Minmetals Rare Earth:No value digging here;initiating coverage with Sell

A pure smelter likely to struggle; Sell.

    Minmetals Rare Earth, with 12kt of smelting/separation capacity and a 4.7ktproduction quota, is an industry leader in heavy rare earth separation.

    However, its gross margin was squeezed from 25% in 2013 to 12% in 2014 byrare earth price weakness and severe overcapacity in smelting/separation andconsensus earnings look far too optimistic. Although there could be potentialrare earth-related asset injections from parent Minmetal Group in 2017, webelieve the stock's demanding valuation is unsustainable and initiate with aSell rating and a DCF-based TP of RMB6.0, implying ~60% potential downside.

    Focused on middle and heavy rare earths, but not capturing value.

    Minmetals Rare Earth is the largest Chinese rare earth smelter, focusing onmiddle and heavy rare earth smelting/separation. After the acquisition ofJianfeng in late 2014, it now owns three separation plants with a totalproduction quota of 4.7kt. Although we expect its margin to improve on aprice recovery in praseodymium, neodymium, and, to a lesser extent,dysprosium and terbium oxides, upstream miners and downstream high-endproducers are likely to be more significant beneficiaries of new dynamics in therare earth industry. As a pure smelter, Minmetals Rare Earth will likely beimpacted by the overcapacity situation in China’s smelting industry.

    Potential asset injections from parent company, but already in the share price.

    The potential asset injections from parent company Minmetal Group have beenthe major focus of investors. Minmetal Group currently owns three miningcompanies with a ~2,140t mining quota and another three separation plantswith a ~2,570t separation quota. The potential injections of separation plantsare already reflected in our model. There’s still substantial uncertaintyregarding mine injections. Based on our analysis, however, its valuation stilllooks demanding after incorporating all potential asset injections.

    Initiating with Sell on 60% potential downside; higher rare earth price a risk.

    We adopt DCF (WACC: 8.8%, tgr: 2%, in line with industry LT growth rate) toderive our target price of RMB6.0. Our TP translates into ~2.3x 2016E BVPS.

    The stock currently trades at ~5.8x 2016E BVPS, far higher than domesticsmelters’ ~3.0x 2016E BVPS. With c.3%/7% ROAE in 2016 and 2017, webelieve the valuation is unsustainable. We initiate coverage on this companywith a Sell. Risks: higher rare earth prices.