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By Ahmed Ishtiaq

Molycorp (NYSE:MCP) mines and produces lanthanide and molybdenum compounds, concentrates, and oxides using open-pit mining techniques. Molycorp's top-level product is bastnasite, which is a mixture of rare earth metals in their flurocarbonate form. From this ore, mischmetal can be extracted. On the other hand, bastnasite can be used in the later purification processes of many rare earth metals. Bastnasite also serves as a high-performance polishing product for optics and sensitive equipment.

Lanthanides (which include cerium, lanthanum, and yttrium) are used in everything from cell phones and computers to X-ray film and television glass. The company is staking its future on the production of rare earth oxides (REOs). Molycorp went public in July 2010 with an initial public offering (NYSEARCA:IPO). Since its IPO, it has been making acquisitions and investing in joint ventures to further its growth. In its biggest takeover to date, Molycorp acquired rare earth processor Neo Material Technologies for about $1.3 billion in 2012.

Current Rare Earth Metals Landscape

China controls about 95% of the global rare earth metals supply, and its restriction on global access has had an interesting affect on the market. China is the biggest producer, as well as consumer, of rare earth elements. As a result of restrictions by China, manufacturers and miners are currently working on finding alternatives to Chinese supply. At the moment, companies are increasing their presence in Central and Southeast Asia. Electronics manufacturers will continue to increase demand as the demand for products increases. However, the U.S. has not been able to devise a plan to cope with the dependence on one supplier.

Japan, the biggest importer of rare earth elements, has increased its efforts to counter the restrictions by China. China's Bayo Obo mine is in close proximity to Mongolia. As a result, Mongolia is getting substantial offers from miners and manufacturers. Japan recently signed a free trade agreement with Mongolia in order to get access to rare earth metals. In addition, Germany and Kazakhstan signed a $4 billion agreement allowing German mining companies access to Kazakhstan's rare earth elements. Germany will provide technical assistance in modernizing railroads and building chemical plants in exchange for the privilege of mining in Kazakhstan.

Furthermore, Japan is also collaborating with India to decrease dependence on China. The Indian state of Orissa has deposits of rare earth elements, which the country is looking to exploit. India is looking to build facilities in Orissa and Central Asia to get a share of this lucrative market.

Importance to the U.S.

Molycorp products are extremely important for the U.S. defense applications. Rare earth elements are used in underwater mine detection equipment, radar systems, jet engine coatings, optics and scopes, lasers, electronic counter measures, and precision guided bombs. The Department of Defense highlighted the importance of rare earth elements to the country, as well as the consequences of China being the only supplier. Molycorp is the answer to the problem for the U.S. The company has suffered due to lower prices, lower product volumes, and higher transaction costs. Molycorp will benefit from its Canadian acquisition and Phoenix project. I expect the company to see more profitability in 2013. It is also expected that the hoards of rare earth metals will start to decrease, and demand will increase. In addition, stricter regulations from the Chinese government will help bring supply down. The Chinese government is trying to stop the illegal mining in order to decrease supply. Decreasing supply should bring prices up, and we should see some recovery in 2013.

Comparison With Peers

Molycorp peers include Lynas Corporation Ltd. (OTCPK:LYSCF) and Avalon Rare Metals, Inc. (NYSEMKT:AVL). The table below lists some important metrics for the sake of comparison between these companies.

MCP

AVL

LYSCF.PK

Forward P/E

2.8

N/A

6.0

P/B

0.8

1.2

2.1

P/S

1.8

129.4

N/A

EPS Growth

N/A

N/A

N/A

Operating Margin

-8.60%

-1012.70%

N/A

Net Margin

-12.00%

N/A

N/A

ROE TTM

-5.20%

-9.40%

-14.80%

Debt to Equity

0.70

0.00

0.00

Source: Morningstar.

Companies in the rare earth metals segment are trading at low forward multiples. However, a look at margins shows that the industry has been hit hard by low prices. All three companies have negative ROE at the moment. Molycorp is the only company among the three to have debt; the other two companies do not have long-term debt.

Summary

Rare earth metals are an integral component of a lot of products. Demand for these products will remain high as the global economy recovers. The recovering global economy will increase consumers' disposable income, resulting in increased demand. Furthermore, the Phoenix project and the Canadian acquisition will help Molycorp improve its profitability.

However, Molycorp has several risks associated with it, and only investors with a high risk tolerance should consider it. The biggest risks are a slow recovery in prices and the company's failure to bring down the costs. Molycorp needs to control its costs in order to bring down its losses. Out of the two biggest risks, high cost is the company-specific risk that Molycorp can control. The company should focus on bringing down its costs and augmenting the profit margins.

There is still a lot of uncertainty about the market at the moment, despite some positive steps taken by the Chinese government. If the proposed measures do not yield expected results, the prices for rare earth elements could remain low during 2013. As a result, Molycorp could suffer and stock price may not move much. That's why I believe only investors with a high risk tolerance should consider investing in Molycorp.

Source: Molycorp Set To Have A Better 2013