Your favourite small-cap is down 50% year-to-date. Is it time to buy the dip?

Arafura Rare Earths (ASX: ARU) was once viewed as the next big thing in the ASX-listed battery metals space as it progressed the globally significant Nolans Project in Western Australia, which seeks to supply approximately 5% of global magnet demand for NdPr oxide.

Its market darling status was further validated by taking the #1 spot in Livewire’s most-tipped small-cap stocks survey for 2023. But as it turns out, the hype was a signal for a blow-off top as the stock is now down more than 60% from its February 2023 peak.

Its peers have also sold off dramatically on the back of weakening rare earth prices and higher-than-expected project costs, notably:

• Iluka Resources (ASX: ILU): -27% from April 2022 peak
• Lynas Rare Earths (ASX: LYC): -41.0% from April 2022 peak
• Hastings Technology Metals (ASX: HAS): -85% from January 2022 peak

Arafura is trading at levels not seen since March 2022, which begs the question – Should you buy into its recent underperformance? Or is this an all too familiar situation where your hands get cut from trying to catch a falling knife?

Jevons Global's Kingsley Jones says there could be more weakness as the market waits for the company to de-risk key milestones such as final offtakes and project financing. In this wire, Jones talks about the state of play for the beaten up Arafura and rare earths sector.

Arafura’s FY23 highlights

• Signed binding offtake agreements with foundation customers Hyundai, Kia and Siemens
• Advancing negotiations with several other global Tier 1 businesses and OEMs
• Completed FEED and commenced detailed design on Nolans’ hydrometallurgical plant
  
• Commenced enabling works and early construction activities at Nolans in the second-half
  
• NdPr prices eased from early highs of US$140 to around US$60 per kilogram

Financial highlights:

• Raised more than $180 million in FY23
• Net loss of $96.3 million
• Cash position of $128.8 million as at 30 June 2023
  
  

Arafura shares are down almost 50% year-to-date. Is this an overreaction, underreaction or appropriate?

Reaction: Appropriate

It’s a normal reaction for a project that is close completing offtake deals and closing financing to move fully into construction. During this period, projects go a bit quiet and the share price tends to be a little weak until that risk is removed.

On top of that, rare earth prices have been pretty weak.

Those two things have come together and that’s why the stock price is so low.

Would you buy, hold or sell Arafura at current levels?

Rating: Hold

If it was at the appropriate size in a long-term portfolio structure, we would continue to own it.

As I mentioned, it’s normal for projects that need to close the last element of risk to have a weak share price. Normally, you would own them at a level that justifies such risk and we would continue to own Arafura because of its long 38 year life of mine.

That’s a very long dated project and therefore it’s got significant upside if it can execute. It’s just that it won’t get things down right now, it needs higher rare earth prices to do so.

Going forward, you’d be looking to get a bigger chunk of the stock at lower prices and we think those lower prices will come.

What’s your outlook on Arafura and the rare earths sector over the next 12 months?

Arafura: Over the next 12 months, the dominant factor will be the need to close on necessary offtake deals and financing to move fully into construction. Unfortunately, that’s going to be held hostage to low rare earth prices.

You’ll need a basing of rare earth prices and some upward momentum to get prices back towards US$100 a kilogram. And then I think this project is good to go.

Rare earths: Our expectation is that prices should firm as it’s pretty much a cyclical industry. The thing to note is that about 90% of the market in terms of end use is in China. Therefore what we’re really talking about is how the Chinese economy will be doing and it’s a little sluggish right now.

On the bright side, the Chinese EV sector is growing like a topsy. What will help get rare earth prices up is this explosive in Chinese EV manufactures and exports. For car exports in total, China recently surpassed Japan to become the largest in the world, with China holding 89% market share of EV imports to Australia and showing significant headway in Europe.

Are there any risks to this company and its sector that investors should be aware of?

Arafura: The main risk is the chunky capital spend of $1.4 billion plus a $200 million contingency to bring the Nolans Project into production. So we’re talking about a $1.6 billion project. Let’s also remember that Arafura is a long way from the ocean, there are a lot of factors that pose a risk for this project, which is why it’s been a long time in the making.

That said, Nolans is a quality project with a production profile of 4,400 tonnes per annum of NdPr oxide. That’s a size where it won’t saturate the market.

Rare earths sector: The demand landscape is still very China and Japan dominant. There is currently a lot of talk about bringing rare earths and magnet production back into Europe and the United States, but this could take time. Companies like Arafura have declared to the market that they don’t want to sell to China. If that ex-China market doesn’t emerge with the strength that people are hoping for, that could pose a big risk. You could have a lot of companies all trying to squeeze through the same door to serve a small market.

From 1-5, where 1 is cheap and 5 is expensive, how much value are you seeing on the ASX right now? Are you excited or are you cautious about the market in general?

Rating: 2

The Australian market is presenting an interesting discount, which is why we have two. We like the large cap banks and resource companies but think some of the defensives are a bit overvalued. 

As the US bond tracks up, we expect some heat to come out of the market and we’d be looking to buy value around the November to December time. The market isn’t at peak value yet, we think there’s more pain to come due to at least another Fed rate hike and China presenting us with a bit of a puzzle.

We fully expect China-related risks to materialise in scary ways over the next three months but we think it will be managed successfully by a combination of the People’s Bank of China backstopping any financial dislocation and the government forcing some kind of resolution of the bad debt.