powders and magnets;
2. Chemicals and oxides -- processing of minerals concentrate into advanced industrial materials, and;
3. Rare Metals -- refining of rare metals and their compounds like superalloys for jet engines, wireless technologies, and LED lightning.

The company was formed due to the infamous Molycorp restructuring, back in 2016. Since 2016 the company has constantly been in the net cash position, allowing it to undertake minor M&As across the board and enjoy uninterrupted business activity during less opportune times. Considering the „electrification of everything“ trend globally, we see demand for products produced by the company being attractively positioned for long-term growth.

Investment thesis

The world goes more and more in the direction of electrification trends, which concerns increasing production of EVs, but also already existing electrical devices becoming more and more efficient. On top of that, the promises for lower GHG emissions globally and a more significant share of sustainable energy sources are quite unquestioned trends we are witnessing. To do all of that, a simple thing is required – REE-based magnets and magnetic powders, which are set to increase in demand by more than 2x in the following decade.

As such, NPM’s products deliver magnetic, catalytic, luminescent, electrochemical, and enhanced thermal stability properties that enable technologies to be considered vital.

To make things clear, NPM is not an REE mining or vertically integrated company – though the company has a rare earth project in Greenland under development – their value-added lies in the processing part of the supply chain, making the business somewhat less cyclical (but not immune), and not being interested that much in sky-high prices of the product, but in high demand of those magnets (that sometimes become less affordable, like in the past couple of years). And lower affordability can translate into customers thinking about alternatives (like ferrites, which are cheaper but less efficient). But, at the end of the day, considering the pass-through mechanism put in place across major parts of NPM contracts, the company just enjoys its’ margin-earning process, which so far has been very cash-generative.

Differentiation

So what’s so special in NPM’s operations?

REE mining, separation, and all other parts of the supply chain are mostly located in China. China is unquestionably the largest REE producer and exporter globally, where companies are usually subject to production quotas. NPM has advantageous positioning since the company’s operations are diversified across the globe. The company has in total 9 manufacturing facilities in China, the US, Germany, Canada, Estonia, and Thailand. As such, NPM operates a unique dual supply chain inside and outside of China for REE separation and REE advanced materials. In Europe, the company is the only player operating commercial RE separation and rare metals facility in Europe.

At the end of the day, NPM is serving a bunch of well-known names to anyone:

Ongoing investment cycle

2023-2024 will be record years in terms of capex for the company. On average between 2017-2022, NPM was spending 10-12mln USD on capex (while generating ~50-70mln USD on EBITDA level). This year, though, according to our estimates, the company will spend ~90mln USD as 2 high-importance projects are going on:

1. reallocation of the Zibo-located production facility in China,
2. commencement of the first rare earth magnet manufacturing facility in Europe designed to produce specialized rare earth permanent magnets for use in electric vehicles, wind turbines, and other clean energy technologies (will be located in Estonia, a nearby operating facility to existing Silmet facility).

In total, the Zibo reallocation project should cost ~75mln USD (12mln USD already spent, to be finished in 1Q24), while Sintered Magnets project in Europe costs ~107mln USD (20mln funded by EU grant; will be finished in 2025). Considering the 300mln USD market cap of the company, those projects are sizable and important strategically.

Recent results

In previous years, results were affected by general economic slowdowns and cautious economic outlooks, putting sales volumes of Magnequench’s and C&O under pressure from time to time (especially in cases when global car sales are sluggish). Recently, the same reason affected results, but also add to that global shortage of chips and economic issues in China + local covid lockdowns, putting results under pressure.

Interestingly enough, the CEO and CFO commented during recent conference calls, that their recent conversations with customers indicate that demand could be back to a more normalized environment already in the second half of the year.

Quite the same goes for EBITDA generation, but also it should be noted, that at the moment the company has a high-cost inventory on hand, which gets processed step-by-step (while selling prices for NPM change either monthly or quarterly in most cases), creating artifically low reported figures (as later on, at some point, NPM enjoys the opposite situation and „overearns“ when prices are rising, but has low-cost inventory on hand). At the end of the day, the EBITDA margin profile throughout the years is more-or-less steady and stays in between 10-14%, while gross margin historically has been 23-25% with a couple of hiccup-years, jumping to ~30%.

Cash generation has been heavily affected since 2020 by i) covid-effects (lower demand = more inventories on hand), and ii) considerably higher prices for magnets globally, which start falling to pieces only recently with the first positive working capital effects visible in the first quarter of 2023.

At the moment, the NWC/Sales ratio stays around 37%; while if history is any guide, then it should be closer to 31-32%, meaning that partially the upcoming capex cycle will be covered by cash released from working capital. During the next 5 years, we foresee the company generating around 70mln USD of free cash flow. 2023-24 are set to be CAPEX-heavy years, with 2025 onwards CAPEX = depreciation and NPM generating ca. 50m USD in FCF p.a. or 16-17% FCF yield on EV.

Valuation

We approach the case with 2 scenarios, one of which is quite conservative (base case), while the other one is more upbeat.

• We forecast a relatively tough 2 years with volumes going down from 13k tons in 2022 to 12k tons in 2024 (mostly due to the currently visible slowdown in terms of demand across the globe, but especially in automotive and broadly China-related post-covid effects). Since 2025, though, Estonian new Sintered Magnets facilities should start contributing more and more volumes-wise (initial capacity of 2k tons, with an expansion option to 5k tons, but not in our scenario at this point). All-in-all, coupled with a better macro outlook and hopefully forever gone into history issues with semiconductors, should lead us to a total capacity of ~14.8k tons by 2026.
• We acknowledge, that the average revenue per kg in the past years has been somewhat higher than historically, and as such we do not want to extrapolate here too much.  Our basic assumption at this point is that the average price per kg will go down from 49 USD to just 42 USD by 2025 and then will stay flat thereafter.
• All this translates into revenues dropping by 25% this year to 480mln USD from 640mln USD a year ago, and then recovering to 590 and 620mln USD by 2025-2026, mostly due to volumes factor.
• Margins-wise we stick to a „back to normal“ method and assume that after digesting higher-cost inventories, the company will return to 9-10% EBITDA margin by 2025 and will stay on this level thereafter.
• Assuming a historical average OCF conversion from EBITDA of ~100% (before working capital changes), and taking into account ~90/60/20/15/15 mln USD of capex for 2023-2027 respectively, we reach 40-50mln USD free cash flow generation capacity starting 2025, which translates into a hefty 15% FCF yield.
• Accounting for potential capital returns in the form of dividends and applying a historical median EV/EBITDA multiple of 5.3x, we reach a potential price target of around 11.5 CAD/share, implying a 30% upside.

2. We may foresee around a 50% upside in the case of considerably better demand seen around the globe or, for example, another sudden spike in prices, allowing NPM to once again „overearn“ for some time and enjoy trading at higher-than-average EV/EBITDA multiple (for example, it traded at ~9x multiple during 2021, when post-covid recovery took place globally excl China and prices skyrocketed suddenly as well). Also, we note that the new Sintered Magnets project could generate something around 14-18% ROIC (taking into account the EU grant received), while historically NPM generated through the cycle around 12% ROIC, which may trigger some rerating, but it would not be our base-case at this point.
3. All-in-all, we consider 11-14 CAD/share a fair range for the stock price depending on the macro conditions and execution. Cross-checking our forecasts with S&P Global estimates we see that our figures are considerably more conservative at -3 / 21 / 43 mln USD vs 17 / 37 / 60 mln USD provided by the consensus on the EBIT level for 2023-2025 respectively.

Risks:

• Any kind of technological breakthrough (unknown to us), which puts neodymium-iron-boron (NdFeB) magnets into a disadvanced position
• Significant, protracted economic slowdown, resulting in lower demand for NPM’s products
• Supply chain risks – Estonian entity is still sourcing rare earth oxide from a Russian company (which is not a sanctioned entity)
• The company falls into protracted long-lasting high-capex cycle
• Company loses all ongoing legal cases related to patent infringement, resulting in ~60mln USD cash payment (current specific estimated damages)

Catalyst

China's macro suddenly improves ahead of the current consensus expectations, triggering a better economic outlook across the globe as well