Anthony Alfidi: Rare Earth Metals Bears & Bulls

Shrinking Chinese export quotas and market sentiment have made for unpredictable prices for rare earth elements, but the real opportunity lies with mining stocks. In this interview with The Critical Metals Report, Anthony Alfidi gives a rundown of his due diligence checklist and shares some junior companies poised for success in this exciting, yet challenging sector.

The Critical Metals Report: In your Alfidi Capital investment research blog, you talked about the wild ride rare earth element (REE) prices had in 2010, as well their the general drop this year. What are you predicting for 2012?

Anthony Alfidi: I believe rare earth elements prices will continue to fall. They had a run-up until this summer, primarily based on Chinese export restrictions and the enthusiasm that some speculators had for the sector. But those conditions are both absent now. I believe that economic fundamentals are weakening around the world and the resulting credit crunch will hurt trade, finance and manufacturing. Demand for rare earth elements is derived from demand for finished goods. Therefore, it's very much dependent on the overall health of the manufacturing sector. I expect prices for rare earth elements to fall further in 2012.

TCMR: China is both enforcing export quotas and moving to transition from REE producer to REE importer. How will this affect the market, and how much credence to you give to China's policy goals in this sector?

AA: I believe China will not be able to enforce additional export quotas to support rare earth prices. The coming global market slowdown will tie China's hands policy-wise. The country needs to keep exports up because it still has a primarily export-driven growth policy. Many analysts were predicting stronger economic growth up until late this summer, when China announced its most recent export quota targets.

TCMR: So you expect the sector to be based on free-market, supply-and-demand principles?

AA: Yes, absolutely. And, my outlook reflects weakness in the global economy, which is beyond Chinese influence.

TCMR: Some rare earths are much rarer and have significant market demand. Do you expect better performance in 2012 for these metals, and which REEs are at the top of your list?

AA: If I had to pick one, it would be dysprosium, one of the heavy rare earth elements. Demand for dysprosium will remain fairly healthy as long as the market for wind turbines remains healthy and is supported by government subsidies and stimulus spending.

TCMR: How is dysprosium used in wind turbines?

AA: It's used in the generator magnets and, when combined with neodymium, it helps neodymium retain its magnetism at high temperatures.

TCMR: You spoke at the Hard Assets Rare Earth Investment Summit in San Francisco on November 29th along with John Thomas, Jeb Handwerger and Mickey Fulp. Was there a consensus opinion for industry prospects?

AA: I'm not sure if there was a consensus from the panel. The other panelists seemed to think that rare earth elements had a healthy future of growth due to constrained supply and a lack of substitution, technology-wise. I'm not nearly as bullish as John and Jeb were. I think it has a future out to about 2016. By then, demand weakness due to the renewed recession in the developed world is going to run headlong into new supply coming online. Also, technology innovations by manufacturers could reduce demand for rare earths.

So, putting it all together, all those factors will put a long-term price ceiling on the rare earth elements. Only the lowest-cost producers are going to survive. In the long-term, REE substitutes will eventually become available, thanks to some long-overdue research and current development underway.

TCMR: The big play is the mining stocks, which have offered more opportunity than the price of the metals themselves. Some analysts anticipate major gains as projects come online. Furthermore, demand for electric vehicles is expected to be the governing factor in REE markets. What's your take?

AA: I think electric vehicles will play an enormous role. Lanthanum is important because it's useful in batteries, but not nearly as powerful as lithium-ion batteries. Lithium-ion batteries are going to be used in the 2012 Honda Civic hybrid, the Nissan Leaf and the Chevy Volt. That's an important distinction because the range of a hybrid or electric vehicle is a significant issue for buyers, due to the lack of charging stations that will limit that range. So, lithium-ion battery technology has a competitive advantage over nickel-metal hydrides with lanthanum.

TCMR: In your Nov. 28th post, you wrote that miners that were previously digging for uranium, cobalt, gold and other prosaic metals were rebranding themselves as rare earth explorers in order to gain cache from nervous investors. Then you warned that finding trace amounts of rare earth elements in a large ore body doesn't make an exploration company viable as a rare earth producer. How can investors separate the rare earth posers from the actual junior miners that have a reasonable chance of making money in this market?

AA: As I said at the Hard Assets Panel, I'd like to see operating geologists as CEOs and senior managers because geologists know how to pull rocks out of the earth's crust and turn them into metals. Venture capitalists in Silicon Valley call that betting on the jockey, not the horse. I would apply the same methodology to the mining sector. I would also add that in addition to the quality of management, I would look for the logistics trifecta. Besides an economic ore body, water, power and roads are what make a project economically viable. A water source is needed for a mine to use heap leaching, which is the predominate method for ore recovery today. A power source is needed to run the operations and good road access connects the mine to national infrastructure.

Most junior mining companies experience net losses until they go into full production. They're spending money in startup mode and management has to know the burn rate. If management tells you the burn rate is x and I do my own calculations based on publicly available financial statements that tell me something different, that tells me that management doesn't understand their own cost of exploration and production and they're going to have problems down the road.

Evaluating projects on these criteria helps me quickly eliminate companies that have poor prospects.

It's also important to remember that some concepts that apply to judging larger resource companies don't work very well in evaluating rare earth element producers. That's because there are a much smaller number of mines operating worldwide and those that are, primarily in China for example, are not necessarily financially transparent.

TCMR: What are some individual investment opportunities you'd like to comment on?

AA: Sure. I've looked at Quest Rare Minerals Ltd. (QRM:TSX.V; QRM:NYSE.A) and actually had a blog post about them a couple of weeks ago. The deposit at Strange Lake looks like it has some really high-quality ore. The problem I have with Quest is that this property has never been viable because it has always lacked a road network connecting it to the outside world. But Quest has a plan to build a 75-mile road through the Qu'ebec wilderness to Voisey Bay at a cost of $135M. If the Qu'ebec Government is willing to subsidize the cost of that road then that will certainly make Quest's prospects that much more viable and the company won't have to raise as much money.

TCMR: What else looks interesting?

AA: I'm fairly optimistic about Rare Element Resources Ltd. (RES:TSX; REE:NYSE.A). All of its executives and directors have mining backgrounds, not just the CEO, who is a geologist. That's really good. The results of its drilling program this year are very encouraging and it does have an NI 43-101 report. Its Bear Lodge Property has the logistics trifecta, big bonus points in my book. And, I also think that its adaptation of gravel washing techniques to the type of ore it found on site is truly outside-the-box thinking. That demonstrates why it's beneficial to have a CEO who is a geologist running the company. However, I do have some caveats about RES. I think its most expensive deposits, according to what it publishes on its website, are cerium and lanthanum. Cerium suffered a big price collapse this year, going from $170 per kilogram (kg) to about $45/kg. As I already noted, automakers are looking at lithium-ion as an alternative to lanthanum in hybrid batteries. So, maybe demand for lanthanum won't be as strong as the company is hoping.

TCMR: What's your appraisal of where the company is in the development process?

AA: It looks like the company has one more drill program to go next year. If the results next year are just as encouraging, that should be the last exploratory program it needs before it can estimate what it needs for full production. I think it will be ready to produce in a couple of years. It's much more mature than any of the other comparable companies I saw at the Hard Assets Summit.

TCMR: Any others you like?

AA: Dacha Strategic Metals Inc. (DSM:TSX.V; DCHAF:OTCQX) is an interesting company. It has a unique business model. The way it stockpiles metals means it functions more like an ETF than an operating company. The company has done a very smart thing in locating its three warehouses in Korea, Singapore and Shanghai, close to manufacturers who will need the inputs. It's good that its inventory is primarily heavy rare earths (HREEs), which are the more valuable ones. I would say the value of its metals inventory would have to be higher than its market capitalization for Dacha to be a buying opportunity. So, tracking this stock, the question for investors then becomes whether they're willing to track the weekly report of metal inventories on Dacha's website. The company is unique. It stands out as a business model.

TCMR: Any other ones that you think people ought to consider for some sort of positive market reaction next year?

AA: I'm doing my homework on Pele Mountain Resources Inc. (GEM:TSX.V) and a couple of others that I saw at the Hard Assets Conference. So, I may have something to blog about in the next couple of weeks.

TCMR: What was the mood like at the Conference?

AA: It was as lively as ever, and the Rare Earth Summit was definitely fascinating. Attendees were primarily individual and accredited investors. I would've liked to see more sell side analysts from investment banks. I think the rare earth metal sector is tracked mainly by Canadian investment banks. This sector needs publicity both from a bull standpoint, meaning people who want to get into the sector and a bear standpoint, meaning people like me who are cautious. We need more debate, analysis and transparency of this sector. The Rare Earth Summit was a step in the right direction.

TCMR: Do you have any parting thoughts or tips for investors that are thinking of getting into the critical metals space?

AA: I think investors should read articles published by leading analysts such as Jack Lifton, Mickey Fulp and Gareth Hatch. They were all present at the Conference and the Rare Earth Summit. These are independent analysts who've been evaluating mining companies their entire careers. Investors should also develop a simple checklist similar to mine, which they can use to run through many companies to find the ones that have the best prospects for success. They should also realize that rare earth prices are extremely volatile, partly due to political decisions outside of the marketplace, like China's export policies. Finally, I also think investors should be skeptical of so-called bonanza mother lode stories from places that have had very little exploration or development.

Afghanistan jumps right out at me. The U.S. Government has publicized some studies claiming that there are trillions of dollars worth of metals in Afghanistan. That may be true, but going back to the logistics trifecta, where are the roads in Afghanistan to take all this stuff out? When you look at emerging markets or markets that have never emerged, like Afghanistan or other places in Africa that have had questionable political histories, you have to really question any company that claims that it can operate successfully in those areas. I would take that with a big grain of salt.

TCMR: Thanks for your interesting, useful input. We'll look forward to talking to you again in 2012.

AA: Great.

Anthony Alfidi is the founder and CEO of Alfidi Capital, an investment research firm in San Francisco, Calif. Alfidi Capital publishes free investment research with honesty and humor. Mr. Alfidi holds a Bachelor's degree in human resource management from the University of Notre Dame and an MBA in finance from the University of San Francisco. He is a life member of Beta Gamma Sigma, an academic honors society for business majors. He has been a private investor since the 1990s.

Disclosure:
1) Zig Lambo of The Critical Metals Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Critical Metals Report: Quest Rare Minerals Ltd., Dacha Strategic Minerals Inc. and Rare Element Resources Ltd. Streetwise Reports does not accept stock in exchange for services.
3) Anthony Alfidi: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. Anthony Alfidi was not paid by Streetwise for participating in this story.

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