Neo Performance Materials Inc

TSX:NEO

Earnings Call Transcript 2023-Q2

[Operator]

Good morning, ladies and gentlemen. And welcome to the Neo Performance Materials Second Quarter 2023 Earnings Conference Call. [Operator Instructions] This call is being recorded on Friday August 11, 2023. I would now like to turn the conference over to Ali Mahdavi, Senior Vice President of Corporate Development and Capital Markets. Please go ahead, sir.

[Ali Mahdavi]

Thank you, operator and good morning everyone. Thanks for joining us for Neo Performance Materials second quarter earnings call. Just as a reminder, a replay of this call will be available starting tomorrow and the Investor Center of our website at neomaterials.com.

Joining me this morning are Rahim Suleman, Neo’s Chief Executive Officer and Jonathan Baksh, Neo’s Chief Financial Officer. Please note that some of the information you will hear during today’s presentation and discussion will consist of forward-looking statements including without limitation, those regarding revenue, EBITDA, adjusted EBITDA, product volumes, product pricing, other income and expense measures, cash returns and future business outlook including potential expansion plans. Actual results or trends could differ materially from those discussed today. For more information, please refer to the risk factors discussed in Neo’s most recent financial filings, which were filed on SEDAR earlier today, and are also available on our website.

Neo assumes no obligation to update any forward-looking statements or information, which speak as of their respective dates. Financial amounts presented today will be in U.S dollars. Non-IFRS financial measures will be used during this conference call. Further information regarding Neo’s use of non-IFRS measures is available in Neo’s year-end earnings press release, which is available on SEDAR and on our website at neomaterials.com.

I will now turn the call over to Rahim.

[Rahim Suleman, Chief Executive Officer]

Thanks, Ali and good morning, everyone. We are excited to speak with you today and speak to our mid-year business update. For a quick roadmap, I would like to first review some significant updates for Neo. Second touch on some key industry and market dynamics, and third, revisit Neo’s long-term strategy for growth. Jonathan will then provide an overview of our financial and operating results.

So first, there is a couple of obvious changes in our conference room this morning. As Constantine retired as Neo’s CEO last month, we would again like to thank Constantine for his more than 30-year commitment to building the owner of a thriving company that it is today. His guidance, his leadership and vision will help continue to shape Neo’s growth trajectory for the years to come. The other obvious change is that there is a new face or at least voice on the call today as Jonathan Baksh has been in the CFO seat for nearly two months. We couldn’t be more thrilled to have him on Board. Jonathan is an accomplished operational CFO, most recently joining us from Celestica, where he was the divisional CFO of a $3 billion manufacturing business. Prior to that, he built a career with General Electric with a number of financial leadership roles across capital intensive and highly regulated industries.

So turning to Neo. During the second quarter, Neo continued to operate strongly on all fronts, as a leading global rare earth magnetics company with parallel supply chains inside and outside of China. It was a very busy quarter with some notable highlights. One, we made demonstrable progress on our two large capital projects. First in Narva Estonia, with the groundbreaking of our new European magnetics plant, and second in Zibo, China, where we continue to our expansion relocation of our missions catalyst business and value-added rare earth business. Two, we continue to navigate very challenging demand trends for magnetic materials and continued softness in rare earth pricing. Three, we achieve record-breaking results in our rare metals business, particularly for products where recycled material is a major input, and most notably our Hafnium business. Four, we are continuing to methodically review our working capital employed, particularly as the dynamic pricing environment continues to evolve sorry, achieving a $34 million reduction in inventory balances compared to year-end. Five, we made a strategic investment of $4.5 million in Neo Northstar resources taking a strong minority position with an offtake agreement for 60% of the available rare earth feedstock in the Greenland rare earth mining project that we have discussed previously. And six, we closed the acquisition of SGTech, a premier European Magnetics Manufacturer in Europe

In terms of SGTech, we are pleased to have completed the acquisition early in the second quarter and we are currently in process of integrating our management teams and operations. We are very pleased with commercial and technical cooperation between our magnetics teams, and the integration of SGTech is tracking according to plan. On June 28, we broke ground on our new magnet facility in Estonia, a first for Europe. We were proud to host high-ranking government officials from multiple countries along our supply chain, as well as customers, suppliers and investors. A highlight of the event was the speech by the European Commission President. President von der Leyen commended the partnership between Neo and the government of Estonia for the fast issuing permits, and the rallying of all local stakeholders behind this project. In her words, and I quote, the rare earth magnets that will be produced by Neo are indispensable to growth and innovation in sectors like electric mobility, wind energy and microelectronics on quote. We appreciate this specific recognition by the President of the European Commission, citing Neo by name, and we continue to stay the course of our growth strategy, with our timeline to bring rare earth permanent magnets to the European supply chain.

Neo has manufactured its rare earth magnetic products both inside and outside of China for decades, including our Thailand Manufacturing Facility, which has been operating for over 25 years, and our center of R&D excellence located in Singapore. We continue to believe in the long-term success of localized magnetic supply chains, and our expanded manufacturing hub in Estonia will help address the growing need for rare earths magnetics within Europe. Taking a step back for an overview of the market environment, where pricing continued to decline through the second quarter. Magnetic rare earth pricing for neodymium and Praseodymium are down approximately 35% from the start of the year, and are down almost 50% compared to the same quarter last year.

Terbium, a critical rare earth material also used in permanent magnets, is also down nearly 50% from just the start of this year. This is reflective of a sluggish demand environment for magnetics in nearly every geography and maybe offsetting some of the rapid price increases in 2020 and 2021. We have covered much of this dynamic in the past. But suffice to say the magnetics industry is currently in a market low. Despite the favorable long-term trends, there are very consistent views across the rare earth industry and automotive industry that this is a short-term market law. And nothing has fundamentally changed the long-term demand and requirement for more rare earth magnets.

Rare earth magnetic elements remain high on the critical material list of just about every jurisdiction, and remain a very high priority for customers to have options inside and outside of China for this material is also evidenced by the continued announcement of other players desiring to enter the rare earth magnetics space. A place, where Neo has operated within for the past 25 years, understands well and is complemented by Neo’s rare earth separation business. The declining price environment has somewhat slowed over the past few months. Although we believe that, this is just a template demand recovery at presence.

On another market topic, we have received numerous questions about the global dynamics for Gallium after the announced regulatory changes within China. To be clear, our Gallium recycling business is located in North America across two operations in Canada in the U.S, and we do not have Gallium operations in China. To date, there have been no discernible impact on our Gallium business operations, and we do not source feedstock from China. Customer inquiries are clearly increasing, and we continue to seek additional waste streams that we can recycle into valuable material. Our Gallium business is a relatively small component of our rare metals business and to Neo as a whole. Yet trade policies can change quickly. And this is a primary reason that we have mature dual supply chains for Neo’s rare earth magnetics and separated rare earth products inside and outside of China. This is a key competitive advantage for Neo that we will continue to build upon.

Before I turn the call over to Jonathan, I have been getting a number of questions from shareholders and customers relating to my view of Neo’s long-term vision and strategy. I have had the pleasure of working with our business units for the past six years and my vision for Neo’s future is fundamentally aligned with our core vision over those past six years, with some adjustments that will become evident in the periods to come. Neo is a Global Rare Earth Magnetics company with operations inside and outside of China. Our core values remain the same, our core value proposition to our customers remains the same, and it grows with the expanding size and breadth of our business. Yet there are areas of opportunity upon which we intend to capitalize.

In terms of our upstream raw material strategy, we will continue to focus on enlisting more suppliers with more geographic diversity. Neo already receives the most geographically diverse, where feedstock and this will continue to grow. And we will continue to evaluate strategic partnerships for long-term cooperation. But you should not expect Neo to become a mining company. It is not part of our core business model. What you should expect is for Neo to continue to develop strategic relationships for additional supply outside of China. Neo has a unique capability of separating light and heavy rare earths and transforming that material into high value products, including magnetic materials. These high value opportunities will remain the focus of the company.

In terms of style, we will continue to invest in building a culture of continuous improvement and to have a defined focus to execute our key projects. Top of mind for me, is executing our growth plans. And the European magnetic strategy is the first piece that puts me on the offensive. Developing keen awareness and forethought to ensure that the Estonian magnetic project comes to fruition is one of the highest priorities for our company. And it exemplifies a philosophy of ensuring that we allocate more resources to our top projects. I refer to this as having the right focus. And so having the right focus for each of our teams is where I have been and will be spending my time. That focus needs to be on the highest growth and highest value activities in front of us. And I believe we have a generational opportunity in things like rare earths magnetic, driven partly by the electrification of automobiles and other energy efficient applications. Neo is operating at the right time, in the right geographies with the right technology and expertise. In a market that is on the cusp of exploding. We will focused on executing our part to more toward making the world a more sustainable place and capitalize on the immense demand and growth opportunities that everyone believes is on the horizon. I will have more to share in terms of Neo’s long-term roadmap. But in the meantime, you can expect us to operate our business profitably. Execute key milestones on our growth projects, add data tools to improve operations and metrics, like the return on capital and ultimately drive more shareholder value.

With that, I would like to turn the call over to Jonathan.

[Jonathan Baksh, Chief Financial Officer]

Thanks, Rahim and good morning, everyone. As I run through our financial performance for the quarter, I would like to underscore the strength in our current financial position, as well as the key factors shaping our results, which include continued headwinds in rare earth pricing and mixed market demand dynamics, with top line sales of $170 million and adjusted EBITDA of $90 million, Neo had a strong quarter despite a tough market environment.

From a cash generation perspective, we delivered $24 million in cash from operations during the quarter and $43 million year-to-date, that represents Neo’s fifth consecutive quarter of positive cash from operations. This financial strength allowed us to fund growth initiatives and further return capital to shareholders in the quarter; we invested $14 million into the acquisition of SGTech and contributed $4.5 million into upstream ventures. We also get began to execute against our NCIB share repurchase plan, while continuing to fund our shareholder dividend. Combined the share repurchase and dividend were $4.5 million during the second quarter. With $127 million of cash and cash equivalents and no short-term debt, we are well positioned to execute our growth initiatives.

Operationally, we continue to convert higher cost inventories into cash as our inventory balance declined to $178 million, an improvement of $34 million from the start of this year. We are continuing to work towards our established working capital targets. Managing the appropriate amount of inventory in a declining price environment is always a challenge, but it is a primary focus and we are making incremental improvements. Neo’s long-term fundamental value contribution, despite the direction of rare earth pricing is starting to become more prominent in today’s market environment. The impact of negative lead lag compresses our margins in the short-term, but ultimately this will free up cash given the current trajectory of price spends.

Now looking at the performance of our three business units starting with Magnequench, Rahim discussed some of the key trends within the magnetics industry. The lower demand environment continued through the second quarter reflecting the macroeconomic headwinds impacting most of our magnetic end markets. Although we still believe the long-term trends supporting this business are strong, the short-term demand challenges do create uncertainty, giving us very limited visibility into volume levels for the second half of 2023. With that said, Magnequench took action early in the year with cost cutting measures to right sides of the business. These actions combined with the continued operational improvements have allowed the business to effectively and proactively manage its cost base in a declining market environment.

In addition, we continue to secure new wins and manufacture record numbers of magnets. This organic growth combined with the high-value magnet business in SGTech is allowing Magnequench to build a strong book of long-term business. It is worth noting that both the cost cutting measures and the SGTech acquisition included some one-time expenses, which cause our SD&A run rate to be a little higher than historical trends for Magnequench. Despite the current soft market environment, we continue to believe that we have the correct assets in service around the world to meet the needs of our magnetics customers.

Shifting to CNO, the business unit delivered $71 million in revenue, up 39% versus prior quarter driven by demand for high-value products including environmental emission catalysts, and Dysprosium, which goes into the multi layer ceramic capacitor market. However, the overarching headwind within CNO remains the rare earth market pricing as finished goods around the world today were originally purchased using rare earths feedstock, when pricing was 35% to 50% higher. This flow through has resulted in downward pressure on thinos margins, which will continue until rare earth market pricing stabilizes.

From a demand perspective, I’d like to emphasize that there remains regular buying for the non-magnetic products and thinos benefited from having strong spot sales during the second quarter. Value added materials continue to have strong and consistent buying patterns. However, the softness in magnetics, and the impact of lead lag continue to have an outsized impact on thinos performance.

Last but certainly not least, rare metals continue to outperform in Q2, it outperformed relative to our expectations, and it made substantial contributions to the total company’s bottom line. This was driven by the strong demand and upward pricing trend in the half year market, which is seen higher and used demand within the memory chips and aerospace industry against a short supply scenario.

While we try not to establish commodity pricing predictions on these calls, it’s worth noting that we do expect hafnium pricing to moderate as a normal level of supply and demand play out over the coming quarters. However, we believe we still see stronger margins than historical periods as Neo capitalizes on its unique capabilities to use scrap material and recycle it. This strategy provides for better utilization of critical materials is better for the environment, and provides additional margin to Neo as input costs for scrap materials are not rising at the same rate as finished goods.

Our rare metals team continues to make progress on optimizing its business model and economics for tantalum and niobium products, which we believe will be another growth driver for the business over the long-term.

Last week, on a personal note, I’d like to talk about the underlying culture that truly differentiates Neo. As I went through my journey of joining the company, I was impressed by the talented and capable people as well as the technical expertise and compelling strategy for growth. After 2 months in the company, I can tell you that my already high expectations have been exceeded. I’m thrilled to be part of the Neo team and I look forward to spending more time with our shareholders to tell Neo’s story and to talk about the company’s vision for the future.

With that, I’d like to open it up line for questions.

[Operator]

Thank you, sir. [Operator Instructions] First question comes from David Ocampo with Cormark Securities. Please go ahead.

[David Ocampo, Cormark Securities]

Thanks. Thanks for taking my questions, everyone. Rahim maybe we could start on the lead lag component of your business. I think in previous calls, you talked about it 3 to 5-month lag. And just curious. You mentioned on the call or Jonathan mentioned that you were able to drive at large, just curious, by one order of magnitude. And maybe you guys can explain why you need to keep so much feedstock on your books?

[Rahim Suleman, Chief Executive Officer]

Sure. So the [indiscernible] lead lag continues to be an issue. And I and it is driven partly by the, let’s say, unusual level of volatility of rare prices over the last call it 24 months, even 30 months. So the way that we need to manage that, and I think we’re on a journey of continuing to manage that is twofold. One is we need to think about our overall inventory levels on our overall inventory turns, and how do we actually improve kind of the turns and the cycle and the speed upon which the – upon which our business will operate. To do that will be a series of data tools that we will put in place that are managing where we see demand fluctuations, how we can accurately see customer forecasts better, and how we can react our planning cycles to match those in a much more closely aligned method.

The second thing that we would need to do is to think of a better alignment between customer POs and our existing buying patterns, we are naturally long on all the inventory, obviously, because we have 3 to 5 months of inventory. And historically, the – we have received lesser kind of fixed price contracts for customers. And when we do we tend to hedge against those fixed price contracts, I think we need to review, inventory matching as a duration over the entire book of business to just think a little bit about how we can do that differently. So it’s a journey. David, I think we’re at just at the beginning of that journey. I mean, we’ve been talking about reducing inventory for some time, the team has done some excellent work. on doing that, I think the next step of that journey is just to, to take advantage of the data tools that are available, so that we can make better decisions and react quicker.

[David Ocampo, Cormark Securities]

Got it. I guess we will keep a closer eye on that one and see how that unfolds over the upcoming quarters, but maybe on rare metals. I mean, that’s a business that’s done extremely well. And you guys call it out in your prepared remarks. Just curious if that business is entirely on spot, or is there some contract element as it relates to the metals that are doing extraordinary well, at this time?

[Rahim Suleman, Chief Executive Officer]

Yes, actually more of the businesses on long-term contracts than any of our other businesses, quite honestly, we, the other businesses, and I would say, particularly the rare is separation businesses where the vast majority of volatility exists. And the vast majority of the product that actually gets sold on spot, gets sold on spot, it’s all on the rare separation side. The Magnequench side, again, has long-term contracts with customers just demand changes and pricing moves through pass through agreements. But the rare metals business is one where we get longer-term contracts for customers. And I think hafnium is probably even on the longer-term of those. So the upside here is that we’ve got contracts for the balance of this year that reflected pricing, we’ve got contracts going into next year to reflect good pricing. And I’ll tell you what, the pricing that we’re seeing today is higher than the pricing that’s going to our average book today. Because those contracts would have been entered into 6 months ago in the like or 12 months ago, even so, rare prices were actually lower, sorry, rare metals prices and hafnium prices were lower, so are realized ASP in our P&L from our hafnium business is lower than the current POs that we’re signing up for. So we still see continued opportunity there. We have good demand profile there. I’ll tell you this quarter’s demand, like just number of shipments of hafnium product was really high. So in terms of – is that number as repeatable as folks would like it to be? I think margin expansion will continue to be a positive trend. But we did have an extraordinary amount of volume of this high value product in the quarter.

[David Ocampo, Cormark Securities]

And out of curiosity, is the lead lag component, is that also kind of not 3 to 5-month ballpark?

[Rahim Suleman, Chief Executive Officer]

Yes, and no, the strategies are a little bit different. And it actually take it for good or bad, it actually causes us to hold more inventory. But because we have customers that are willing to agree to long-term contracts, we are much more inclined to actually just take physical. So we actually have significant amount of inventory locked in against those sales contracts that we’ve talked about. So the benefits in rare metals is less about lead lag in the period. And it is more about just the lead portion, I guess it is a fundamentally increasing pricing environment. And it’s not about inventory necessarily being mismatched because we bought that inventory at the time that we entered into the sales PO with the customer too. So it’s not a mismatch lead lag, but because of higher finished good prices, and we’re using scrap material as our input there’s more margins available. So it is a fundamental improvement in the business.

[David Ocampo, Cormark Securities]

Okay, got it.

[Rahim Suleman, Chief Executive Officer]

Thank you, David.

[Operator]

Thank you. [Operator Instructions] Your next question comes from Yuri Lynk with Canaccord Genuity. Please go ahead.

[Yuri Lynk, Canaccord Genuity]

Hey, Rahim. Just following up on rare metals. I mean, just since it was such a strong quarter, from EBITDA perspective. I mean, what, how’s q3 shaping up? Or how’s it been to date? Anything you can give us to help form expectations for the current quarter?

[Rahim Suleman, Chief Executive Officer]

Yes, I think that rare metals will have a difficult time repeating that level of EBITDA in future quarters, whether that’s next quarter or the quarter go on, as I said, it was a very high volume quarter. I don’t think that means it returns to kind of historical norms, as you know, that this is had much lower EBITDA levels for between 2017 and 2020 ish. I Don’t think it returns to those levels, I think it remains fundamentally higher and fundamentally better. But certainly, this quarter is outsized, as I said due to volume. But margins will remain healthy and the business remains healthy.

[Yuri Lynk, Canaccord Genuity]

Okay. Just on Magnequench volumes, I mean, these – yes, it’s some pretty easy comps in the first half of last year, and we’re down materially on those I mean, is there something else fundamental going on to explain, besides inventory, destocking? Like, is there substitution from other magnetic materials that might be more attractively priced? Some kind of demand destruction, anything there to explain pretty weak volumes?

[Rahim Suleman, Chief Executive Officer]

Yes, I don’t think there’s demand destruction, if anything, given where those prices are now. It’s a benefit to Magnequench, right when neodymium and praseodymium was twice the value that it was. There was a lot more concern, and rightly so about customers looking for substitution of alternative solutions, where prices are now customers are less motivated, because the energy efficiency factor is just that much more important. And we’ve talked about it in the past that it’s a rare earth magnet 10x stronger than a ferrite magnet. There’s just different applications that can afford to do that. And I think the majority of the growth and the applications are going to continue to need rare earth magnets. And I think that’s why you’re seeing kind of the whole market looking in that direction.

Having said that, your comments about the factor are absolutely correct, right, there is less volume this year than there was last year, and there’s certainly less margin this year than last year. I think the volumes are going to return. I think that the volumes are this – what we see is still being a temporary low, they’re probably still loading Q3. Although I think that they’re better everything that we’re seeing is better than the existing quarter. But it’s probably not ramping up to our expectation relative to the book that we expect from our customers still for another couple of months. So I think that the volume ramp is slower – the volume return is slower than we would have liked to see. But I still think we’re on that path.

In terms of the margins, though, when you’re looking at EBITDA margins per kilo I think we’ve talked about Magnequench having benefited from despite have been on pass through there is still a quarter to quarter dynamic. And when rare earth prices went up for six consecutive quarters Magnequench was making outsized gross margin per kilo or EBITDA per kilo metrics when rare earth prices have declined six consecutive quarters Magnequench making lower EBITDA per kilo metrics. As the business is on passthrough it’s actually not going to be terribly dissimilar to the EBITDA margins per kilo that you would have seen in more steadier times ‘18, ‘19 and ‘20. And if you look at it that way, you’ll see that the margins should be higher than they are today, but not as high as they were in 2021.

[Yuri Lynk, Canaccord Genuity]

Even though that you control such a large portion of that market, in Magnequench, can’t you negotiate better terms on reducing the impact of the lead lag like you’ve – I think in some of your AIF and some of the prospectuses you’ve said you’ve got, upwards of 70% market share. So I would just think that you’d be able to negotiate better commercial terms to have a more predictable business.

[Rahim Suleman, Chief Executive Officer]

Well, we have the larger market share and kind of the outside of China environment, we have a much lower market share inside of China, just depending on I think the specificity of the application. And the challenge for us, honestly, in the outside of China market is we have to keep inventory for customers in those jurisdictions. So it does hurt us a little bit on working capital, it does hurt us a little bit, then on lead lag because we have a longer cycle when we have to keep the material outside of China. Inside of China, we see much less variability on margins, it’s because our business is so slated to work outside of China customers that we have a little bit more variation. But Magnequench’s margins are healthy. When we look at it from a conversion cost to gross margin type ratio, it’s a very healthy, a very strong business, we are getting paid for our technological leadership, the quality of our product and the availability to our customers. So I don’t know that I think that it is a lack of a dominant pricing position with customers that can change, or [indiscernible] creation of a dominant position with customers can really change lead lag, I think it is more us just kind of sharpening our pencil to get the right amount of inventory in the right jurisdictions and maybe analyzing customer behaviors a little bit closer and making tougher decisions on how much inventory to carry in each of those foreign jurisdictions. I guess that, David, I don’t think it goes away. I just think that we get better at it. And I say, hopefully, I would not expect rare earth prices to jump around, but the way they have in the last 24 months. So we didn’t, we did talk about lead lag a little bit in 2017, ‘18, ‘19, but certainly not the way that we’ve had to talk about it over the last 2 years.

[Yuri Lynk, Canaccord Genuity]

And just last question on the Magnequench volumes, what would have SGTec have contributed to the 1037 tons?

[Rahim Suleman, Chief Executive Officer]

A really tiny amount. And that’s only – not because SGTec is a really small business, but because SGTec is more than bonded magnets. So that number and there’s generally a bonded magnet type number. So it is a couple of percent off the top of my head, I’d say like 5%. There’s – so we’re trying to figure out what the right reporting structure will be with SGTec because some of what they do would be in the kind of rare earth magnetic space and some of what they do is in the soft magnetic space. So how do we kind of now start combining the multiple metrics together? So overall, their contribution look, we’re really thrilled with how that – how they are operating, how we are operating with SGTec with they are also seeing in terms of their customers, and now our customers demand challenges. So we think that there’s much more opportunity for that business than its current contribution. But today, I’d say it’s like 5% of Magnequench volumes.

[Yuri Lynk, Canaccord Genuity]

But their contribution to Magnequench revenue would be above that, if I understand.

[Rahim Suleman, Chief Executive Officer]

Above that. We haven’t been specific on providing kind of location by location information in the quarter. Less than 5% of EBITDA and I’d say significantly less than 5% of EBITDA came from SGTec.

[Yuri Lynk, Canaccord Genuity]

Okay. Okay. Thanks very much. I’ll turn it over.

[Rahim Suleman, Chief Executive Officer]

Thank you, Yuri.

[Operator]

Thank you. There are no further questions at this time you may proceed.

[Ali Mahdavi]

Once again, on behalf of the Neo team, thank you for joining us today. If you have any follow up calls questions feel free to reach out to myself. That concludes today’s call. We look forward to speaking to on our third quarter conference call. Have a great weekend. I’ll hand it over to the operator to close the call.

[Operator]

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating. And ask that you please disconnect your line.