We’re all aware that the relationship between the U.S. and China is not, um, good.
China’s been a pretty lame economic partner ever since it entered the WTO on December 11, 2001. Stealing technology, manipulating its currency, allowing fraudulent accounting, subsidizing various industries to undercut global pricing – China’s never played by the rules.
And for most of the last 20 years, China’s tactics have been just a nuisance. Access to China’s massive consumer market and cheap labor was a totally acceptable trade-off.
Obviously that’s changed.
China’s COVID shutdowns were a wake-up call for companies with supply chains that depended on China. But it was China’s alliance with Russia combined with its stated intention to act on its One China policy and take over Taiwan that really got us where we are…
It’s important to understand that China doesn’t really factor into the supply chain for the chips that power Artificial Intelligence (AI), smartphones, and advanced weaponry. Virtually all (+90%) of the world’s high-end semiconductors are manufactured in Taiwan, using designs from U.S., Japanese, South Korean and European companies.
I’m sure it seemed like a solid plan: take over Taiwan, control the global supply of semiconductors and force the world to bow to President Xi’s Dr. Evil genius…
Of course, all Americans grew up watching megalomaniacal Bond villains plot to take over the world. We know a Dr. Evil when we see one. And the U.S. has made some serious moves to block China’s ambition – nuclear sub deal with Australia, Tomahawk missiles to Japan, military bases in Singapore, arms sales and training to Taiwan, defense agreement with South Korea, and of course, the ban on selling advanced chips and the equipment to make them to China.
All About the Benjamins
So while all these cards are on the table for everyone to see, I find it troubling that individual investors don’t seem overly concerned about the hand they’re getting dealt.
One venture capitalist told Bloomoberg (under conditions of anonymity) that they:
“… marveled at how shareholders in Western technology companies with the largest revenues in [China] have yet to accept the new reality. Shareholders do not seem particularly troubled at Apple Inc. (which gets 19% of revenue from China while its stock is up 33% this year), Micron (10% revenue, up 22%), Broadcom Inc. (35% revenue, up 13%) or Qualcomm (64% revenue, down 6%).
[Investors are] either overconfident that China can’t block such popular products and important supply chain components or simply naïve about worsening prospects for American tech companies in China…”
Yeah, I know, that’s just one person. But America’s biggest investment banks – Goldman Sachs, Bank of America, JP Morgan, Citigroup – are all scaling back their operations in China. Vanguard is closing its Chinese business altogether.
“Wall Street banks should have factored in geopolitical risks a long time ago…” – University of Hong Kong business professor
It’s not just geopolitical risk. U.S. investment banks are being systematically cut out of Chinese dealmaking…
Morgan Stanley, Goldman Sachs and other foreign banks participated in over $120 billion in Chinese equity deals in both 2020 and 2021. Last year, 2022, the total was $19.4 billion. And this year looks about as bad, with these banks participating in just $8 in deals so far.
Personally, I don’t think it takes a lot of imagination to see where this is all headed…
The Cartman Doctrine
It’s pretty obvious that many U.S. companies are already implementing their own Cartman Doctrine – they are taking their supply chains and going home, or, at least to more friendly countries that don’t carry the geopolitical risk that China does.
The U.S. government is doing the same thing with semiconductors. New rules for accounting disclosure from Chinese companies means fewer Chinese listings on U.S. stock exchanges. And it’s also mulling restrictions on direct investment in China.
China too is already moving to take their ball and go home (which is fine because who wants to play with…nevermind).
Yes, China is restricting U.S. investment bank access to deals. And has said it will invest heavily to promote its domestic semiconductor industry.
But really, China does not have very many homegrown industries upon which the U.S. is truly dependent. Which means that there are only a few choke points that China can leverage.
Lithium-ion batteries appear to be one such chokepoint. As I wrote on March 1:
China’s electric vehicle market is also heavily subsidized. The effect of those subsidies has made China the biggest EV market in the world – $87 billion in revenue last year. And that is a simple reason why China has also become the biggest supplier of lithium batteries in the world.
Six of the world’s ten biggest battery makers in the world are in China and they account for nearly 80% of the world’s battery supply.
One company in particular – China’s Contemporary Amperex Technology Company, or CATL – dominates, with a 37% share of the global battery market. And it is the biggest maker of lithium iron phosphate batteries. Lithium iron phosphate batteries are cheaper and last longer than traditional lithium ion batteries, which is why this battery tech is found in 40% of EVs.
80% of the world’s lithium-ion battery supply is substantial. So is the fact that China produces 65% of the world’s supply of battery-grade lithium. But what investors miss is that China only mines around 25% of the world’s lithium. It is its lithium refining capacity that gives it an edge.
Australia is the world’s biggest lithium miner, followed by Chile. Chile recently announced that it is nationalizing its lithium industry for the purpose of vertically integrating it. Which means that instead of just shipping out the ore to be refined elsewhere. Which means that Chile will become a direct competitor to China for battery grade lithium.
Interestingly, Lithium Americas (NYSE: LAC) is spinning off its Argentina mining operations into a separate company because its Argentinian business is in partnership with a Chinese company, Gangfeng. Any U.S. made batteries using Lithium Americas lithium will not qualify for tax credits if there’s a Chinese company involved.
Canada has forced three Chinese companies to divest their investments in 3 Canadian lithium miners to protect national interests.
The U.S., Chile and Canada are implementing the Cartman Doctrine for lithium supply…
I Came Not To Praise Lithium…
What I really wanted to talk about today was rare earth minerals and MP Materials (NYSE: MP). Because MP Materials stands to benefit from the Cartman Doctrine as it applies rare earth minerals and especially to rare earth magnets.
You can read my original recommendation for MP Materials here.
To make a long story short, the stock was trading for $28 a share when I recommended it on April 17, and it’s just under $22 today. Seems like that requires a response from me. MP Materials reported Q1 2023 earnings last week, so let’s start there…
The first thing to note about MP Materials is that it is transitioning from a simple mining operation that sells rare earth ore to being a vertically integrated miner that also refines rare earth ore into rare earth metals and makes rare earth magnets.
CAPEX for the buildout is forecast to consume $300 million of its $500 million net cash position. Plus, many of the new employees needed for the expansion are already on payroll, so costs are higher. Point being that, for the next 12 months or so, earnings and margins won’t be as strong as they have been in the past, and will be in the future, when the expansion is complete.
The rare earth magnet facility is expected to start making magnets this fiscal year, so, sometime in the next ~6 months. MP Materials expects the magnet facility to use a bit less than 10% of its annual ore production (+40,000 tons). And it already has a sales agreement with GM (NYSE: GM).
The second thing to note is that MP Materials is a miner. Rare earths are a commodity just like lithium, or copper, or oil, or natural gas. And just like each of those commodities, rare earth prices have been trending lower – MP’s Q1 sale price for rare earth ore was down 32% over last year. And second quarter sale price will be lower than Q1.
That’s the big reason why the stock is lower than it was a month ago. And that’s also why, after last week’s earnings report, analysts have lowered their earnings estimates from $0.89 a share to $0.68 for the full year 2023.
Yes, that is a pretty substantial drop for earnings. Still, the stock is trading for 16x 2024 earnings, which isn’t terrible. And if China does indeed implement its own Cartman Doctrine and begin to restrict its rare earth exports, well, that will push rare earth prices higher overnight.
Of course recession fears are weighing on all commodity prices, too. And I acknowledge that recession is a risk. But it’s not a risk that I’m ready to say is unavoidable. Which means investors shouldn’t avoid stocks because they think recession is a foregone conclusion.
MP Materials remains on my recommended list.
Chief Investment Strategist
Pro Trader Today