Molycorp Setting Up A Second Chance

By Stephen D. Simpson, CFA | February 26, 2012 AAA

Almost every stock will give the patient investor a second chance, and now may be that time for investors looking to get exposure to the rare earth metal space. Severe Chinese export controls have led to demand destruction (mostly through accelerated substitution and recycling) and prices have plunged. While a tough pricing environment does no favors to Molycorp (NYSE:MCP), the quality of this American miner merits a second look at today's prices.

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Few Surprises to Close the Year
For all of the rare earth metal pricing drama, Molycorp's fourth quarter went more or less as expected. Revenue dropped 4% sequentially as strong volume growth (237% in cerium products) was offset by a nearly 50% quarter-to-quarter price cut.

With this relatively mediocre growth performance, margins were nothing special. Gross margin slid close to seven points and operating income fell by about a third. All in all, none of this was especially surprising.

SEE: Analyzing Operating Margins

A Little Room for Disappointment on Price, Volume and Cost
Molycorp is still in the process of ramping up its mining operations and, like most miners, the company is seeing a few more challenges than optimists originally projected. While the company is still expecting to achieve a production run-rate of over 19,000 tonnes in 2012, early production numbers have been on the lower end of the expectation range. At the same time, products costs have been a little higher than was expected a year or so ago.

The bigger issue is price. Prices for a basket of rare earth metals are down about 62% from peak levels, while particular elements like cerium are down 75%. With about one-fifth of Molycorp's production weighted towards Cerium, that's not a trivial detail.

Greater Production on the Way
China's export controls for rare earth metals have had the impact that any first-year economics student would expect. Companies have reacted to (formerly) soaring prices and more tenuous supply by intensifying recycling efforts and actively searching for substitute products. These artificially higher prices have also stimulated increased production efforts.

Molycorp's Mountain Pass facility is one of the largest on the books right now, but Lynas (OTCBB:LYSDY) is quickly coming on line as well, having recently received permission from Malaysia to go forward with a smelter. After these two are lesser-known names like Arafura, Frontier and Rare Earth (AMEX:REE). While major miners like Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP) are not sleeping on the rare earth opportunity, it's a smaller potential business for them, relative to existing operations in metals like iron and copper.

Ultimately Just Another Commodity
For all of the excitement that rare earth metals used to get, the reality is that they are just commodities. Customers may prefer to use them for their superior performance characteristics, but it's ultimately a price-driven market and substitution does represent a governor on prices, to say nothing of the large expected increase in production unfettered by government (Chinese) export controls.

While it is arguably too soon now, I do also wonder if rare earth companies will become more sensitive to trends in the electronics/technology sector, as has been the case to some extent for other specialty metal companies, like OM Group (NYSE:OMG) and Materion (Nasdaq:MTRN).

The Bottom Line
Commodities are a volume and cost of production story, and Molycorp looks like a sound name in that respect, in rare earth metals. When fully up to speed, Molycorp will likely have an attractive cost structure relative to its Chinese competitors and the lack of government shielding will force the company to be a leaner, more competitive company.

Rare earth bulls will be annoyed that I give no premium to the fact that Molycorp mines rare earth metals, but that's how I value the company. With production still ramping up, I would argue that it's more fair to use the EBITDA number for 2013 and a lower EV/EBITDA multiple of around 5. At that valuation, Molycorp has a fair value in the lows $40s. Taking the lowest EBITDA estimate out there today, the fair value drops to about $29, suggesting that Molycorp is offering a reasonably attractive risk/return trade-off at today's prices.

SEE: A Clear Look At EBITDA

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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