"Attractive": Neo Material Technologies

In keeping with my philosophy of investing only in "good" companies with strong balance sheet and solid free cash flow generation, I came up with Neo Material Technologies (ticker: NEM in Toronto, market cap of $149 million @ $1.22/share). Their website is here. Neo is a producer of high-quality rare earth and magnetic powders that are essential in the manufacture of many high-tech products.

The company is an intermediary between the mining company and the manufacturers. It buys rare earths mineral concentrates in China and separates the individual elements, which are then sold. Some of the processes used by Neo are protected by patents (expiring in 2014) and as such, the company enjoys a very high market share in some of its markets. For example, the company sells 80% of the "neo powders" sold worldwide. Neo powder is used to make very strong magnets. Neo's products are essential to the manufacture of various high tech products including: micro motors, computers, optical lenses, mobile phones, display panels and electronic chips. Some of Neo's clients include: Daido, Epson, Panasonic, Hitachi, BASF, Philips, Samsung, Canon, and 3M. Not bad for a small company.

Why invest in rare earths? Rare earths are part of the Minor Metals group, which got its name from the fact that these metals were initially considered of minor industrial importance as compared to Major Metals (iron, lead, copper, etc.). I believe that we have entered a new age: the Age of the Minor Metals. We went through the Stone Age, the Bronze Age, the Iron Age and now we are in the Age of the Minor Metals. Minor metals are essential to our high tech world. While the quantity of minor metals produced will be dwarfed by the quantity of copper, zinc, .... produced , the importance of minor metals should not be underestimated. No minor metals = no iPhone and no flat screen TV.

I believe that, while the cyclical forces currently affecting the global economy will hurt Neo, the secular trend is for continued growth. As such, the current environment could enable us to get a good company at a great price.

At the end of the last reported quarter, Neo had a net cash position of about $32 million (that's $0.27 per share on a fully diluted basis) and the company was generating cash from its operations. In the last 4 quarters, the company reported earnings of $0.30/share and as such, it is trading at 3x to 4x trailing EPS, depending on how you adjust for the net cash. This does not look very expensive but earnings will likely be lower going forward due to the recession. So in the short term, Neo's financial results should be less than inspiring, however, this represents an opportunity for investors with a longer term view.

One of the risks with Neo is that the company relies on Chinese mining companies for its concentrates. China dominates the world's production of rare earths and therefore, it is not surprising that Neo uses Chinese suppliers. As Chinese internal demand for rare earths increases, it is possible that the Chinese government will erect export barriers, making more difficult for Neo to supply its clients. It is something to watch.

Of note, Pala Investments, owner of about 20% of Neo's share outstanding, has announced its intention to bid for up to 23 million Neo shares (representing about 20% of shares outstanding) at $1.40. For the flippers out there, you can buy Neo today at $1.22 and sell your shares to Pala Investments for $1.40 for a quick 15% profit. Sounds good but there is a risk. Neo has a poison pill provision, which states that 50% of the independent shares must be tendered in order for the proposed bid to proceed. Pala has asked Neo's Board of Directors to waive this provision to allow the bid to proceed. I have not insight on what the Board will do but if it waives the provision, the shares should climb quickly to near $1.40 while if the provision is not waived, the stock could go down to where it was before the bid, which is below $1.10.

Pala, a long term investor in Neo, sees value in the company and is, in my view, being opportunistic. As a long term investor, I also see value in Neo and I think that 2009 should offer a very attractive entry point.

CSC

Note: Do your own due dilligence. I am Evil.