First, I need to give credit where credit is due. Ruby831 posted on Neomaterial Technologies stock in October, 2010 (at http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/39739). My firm's primary position in this name is long the stock, with respect to which we are very bullish, but we also believe that the market is seriously undervaluing the convert. This is true even if you believe the equity is correctly priced, which we do not.
All dollar values in this write-up are in Canadian dollars.
In brief, Neomaterials is a processor of rare earths and zirconium. Their Magnaquench division sells 80% of neodymium powders used in the production of neodymium magnets, and the only supplier of these powders in the US, due to patents that expire over the next three years. The company's Performance Materials division produces oxides and salts of rare earths, plus mixed rare earth/zirconium oxides. They also have a small rhenium and tantalum recycling business. These products are used in LEDs, flat panel displays, wireless consumer products, solar cells, and industrial products. Both divisions purchase nearly all of their raw materials from Chinese miners (rare earths are usually found in association with other metals such as tin).
China produces around 97% of current worldwide production of rare earths, so that is where most of NEM's operations are located.
I encourage everyone to read ruby831's description and the comments there for a more thorough discussion.
Recent Developments and Upcoming Catalysts
The company is currently evaluating extracting rare earths from the Pitinga tin mine in Brazil, for which they have an exclusive right to investigate the property for its rare earth development potential and a right of first refusal to commercialize rare earth production there. The company is completing its analysis and continues to sound an optimistic note about the commercial potential of Pitinga.
Neomaterials also has a non-binding agreement to process rare earths from Molycorp's Mountain Pass rare earths mine in California (which they are reopening). This was once the world's highest volume rare earth producing mine. Molycorp plans to open their own processing plant on site a year later, so the size of this opportunity may be limited for Neomaterials.
The company has benefitted considerably from the drastic limitation of Chinese export quotas on rare earths in late 2010. China established limits for the export of rare earth oxides and salts, with the goal of bringing more production of value-added products into China. This has raised prices considerably outside China, with the boost in prices creating far more value for NEM than the limitation on export costs. This is a largely transitory phenomenon, with the Mountain Pass mine scheduled to begin operations later this year (though I expect 2012 to be a more realistic time frame) and with Lynas gearing up for production, also scheduled for later this year (and more likely to start in 2012 or 2013) in Indonesia.
On May 12, Neomaterials announced their 1Q11 earnings, far exceeding my expectations. At the same time, the company announced a $200 million offering of convertible bonds, the subject of this write-up. This caused the stock to plunge over two days from $10.00 to $8.69, which I attribute to convertible arb funds shorting into a relatively illiquid market. The stock recovered after two weeks, but then, three days ago, again fell from $10.00 to $8.67. Again, I think convert-related shorting was the main culprit (the underwriters exercised a $30 million green shoe, and the converts were delivered, on June 2). My take on this is that management, which is first rate operationally, is just learning how to deal with the capital markets. I think the company would have been better served had they listed in the US first before they raised new money. It is possible, however, that they needed to raise quickly, and therefore didn't have time to list in the US first, to complete an acquisition.
An additional factor is the increasing scrutiny of companies operating in China when reports surfaced that Sino-Forest Corp (ticker TRE in Canada) may be a fraud. I don't think that Neomaterials, which is a Canadian company that does business in China and has well established customers who buy all of its annual production, should suffer alongside a Chinese forestry company that may or may not own the forests it claims it owns.
In any case, I think the recent decline is a good buying opportunity for the stock, which plays out in the converts as well.
The converts trade on the Toronto Stock Exchange under the ticker NEM.DB.U. Each bond has a par value of $1,000, and pays interest at a rate of 5.0% semi-annually on June 30 and December 31 of each year, starting December 31, 2011 (the December payment will include full accrued but unpaid interest since the issue date). The bonds are debentures, so have little covenant protection, and standard change of control terms. Each bond converts at any time at the option of the holder into 72.4638 shares ($628.26 at today's closing price of $8.67) until one day before the December 17, 2017 maturity date.
I used the Bloomberg convertible model to value the bond; this model combines a simple credit analysis and a Black-Scholes option valuation. I assumed an OAS of 350 basis points, based on my firm's distance-to-default (aka Merton) model, which suggested the fair rating for the bonds would be BB, which translates into a 3.5% spread to Canadian 6-year treasuries. I also reduced the volatility from its historical 50% range to 35%, which is more appropriate for the more mature firm that Neomaterials is becoming.
Based on this analysis, I get a fixed income value of $95.19 and an option value of $18.20, for a total value of $113.39, with a delta of 0.57. The bonds closed today at $99.90. The bonds traded around $8 million and $11 million over the last two trading sessions.
Stock versus Convert - Qualitative
As I mentioned above, we are very positive on the stock, so our position is focused on the equity. However, I will make the case that, for more risk-averse investors, the bonds are the better investment. The main reason we are so bullish on the stock is the opportunities available to the company, particularly with the opening of the Pitinga mine. Should that project fail because the mine owner finds another partner (or causes Neomaterials to contract on unfavorable terms because of a bidding war), the bonds will be better able to withstand the loss, given the steady profits that the company should deliver once the rare earth's business normalizes.
Pitinga mine, Mountain Pass arrangement with Molycorp, continued craziness in rare earth prices