On the morning of January 25th - exactly two months ago - I set a price target on Molycorp (NYSE:MCP) of $3.50-$6.10/share and shareholders nearly had a revolt. The company had just had a successful capital raise and the stock closed that day at $8.08/share. A few weeks prior, it at been as high as $11.81. In the article, "Molycorp: Price Target $3.50 - $6.10 Per Share Due To Asset Impairment Risk," I explained the rationale for such a low price target:
Prior to the announcement of the capital raise, Molycorp's stock was around $8.84/share. Its market capitalization was $1.2 billion or a 25% discount to its $1.6 billion book value. Given the deterioration in Molycorp's revenue and earnings, this is where the market thinks the stock should trade.
Under a "base case" scenario, the company writes off the entire $502 million in goodwill associated with Molycorp Canada. I assumed the deferred taxes (tax shield) created by the goodwill write-down was not admitted since the company needs to earn future profits in order to utilize the deferred taxes.
At 75% of its pro forma book value of $1.2 billion, Molycorp's market capitalization would be $840 million, or $6.09/share.
In the "downside case" all of Molycorp's goodwill and intangibles of $978 million are written off. At 75% of its pro forma book value of $643 million, its market capitalization would be approximately $484 million or $3.51/share.
Commenters criticized me as being "speculative" and that my call on Molycorp was erroneous.
Commenter 1: Reckless & irresponsible speculative fictional writing is the best way to describe your article. I'm surprised you didn't suggest the USA defense department had found replacements for all REE used in their national security applications ... shame short seller, shame!
Commenter 2: I hope no one takes his advice on buying or selling, at least not yet. Look at how well his recent calls were on Bank of America (NYSE:BAC), Morgan Stanley (NYSE:MS), and Goldman Sachs (NYSE:GS), all of which immediately rose on his call (up 28%, 16%, and 8%). His price call today, as evidenced by the facts at the closing bell show this call will be worse - up 13% on the 1st day!
Molycorp Has Entered My Price Range. Now What?
Yesterday Molycorp closed at $5.67, within my original price range. The question remains, "Now what?" In January I would have thought a sub $6 share price would have been a steal. However, the rare earth market, and Molycorp's business prospects have continued to deteriorate. The company has experienced quarterly price declines of nearly 30%. That said, I will consider the following issues when reaffirming my price target on the company this week.
Catching a Falling Knife
For fourth quarter 2012, Molycorp generated revenues of $134.5 million, a 34.7% decline from third quarter revenues of $205.6 million. Gross profit for third quarter 2012 was $10.9 million while it generated a gross loss of $20.9 million for fourth quarter 2012. Its loss attributable to shareholders for third quarter and fourth quarter 2012 was $18.9 million and $362.4 million, respectively. And management did not offer much comfort on its earnings call last week. The company represented that revenues and earnings for the first half of 2013 could be worse than the second half of 2012. Molycorp also experienced negative cash flows of about $40 - $45 million for the fourth quarter. Similar cash outflows over the next two quarters will eat away the $414 million it raised in January. At this point, investing in Molycorp is the equivalent to trying to catch a falling knife.
Inventory a Bigger Problem Than I Thought
Molycorp's year-end inventory of $313.5 million represents an 8% increase over third quarter 2012 inventory of $290.7 million. Inventory increased despite a revenue decline of 35% over the same period. As a percentage of tangible GAAP book value, inventory was 5.4%, 13.9%, 45.6% and 57.4% at 2010, 2011, September 30, 2012 and year-end 2012, respectively. Finished goods and work-in-progress represented 4,671mt, up from 577mt and 752mt at 2010 and 2011, respectively. Part of the rising inventory could be caused by a rapid decline in demand. However, if the decline is due to the fact that the company's production costs are higher than the market price, Molycorp could have a bigger problem. In the article, Avoid Molycorp: Inventory Overstated By $134MM, noted rare earth industry consultant, Jack Lifton, came to a similar conclusion:
You've hit on a key issue with rare earth junior planning. I have never liked the term "basket price," because it assumes that all of the rare earths from a deposit are equally sale-able when produced. This is not true unless a strong and credible and successful marketing plan is in place before production commences ... Very few junior rare earth projects are going to survive. This author is absolutely correct. Business is about making profits not building inventory.
More Debt Ahead?
On the fourth quarter earnings call, Management represented that employee layoffs would occur. However, layoffs would only come from corporate overhead which was about $17.2 million for third quarter 2012. Management also revealed more financial machinations to stem its cash outflows - a $100 million or so "global asset based revolving credit facility." Such a facility would most likely be backed by accounts receivable and inventory. Molycorp's true problem - its inability to produce rare earths at costs below the current market price - will not be solved by more debt. The company needs to adopt a partnership culture like the one I recommended for Morgan Stanley weeks ago. Executives and/or employees should take a lower than normal base salary in these difficult times for a higher upside later.
Investing in Molycorp is equivalent to trying to catch a "falling knife." Its revenues, cash flows and business prospects are declining rapidly and there are no near term catalysts - rising rare earth prices or capital raise - to stem the decline. For the reasons I mentioned earlier, I expect to lower my price target on the company. Given that management expects the first half of 2013 to be worse than the second half of 2012, I rate the company a sell.