The Only Way To Own Molycorp

| About: Molycorp, Inc. (MCPIQ)

There are three ways to own rare earths giant Molycorp. You can buy the common stock (MCP), which is as far as most investors look. Or you can buy the soon-to-be-redeemed convertible preferred shares (MCP pr A), which we've now bought and sold 3 times and made good money on over the years. I no longer recommend these. The third way is little-known, but as the old Western Airlines ad used to say, for me it is "the only way to fly."

MCP has definitely had its problems this year, descending from a high of 35.79 all the way down to 5.75, before recently recovering to just under 11. A big part of the slide was attributable to former (as of yesterday) CEO Mark Smith's constant cheerleading - some might call it hucksterism - when in fact the company was experiencing the usual growing pains, missed deadlines, difficulties in finding and wisely deploying capital, permitting requirements (especially in California) and other issues that plague all young and growing enterprises.

He resigned "by mutual consent" yesterday (often corporate-speak for "the board fired him.") His replacement as interim CEO, current Vice Constantine Karayannopoulos, is the former CEO of recently-acquired (in June of 2012) Neo Material Technologies. Mr. Karayannopoulos actually comes from the processing and manufacturing side of the rare earth business and is, I imagine, far more likely to understand the intricacies of what is required to bring the company's operations up to snuff. Young companies need to remember: "Operational success first, then marketing."

But there are other problems with Molycorp that make buying the common stock a pure speculation right now. They are likely to slide further as a result of California permitting and their own engineering issues / mistakes in getting the Mountain Pass mine up to full and fully-compliant operation. Further, there is still a pending class action complaint against Mr. Smith and Molycorp's former CFO of making false and misleading statements about the Mountain Pass facility's production timetable, as well as the company's earnings.

Also, Molycorp's too-frequent returns to the equity markets did not sit well with many investors; this was one of the reasons I switched to the MCP convertible preferred shares rather than buying the stock outright.

The final straw came on November 16th when the company revealed it was under investigation by the SEC regarding the accuracy of its public disclosures. That "broke the camel's back" and sent the shares reeling down to single digits.

All this turmoil and bad news may provide a buying opportunity for the brave. After all, the world's appetite for rare earths is growing. This is one of those macro trends where my research covers both the economic and geopolitical realms, but my analysis and conclusions heavily favor the geopolitical.

Oversimplifying, my case is simple: China has some 50% of the world's rare earths but produces 96% of the finished product. Geopolitically, the United States cannot allow its national defense, energy, and health care systems to be at the mercy of a foreign power whose interests may not align with our own and one day may be inimical to them. Economically, while China once forced prices down to discourage entry and obstructed external development, it cannot now hold back the tsunami.

The U.S. Congressional Research Service estimates the current global demand for rare earths is approximately 136,000 metric tons a year. That number is expected to grow to 185,000 tons by 2015. So many products we use daily depend upon rare earths to function; here's just one example:

(Click to enlarge)

Which non-China companies are best-positioned to benefit from the US' and the rest of the world's need for these essential building blocks of the 21st century? I believe two stand out: Lynas (OTCPK:LYSCF) and Molycorp. Molycorp is the one headquartered and with most of its raw material in the USA (but with 26 locations in 11 different countries.) But if I've branded it "pure speculation" and "for the brave" is there a way to take part in the future of the company without taking as much risk?

I believe there is. Molycorp some convertible bonds a few months back in order to finish the remaining 20% of their Mountain Pass and bring it to full operating capacity. (Technically, since they were issued for just 5 years, they are "notes," which is how I will refer to them going forward.) Upon completion, thanks to this half-billion dollar (equity and note) infusion, MCP projects a run rate of 19,000 metric tons (19kmt) of rare earth oxide equivalent per annum.

Most investors who agree with my analysis have purchased the common stock. A few own the convertible preferred. However, now that the convertible notes are available, I believe they represent a far greater probability of capital gains as well as solid income. These Molycorp 6s of March 2017 yield 6% if purchased at par ($1000 per bond) and are held to maturity in 4 1/2 years. Conversion parity, the price at which the notes are convertible for a break-even, is $12. That means that any recovery over $12 per common share will raise the value of these notes above par.

We started buying them above par, as high as $1120 per bond, a pretty reasonable price for a stock then at $11. We were getting a 5% yield to maturity in 4 1/2 years with notes which reach conversion parity at $12! But then the SEC announced an investigation into Molycorp's finances and the stock plunged to $5.75 before recovering to its current $10.90. We averaged down, buying some notes as low as $790.

What is the worst case scenario? The same as it is for any company, whether it is GM, Penn Central or Apple: MCP goes bankrupt. If that happens, the stockholders lose everything. Period. Ah, but bondholders and noteholders are creditors, with first claim on the assets of the company. I view the odds of bankruptcy for MCP as remote, but even if it happened I believe a big firm like BHP or Freeport or Barrick would buy the company's assets in a New York minute -- and have to assume its debts as well. That means those of us who are creditors of the company (we loaned it money, we didn't give it the company like common shareholders do) would likely be paid off.

In the most egregious circumstance, we might not be made whole at par, but it is unlikely we would lose everything. And along the way, we would get our 6% interest every year until maturity or bankruptcy.

Now, if this is a typical SEC investigation, they'll find something (they have to; that's how they pay their salaries) and MCP will get their hand slapped and pay a fine. With the end of the uncertainty, I believe the stock will rise to at least 12, where we are at conversion parity for our notes -- they would rise even higher above par because of the 4 ½ year time premium. At 18, we would have at least a 50% gain. At 24, we would have at least a 100% gain. Dare to dream, if the stock returns to its high of 36 in 2012, our notes must be worth, on conversion value alone without any premium for the remaining time value, $3000 a bond, not the $1000 or less that we paid. That's a nice way to buy "income" - by combining it with a possibly substantial growth kicker.

If you decide to participate in this investment, let me add one more caveat: these notes are currently thinly traded. They trade over-the-counter, though I am told by their Corporate Communications department that they plan to list them on the NYSE. Until then, you may expect massive bid-ask spreads. (I bought some one day at 88 ($880) when the bid was 85 and the ask was 95 …) In addition to the huge bid-ask spread, there is also the natural volatility of the company itself. If you buy, use limit orders. And consider buying incrementally to average in the lowest price possible. The CUSIP you'll need when speaking to the various brokerage bond desks is: 608753AF6.

I believe in the necessity of finding rare earths in North America and processing and refining those elements into end-products we use every day. I believe this industry is in its infancy. And I believe Molycorp is likely to be a survivor if not the giant in this hemisphere. But I also believe in buying smart …

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Disclosure: I am long MCP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.I am long these notes, not MCP. But without a symbol, SA's article submission system does not allow submission.

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