Industrial Metals And Mining: Digging For Opportunities - Seeking Alpha

Despite a global movement to reduce pollution, the industrial mining sector continues to see strong deal flow. According to trade publication miningmx, merger and acquisition activity in the sector was up 10% in 2017, with deals totaling $96.8 billion. Analysts continue to be bullish on deal flow heading into 2018, with a particular focus on coal, which led the sector in M&A activity last year. Still, M&A transactions are off from their peak of $150 billion to $250 billion per year at the height of the commodity bull market.

That said, we have heard recently from a few Seeking Alpha authors who follow industrial mining and metals, and their take is that the sector is on the cusp of a breakout. So, is now the time to back up the truck and load up on industrial miners and related names (i.e., Tesla (TSLA))? There are a ton of moving parts in the sector, so we thought it would be useful to gain some perspective from an author who not only follows industrial miners and companies with exposure to electric vehicles (EVs) but who's also built a premium service on Marketplace dedicated to sussing out top opportunities in the space.

Joshua Hall, who writes the Industrial Minefinder on Marketplace, is understandably bullish on the sector, and he discusses his top picks vis a vis what's happening in related markets, as well as from a macro perspective. Without further ado, here is Joshua's take on industrial metals, mining and electric vehicles, and some ideas for investors to take advantage of key trends in the sector in 2018 and beyond.

(Editor's Note: author's responses were submitted on December 29, 2017)

Seeking Alpha: We've heard a few authors who follow the industrial mining space say that the sector is poised for a breakout. What are you seeing that causes you to say that, and why is this happening now?

Joshua Hall: There are 3 major catalysts right now that are affecting each industrial metal to varying degrees.

First, you have the backdrop of solid global economic growth. For example, JPMorgan Asset Management's most recent quarterly Guide to the Markets (slide 42) shows a broad-based acceleration in Global Purchasing Managers' Indexes (PMIs) for manufacturing, especially in the Developed Markets. Copper is also reflecting this. Copper supply and demand is relatively balanced, but the price continues to climb. It just broke out to a new multi-year high.

Something I have been thinking about lately is the fact that the global economy really hit a sort of mini-downturn in 2014-15, and it could still be several more years until the U.S. and the global economy finds itself in a downturn. Many small-cap stocks were down 20% to 30% back then - a sort of normal recessionary decline - while the stock indexes were held up by several popular large-cap names. The mining industry was hit very hard and is really in the early stages of a cyclical recovery at this point.

Miners tend to perform best during the late stages of an economic cycle. Inflation is picking up and commodities, in general, are under-owned. They have not hit their sweet spot yet, but it is coming.

Second, some metals like lead and zinc are being boosted by significant supply deficits. In particular, the zinc deficit is something that I have covered in-depth on Seeking Alpha. I really like zinc here. The fundamentals are exceptionally strong, but the psychology has not yet turned. Analysts and investors are still in disbelief. If Chinese mine production continues to decline, all bets are off. We could see a panic price spike in zinc in 2018. Either way, a large number of zinc juniors are mobilizing new projects in anticipation of structurally higher prices. 2018 should be a very active year for mergers and acquisitions in the junior zinc space.

Third, we have the electric vehicles (EVs) story that everyone is familiar with by now. I was skeptical of this until China announced its plans to eventually move to all EVs. This was a real game changer and probably the most significant news item in 2017 for the sector. China's leadership has ambitious plans to be leaders in new technological industries, and I expect them to continue to throw their weight behind this trend. As the prices of cobalt and lithium continue to soar, capital is flowing to this subsector, and miners across the globe are scrambling to find and develop quality deposits.

SA: Beyond that, what other trends in the sector are you watching as 2018 approaches?

JH: World production of nickel is about 2.1 million tonnes, but only about half of this is Class 1 nickel suitable for nickel sulphate production. This is important because nickel sulphate looks poised to gain an increasing share of the EV battery cathode mix. The London Metals Exchange (LME) is planning to launch a separate nickel sulphate contract, so we may see a bifurcation in the nickel market develop. Producers with deposits suitable for sulphate production may eventually realize significantly higher prices compared to the producers of lower quality laterite ores. The price of Class 1 nickel and nickel sulphates is going to have to increase significantly over the coming years to incentivize the level of production needed to match the projected demand for EV batteries.

To be sure, this is not going to happen in 2018, but discussions will emerge, especially if the LME implements the contract. Now is the time for forward-looking investors to see what types of nickel miners may be able to benefit from this potential bifurcation. This has the potential to unlock extra value for nickel miners with the right types of deposits, especially those that invest in the processing facilities required to produce the sulphates.

SA: What are some of the inherent risks of industrial miners, and how are you and Industrial Minefinder members managing those risks?

JH: Other than the inherent cyclicality of metals prices that can lead to the evaporation of investment capital, the primary risks tend to be environmental and jurisdiction. These risks can be reduced by simply avoiding certain jurisdictions, and also, by focusing on companies that have experienced and proven leadership.

Outside of these, the best way to overcome obstacles is by focusing on projects that are highly economic. This is the primary way I help members manage the inherent risks of mining. Superior economics overcomes many obstacles.

The popularity of EVs is bringing new investors into the sector that want to invest in the battery metals like cobalt and lithium. Many of these are junior miners that carry their own set of unique risks, such as dilutive equity financing. By knowing what to look for and what to avoid, investors can increase the potential for outsized returns. This is one of the valuable aspects of a subscription to the Industrial Minefinder.

SA: You wrote recently "While many investors will rush to buy shares of the hottest car company, the real money to be made is in the materials." Why do you believe that, and can you elaborate on the opportunity?

JH: Just compare the valuation of Tesla to Clean TeQ Holdings (OTCQX:CTEQF), an Australian junior miner, with a promising cobalt, nickel, and scandium deposit in New South Wales. Tesla is unprofitable, whereas Clean TeQ's Syerston Project will generate free cash flow (FCF) margins exceeding 40% at current metals prices. Clean TeQ trades for only 2 times the FCF it is likely to generate in its first year of production (2020).

My point is that high quality miners can generate profit margins that compete with tech companies, whereas auto manufacturing is a highly competitive, low margin business.

SA: As a follow on to that, what names in the space look attractive to you in light of your observations?

JH: Clean TeQ is one. The company's Syerston Project is going to be one of the lowest cost nickel operations in the world (after by-product credits). The deposit is not only suitable for cobalt and nickel sulphates, but the company is developing an integrated operation where the mine will be the first one in the world dedicated exclusively to producing cobalt and nickel sulphates for the battery industry.

I think the market may have missed the fact that Clean TeQ is going to "high-grade" the cobalt at Syerston for the first 10 years of production. Despite the fact that Syerston contains an advertised 101 million tonne Measured & Indicated Resource grading only .10% cobalt, the company is going to selectively mine the higher grade portion of this for the first 10 years. Based on its preliminary production guidance, I estimate that the material it mines for these first 10 years will grade roughly .22% cobalt. This will be well-timed to coincide with soaring cobalt prices. When the company releases its definitive feasibility study in Q1 2018, the economics are likely to surprise to the upside. The company has already received commitments to fund most of the project's initial CAPEX. Importantly, it is debt financing, which is ideal in this low interest rate environment and avoids shareholder dilution.

The same Syerston deposit also contains the only primary scandium deposit in the world. Scandium is used by the transportation industry to make aluminum alloys stronger and lighter weight. The Syerston resource is so large that the company has the scope to essentially create a market for scandium where one is almost non-existent due to the fact that it can provide a stable, lower cost supply for decades upon decades. The scandium in the ground at Syerston is worth about $29 billion at $1,000 per kilogram, which is even less than what this specialty metal has historically traded for. However, it is worth little if there is no market. If the company can assemble enough committed offtake partners from the transportation industry (e.g., aerospace), then this will truly be a prized asset that can reward shareholders for decades.

Investors considering lithium need to understand that this is really more of a chemical business than a mining business. Because of this, I really like Neo Lithium (OTCQX:NTTHF). It has an impressive management team with decades of experience from their time at SQM (SQM). President & CEO, Dr. Waldo Perez has brought 4 mines from discovery to production in his career and was also the founder and technical leader of the highly successful Lithium Americas (OTCQX:LACDF). The company's 3Q Project in Argentina has everything you want - size, grade, low cost potential, and the least amount of impurities of any salar deposit in the world. The project's NPV at a 10% discount rate is $933 million - over 4 times the current market capitalization of the company. The project is also 100% owned and fully permitted. It is backed by significant institutional investors (about 45%) that management says is prepared to commit the funding necessary to bring the project into production.

SA: Do you think electric vehicles (EVs) will take over the world? If so, how soon do you see that happening?

JH: I am bullish on EVs but not because of EVs per se. I am bullish on EVs because (1) I am bullish on oil prices and (2) it is in China's best interest.

The world has not been investing in new oil projects. As demand growth continues and U.S. shale reaches its zenith, oil prices are going to continue to climb. This will make EVs economically viable, without government subsidies. The market has grown accustomed to low oil prices and does not see this coming. Under this scenario, the path of adoption that analysts are modelling will be achievable. I do think some oil majors see this coming, which is why they are investing in natural gas. Natural gas will be relied upon more to generate the electricity required to charge the vehicles.

EV adoption is in China's best interest for three reasons. First, it reduces pollution, which is a major problem. Second, it presents a new technological driven industry that China has the opportunity to become a leader in. Chinese leadership wants to move the country to higher value manufacturing. Third, it gives China an avenue to potentially not have to increase its reliance on oil imports. This may have geopolitical implications that I am still contemplating.

Also, there are a lot of smart people working on batteries that will charge faster and extend the range of EVs. There is every reason to expect that we will continue to see advances in battery technology that will make EV performance more attractive to consumers.

SA: You wrote an article on the divergence of the Lithium ETF (LIT) and Tesla stock back in November. At the time, you cautioned that Lithium investors should brace for a deep correction if the TSLA story unravels. What's your take today, and where do you see Lithium, and Tesla, headed in the near term and into early 2018?

JH: To be clear, this view is not my expectation. Many readers misunderstood me, and I think this is because they are used to contributors presenting a bull or bear thesis that they are somewhat wedded to. This article was me thinking out loud and testing this with the broader investor community. It is important for investors to always consider what could go wrong and why. Some people refuse to listen to the bear case, which is a sign of weakness. It is not my expectation because I think the big money clearly sees that EVs are now far greater than Tesla.

Nevertheless, the Lithium ETF is an investment vehicle for traders playing the theme. If Tesla unravels, the financial media could spin headlines like, "EV economics questioned by the demise of Tesla." This could lead to a temporary correction. At the end of the day, the price of lithium is ultimately what matters most.

SA: What's one of your top industrial mining ideas right now, and what's the story?

JH: Back in June, in a Seeking Alpha article titled, "Time to Back up the Truck on Trevali Mining," I recommended Trevali Mining (OTCQX:TREVF) at CAD $1.10. It's now at CAD $1.51, and I expect it to move to the CAD $2.00 level when zinc prices make their next move higher. I expect to see zinc prices spike in 2018. China is the largest producer, and its output has been declining. Exchange stocks are down to critically low levels.

Trevali Mining is an almost pure play on zinc and lead (lead prices are also soaring) trading for less than 6 times my 2018 earnings estimate for the company assuming only $2,800 per tonne ($1.27 per lb.) zinc. The company is set to generate enough free cash flow in 2018 to pay down all their debt, if they choose, and also expand or initiate a dividend. Management knows what it is doing. They founded this company years ago to focus on zinc in anticipation of the current zinc deficit.

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Thanks again to Joshua for sharing his industrial mining savvy. If you're interested in seeing more of his work, you can check it out here, or learn more about the Industrial Minefinder here.

What are your thoughts on the industrial mining sector in the year ahead? Are you watching any interesting opportunities? Share your thoughts and ideas in the comments below.

As always, follow us to keep apace of Marketplace developments and to read more insightful interviews with Seeking Alpha authors. We're gearing up for an exciting year ahead.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: CleanTeQ, NEO Lithium, and Trevali are holdings in client portfolios that Joshua Hall manages, through which he derives most of his salary. He has an economic interest in their performance.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.