On February 28th Molycorp (MCP) will issue its earnings release, and hopefully offer guidance on its expected cash flows and revenues over the next 12 months. I have the following questions I would like for management to address on its earnings call:
How Far is Management Willing to go to Turn Cash Flow Positive?
In January management alerted shareholders that the company expected a 2013 cashflow shortfall of about $250 million. In its January 23rd 8-K pursuant to its capital raise, management implied that fourth quarter 2012 revenue could be as much as 30% less than the previous quarter's:
- For the three months ended September 30, 2012, the company achieved revenues (prior to eliminations and corporate allocations) of $205.6 million and a pretax loss of $26.9 million.
- For the three months ended December 31, 2012, volume, prices, and ultimately revenue were derived by taking the mid-point of management's estimates for volume and price per segment. The estimates were provided in Molycorp's January 23, 2013 8-K pursuant to its common stock offering.
- That said, estimated revenue for the fourth quarter is $146.8 million, or about 29% less than the third quarter's.
- I ran what I would call a "best case scenario" on expenses for fourth quarter 2012. I assumed that expenses were 60% variable, i.e. for every dollar of revenue reduction, Molycorp would be able to cut expenses by 60 cents.
- The reduction in eliminations and Corporate & Other expenses were reduced by the weighted average reductions for total sales and total expenses, respectively.
- Under this "best case scenario," Molycorp would generate a quarterly pretax loss of approximately $71.4 million.
Even under a "best case scenario" the company's pretax loss would reflect a run-rate about $286 million (excludes changes in capital expenditures or working capital), much higher than Molycorp's estimate of a $250 million shortfall for 2013. The only way to help stem losses is for management to adopt a partnership culture, similar to the culture I recommended for Morgan Stanley (MS) weeks ago; senior executives should take a lower than normal base salary in these difficult times for a higher upside later. There have been several articles of how senior management has purchased shares in the company, and what a bullish sign it is. If management wants to show its faith in Molycorp's business prospects, it should do it now by reducing base pay for executives. Every dollar in expense reductions will spare shareholders more potential dilution of the shares with the next capital raise.
Will Interim CEO Constantine Karayannopoulos Remove "Interim Title?"
Mr. Karayannopoulos, who was CEO of Neo Materials when Molycorp acquired it, took over as interim CEO after former CEO Mark Smith resigned in December 2012. Given the company's financial straits, this is a very precarious time for Molycorp. The company needs someone who can motivate employees and assuage shareholders that Molycorp's plan to return to generating positive cash flows is realistic. The problems facing the company - deteriorating rare earth prices and negative cash flows - are not unlike those faced by Molycorp when it was forced to close its Mountain Pass mine nearly two decadeds ago. Turning the company around is not quick fix, and having a capable CEO who is committed for the long haul is the first step in that process. I expect Molycorp to be prepared to answer this "interim CEO question."
Will MCP Sever Ties With Morgan Stanley, Advisor On Neo Deal?
Financially, Molycorp's Neo acquisition has underperformed. The company acquired Neo for $1.2 billion in the second quarter of 2012. However, through nine months ended September 30, 2012, Magnetic Material and Alloys, the division where Neo's financial results are reported, recorded a pretax loss of $2.4 million. Morgan Stanley advised Molycorp on the Neo acquistion and along with Goldman Sachs (GS), underwrote the company's offering of common stock and convertible notes just last month. The article, Molycorp: Is CEO Constantine Karayannopoulos In It For The Long Haul?, questioned whether the Neo acquisition was Mark Smith's undoing:
The market assumed the embarrassing SEC investigation led to Smith's departure; however, his resignation also came merely six months after Molycorp acquired Neo Materials Technology for $1.2 billion. Management claimed that Neo, affectionately renamed "Molycorp Canada," gave Molycorp new processing technologies in powders used in sophisticated high-performance bonded magnets, expanded production capacity and expanded its customer base. Financially, however, the Neo transaction has been underwhelming.
If the Neo transaction, which was priced when rare earth prices were more buoyant, caused Molycorp to sever ties with Mark Smith, then why hasn't the company severed ties with the firm who advised Smith to do the deal?
How Will Molycorp Survive The Rare Earth Shakeout?
I believe the deterioration in rare earth prices will cause an eventual shakeout in the market - some junior minors will survive and others will not. The lion's share of Molycorp's product suite is heavily weighted towards light rare earths which the Department of Energy does not deem critical due to their supply risk, or their importance to clean energy. However, many junior minors who possess a suite of substantial "critical rare earths" - Tasman Metals (TAS), Matamec [Matamec Explorations (MHREF.OB)], or Rare Element Resources (REE) - are still in the exploration phase. Such junior minors will have to fund years of exploration costs and operating losses before they bring commercially viable products to market. I am of the opinion that since companies like Molycorp and Lynas Corporation (LYSDY.PK), are either producing commercially viable rare earths or are weeks away, they have a "first to market" advantage. However, noted advisor to the White House on the rare earth industry, Jack Lifton, had the following dissenting comments:
There is no first to market advantage for Molycorp. The Lynas Advanced Materials (LAMP) plant in Malaysia is now running and will begin to deliver commercial (to specification) materials to AAA customers early in the next quarter. It looks like it will then ramp up to full production (11,000 to 22,000 MTA) by the end of the year ... Molycorp's problem is credibility: Will it be able to supply, on time, to specification? Note that both Molycorp and Lynas have to prove their ability to deliver to specification, on time, the quantities agreed, and at the negotiated price. Both are new suppliers and as such, get a small percentage (10%-20%) of the demand until the end-user is satisfied that they are reliable. The market today does not need both of them, and the market will decide which one survives. My guess, and it is in the end just that, is that Lynas will win the race due to its much lower operating costs and the experience of its operating team.
How does management see Molycorp surviving the rare earth shakeout? Can it reduce its operating costs on par with Lynas? Is it takeover bait or an acquirer? And lastly, will the company attempt to align itself with a junior minor that possesses the critical rare earth products that it lacks?
I continue to be intrigued by the Molycorp story. However, things have changed in the rare earth industry and with the company since last quarter. In order to decide the appropriate entry point for the stock, I advise investors to wait for further guidance from management on [i] estimates of 2013 revenues and cash flows and [ii] how it expects to survive the pending industry shakeout.