This week we take a dive into energy markets, in particular the likely medium to long term outlook for the sector. We have previously written on the potential dislocations both in uranium spot prices (which we wrote off last year) and the potential upward trajectory in oil prices. The former has seemingly played out (though it may still be very much in its infancy) and the second seems to be playing out in real time with Brent futures trading at US$85.45 per barrel and WTI at US$83.73 per barrel. Many would also be aware of the sheer scale of disruptions in the UK and broader shortages of LNG in the Eurozone heading into winter. Even more recently, the headlines have been taken over by blackouts in China in the face of increased demand.
So, what has happened? Especially after coming off negative prices in the middle of 2020 and a seeming supply glut in oil.
Context
Author: Sid Ruttala
For those that have watched recent price action, there has seemingly been an upward trajectory in spot prices despite bearish signals. Per the last EIA report, US crude inventories building close to 6m barrels and doing so within broader expectations of drawdowns, while gasoline and distillates drew down approximately 2m barrels. Combine this with US production bouncing back to 11m barrels and this would usually indicate rather bearish signals. However, there is a catch, the underlying data isn’t necessarily what is important, rather how the market reacts to said data. In this instance, it is a clear indication that the market is seeing something that we may be missing.
Before we go further, understand that shorter term spikes may be due to certain intricacies and quirks of the calendar. For example, the price action and moves earlier this month (on 11 September) may have been due to Columbus Day. The nature of the futures market is such that traders have to consistently roll contracts in order to maintain positions. Days like that, when the futures market remains open whilst the banks close, will inevitably mean a little manipulation (i.e. same day settlement requirement while banks remain closed).
But, taking those exceptions out of the equation, we are clearly seeing signs that we may be in for a bumpy ride. For those that have read our previous articles on this issue, our base case was that when demand does inevitably pick up post-covid we are likely to see supply bottlenecks precisely at a time when demand started to pick up. This was during the depths of covid when prices became negative and when the question became where to store the product; we saw the flip side with an increasing lack of investment in the western world (due to climate policy), high cost of production for shale in the US (which saw increased shut ins). What we were perhaps wrong on was the resurgence of US production, which beat even our most optimistic expectations.
So, what has led to this situation?
We are by no means climate change sceptics nor are we against renewables, the infrastructure for which still requires investment in the underlying technologies and associated capital for commercialisation and global scale. What we have found bizarre is the sheer lack of nuance and understanding of the dislocations that may take place. Take for example, the recent International Energy Agency (IEA) report whose STEPS model presents the below case:
Demand (for oil) levels off at 104 mb/d in the mid-2030’s and then declines slightly to 2050;
Oil in transportation increases and peaks around 2025 at 97 mb/d and declines to 77 mb/d in 2050;
Oil falls by around 4mb/d in countries with net zero pledges between 2020 and 2030 which is then offset by an increase in 8 mb/d in the rest of the world;
Coal exports from Australia will fall by 5% to 2030;
Oil prices will rise to around US$77 per barrel in 2030.
The above seems plausible aside from some fundamental assumptions that don’t sit well with even the most basic understanding of how economies transition or political incentives operate. For one thing, it assumes that nations with net zero targets stick to their goals. After the recent blackouts in China and the long queues at petrol stations (in the UK) we don’t think the transition occurs quite so smoothly. Secondly, there is also the assumption that 45% of the energy mix in the Asia region will be accounted for by renewables, as some of these emerging markets move into middle income countries. In fact, it is assumed that energy consumption will flatline or decline in emerging markets such as India. History, however, tells us that it is simply not true, consumption increases exponentially as people and nations move into middle-income.
The problem? A lot of these assumptions not only determined the policy environment but also the flow of investment and capital. Think for a moment about the yield on bonds for coal or oil producers such as Newcastle Coal (yielding 10.29%) or AGL’s inability to find requisite debt financing. Can you really blame investors? Think for a moment about a bank trying to finance said deal, requiring capex that typically has a pay off over a multi-decade period. Assuming that at some point the transition occurs and the market has dried up, what then happens to said assets? They are what is termed stranded assets.
Many have commented on the ability of nations such as Saudi Arabia or Russia to increase production, especially given their low cost of production. Saudi for example has a cost base of US$2.80 per barrel. What we feel is that investors should rather use what is termed the budgetary breakeven, which is the breakeven price in order to run a balanced budget (especially in the absence of taxation) which currently stands at US$67.80 per barrel for the Kingdom. Suffice it to say, OPEC broadly has an incentive to keep supply limited in order to drive gross margins and profitability.
Here is where the IEA may be onto something. It makes the conclusion that producers are incentivised, given the uncertainty around the future, to focus on existing production (as opposed to bringing on new production) in order to generate the highest possible profits. So, what does this mean?
Put simply, we will see a massive disincentivisation to bring on additional production, despite demand as the world transitions over a twenty year period (the IEA’s most optimistic forecast). Given this base case and assuming current trends continue to stay at status quo, we are likely to see increased oil prices. We previously made the call that we would see this happen this year. We very much see this still in its infancy with triple digits quite possible in the near-term.
What are the implications?
When we talk about the price of oil, many immediately equate it to the price paid at the petrol station. Consider the broader implications of this. The chart below shows the FAO Food Price Index, a measure of the monthly change in international prices of a basket of staple food commodities, between 1990 to 2015. The highest period of per annum growth? Between 2003 to 2008. The price of oil during the same period? Went from US$20 per barrel to a peak of US$140 per barrel.
Source: FAO
Consider the follow-on impact on CPI and inflation in an era where monetary policy is likely to be curtailed due to the sheer size of debt issued over the decade since the GFC. Consider also the implications for large energy importers such as India and China, who are heavily dependent on the sector and the consequent lower growth prospects in the broader global economy.
How do we profit? We’ve previously written on Woodside (WPL.ASX) and continue to feel that this is a fantastic prospect. Buying larger companies (i.e. further up the maturity curve) with existing low cost production is the more reasonable way to generate returns (as opposed to smaller ones unless looking at M&A prospects). Looking globally, those looking like good buys are Exxon Mobil (XOM.NYSE), Enbridge (ENB.TSE) – pipelines – and APA Group (APA.ASX). These businesses should continue to generate massive cash flows over the next decade.Looking more broadly, as upward pressure on inflation continues despite lower real growth rates, focusing on defensive plays should be beneficial. BHP’s recent venture into potash and price action in fertilizers is rather telling. Defensive here means generating revenues that are correlated to inflation (as opposed to growth,which has consistently done well for investors in the past two decades).This morning WPL released its quarterly guidance, where the realised price stood at US$59 per barrel and sales revenue up 19% despite a slight decline in production (by 2%).
This is the market’s incentive. Focus on margins through higher price realisation while at the same time flatlining or downward pressure on production.
Disclaimer: WPL.ASX and XOM.NYSE are both currently held in TAMIM portfolios.
A few weeks ago we covered a key holding in the TAMIM Global Mobility portfolio, a fully integrated lithium company called Albemarle (ALB.NYSE) that is poised to benefit from increased production of electric vehicles. This week we revisit lithium and take a look at three heavyweight ASX stocks that are shaping up as market leaders.
Author: Adam Wolf
The lithium space has received a lot of attention recently with investors sending any companies with lithium exposure to sky high prices, similar to what we have seen with uranium. Lithium is the primary component of lithium-ion batteries (LIB), which are rapidly gaining traction due to their wide applicability in energy storage. In particular, solar and wind energy projects and the increasing demand from the electric vehicle (EV) sector. With the push for green energy and rise of electric vehicle production, everyone can see the upside in lithium. While the easy money may have been made, these lithium companies still pose an interesting proposition to investors looking to gain exposure to the broader electric vehicle thematic.
Source: Albemarle company filings
Data from Benchmark’s Lithium Forecast shows a projected annual lithium supply deficit of up to 225,000 tonnes in North America and 500,000 tonnes in Europe by 2030. To incentivise the right amount of investment in new mines there is going to have to be a sustained period of elevated prices.
Source: VUL company filings
Bringing deposits into production is a time consuming process and it can take years to complete the necessary feasibility studies and actually construct a mine. In order to understand the merits of a lithium deposit we first need to understand the difference between brine and hard rock deposits. Lithium deposits can either be produced from brine or spodumene rock production. Brine production is typically cheaper and significantly more environmentally friendly. Brine deposits are typically found in South American countries like Chile and Argentina. However, there is a catch with producing carbonate from brines. Although lithium carbonate can be converted into lithium hydroxide (what is used to make the batteries for EVs), it comes at an additional cost. This is causing brines to look less attractive to battery producers, leading to industry players scaling up or increasing their hard rock mine assets. Although brine deposits are cheaper to extract they require more processing and are typically used in lower density batteries, the batteries that enable electric vehicles to drive for long distances require higher density lithium which is found in hard rock and is therefore better suited. The lithium explorers in Australia are looking for hard rock lithium.
Source: newagemetals.com
Mineral Resources (MIN.ASX)
Mineral Resources Limited is a mining services company with a portfolio of mining operations across both lithium and iron ore. Their mining services segment comprises of crushing/processing, mine construction as well other services. The mining services/engineering sector has typically attracted very little attention from investors and historically trades on very low multiples as a result of cyclicality and the nature of their revenues, which are contracted. More recently we have seen higher labour costs due to labour shortages which have impacted margins. MIN offers more upside than your usual mining services company through their iron ore and lithium operations yet they are still trading on low multiples alongside other mining services companies.
MIN is a top five global exporter of lithium, they have interests in two lithium mines and a lithium hydroxide plant in Perth. In 2019, MIN sold 60% of its ownership in the Wodgina lithium hard rock mine, a Tier 1 asset, to US based Albemarle (a holding in our Global Mobility portfolio, as mentioned). The Wodgina mine is currently under care and maintenance, the mine would be a 750,000 t/yr operations. The JV is also building a processing operation and the 50,000 t/yr Kemerton lithium hydroxide plant, under development southwest of Perth. Through its shareholdings in Mt Marion and Wodgina, Mineral Resources has access to significant amounts of spodumene, which can be used as feedstock for much higher margin lithium hydroxide production.
Outlook
Mineral Resources recorded an EBITDA of $1.9bn in FY21. Yes, this was inflated by sky high iron ore prices but if you look at a more normalised environment with lower iron ore prices, a cheaper labour market and accounting for the production that the Wodgina Project will bring once brought back online, a sustainable EBITDA of $1bn is certainly not out of the question. This would see MIN trading on an EV/EBITDA of less than 8x. MIN also have 5.5% stake in fellow lithium producer Pilbara Minerals.
Pilbara Minerals (PLS.ASX)
Pilbara Minerals is an emerging lithium company producing spodumene concentrate with operations in the Pilbara region in Western Australia. PLS has 100% ownership of the world-class Pilgangoora Lithium-Tantalum Project (“Pilgangoora Project”), the largest independent hard-rock lithium operation in the world. PLS is looking to become a fully integrated lithium raw materials and chemicals supplier. The significant scale and quality of the operation has attracted a consortium of high quality, global partners including Ganfeng Lithium, General Lithium, Great Wall Motor Company, POSCO, CATL and Yibin Tianyi. PLS is one of Australia’s largest lithium focused companies and with good reason. They have made several strategic moves that have separated them from the other lithium producers, some of which we will delve into.
Battery Materials Exchange
Pilbara Minerals executed an agreement with GLX Digital Limited (a private company) for the launch of a new sales and trading software platform for the Pilgangoora Project, providing flexibility to transact by auction, tender process or bilateral sale. This battery metal exchange serves as an auction house to bid for Pilbara’s offtake from the Pilgangoora project. So far the exchange has yielded prices far above the spot price of lithium.
The excessive prices PLS has fetched so far is a testament to how limited the supply of quality hard rock lithium really is. The battery metal exchange is a huge competitive advantage for PLS and provides them with greater flexibility in terms of selling their product that has so far maximised their margins. This is yet another well executed strategic move by the PLS team, the next auction is on October 26 so all eyes will be on whether PLS continues to achieve such premiums on the exchange.
Altura Project Acquisition
In late 2020, PLS announced the acquisition of the Altura Project for a consideration of $175m USD. The Altura Project is located on an adjoining tenement package immediately to the west of Pilbara Minerals’ Pilgangoora Project. The operation is part of the same mineralised system that underpins the Pilgangoora Project and uses similar open-pit mining methods, processing flowsheets and mining equipment The acquisition of the Altura Project should provide Pilbara Minerals with a unique opportunity to realise tangible operational synergies by consolidating the two neighbouring projects into a single integrated operation. Of particular interest to the PLS is the opportunity to mine that section of the Altura orebody that is otherwise sterilised without access being granted to Pilbara Minerals’ ground to undertake mining activities.
Downstream Opportunity
PLS entered into an agreement with POSCO (005490.KRX) where PLS will have ownership of up to 30% in a downstream JV for a lithium chemical conversion facility in South Korea. This joint venture will give Pilbara Minerals significant exposure to one of the world’s most dynamic and fastest growing markets for lithium chemicals. This downstream opportunity would shift PLS up the value chain which could see them get higher margins and earnings from their offtake. The project is still subject to a final investment decision and approvals but the proposed facility will have the capacity to to produce approximately 40k tonnes of lithium hydroxide p.a., enough to produce the batteries of one million electric vehicles.
Outlook
PLS produced 280kdmt (thousand dry metric tonnes) of lithium in FY21. PLS expects to be producing 580kt p.a. by mid-2022, this is more than doubling their production and it’s all at a measured capex. Simply put, PLS ticks all the boxes. They are operating in a world class mining jurisdiction, they have long mine life of more than twenty years, it is open pit (cheaper and easier to mine), they have cost advantages over the brine operators in South America (who are producing an inferior product) and they have significant synergies to be realised through their acquisition of the neighbouring Altura lithium. PLS are expanding their capabilities through both midstream and downstream operations which should add significant value to their final product, increase their margins and give them even more flexibility with their offtake.
Source: PLS company filings
Vulcan Energy Resources (VUL.ASX)
VUL has been one of the market’s biggest winners over the past year (up 1000%+). Vulcan is developing the world’s first and only zero-carbon lithium process and plans to produce battery-grade lithium hydroxide from geothermal brines pumped from wells with a renewable geothermal energy by-product. VUL are currently conducting a definitive feasibility study for their lithium project; this is the final step before commencing construction on the operation. Everything Vulcan touches seems to turn to gold. Recently, we saw their spinoff KNI reach multiples of its offer price after listing. To understand why VUL has been one of, if not the hottest stock on the ASX we first need to make sense of how geothermal energy works.
Source: VUL company filings
Geothermal Energy
Geothermal lithium offers a more sustainable and less impactful way of extracting lithium. Geothermal lithium mining has nearly zero environmental impacts and leaves a marginal ground or water footprint. While traditional lithium brines rely on evaporation processes to collect the precious metal, in geothermal plants lithium-rich brine is pumped to the surface from geothermal reservoirs. The heat carried by the brine is used to produce renewable energy and the brine is re-injected in the reservoir. A geothermal plant can not only produce lithium but also produce renewable energy, giving Vulcan two different streams of revenue.
Source: VUL company filings
The onset of ESG-focus has changed the way investors allocate capital and has led to the rise of a green premium for lithium amid heightened demand for more environmentally friendly resources. Given VUL’s zero-carbon process they have received a huge premium from the market.
Gec-Co Acquisition
Gec-Co Global Engineering is a consultancy company focused on deep geothermal projects at surface. Gec-Co has a highly credentialed scientific team with 100+ years of combined world-leading expertise in developing geothermal projects, from exploration to production. Motivations are fully aligned: to decarbonize heat and power in Europe with geothermal development in the Upper Rhine Valley in Germany. The acquisition is part of Vulcan’s plans to rapidly grow its development team in Germany and accelerate its Zero Carbon Lithium project towards production
Processing Hub
In line with other producers like PLS, VUL will be developing their own processing hub which will add value to their lithium end product. The Central Lithium Plant is intended as a processing hub, processing lithium chloride from multiple combined geothermal and lithium sorption plants into lithium hydroxide. VUL secured a site just outside of Frankfurt with the location allowing for low carbon transport options from their nearby project areas, as well as renewable energy to power the proposed plant, which underpins Vulcan’s commitment to minimising their carbon footprint at each step of their process.
Source: VUL company filings
VUL’s Zero Carbon Lithium project is located in Germany, the company owns Europe’s largest JORC-compliant lithium resource. The project is located in what Vulcan describes as the heart of the European lithium-ion battery industry, VUL are looking to address Europe’s decarbonisation needs. Europe is the largest growing lithium market in the world and hosts many of the biggest car manufacturers yet they don’t have any local supply of Lithium hydroxide.
Note 2: Based on electric vehicle sales and lithium-ion battery production growth
Source: VUL company filings
VUL is planning to produce 40k tonnes of lithium hydroxide p.a. as well as produce 74MW of renewable electricity. This week VUL signed yet another offtake deal for its hydroxide with Umicore, a leader in cathode materials production used in lithium-ion batteries for electrified transportation. We expect that VUL’s final product will command a premium over market prices due to the environment-conscious nature of the project.
OutlookVulcan’s Zero Carbon Lithium project is arguably the most interesting lithium production plan in the world. Not only will they provide lithium hydroxide for electric vehicles but they will also produce renewable electricity, you can’t get a more net positive mining operation than that, can you?
Their project is also in a convenient location. Being in the heart of Europe gives them the opportunity to benefit from the EU’s growing environmental mandates. VUL is also well funded following their recent cap raise with $331m in cash. This gives them more than enough cash to expand via the acquisition of other projects. They are planning to have operations underway in 2024. Their energy and lithium projects have a post tax NPV of over €2.6bn.
The share price was under $1 in 2020 and is now over $13.50. It is easy to say that the market has priced in the upside for VUL but, given the significance of this project and the rapidly growing thematics they are targeting, at a market cap of $1.6bn who knows where this will be in a few years when they actually start producing lithium hydroxide and renewable energy. VUL also announced they will be dual listing on the Frankfurt exchange, giving them access to European investors; we expect to see a lot of news flow over the next few months. When VUL releases the results of their definitive feasibility study the market will know in more detail the true economics of the project. In the current environment, the market is rewarding companies for sustainable operations and Vulcan’s commitment to minimising their carbon footprint is attracting lots of interest from investors and offtake partners. If they execute their Zero Carbon Lithium operations, they could be a global pioneer in lithium.
Summary
Through its applications in electric vehicle batteries and green energy storage, there is no doubt that lithium will be an essential component of the decarbonisation process. The rapid rise in carbon mandates and electric vehicle production has seen demand for the metal rise significantly, sending supply for lithium into a deficit and prices flying as a result. When looking for exposure to lithium, investors have a plethora of opportunities and a lot of junior miners are pivoting their focus to look for lithium deposits. The companies mentioned in this article each have their own merits but most of all they have the resources to become the BHP-equivalent in the lithium production industry alongside our Global Mobility holding and largest lithium producer in the world Albemarle. All the stocks mentioned in the article are developing their mid and downstream capabilities which will enable them to deliver a higher value product. While MIN may not be as enterprising as PLS and VUL, they offer a cheaper entry into lithium exposure hiding behind their not-so-sexy mining services business. As for PLS and VUL, they are both making strategic moves in the industry and have considerable competitive advantages over other players.
Disclaimer: Albemarle (ALB.NYSE) is held as a long position in TAMIM’s Global Mobility portfolio. The TAMIM Global Mobility strategy seeks to to capitalise on the ongoing $7 trillion autonomous and electric vehicle revolution.
Speaking to prospective and actual clients everyday, we get a fair sense and understanding as to the pulse of the market. Throughout those conversations, there are often common themes and questions. Among these, first, should we continue to own equities? Second question, where to allocate in a world of continued low interest rates? Thirdly, we keep hearing about inflation, but what does this actually mean?
While we are unable to provide advice or answer these questions directly and individually, we are able to voice our general opinions and positions on the subjects in question. For us, we continue to stay fully invested from an equities perspective. This is with the understanding that there is, as with any given market context, always the possibility of a sell-off. In doing so we prefer to make use of prudent risk-mitigation strategies such as put-options over the index as opposed to trying to time the market. Why? Simple, we aren’t smart enough to predict exactly when or where the catalyst for the next sell-off may come from (far too many moving parts). Anyone that tells you they can? Run the other way. With that bit of context, let’s get to unpacking the questions listed in reverse order.
Inflation
Author: Sid Ruttala
For those that have read previous articles, you may be aware that I am somewhat of an inflationista. Despite rhetoric and the consistent management of inflation expectations by central bankers across the planet pertaining to the transitory nature of current trends, we simply don’t buy it. This time it really may be different. This was never our base case historically, despite the doomsday predictions during the initial rounds of QE (Quantitative Easing), where commentators consistently mentioned that liquidity injections into the financial system would result in runaway inflation. This is, we feel, a rather basic misunderstanding of the process through which it takes place. Firstly, increasing bank reserves does not necessarily translate or correlate into credit growth in and of itself. In fact, one could argue that money was stuck within the commercial banking system and this was reflected through increased asset price inflation. Credit growth is what is required in bringing about inflation in the real economy, via the money multiplier effect. Instead we saw continued downward pressure on the cost of capital for businesses (reflected in margins) and the increased use of share buybacks, especially in the US, which translated into massive EPS (or earnings per share growth).
Secondly, the labor arbitrage in the form of China and the ever downward pressure on real wages as a result, combined with technological innovation, saw a perfect deflationary scenario. Something that Japan and the EU continued to grapple with until quite recently. So, what about this time is different?
What Covid brought to the forefront, we argue, is the fragility of supply chains globally. Just-In-Time inventory systems and interconnectedness that were at the heart of historic earnings and equities growth. Yes, it is true that these supply bottlenecks, as indicated by the increased shipping rates and border closures, are transitory. What is not is the increasing role that governments are playing in re-calibrating supply chains which will put increasing cost pressures on companies which will inevitably be passed on to consumers. Secondly, the labour dynamic. Labour and wages continue to be the biggest driver of inflation to this day. Historically, since the 80s, monetary policy makers have been reluctant to see what is termed in economics as secondary round inflation. That is, the increased cost of living leading to wage earners demanding higher salaries which then causes another round of inflation in a somewhat self-perpetuating manner. It is rather telling that even the RBA Governor constantly talks about wage growth (not full employment) when coming up with his reasoning for the cash rate policy. Similarly, the appointment of Janet Yellen, a labour economist, as Treasury Secretary in the US is another sign of the priorities of policy makers. There is the second point, we will likely see an increase in labour’s share of GDP in the real economy (again, inflationary). Combine this with falls in immigration and more generous social benefits which enable workers to be more discerning and increases bargaining power. This brings us to the first point to watch out for as investors, don’t just look at the headline employment data but rather the transition time in short-term unemployment. This is a good indicator of the actual nature of unemployment. Workers being incentivised to stay out of the workforce for longer because of better bargaining power is inflationary. This is perhaps the reason why we continue to hear about labour shortages in the US, for example, despite official unemployment figures staying above 5%.
Returning to the China question, we believe the Evergrande crisis may in fact be a catalyst for a rethink of policy making. The controlled exchange rates which saw the PBOC hoard a phenomenal amount of foreign currency and debt on its balance sheet may be in its final stages. The nation is the only outlier in terms of broad money growth, only annualising 8% (compare this to developed economies such as the US and Australia which remain in the higher double digits). The reason we raise this is that having pegged or managed currency limits the monetary authorities in their policy making. Currently, the RMB is allowed to operate within a band that is deemed acceptable. However, in order to do this, it is disproportionately impacted by outside influences in its policy decisions. Should this happen, there will be a short-term deflationary shock as the RMB is likely to fall on a relative basis, providing a short term boost to exports and foreign investment. But longer term, given the policy impetus, we see this aspect to be rather transitory. This aspect is perhaps the other reason for Beijing’s confrontational tone as it pertains to cryptocurrency (they more than most cannot afford an alternative to the home currency).
So, point number one, inflation is coming. Not runaway as many of the readership may currently believe, like the 70s but a secular trend. Our call is that it will continue to average around 4% for the foreseeable future. The reason we don’t say runaway is, one, that it is very likely that measurements will be changed (important as this is what markets use in any case) and, two, the aging demographic and associated excess liquidity will put a dent. Think about when the period of greatest expenditure often is in a person’s life, usually in their mid-30s and when starting a family.
So, where do we allocate?
Allocation
Before going any further, consider this fact. The current portion of the US Federal Budget that services outstanding debt stands at 7.8% as of 2021, the numbers are similar in Australia. This is with the Fed Funds rate at 0.75 – 1% (expected between now and 2023) and the RBA cash rate at 0.10%. The question then becomes what would happen to this number should rates go back to 2007 pre-GFC levels of around 5%? This would imply that close to half of these respective government budgets would be allocated just to servicing the debt without any new expenditure. So we feel certain of one thing, we will not see a “normalisation” of monetary policy for the foreseeable future. What does this mean for you? First, the implication will be that the secular run in the bond-bull market is over, with real yields quickly going negative (they arguably already are). The only way out of this pickle, returning to the inflation thesis, is that inflation will be allowed to go above the official target rates (all things equal) and inflation control will increasingly come in the form of regulatory intervention rather than through an “independent” central bank.
In real terms, this means that the nominal growth rates of company earnings will continue to outperform while the discount rate (which has always been, and will likely continue to be, the official rates) stays put. Now, this may theoretically imply infinite equities valuations but it is important for investors to be a little more discerning. That is, your growth in dividends or capital must be higher or at least on par with CPI.
For those still unconvinced, think about the centrality of asset prices to the modern day economy that was the direct result of the financialisation of everything.
At TAMIM we continue to invest the equities portfolios in real assets with fixed debt structures, industrials, M&A targets (there will be continued activity here) and infrastructure. A side note about the M&A aspect: many of you may be investors in Sydney Airport (SYD.ASX), there is a different angle you should consider when looking at potential and so-called conservative assets. Let’s use the example of a utilities company with a dividend yield of 6%. For an institutional investor looking at fixed income substitute or similar replacement, happy with say a 3% annuity-like return stream, the equities investor would have also had significant capital growth. This could potentially be both lucrative and rewarding.
This brings us to the second point, the easy returns on the index have already been ascertained. It will pay to be a little more discerning in what you look at going forward. There are certain metrics that will matter more such as 1) pricing power; 2) ROA (Return on Assets); 3) Debt (in particular composition of said debt, for example, a large proportion in long duration and fixed can act as an effective transfer of wealth from the debt holders to the equity holders); and 4) Government or regulatory intervention, for example, recalibrating or reshoring supply chains also has the effect of protecting companies from competition. Finally, chasing M&A activity could be especially rewarding.
Finally, should we continue to own equities?
The answer is a resounding yes. Are valuations beyond historic norms? Yes. Will we see sell-offs? Yes. But where else can one allocate? Cash? We argued that we do not see a normalisation of monetary policy, your purchasing power is eroding by the day. On a side-note, looking Stateside, the recent news has been the Treasury asking banks to disclose a greater amount of detail on customer transactions (i.e. to the IRS). This is a sign of where the wind is blowing. We would rather own good businesses that generate cash flow and maintain our purchasing power as opposed to what is effectively an unfunded state liability.
This week we will be writing about a small cap education stock that has undergone a huge structural change as a result of a major partnership that is transformative to the business. We believe the market isn’t giving due credit for the magnitude of this partnership and the stock is presenting as a compelling opportunity for investors.
Janison Education (JAN.ASX)
Janison is a global leader in digital exam assessments. They are an EdTech company operating in a sector that has grown significantly as a result of the shift towards digitised learning, a shift accelerated further by covid-19. Janison provides online assessment and exam management solutions for global corporations, governments and education bodies.
Authors: Ron Shamgar
Janison specialises in high-stakes, high-volume digital assessment platforms for which there are few competitors able to offer comparable levels of scale, reliability, and exam integrity with demonstrated success with governments and esteemed education institutions.
Janison provides services to some of the biggest examination bodies in Australia and worldwide. Some of their key customers include the National Assessment Program (Naplan), a series of exams I’m sure at least some of ours readers are familiar with, while they also deliver ICAS Assessments, a suite of school tests, and most recently Janison entered into an exclusive partnership with the Organisation for Economic Co-operation and Development (OECD) to deliver its Programme for International Student Assessment PISA for Schools test. We will return to this later.
Source: Company filings
EdTech
Spending on EdTech and digital expenditure is expected to grow by 2.5 x between 2019 and 2025, reaching a total market size of $550bn. As a result of covid-19, the estimated market size for EdTech has expanded by a further $85bn in the past year. The short-term increase in spending through COVID is expected to remain in the long term as education departments uplift infrastructure capability to provide the devices and networking standards required for digital adoption. Schools are more equipped than ever to adopt digital assessments now that teachers are more familiar with technology; schools are expanding the infrastructure necessary to deliver digital exams on a large scale. Janison’s digital assessment solutions address the changing needs of the educational sector, covid-19 has emphasised and validated the advantages of digitisation in education and Janison is well placed to execute its strategy in this market.
Source: Company filings
PISA for Schools
In May 2019 Janison announced that they had entered into an exclusive agreement with OECD to be the provider of PISA for Schools globally. PISA for Schools is providing educators with the best available evidence, drawn from the best available data sets to inform best practices in their schools. The PISA for Schools test will be powered by the Janison Insights platform which offers educators an enhanced dashboard and streamlined reporting structure alongside a suite of practical features enabling schools to explore their own data and compare their results to those of other schools and countries around the world. PISA is the gold standard in international assessments for global benchmarking. This deal will see Janison deliver the PISA for Schools to up to ninety countries (they currently are rolling out across fifteen) and gives them a huge addressable market to capitalise on.
PISA for Schools Revenue Model
Janison’s revenue model for providing the PISA for Schools test will depend on whether they are the National Service Provider (NSP) or the International Service provider (ISP) for the country in which they are rolling the platform out. As the national service provider, Janison will sign up schools themselves through sales representatives and will receive $7000 p.a. from each school they sign up. As an international service provider they will give the platform to a distributor who will then sell the testing platform to the schools, bringing in around $500 p.a. from each school. By rolling out the platform themselves and being the national service provider, Janison can see a much bigger profit margin. This is what they have been doing in major countries like Australia, UK and the US
By becoming the NSP in the UK and the US, Janison’s addressable market is huge and it is all recurring revenue. The PISA partnership is transformative for Janison, management has projected that it will add approx. $30m of ARR. This is a conservative estimate given the size of the market.
Valuation + Outlook
Jansion is currently trading at an enterprise value of $200m, in FY21 Janison did $23m in ARR. As we have said many times before, we love businesses with good earnings visibility that have a recurring revenue model. The majority of Janison’s revenue is from providing assessments to schools through their partnerships with ICAS, PISA for Schools and others. PISA for Schools has provided Janison with a significant runway to scale their ARR. Janison’s cost base from rolling out the exams won’t increase a whole lot and, as they sign up news schools in the UK and US, their EBITDA margin will skyrocket.
Source: Company filings
Looking forward, Janison are in the process of rolling out PISA for Schools across fifteen countries, they are the NSP in six of them. We can see Janison exceeding $100m ARR by 2025, considering the growth in the EdTech sector and the incoming ICAS/PISA for Schools rollout (both of which are international exams that will provide significant scale for Janison).
Janison have also been active on the acquisitions front. They look for businesses with an existing customer base that will provide cross selling opportunities. This week Janison announced the acquisition of Quality Assessment Tasks. The rationale behind this deal is that QAT comes with a bank of past assessments and exam questions which have monetary value within Janison’s school assessment offering. It also introduces a network of over 250 highly skilled test writers and reviewers, supporting Janison’s strategy of developing and refreshing its digital library of assessments and items to the highest quality standards. Janison is in a net cash position of about $20m and no debt, they are well funded to continue M&A activities.
For an enterprise value of ~$200m, Janison is looking like a great proposition. We believe the market isn’t ascribing enough value to the potential upside of the PISA for Schools rollout; Australia, UK and the US are a $237m p.a. opportunity alone and that doesn’t include the eleven other countries in which PISA is being rolled out.
We estimate that Janison’s EBITDA margin will go to around 30-40% when they achieve their ARR of $80-100m, at those levels we see the valuation as multiples of the current market cap. In the short term, we value JAN at $1.60 or around 10x FY22 ARR.
Disclaimer: JAN is currently held in TAMIM portfolios.
This week we are tackling the subject of rare earths, their applications for electric vehicles and how TAMIM’s Global Mobility strategy aims to benefit. The rare earth elements are composed of a group of seventeen metals that are each just as hard to pronounce as the next. They are becoming increasingly vital to a carbon free economy with applications for both electric vehicles and electrical efficiencies.
Author: Adam Wolf
Right now, China is producing over 80% of the world’s rare earth supply. As a result of this, the US is pushing towards domestic production of these elements. Our holding, MP Materials, stands to benefit.
MP Materials (MP.NYSE)
MP Materials owns and operates Mountain Pass, the only integrated rare earth mining and processing site in North America. The Mountain Pass mine is in Nevada, a top tier mining jurisdiction. Mountain Pass is blessed with one of the world’s highest quality deposits of rare earths, allowing MP to be a global low-cost producer The Mountain Pass mine contains more than 800k tons of recoverable rare earth oxides with an average 8% ore grade, one of the highest quality (known) deposits in the world. Mountain Pass is designed as a zero-discharge facility, featuring a dry tailings process that allows recycling of ~95% of the water used in the milling and flotation circuit. The sustainable features of the mine are very favourable given the current ESG-driven environment when it comes to valuation.
MP currently produces ~15% of the global supply of rare earths, currently in the form of an intermediate product — rare earth concentrate — that requires further processing in Asia. It currently sells its output to China-based, and 8% shareholder, Shenghe Resources for further processing but this is subject to change once MP implements their upcoming expansion strategies at the Mountain Pass mine. The company plans to reinvest the free cash flow generated from operations into expanding MP’s US capabilities, including restoration of domestic refining capability at Mountain Pass by next year. MP Materials will relaunch its onsite processing facilities, setting the foundation for a renewed, self-sufficient US rare earth industry. MP Materials shares have more than trebled since listing on the New York Stock Exchange in November 2020.
Rare Earth Elements
Rare earth elements are far more abundant than their name suggests but extracting, processing and refining the metals poses a range of technical, political and environmental issues. Most of the rare earth deposits are found along with radioactive materials that contribute to ecosystem disruption and release hazardous byproducts into the atmosphere. As a result, it is often difficult to receive the necessary environmental approvals to develop a rare earths mine. Environmental regulations are often more stringent than inside China which is why the country dominates the rare earth industry, producing over 80% of global supply as mentioned.
Having a single country, particularly one like China, dominating the supply of such critical elements poses a number of issues for the US. This is especially the case given the current geopolitical environment and the supply chain issues that are not only threatening inflation but also causing shortages in electronics and other industrial goods. President Biden signed an executive order requiring the US Government to review supply chains for critical minerals and other identified strategic materials, including rare earth elements, in an effort to ensure that the US is not reliant on other countries, i.e. China.
Electric Vehicles
With electric vehicles being one of the three pillars of our Global Mobility fund (along with autonomy and sharing/connectivity), we look for companies that will benefit from the imminent growth in electric vehicle production by participating in the ecosystem that is being built around the industry. While the US intends to shift away from China to source their rare earth supply, without domestic production this would have a significant effect on American consumers as domestic demand for batteries and electric vehicles ramps up. The pace of demand growth is expected to rise rapidly over the next few years as sales of electric vehicles are slated to reach 12.2m in 2025, according to data from IHS Markit.
Source: MP Materials company website
Rare earths are going to be a vital component in humanity’s shift towards cleaner energy. Not only will they be integral for electric vehicles but they are also used for things like wind turbines. Neodymium and dysprosium are the key components of the magnets used in modern wind turbines
” The wind turbine market is anticipated to account for ~30% of the global growth in the use of rare earth magnets from 2015-2025. Using rare earth metals prevents the use of gearbox. Rare earth magnets make the turbines lighter, cheaper, more reliable, easier to maintain and capable of generating electricity at lower wind speeds.”
– UBS Research, 23 July 2018
Stage II + III Strategy
As it currently stands, all of MP’s rare earth production requires further processing in Asia, something that the US is clearly anxious about. Following the acquisition of the Mountain Pass mine in 2017, the mine’s production is approximately 3.2x greater than the highest ever production in a twelve-month period by the former operator using the same capital equipment. That was the first stage of MP’s strategy. The second stage of MP’s Mountain Pass strategy will see MP Materials relaunch its onsite processing facilities, setting the foundation for a renewed and self-sufficient US rare earth industry. This would mean that MP Materials no longer has to send their product for further processing in Asia, they will now be able to sell their concentrate to end users which will have a huge cost-benefit. MP is aiming to finish their second stage in 2022. Stage III would be downstream integration, to be completed via either building a captive integrated magnet supply chain or investing in this capability via an acquisition, partnership or joint venture. The integration of magnet production would establish MP as the first and only fully-integrated source of supply for rare earth magnets in the Western Hemisphere. In addition to offering end-market magnet customers a complete Western supply chain solution, MP believe downstream integration would also create a material incremental value creation opportunity.
Outlook & Thesis
We see MP Materials as a company with multiple tailwinds moving forward. The shift toward a self-sustained supply chain in the US will obviously have a favourable outcome for US rare earths miners and provide further support for future projects. The demand side for rare earths is looking strong with electric vehicle production ramping up as well as other applications in things like electronics and wind turbines. Looking over at the supply side, due to the radioactive material that is usually found with rare earths, these mines are hard to bring into production so our outlook for the price of these elements is very strong. The completion of MP’s Stage II plans will be a major catalyst for the company, it will make them the only US company that can provide a rare earth end product to consumers. This will not only be cost-effective but will give them sizable leverage when negotiating off take agreements with US consumers.
MP are currently sitting on over US$1.1bn in cash, enabling them to execute their strategy at the Mountain Pass mine while also allowing them the opportunity to make further acquisitions or JV agreements, further increasing their production and presence in the future. In their last quarterly announcement, MP had an underlying EBITDA of 64%. Considering the cost benefits of their Stage II implementation and their increased bargaining power in terms of off take agreements, MP is sitting on a highly profitable mine. MP Materials is another company in TAMIM’s Global Mobility portfolio that will benefit from the shift towards decarbonisation through electric vehicles and clean energy applications. We see MP Materials dominating the rare earths industry in America and they will be the only US based company that has the ability to provide an end product to consumers without relying on Asia.
Disclaimer: MP Materials is currently held as a long position in TAMIM’s Global Mobility portfolio. The TAMIM Global Mobility strategy seeks to to capitalise on the ongoing $7 trillion autonomous and electric vehicle revolution.
