Molycorp (MCP) has been reeling from a deterioration in pricing of its rare earth oxides, causing a decline in revenues and cash flows. Last week management announced a two week delay in filing its 10K and Q4 earnings call, causing the stock to decline 6.6% in pre-market trading. The delay is needed to determine the amount of its goodwill impairment charge which it "estimates will be substantial." With the January 2013 article, "Are Molycorp's $1 Billion Intangible Assets Impaired?", I alerted investors that Molycorp would need to write off goodwill related to the $1.2 billion acquisition of Neo Materials Technology:
Neo's potential, and Molycorp's for that matter, has been a consistent theme. However, the Neo acquisition was made when rare-earth prices were more buoyant than they are today, it created a higher expense burden at Molycorp, and it created nearly $1 billion in intangible assets, including over $500 million in goodwill. That said, given that the company's operating losses may not abate any time soon, a portion of those intangible assets may be impaired.
While analyzing Molycorp's balance sheet and cash flow statement, I noticed another potential asset impairment - overvalued inventory. As part of the controversial Neo acquisition, Molycorp also acquired Neo's $251.0 million of inventory. As the company's sales and operating results have declined, its inventory has been slow to move; through the nine months ended September 30, 2012, Molycorp wrote off $41.1 million of overvalued inventory. On September 30, 2012, the company's inventory level was $290.7 million - approximately 48% of its $637.0 million tangible GAAP book value. Meanwhile, its basket price for rare earths has declined from $82.00/kg in 2011 to an estimated $36.43/kg for the three months ended December 31, 2012. I took the following steps to determine the potential inventory write-off going forward.
Estimated Fourth Quarter Revenue and Gross Margin
- For the three months ended September 30, 2012, the company achieved revenues of $205.6 million and gross profit of $21.5 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 recent capital raise.
- That said, estimated revenue for the fourth quarter is $135.9 million, or about 34% less than the third quarter's.
- I assumed a gross profit margin of 10.4%, in line with that of third quarter 2012.
Projected Year-end 2012 Inventory
The following table projects Molycorp's inventory level at year-end 2012, based upon inventory days outstanding at September 30, 2012.
- Inventory was $116.3 million, $290.7 million at 2011 and September 30, 2012, respectively. The rapid inventory increase was mostly due to the $251.0 million in inventory acquired in the Neo acquisition in June 2012.
- I estimated year-end 2012 inventory of $325.8 million based on [i] estimated cost of goods sold of $459.4 million for full-year 2012 and [ii] inventory days outstanding of 259 days, in line with September 30, 2012.
- Of note is that Molycorp's basket price for rare earths was $19.20/kg, $82.00/kg, $46.82/kg, and $36.43/kg for 2010, 2011, three months ended September 30, 2012 and estimated three months ended December 31, 2012.
- The basket price decrease from 2011 to estimated three months ended December 31, 2012 is 56%; the basket price decrease from three months ended September 30, 2012 to estimated three months ended December 31, 2012 is 22%. Based upon whether the company revalues its inventory quarterly or not, those price declines represent the potential write-offs in outstanding work-in-progress and finished goods inventory, in my estimation.
- Of note are raw materials of $93.9 million and $105.2 million at September 30, 2012 and estimated December 30, 2012, respectively. Though I did not estimate a write-off of raw materials, they appear high given the rapid decline in the company's profitability.
- Also, finished goods inventory in terms of metric tons, has ballooned over time.
Estimated Write-off Based on Current Prices
On the article, "Molycorp: 4 Reasons to Take That $1Billion Intangible Write-Off Now", one commenter gave a tutorial on Molycorp's inventory dilemma:
You just need to have a look at Molycorp's latest balance sheet to see the trouble they are in. From January 2012 to September 2012 it has been loaded up with some very questionable numbers.
The best example is "goodwill and intangibles" which soared from $6 million to $980 million, with over half of that attributed to goodwill ... There will be some [intellectual property] from recent acquisitions, particularly Neo, but really, is it worth $500 million? I really doubt it. It is also worth noting that their inventory has more than doubled to $281 million. Is that number based on the current basket price or the price when produced? Why are they having trouble selling their product? The financials of Molycorp are dreadful.
The following table illustrates the potential mark-to-market adjustment of the company's inventory based upon the current basket price of Molycorp's product suite.
- A mark-to-market based on price declines of 22% to 56% in Molycorp's product suite would yield inventory reductions of $43.7 million to $109.2 million, respectively. The mark-to-market was applied only to work-in-progress and finished goods inventory, estimated at $196.6 million at year-end 2012.
- I did not estimate write-offs for obsolete or slow moving inventory which could make the write-off even more substantial.
Molycorp's inventory has ballooned from $116.3 million in 2011 to $290.7 million at September 30, 2012. Based on past inventory days outstanding, I estimated an even higher inventory level at year-end 2012, which may have contributed to the company's cash flow shortfall and recent capital raise. Meanwhile, the company's basket price for its product suite has deteriorated, which may affect the market value of its inventory. That said, I believe a pending inventory write-off is imminent which could drive the stock price lower. In order to decide the appropriate entry point for the stock, I advise investors to wait for further guidance from Molycorp on the mark-to-market of current inventory, potential write-offs of obsolete inventory, and how it plans to better manage working capital going forward.