Spec Value Hunter Comment - July 8, 2011: Avalon updates Nechalacho prefeasibility study
Avalon Rare Metals Inc has published an update of last year's prefeasibility study which incorporates a new resource estimate, ramps up quickly to 2,000 tpd, and applies higher rare earth oxide prices to achieve an after-tax internal rate of return of 34% and net present value of $1.27 billion using a 10% discount rate. Don Bubar even briefly casts off his conservative mantle to declare that the after-tax IRR and NPV zoom to 102% and $5.59 billion if FOB rare earth oxide prices as of June 17, 2011 (Metal-Pages) are used, though he warns that as new supply comes on stream current prices will come down. REO prices have increased further since June 17 when the Nechalacho Basal Zone FOB basket price stood at $153.83; as of July 7, 2011 the basket price is $184/kg for domestic and $322/kg FOB (see table at end of comment for price breakdown). The updated PFS uses a basket price of $46.33/kg compared to $21.94/kg when the initial PFS was published on June 21, 2010 just before China slashed the export quotas and FOB spot prices soared. Since the start of 2011 domestic prices overall have also soared, and the more expensive heavy rare earths such as europium, dysprosium, and terbium which languished in both domestic and FOB terms during H2 of 2010 have soared. In fact, on July 7 their FOB prices, which on July 5 were lower than domestic prices despite a 25% export duty, jumped dramatically. The updated PFS still does not include a separation facility which Avalon plans to include in its bankable feasibility study expected in late 2012. However, Avalon has indirectly given us what it internally expects its separation costs to be, having discounted separated REO revenues "to account for the cost of revenues".
Avalon states that it has discounted the $46.33/kg value of its "mixed oxide" basket by 38% from what the basket price would be for separated oxides. That implies a price of $74.73/kg, which is 41% of what Avalon's basket would be worth at today's domestic oxide prices ($184/kg) and 14% of the current FOB basket price of $322/kg which is fairly conservative, though the 3 year averages for domestic and FOB are $26.51/kg and $50.91/kg respectively. If we treat the discount as the cost of separating the mixed oxides, the separation cost works out to $28.40/kg or $28,400 per tonne REO, which seems rather high. If I apply the 2015 price forecast (at the behest of RPA Avalon used the price forecasts made by CIBC World Markets in its Rare Earth Industry Overview dated March 6, 2011 except for holmium, erbium, and lutetium for which it used the initial PFS assumptions) to the distribution of Avalon's probable reserve, which has 26% heavy rare earths rather than the 21% in the indicated resource, the separated oxide basket price works out to $67.86/kg, which implies a separation cost of $21.53/kg which seems a little more reasonable.
In order to see the after-tax net present value sensitivity of Avalon's mining plan for the Nechalacho Basal Zone I have adapted Avalon's discounted cash flow model to include the separation stage. On October 21, 2010 Avalon announced that an SNC-Lavalin scoping study pegged the capital cost for a 25,000 tpa separation facility at $346 million with a 35% error margin. Assuming Avalon's projected recoveries hold up, the proposed underground mine will average 8,243 tonnes of REO annually over the 20 year mine life implied by the probable mineral reserve of 14,539,167 tonnes of 1.53% TREO. Avalon thus does not need such a large facility, though it is conceivable that it might seek to ramp up production down the road. (The indicated resource for the Basal Zone stands at 57,486,089 tonnes of 1.56% TREO of which 21% are the heavy rare earths; the heavy percentage jumps to 26% in the probable reserve which reflects mining plan optimization to tap the HREO enrichment at the base of the Basal Zone.) So I have assumed a separation facility with capacity in the 10,000-15,000 tpa range with a capital cost of $200 million. Avalon did not disclose the operating cost, presumably to keep the competition from applying similar numbers to their DCF models, but the latest news release allows us to reverse calculate the separation cost. For my DCF model I have assumed a separation cost of $20/kg of REO or $20,000 per tonne. This is less than $21.53-$28.40 per kg implied by Avalon's discounting, but Avalon's discounting likely includes amortization of the facility's capital cost, which I am including in my model as a capital cost. I have not used Avalon's optimized production schedule whereby it mines higher grade material during the first couple years and have instead "mined" the same amount each year with full production achieved in the first year. I have applied an effective 26.5% tax rate and assumed no taxes until payback, US/CAD currency parity, a $269/t operating cost plus a $20/kg separation cost which works out to $231 per tonne of ore mined, and a $1,102,000,000 capital cost that includes $200 million for a separation facility. Fully diluted is 103,550,965 shares. My model, which includes ytterbium and thulium output, produces 8,415 tonnes of REO annually. I have used the new probable reserve grades for zirconium, niobium and tantalum as well as Avalon''s 2015 forecast prices while keeping the original recovery rates. The chart above depicts the rare earth production profile for Nechalacho while the chart below shows how the after-tax NPV per fully diluted share varies at different basket prices using a 10% discount rate. (Note that a higher basket price is not the same as a higher price for a metal such as gold or copper; the basket price is controlled by each project's recoverable REO distribution as well as the prices for each REO.)
My DCF analysis indicates that Nechalacho is sub-economic if we apply a basket price representing three year average domestic prices, a $4.24 price target if we use the 3 year average for FOB prices, and an $11.66 price if we use the CIBC based 2015 forecast from which Avalon discounted its $46.33/kg base case basket price for a mixed oxide product. Clearly if we return to three year average domestic or FOB prices Nechalacho does not look very good. Avalon's own after-tax NPV of $1.27 billion works out to a target of $12.26 per share, which is very close to the $1.2 billion NPV I get using the CIBC 2015 forecast basket price of $67.86 per kg. This gives me confidence that my adaptation of the model to include a separation facility is plausible, which is important with regard to seeing what happens to the NPV when we run the model at spot domestic and FOB prices. The result is staggering: at the domestic spot basket price of $184.29/kg the after-tax NPV is $6.4 billion or $61.62 per share, which is close to the $5.59 billion number Avalon generated using "current" REO prices, and at the FOB spot basket price of $321.81/kg the after-tax NPV is $12.5 billion or $120.35 per share. At Avalon's $6.35 stock price the market is either 1) rejecting Avalon's cost assumptions, 2) rejecting Avalon's recovery flow-sheet, 3) assuming it will take forever to permit the project, or, 4) expecting rare earth oxide prices to plunge back to historical levels by the time Nechalacho comes on stream in 2016 or beyond.
I believe the market is wrong on all these scenarios, and because Avalon is the most advanced rare earth junior outside of Molycorp and Lynas with large scale supply potential that includes a meaningful amount of heavy rare earths, I do believe Avalon will attract the capital needed to develop Nechalacho. A retreat in domestic and FOB prices to levels reflecting an $85-$90/kg basket price range is plausible, given that the heavy rare earths are 26% of the projected output. At those prices Nechalacho would have an after-tax NPV of about $2 billion, representing a price target just under $20 for Avalon. On April 6, 2011, when the stock was trading at $8.34, I converted my open Good Absolute Spec Value Buy to a Fair Relative Spec Value Hold which reflected my uncertainty over how to value Nechalacho. I suggested that Avalon would largely trade in sympathy with the overall rare earth sector trend, which has been downwards until the past couple weeks. The updated PFS is helpful in providing a better basis to evaluate the Nechalacho project, and I am considerably more comfortable in setting a $15-$20 price target by the end of 2012 on the assumption that the bankable feasibility study will confirm the PFS assumptions. Effective July 8, 2011 I am converting Avalon back to a Good Absolute Spec Value Buy at $6.30 with the expectation that Avalon will outperform the overall rare earth sector during the next 12 months as end-users act to secure their long term rare earth supply.