Martin Barraud Investment Thesis After falling 46.54% over the past year, MP Materials (NYSE:MP) is undervalued. By becoming vertically integrated they will be able to better serve their customers and improve operating margins. In addition, current and future supply agreements and government support significantly reduce the business risk traditionally associated with commodity companies. Vertical Integration In an effort to grow their business and achieve higher margins, MP Materials has implemented a vertical integration plan that spans multiple years. They refer to the steps in their plan as “Stage II” and Stage “III”. According to MP Material’s most recent 10-Q, Stage II will “reintroduce the oxidizing roasting step which will allow MP Materials to capitalize on the inherent advantages of the bastnaesite ore at Mountain Pass, which is uniquely suitable to low-cost refining by selectively eliminating the need to carry lower-value cerium through the separation process”. Stage II will help them streamline their operations at Mountain Pass. Stage III involves the construction of their rare earth metal, alloy, and magnet manufacturing facility. They will be able to use this facility to better serve their domestic customers and expand margins. Reducing reliance on China is also a positive of becoming vertically integrated in the US as by building their own facility MP Materials reduces the risk of being cut off from processing and refining capabilities. Q3 earnings revealed the progress of stage II and III. “We reached a major milestone by beginning the commissioning of our Stage II assets starting with the concentrate drying and roasting circuits. We also completed the building shell of our Stage III magnetics facility in just seven months,” said MP Materials Chairman and CEO, James H. Litinsky. The completion of these steps will allow MP Materials to create significantly more value in the supply chain and increase revenue accordingly. They will also be able to expand operating margins because of their increased size and by being able to perform manufacturing activities in house instead of paying firms that they used to export raw materials to. A major risk to their vertical integration plans is if they are unable to fund the required capital expenditures. Fortunately, MP Materials has a strong financial position. Sufficient Resources to Fund Expansion MP Materials is more than adequately capitalized to fund their expansion plans and have a fortress-like balance sheet. Balance sheet from MP Materials Q3 Earnings Report (MP Materials Q3 Earnings Report) We can see that they have cash, cash equivalents, and short-term investments that more than cover their total liabilities. Their debt is comprised of 0.25% rate convertible notes due April 1, 2026. The strike for these converts is $44.28. Debt Obligations of MP Materials Q3 Earnings Report (MP Materials Q3 Earnings Report) Their massive cash hoard and the nature of the debt allows MP Materials to freely invest in their operations and increase capex. In a worst-case scenario where MP Materials is unable to timely ramp their stage II and stage III operations, they will likely be able to tap the bond markets again without much trouble due to the systemically important nature of their business. Supply Agreements and Government Support In 2021, General Motors Company (GM) and MP Materials entered a long-term supply agreement. In 2022, MP Materials began construction on their Texas rare earth magnetics factory and finalized their agreement to provide GM with rare earth alloys and magnets. These agreements were made with the goal of creating a fully integrated US supply chain for rare earths. Other companies will want to ensure that they have supply of these metals in case China decides to stop exporting them to the US and will likely sign supply agreements with MP Materials. The company should be able to use their leverage and sign long-term contracts that lock buyers in on pricing and quantity. If supply agreements can be structured this way, it would give MP Materials predictable cash flows and less risk of getting hammered by price declines. The US government has supported MP Materials both directly with a $35 million contract, and indirectly through the passage of the Inflation Reduction Act. The potential demand boost provided by the Inflation Reduction Act is a near term catalyst that could cause the price of rare earths to reach new highs. As companies begin to think about what this legislation means for their long-term business plans and could cause them to rush out and buy the materials they need or lock in future supply. This rush to secure rare earths (especially from a domestic source) could cause the price to increase before new supply can reach the market. The increased adoption of “green” energy requires rare earth metals (among others), and demand can easily run above supply for years to come if governments keep introducing environmentally friendly legislation. MP Materials has an opportunity to position themselves as “too important to fail”. Their goal is to build out the entire rare earth mining and processing supply chain. The US government doesn’t want to rely on exporting raw material to China anymore, and companies want to secure future supply. Becoming critical to national security is important because the mining sector is traditionally exposed to sizeable boom and bust cycles. By making the most of long-term supply contracts and government support MP Materials is able to significantly de-risk their company. Financial Performance MP Materials reported their Q3 earnings on November 3. Their revenue came in at $124.4 million and earnings came in at $0.33 per share on a diluted GAAP basis. They showed growing operating leverage in their business model, with revenue increasing 25% year over year and net income increasing by 48% over the same timeframe. MP Materials Q3 Earnings Presentation MP Materials Q3 Earnings Presentation On a year-over-year basis the results looked good. The problem is that numbers were down across the board compared to Q2, largely due to a decline in realized prices. The company seems to be executing well regarding factors that are within their control, and we believe that investors should look past near term pricing declines. Stock Performance The stock was down 46.54% in 2022 compared to the SPY’s decline of 18.17%. The stock fell a whopping 26.98% in December as the broader market sold off and recession fears grew stronger. Investors have also been forecasting a decline in the price of rare earths, which is hindering the stock in the short term. Data by YCharts Valuation MP Materials currently trades at a forward PE multiple of 18.59 due to an expected decline in realized prices for rare earths. The forward PE of the S&P 500 materials sector is 16.1. Aluminum, copper, and steel companies are a better comparison to MP Materials than the materials sector at large because aluminum, copper, steel, and rare earths are all metals required to fuel the “green energy transition”. We can see those forward PEs in the chart below. S&P 500 Sectors & Industries Forward P/Es / December 28, 2022 (Yardeni Research) At the end of the day, MP Materials sells a commodity. They are positioning themselves to be strategically important and are seeking to create more value in the supply chain, increasing margins and decreasing typical commodity risk. We believe that due to MP Materials’ unique situation they should trade at a premium to other materials companies. A forward PE multiple of 21.5 seems more than reasonable, bringing it in line with the average for copper miners. Rare earths have a less extreme boom/bust cycle than copper, so it’s possible that the market rewards MP Materials with an even higher multiple than 21.5, especially if they can continue their margin expansion and earnings growth. The market could also give MP Materials a premium valuation if investors view them as a play on the “green energy transition”. A forward multiple of 21.5 prices MP Materials stock at $28.16, which is roughly a 16.84% increase from these levels. This is based on modest expectations for earnings. Prices for rare earths may not decline as much as feared. MP Materials might do a good job of keeping input costs under control despite the inflationary environment. For this reason, MP Materials has a lot of potential upside if things go right, and not much downside if things go wrong because of the nature of their business and how important they are becoming to the US supply chain. It wouldn’t surprise us for the stock price to hit $40 this year if everything goes right, but we would rather be cautious and see how the macroeconomic environment develops and if the company can continue their strong execution. Risks/Negatives MP Materials may be forced to refinance their current debt at much higher rates. This would hurt margins and increase the risk of a business failure. They may not have enough cash to finance their expansion plans and need to borrow more total debt. Investors should keep an eye on how MP Materials’ debt is priced by the bond market to gauge the probability of debt issues down the road. Due to the nature of the industry, commodity companies can be required to invest a lot of money into their operations. A high amount of ongoing capex will decrease the free cash flow available to equity holders. For this reason, many commodity companies appear cheaper than they really are, and their levels of capex are worth keeping an eye on. MP Materials has some ownership characteristics that could become problematic. JHL Capital Group, QVT Financial LP, and Shenghe Resources collectively own a large number of shares due to their roles in creating the entity that would ultimately become MP Materials. JHL Capital and QVT Financial are institutional investors and if they decided to suddenly sell their position it would put pressure on the stock and could be seen by the market as a loss of confidence in the company. Shenghe’s ownership of MP Materials could lead to an adverse conflict of interest situation in their business dealings with the company. CEO James Litinsky is a major shareholder and is also the founder of JHL Capital. If he resigns or begins to sell stock it could spook the market, even if he was doing so for a reason unrelated to the health of the company. Shenghe refines and processes rare earths for MP Materials, and as a result accounted for the vast majority of sales as of Q3 2022. This sales relationship is outlined in their most recent 10-Q: MP Materials Q3 2022 Earnings 10-Q I would encourage everyone to go and read “Note 3—Relationship and Agreements with Shenghe” in the document as it describes the previous commercial agreement and the new “Offtake Agreement”. The most important thing to understand is the current arrangement between the companies which can be found below: MP Materials Q3 2022 Earnings 10-Q While this isn’t too out of the ordinary for a mining company, this sales relationship is slightly concerning because of the related nature of the parties. This is more of something for investors to keep an eye on rather than a current detraction from the bull case for the company. Conclusion We believe that MP Materials is currently undervalued and that it should trade at a forward multiple of 21.5x PE. This implies a value for the stock of $28.16, which is roughly a 16.84% increase from these levels. MP Materials has executed flawlessly up to this point, and they have several tailwinds that point to a bright future. While there are certainly risks to the bull case, we believe that the risk-reward is favorable at this time. The company has the potential to meaningfully exceed analyst forecasts for earnings in the coming years, so there is considerable upside potential beyond our conservative estimates. Despite the moderate upside we see in the shares, they represent a good way to diversify a portfolio, especially for investors that have traditionally shunned commodity companies because of their punishing boom/bust nature. Investors may also view MP Materials as a way to play the “green energy transition” so this could be a good pick for ESG investors as well.

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