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Molycorp, Inc. (NYSE:MCP)

Q1 2013 Earnings Call

May 9, 2013 4:30 pm ET

Executives

Brian Blackman – Vice President-Investor Relations

Constantine Karayannopoulos – President and Chief Executive Officer

Michael F. Doolan – Executive Vice President and Chief Financial Officer

Analysts

Brian Lee – Goldman Sachs

Michael Gambardella – JPMorgan

Jeff Cramer – MorganStanley

Ben Joseph Kallo – Robert W. Baird & Co. Equity Capital Markets

Michael Ritzenthaler – Piper Jaffray

Operator

Good day, ladies and gentlemen, and welcome to the Q1 2013 Molycorp Inc. Earnings Conference Call hosted by Mr. Brian Blackman, Vice President of Investor Relations for Molycorp. My name Warmouth and I’m the event coordinator. During the presentation, your lines will remain on listen-only mode. (Operator Instructions) I would like to advise all parties that this conference is being recorded. The recording is also available via the webcast.

Now I would now like to hand the call over to Mr. Brian Blackman. Please go ahead.

Brian Blackman

Thank you, operator, and good day to everyone. We just released our financial and operating results for the first quarter of 2013. Our press release is posted on the Investor Relations section of our website at molycorp.com. This call is being webcast and replay will be archived on the company’s website. For those of you dialed into the call, a slideshow that accompanies our prepared remarks is available on the Investor page of Molycorp’s website as well. For those of you listening by webcast, the slides will be presented in your webcast player, where you must advance the slides on your own.

During the course of this call, we’ll make forward-looking statements and I direct you to Slide 2 for a view of our disclaimers. All statements that address expectations or projections about the future are forward-looking statements. Although they reflect our current expectations, these statements are not guarantees of future performance but involve a number of risks and assumptions. We urge you to please review Molycorp's SEC filings for a discussion of some of the factors that could cause actual results to differ materially.

We also will refer to non-GAAP financial measures and as you can find reconciliations to the most directly comparable GAAP financial measures in our earnings release issued today.

As you can see on slide three, joining us today is Molycorp’s President and Chief Executive Officer, Constantine Karayannopoulos, Executive Vice President and Chief Financial Officer, Michael Doolan and our Chief Operating Officer, Geoff Bedford. I’d like to now turn the call over to Constantine.

Constantine Karayannopoulos

Thanks, Brian and good day, everyone. Let me make a few high level comments before Michael provides details on our financial performance for the quarter. I’ll then speak to some of the market and technology trends we’re seeing across our business segments and finally Michael, Geoff and I will be happy to take your questions.

Let's start on Slide 4. The first quarter was reflective of the seasonal ebb in market activity that we typically see during this time of year. January and February are always slow months across Asia, given the Chinese New Year and Spring Festival holidays.

We are however beginning to see signs of demand returning to more normal levels across several segments. Customers appear to be working down inventories that were built up in 2011 and 2012 and we are starting to return to more normal purchasing patterns. Our production ramp up of Mountain Pass is progressing well.

We’re now producing at an annual run rate of just over 7,000 metric tons per year and we remain on track at this point to achieve our initial target run rate of about 20,000 metric tons per year by mid year. At this point I see no major technical hurdles to executing on that production ramp up.

We continue to conserve cash aggressively, and have implemented measures such as layoffs, salary cuts for all senior management and other initiatives. Based on our current forecast, I believe we have sufficient liquidity for execution of our business plan. As I have said many times before, it is now all about execution of Mountain Pass, that’s our focus and will continue to be until we deliver on the production that this world class deposit offers to a vertically integrated supply chains and our customers.

Let me turn it over now to Michael for details on our first quarter 2013 financial performance. Michael?

Michael F. Doolan

Thank you, Constantine, and again good afternoon to everyone. First, a quick summary of our quarter, please turn to Slide 6. We reported net revenue of $146.4 million, a 9% increase over the fourth quarter of $134.3 million. And we sold more than 3,200 metric tons of product during the quarter. our gross margin of negative 14% or a gross loss of $20.5 million was a slight improvement in margin compared to the fourth quarter of 2012 of a negative 15.2%.

We reported a loss before interest, tax, depreciation and amortization of $37.1 million, and a positive $7.1 million on an adjusted basis. Our net loss attributable to common stockholders for the quarter was $50.1 million or a loss of $0.33 per share. on an adjusted non-GAAP basis, we had loss of $0.15 per share.

As market pricing continued to make its move downwards, we incurred $37.2 million of inventory write-downs at Mountain Pass, and another $2.9 million at our other divisions.

Moving to our detailed financial performance, our operating segment results begin on Slide 7 with the Resources segment. We sold 763 metric tons of rare earth oxide equivalents products out of Resources during the quarter, an increase of 21% over the fourth quarter 2012. Our average sales price increased compared to Q4 largely due to favorable product mix. Market spot pricing for rare earth oxides was lower during the quarter compared to Q4, although there was little movement through the first three months of the year, which is typical due to the seasonality.

As Constantine mentioned, we continue to move forward with our production ramp although we do not expect to see a major improvement in production costs until the fourth quarter when we have the benefit of recovering our reagents.

Our production of light rare earth concentrate is going according to plan and we are shipping this concentrate to our chemicals and oxide facilities for manufacturing and to value-added products.

On slide 8, our chemicals and oxides revenue increased to 11% from $57.9 million in the fourth quarter of 2012 to $64.2 million during this first quarter largely due to improved volumes and a slight increase in pricing related to a favorable product mix.

Although we experienced normal seasonality of lower demand during the first two months of the year at current REO prices we are encouraged to see customers re-enter the market.

On slide 9, our magnetic materials and alloys revenue was flat quarter-over-quarter with an increase in volumes offsetting a slightly lower average selling price. Our Magnequench bonded and hard-pressed magnetic materials continue to gain traction in the home appliance and automotive markets, and our core business lines are currently sustaining. We continue to remain cautiously optimistic for growth in our bonded powders.

Last on slide 10, our rare metals revenue increased 26% from the prior quarter due to favorable product mix on 81 metric tons. And as a reminder, the top line in this business tends to be quite varied depending on the mix between gallium, niobium and tantalum, which are typically sold in spot transactions. As mentioned on prior calls, our operational initiatives are taking hold through our rare metals facilities and we are continuing to improve throughput against our fixed cost base.

Moving to slide 11, in terms of the balance sheet and statement of cash flow, we used $36.6 million in cash for operations during the quarter, and spent $181 million in capital expenditures. The total capital expenditures for the entire Mountain Pass facility are estimated at approximately $1.53 billion. As of March 31, 2013 we had spent $1.23 billion of this amount and the remaining spent on the project through year-end is approximately $225 million.

We are still planning for approximately $25 million of other maintenance and expansion capital projects during the remainder of 2013 across all other business units for a total CapEx forecast during 2013 of up to $250 million. We have deferred approximately $80 million of discretionary expenditures required for expansion of Mountain Pass capacity beyond our initial annual target production rate of 19,050 metric tons.

We reiterate that we will not expand unless market demand, product pricing, capital availability and financial returns justify such additional production. We continue to pursue the credit revolver that we’ve discussed on prior calls and we continue to make good progress to completing it.

As of March 31, we maintained $404.8 million of cash and cash equivalents on our balance sheet. We are comfortable with our current cash position, but remained cognizant of the need to conserve cash and coordinate our operational and financial activities to ensure our working capital needs are met in an efficient manner.

And now I’d like to turn the call back to Constantine.

Constantine Karayannopoulos

Thanks, Michael. Now let's look at how things are progressing with our Resources segment, beginning on Slide 13. Our current operational ramp up at Mountain Pass continues to proceed well. So far, the main bottlenecks we've had to tackle were related to forming and filtering operations in our leach and crack facility. After some trial and error, experimentation and some reengineering, a new deforming agent and a new process have solved this problem.

We were not seeing the throughput we expected to see with the original filtering system that we had in place. So, we are moving to a new filter system that should significantly increase throughput. We have already repurposed a filter similar to those we will soon install, which is working well and the results have been quite promising, in fact, definitely positive.

We have operated over the past several weeks at levels above 10,000 metric tons per year and we fully expect the new filters to allow us to steadily ramp up to a target operating rate once commissioned at the end of this month. Other than this, I don't expect any material technical hurdles that will prevent us from achieving our full initial run rate by midyear.

I would add that our primary downstream units have all been tested at throughputs higher than our 20,000 ton per year target. While increasing throughput at Mountain Pass, we have continued to produce and ship rare earth feedstock as Michael mentioned to several of our downstream facilities for processing into value-added custom-engineered products eliminating or partially reducing the need to purchase raw materials at those facilities.

As our production levels increase, we expect our cost of production to steadily decline. The low cost power we generate from our natural gas-fired combined heat and power plant is a big driver for these declining costs. And when our chloralkali facility comes online later this year, we will see our reagent and wastewater management’s costs decline even more.

Our initial target or cash production cost in the $6 to $7 per kilogram REO range still appears to be achievable in my view. When we reach our cost profile, we will be the lowest cost rare earth producer in the world. You can see various photos in Slides 14 to 21 of our new facilities which were taken not too long ago. Everything is operational with the exception of our chloralkali plant.

Moving to Slide 22, let's start from some highlights for our Chemical and Oxides segment. As we've mentioned, January and February showed the typical seasonal slowness in Asia. Raw material concentrate pricing decrease for our three rare earth manufacturing facilities, but so to – did our rare earth ASPs as customers ordered only what was needed to fulfill manufacturing orders in Q1.

Across individual market segments we see the petroleum refining catalysts or fluid catalytic cracking or FCC and I promise to stay away from jargon for the rest of the call. Market is showing signs of increased demand with volumes of lanthanum orders on the rise out of China and Estonian facilities.

The European pigment market continued to show signs of improvement with increasing sales in the quarter in the ceramic markets and glass markets. In the multi-layer ceramic capacitor or MLCC market in Japan, we are seeing customers back in the market ordering at increasing volumes, albeit of lower than historical levels. As we discussed last quarter, the decrease in physical size of MLCCs is a limiting factor for near-term growth in this segment. By way of illustration multi-layer ceramic capacitors used to be about the size of a dime.

Today, many are manufactured on the scale of a pinhead or smaller, although the numbers used in smartphones, displays and other electronic devices has increased by orders of magnitude. We do see demand improving into next quarter and consistently through the second half of the year. We continue to see the automotive catalyst market as a long-term growth sector for us. One example of the demand driver here is the EURO 6 emissions reduction standards, which come into full effect in early 2014, requiring improved performance from catalytic converters.

This is resulting in new formulations of cerium and zirconium-based mixed oxides that we will start shipping in the second half of 2013 for 2014 models. The new regulations also touched the diesel engine sector leading to new product introductions utilizing rare earths such highly engineered cerium oxides.

The magnetic sector has started to recover with certain segments such as bonded magnet served by our Magnequench Division showing better improvement than others. This is reflected in improving demand for neodymium and praseodymium. Heavy rare earths, on the other hand, such as dysprosium and terbium traditionally used in magnets, continued to suffer from high inventory levels.

Customers are signaling that these levels should return to traditional levels in the second half of 2013, after which we should see restocking efforts starting at that time.

In the near-term, we expect continued downward pressure on rare earth prices and raw material costs driven by the continuing smuggling of rare earths out of China and illegal mining and production in China. On the other hand, we expect the signs of demand recovery we are seeing currently to turn into a real recovery in the second half of the year. Longer-term, we expect global demand for rare earths to increase in most sectors.

Turning to Slide 23, let me give some highlights from our Magnetic Materials and Alloys segment. Shipping volumes of 1,263 metric tons in the first quarter were 9% higher sequentially and flat relative to the first quarter of last year. The first quarter is typically the weakest quarter of the year for Magnequench Neo Powders shipments due to the fact that the first quarter coincides with the end of the fiscal year for most Japanese companies in our supply chain.

The majority of our Neo Powders is sold directly to Japanese customers or to Chinese customers, which ultimately sell their magnets to Japanese and Korean motor manufacturers. When all of these companies make a concerted effort to draw down inventory levels for year-end closing, and that will result in lower shipment volumes for us.

Shipments of Neo Powders into our traditional base business applications and into new applications both increased in the first quarter. Two applications within our targeted, automotive and home appliance markets, automotive fuel pumps and home recirculation pumps, primarily in Europe. So very strong performance in the quarter as both applications continue to ramp in volume.

Demand for these higher efficiency pumps and pump systems is driven increasingly by customer demand and ever tightening government energy efficiency regulations. The neodymium-iron-boron magnetic materials that our Magnequench Division produces help to enable these higher efficiency components. We are also seeing and accelerating technology and market trend across several markets that utilize neo magnets, which I believe, illustrate a competitive advantage we have in this space.

I'm referring to our ability to manufacture rare earth based magnetic materials with little or no need for two very scarce heavy rare earths dysprosium and terbium. Dysprosium or DY traditionally has been required by motor manufacturers to be added to sintered rare earth permitted magnets that operate at relatively higher under the hood temperature environment. A number of other non-automotive applications also requires magnets with higher DY levels for higher temperature applications.

When DY was relatively easy to source and not too expensive, manufacturers specified as much as 8 to 10 times or 11% DY content in magnets. With pricing for DY declining, the pressure has eased somewhat in terms of using DY in neo magnetic materials, although long-term security of supply concerns persist and will persist for some time.

Our research scientists have been working with our customers and motor designers to find material and engineering solutions that allow for the use of rare earth magnets with much less DY and the zero DY in certain cases.

Magnequench's products are uniquely positioned to meet this market need. Our low to zero DY magnetic materials can deliver superior performance even in higher temperature environments of up to 200 degree Celsius. They are providing more and more manufacturers with a significant DY advantage. Here's one example how this trend is now playing out in the market. The major automaker, that traditionally relied upon sintered rare earth permanent magnets with 8% DY for an under the hood motor in a hybrid electric vehicle design, recently engineered a way to utilize low or zero DY magnets made with Magnequench powders.

That’s the kind of technology advantage that’s good for manufacturers, good for consumers, and of course, good for Molycorp. It's also representative of broader trend we're seeing across other markets. While Molycorp has heavy rare earths albeit at relatively low levels in our Mountain Pass or deposit, and while we produce heavy rare earth oxides primarily and currently at our Jiangyin plant in China. This migration towards less and less reliance on heavies in rare earth magnets gives us a distinct competitive advantage.

We have significant reserves in the Mountain Pass deposit of the primary rare earth that go into these magnetic materials, neodymium and praseodymium and we have decades of experience in producing these highly specialized custom-engineered magnetic materials through a Magnequench subsidiary.

Looking out beyond 2013 both of the world’s leading independent rare earth market analysts are forecasting relatively robust 9% to 15% per annum growth for rare earth magnetic materials. Both also believe this growth could be higher if stable and predictable supply of rare earths and magnetic Neo powders were available to the market.

On slide 24 is a quick update on our proprietary SorbX 100 wastewater treatment product. Since announcing our distribution agreement with Univar last quarter, we currently are conducting pilot and full scale tests with Univar to determine the efficacy of SorbX in removing phosphates from municipal wastewater on a commercial basis as compared to other wastewater treatment products.

In addition, we expect to conduct similar tests with industrial wastewater treatment facilities. We’re conducting these tests to determine the efficacy of SorbX beyond the laboratory scale test we previously have conducted. Based on the results of these tests, we expect to be able to determine the size and scope of the municipal and industrial wastewater treatment like SorbX will be effective as well as optimized the SorbX addition parameters and formulations.

It is still early in these evaluations to report on the results. So we will update you on our progress in future quarters. In summary, as shown in slide 25, let me make three points before we turn to questions.

We had a critical point in our production ramp up at Mountain Pass and it is imperative that we closely manage our cash flows. We are on plan and we intend to ramp up Mountain Pass to our initial target rate of about 20,000 metric tons per year by mid-year. But with rare earth pricing continuing to soften, particularly over the past several weeks, we are also conscious of the fact that our Chloralkali plant will not be fully operational until later in the year. That plant is key to bringing down our cost of production. Therefore, after we achieve our full production run rate, it may make sense to dial back production until we can run the facility at a lower cost of production. Fortunately, we have the option of dialing a production rate at Mount Pass to levels that help us maximize positive cash flow.

As part of our cost containment efforts, all members of senior management have taken a 10% cut in pay as I mentioned earlier and bonuses were cut back dramatically. We implemented a series of staff reductions that took effect by the end of the previous quarter and we’re seeing a material – that was the first quarter and we are seeing a material reduction in overhead costs and spending, perhaps a little better than what we had anticipated. We are serious about cutting costs as much as we can until we turn the quarter to profitability.

Looking forward, I believe that our increasing presence in global markets and the increasing diversity of global production we’re bringing should help to bring greater stability to rare earth prices and greater supply security. Our ability to offer our customers long-term arrangements and forward visibility with pricing is something that has not been possible in our industry for the last two decades. Customers have been craving this kind of certainty for years.

Finally, as you will continue to hear me stress, it’s all about execution at this point. we have to deliver our promises and our potential both to our customers and our shareholders. In doing so, we will have achieved the number one goal we have here at Molycorp, increasing shareholder value.

I look forward to your questions. Brian?

Brian Blackman

Operator, thank you very much. With that, we’d like to now turn it over for questions please.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from the line of Brian Lee of Goldman Sachs. Over to you please?

Brian Lee – Goldman Sachs

Hey, guys. Thanks for taking the question. I guess, first off, I was curious if you could talk about any updates on what you’re seeing with respect to the inventory situation at your customers especially on the NdPr side in Japan, but also anywhere else where you have some additional visibility?

Constantine Karayannopoulos

Yeah. Hi, Brian. I tried to address that, I guess, perhaps a little too superficially in my comments, but we are seeing inventories correcting. This is nothing new. What we saw in the first quarter of this year is nothing new. We see it year-after-year primarily by our Japanese customers trying to finish their fiscal year-end at the end of March with low inventories as possible. We are seeing the improvement in the second quarter. We expect our Magnequench business, for example, to sequentially increase. We also expect sales of neodymium and praseodymium to improve. So we are seeing positive signs, but I’m not at a point where I would call these signs a recovery. They’re positive, the sprouts, and that’s why I was saying that they are all pointing to a recovery in the second half. But clearly, they’re not reducing inventories any further. So we’re starting to see projections in actual purchasing activity that’s indicating that the worst is behind us.

Brian Lee – Goldman Sachs

Okay. That’s helpful, and I guess, a follow-up on Japan. We’ve been hearing that some of the – especially on the auto side, some of the manufacturers seem to be bringing production back domestically given the fluctuations in the yen recently. Any implications for your guys, some of that potential shift and anything that you’ve already seen some impact from?

Constantine Karayannopoulos

Not really in the short-term, I wouldn’t expect to see anything this quarter or the next or the one after that. However, long-term I think this is very important. We’re having a number of discussions with Japanese clients of ours who are making the strategic decision to not only produce their cars in North America, but also to repatriate, or reinstitute supply chains in North America, which will necessitate increased levels of production and perhaps will mean the eventual return into all these supply chains that have migrated to Asia and elsewhere, the returning back to the United States. But I wouldn’t hold my breath for anything of this nature to take effect in the next couple of quarters.

Brian Lee – Goldman Sachs

Okay. Last one from me, on Chloralkali quickly, any status update you can provide on the pricing negotiations there with your EPC contractor and expected timing of installation, has that changed? Thanks.

Constantine Karayannopoulos

Yeah, I need to be careful here. On the positive side, the costs have not increased over the last couple of months when we get updates and estimates from our EPC contractor. However, we are getting an update soon. So we expect to see something reasonable from them, let’s put it that way. The target day for completion of construction for the Chloralkali plant is still end of August or beginning of September, and therefore commissioning would be looking at end of September, beginning of August. Again, this is based on the latest information we have.

Our Board and our senior management we were at Mountain Pass yesterday and the day before. We have a tremendously talented and skilled group running Mountain Pass and especially the group at our Chloralkali facility. The place looks great. It’s still a hub of activity, but when you look around the Chloralkali plant, the vast majority of the equipment, piping et cetera seems to be in. So it’s still something that we need to be very careful on, but it’s looking pretty good actually. So I’m quite confident that again without promising that the Chloralkali plant will be fully commissioned by the end of September, I’m very confident that the plant will be up and running in fourth quarter. and I would expect most of the fourth quarter, Mount Pass to operate with the Chloralkali plant in full operation and therefore, delivering the cost reductions that we need to see.

Brian Lee – Goldman Sachs

Okay, thanks guys.

Constantine Karayannopoulos

Thanks, Brian.

Operator

Thank you for your question. The next question is from the line of Michael Gambardella of JPMorgan. Please go ahead.

Michael Gambardella – JPMorgan

Thank you. Hi, Constantine.

Constantine Karayannopoulos

Hi, Michael.

Michael Gambardella – JPMorgan

A couple of questions, one, could you tell us what the EBITDA in the quarter was for the heritage neo materials business?

Michael F. Doolan

Hi, Michael, it’s Michael Doolan. For the first quarter, it would have been about $15.1 million, so down, basically split 12.5, for the legacy Magnequench division, the magnetics. Only 1.5 for rare earth and just over a million for rare metals space. I think the biggest thing in the rare earth segment is that, I mean everybody is well aware of the pricing environment, but both of the Chinese joint ventures haven’t purchased raw material and sometimes notwithstanding feedstock prices are coming down. We’re not benefiting from them yet; certainly, Jiangyin is running off clays that were purchased probably early summer of 2012. So at this point, unfortunately, we’re suffering that margin compression by working through high cost raw materials and into a low price selling environment.

Michael Gambardella – JPMorgan

Okay.

Constantine Karayannopoulos

Michael, we’re having – as Michael further explained, we’re having relatively high cost raw materials and sliding prices, And at the same time as you can tell from our volumes, we’re not back to normal. So we’re having a bit of a double whammy. Under normalized conditions, this business we expect it to get back to historical levels with some degree of comfort.

Michael Gambardella – JPMorgan

So, I mean, I think you had said earlier that you expected this business to generate about $150 million in EBITDA more and you are running at an annual rate of $60 million?

Constantine Karayannopoulos

Yes, but we explained to you the reasons why we're running at 60. Again, when the volumes are what they have been historically in that business and when the cost of raw materials reflects the cost of our selling prices. The available margin that that business captures should not be that far-off that figure that we have said that basically the business has historically made.

Michael Gambardella – JPMorgan

So, you have to get a recovery in the selling prices basically?

Constantine Karayannopoulos

No we need to get cheaper raw materials reflecting today's raw material prices and that business should be a lot closer to that figure. But as Michael said, we're using feed materials that were purchased last year at much higher prices than what we would be buying them at today.

Michael F. Doolan

And with the demand levels, it’s taking us longer to work through them, at more than typical demand.

Michael Gambardella – JPMorgan

Okay.

Michael F. Doolan

So until we get back to delivery and we are separately margin compressing.

Michael Gambardella – JPMorgan

All right. I think at the last offering as, Constantine said that you had you’ve got various pricing which was at or near bottom. I mean it seems to have gone down more what do you think is wrong? What's been wrong across the pricing to go down more than you thought back then?

Constantine Karayannopoulos

Well, when you look at the largest producer in China and the world, which is Baotou, I mean, their fourth quarter was a blood bath. To me that is about as close to the bottom, or as close to a level as the Chinese government will allow their major players in this industry that have been tasked with consolidating all the small producers to operate.

The bigger problem, that in addition to sort of demand being what it is, I think the most fundamental problem that the whole industry faces and I won’t claim that this is my thought, but I’ve been talking about it for a number of quarters. Su Bo, the Vice Minister of the Ministry of Industry in China last month talked about the two main priorities for the Ministry being the continuing consolidation of the small producers into the hands of big Beijing based SOEs, and the second was the elimination of smuggling.

The smuggling is a big problem. You have, first of all, smuggling of rare earths at easily a 40% lower cost than any legal producer like Molycorp in China has. When we export our products, we pay 25% export duty and 17% VAT and naturally the smugglers don’t pay any extra duty nor VAT. In addition, smuggling is sort of the last part of the supply chain within China that mines rare earth illegally, processes them without production quarters. And what that means is that, they pay no resource taxes, no VATs and perhaps more worrisome, they do not operate any environmental systems in those facilities.

So, as a result they have some very significant cost advantages which means that they have their cost of production would be easily 50% of where rare earth prices are today. I’m not saying that prices will have another 50% to go, but I think it’s imperative that the state council in China will take control of the situation. They have been trying for a while. But in fact, when you go to the Southern borders of China, you see trucks going through the border completely uncheck.

So I think if the Chinese mean what they say in terms of controlling the industry, they will have to put an end to the smuggling and illegal production. And if they mean what they say with respect to preserving the environment and protecting the resource in China, they will have to deal with this and I don’t think the state council has a lot more patience.

So this is a very long way of saying that, the current way of operating these illegal operations and smuggling the products out of China is not sustainable. So if we are talking about illegally producing and exporting rare earths out of China, the prices have some more room to go. on the legal basis, no, I think we’re beyond the bottom as far as the Chinese operators – the legal Chinese operators are concerned.

Michael Gambardella – JPMorgan

So, I mean, over the past three years, the Chinese government has been making statements that they’re going to crack down on illegal miners and the smuggling activity in this business and they haven’t. So why do you think what they’re saying today, which is the same thing they have been saying for three, four years now, is any different?

Constantine Karayannopoulos

Well, it’s not that they haven’t done anything, and we have seen people that we know end up in jail, while we also knew that they were unlicensed operators and smugglers. They used to realize and understand that there is a fairly major battle going on in China that Beijing versus the regions and in the middle of their caught, the Chinese citizens who have to live with the environmental implications. The Chinese government has gone to great length to improve the environmental conditions around the cities and small and large.

Clearly, what is going on now is not sustainable. so the Chinese government will have to make a decision whether they need to pay additional heed to what’s going on. Again, I stressed of what we’re talking about is the southern borders, because that we see the bulk of the smuggling going through the southern borders of China. and in my view, it shouldn’t be all that difficult. But there’s a continuing battle between Beijing and local governments in the south. and we have to wait and see who is going to win it. My bet is on Beijing, but I’ve been wrong before. All I can say is that clearly the current situation is not sustainable. The Chinese government at all levels, the Chinese governments have shutdown a number of small facilities. They clearly have not intercepted enough smuggle material, but that maybe the next step.

Again, clearly in China, you cannot continue to do things illegally for far too long. But I do take your points that they have been talking about this for a long time. And don’t forget that, their main defense the China has in front of the WTO on the rare earth cases that what they are doing is designed to protect the environment and preserve the resource, and clearly unless they demonstrate that they’re cracking down on the illegal production and smuggling that argument will not hold much water.

Michael Gambardella – JPMorgan

Yeah. One question for Mike on the write-down, the inventory write-down you had in the quarter?

Michael F. Doolan

Yes.

Michael Gambardella – JPMorgan

Michael, could you discuss that a little bit more especially the component of it and why you did it at the Mountain Pass, which I think it was over 39% you said?

Michael F. Doolan

Correct. 37.2% I mean a lot of that is just that it’s the – given our fixed costs base and a level of production that we have allocating it to the units production just can’t be sustained with the current market price, so essentially that just gets write-off to P&L, that's a good chunk of it. There's also some inventory on hand at year-end that also gets written-down with the movement downward of lanthanum cerium prices. I think the movement has been greater in cerium and lanthanum than it certainly has in NdPr. So the write-downs we've taken is predominantly lanthanum of any other materials.

Michael Gambardella – JPMorgan

So by taking this write-down in this quarter, would that in effect be boosting your income in future quarters, because you…

Michael F. Doolan

Well, it just really depends on ultimate selling prices. I mean, if selling prices go back up, then yes.

Michael Gambardella – JPMorgan

Well, I’m just saying aren’t you just getting rid of high cost material that would have been flowing through the income statement in the future?

Constantine Karayannopoulos

Well, yes, but the issue is that it has to be – [we’re probably in the target] to lesser cost or net realizable value. Right at the moment, net realizable value is just the governing factor. So all those production costs, because we have the high fixed base over the low volume, as I say most of that gets flushed through the P&L in a particular quarter. So until we start to get back up to the Phase 1 rates, you’ll probably continue to see a little bit of this.

Michael F. Doolan

Mountain Pass, Mike, is designed and it’s staffed to produce a lot more than it is producing today. So clearly, all those fixed costs are getting amortized over smaller volumes and they are resulting in production costs that are clearly above what today’s pricing will sustain. So that, and instead of sort of parking high cost, product – produce materials and inventory, we are expensing those costs as we go along.

Michael Gambardella – JPMorgan

Kind of as an extraordinary item though?

Michael F. Doolan

Actually to that point, one of the things – no, I guess, what we've done is the only write-off is there was an additional $2.0 million of write off at other locations. I will agree that that’s just business and that’s the only try to manage that. The issue I believe at Mountain Pass, why it’s unusual is because we have not achieved commercial production as yet. So we're not in a normal business phase. So at this point in our evolution, I would suggest that it's out of the ordinary. Once we're up and running and then we have to manage our inventory levels and keep an eye on the market prices as well, yeah, then we shouldn’t be pulling this out as an unusual item for (inaudible). As it relates to prices, I'm not…

Michael Gambardella – JPMorgan

How much interest was capitalized in the quarter?

Michael F. Doolan

About $21 million.

Michael Gambardella – JPMorgan

$21 million, okay, nice.

Michael F. Doolan

Okay.

Constantine Karayannopoulos

Thanks, Mike.

Operator

I’ll give you a question. The next question is from the line of Jeff Cramer of Morgan Stanley. Over to you please.

Jeff Cramer – MorganStanley

Hi, thanks. Just in terms of the project at Mountain Pass, can you outline what remains from a, I guess, a construction perspective, are you really, this is ramp up mode other than the chloralkali plant, you guys are really just fine tuning at this point?

Constantine Karayannopoulos

The chloralkali is clearly the biggest piece. There are a couple of other, and there’s one other relatively major, clearly much smaller than chloralkali piece, that relates to the purification of our waste water before it gets to the chloralkali plant, internally, we call that brine purification and that’s progressing.

There’s a few other minor projects, one relating to the last stage of our multistage leach and crack facility and that’s – we can operate without it, but with it, we get significantly better recoveries and lower costs. That should be done by mid-summer. There’s some finishing operations that are yet to be installed, but we can operate, as I said before without them. these are smaller projects in the sort of $10 million range as opposed to the $40 million to $50 million, which is what’s left in the – we think is left in the chloralkali plant. So there are three, well, four or five rather well identified projects that are being completed and the rest of the focus is on operations right now.

Jeff Cramer – MorganStanley

Okay. and maybe from a volume perspective over the next couple of quarters, yeah, I guess, fourth quarter, it sounds like it’s the really big push forward. But as we think about volumes as you ramp up in 2Q and 3Q, we have kind of a rough estimate what those will be at Mountain Pass?

Constantine Karayannopoulos

Yeah, that’s a big question. Jeff, now, I said that our target still remains to be up and running at Phase 1 rates by midyear. so June, end of June, July that’s where I would see us being able to demonstrate first to ourselves and then to the markets that Mountain Pass can run consistently, reliably and generating inspect products at the 20,000 ton a year rate. However, given today’s costs, with out the chloralkali plant, we need to be very careful that we’re not operating at those rates at negative cash flows.

As I said, our focus is executing at Mountain Pass, delivering the project, but also cash flow. we have a fixed amount of cash, and we certainly don’t want to go back to the markets, not that we expect to, but at today’s prices, we need to be very careful to make sure that we’re not spending money and burning cash unnecessarily. So the decision that we will have to make in the third quarter when we are up fully capable of running at 20,000 tons is whether we can generate positive cash flow at 20,000 tons. If we do, then we will run at 20,000 tons. If we can’t, then we’ll dial it back down as I said in my comments.

Now, in the first quarter, at those prices, it was clear to us that we could generate positive cash flow in the third quarter. However, at today’s prices, I think, we need to be much more careful. I am not saying that we can not, but we need to continuously evaluate our cost of production versus pricing in volumes before we can commit to running Mountain Pass at 20,000 tons a year run rate. First quarter, I am very confident and very comfortable saying that we should be able to run at 20,000 tons and generate positive cash flow, but in between now and the time when our chloralkali plant comes online, we need to be very careful and our priorities being what they are, we have to make decisions accordingly.

Jeff Cramer – MorganStanley

Understand and thank you for answers, stating my next question. Just – and as far as your customers go and commitments that you have, is there a certain volume commitment you need to be at a minimum of coming fourth quarter?

Constantine Karayannopoulos

Well, we have a lot of commitments by our customers, but we need to be at that stage, where we are producing at the right costs. Otherwise, I think, we’ll be asking our customers to wait until our cost profile allows us to generate positive cash flow. If we can do it in the third quarter, I’ll say we’ll do it in the fourth, but I am not too concerned about the level of commitment that we need. We’re very comfortable in our customers demand and what demand to expect in the second half, and keep in mind that we do have internal demand for a big chunk of our products by our downstream facilities in Estonia, China and Taiwan.

Jeff Cramer – MorganStanley

Right. And then, Michael, just two quick ones, one, I mean, ABL has obviously been in negotiations for some time. If that’s a gating item that’s holding it separate at this point and then I guess is this a – any further write-down from inventory is this just a function of where pricing goes from here?

Michael F. Doolan

As it relates to the ABL revolver, as I think, we've now just completed all of the gating issues and now it's just a matter of process. So, I mean, I know I’ve said it before, but we are step by step closer. So I don’t see any impediments to closing on that. As it relates to the inventory questions, I guess, it's really the two components, there is one that, there is the inventory that we have on hand that we'll have to adjust to market prices, if market prices continue to fall, and then there’s the other piece that I was referring to on a previous call, where we are probably going to have production cost again we cannot support in the inventory value. Just because of the production levels vis-à-vis are fast paced and also [those were] multiple find a way to the P&L in the period as well.

Jeff Cramer – MorganStanley

Okay. Thanks, guys.

Michael F. Doolan

Thanks.

Constantine Karayannopoulos

Thanks

Operator

Thank you for your question. The next question is from the line of Ben Kallo of Robert W. Baird. Over to you please?

Ben Joseph Kallo – Robert W. Baird & Co. Equity Capital Markets

Hey, Constantine. You've been in your seat for a couple of quarters now, any operations or any assets in your operations that you kind of you are looking at maybe shutting down or selling or is there any, is there any fat to trim?

Constantine Karayannopoulos

Good question, Ben. At the end of the first quarter, we did – we had concluded that there was a bit of fat in our overhead and in the way, we were spending money going about in our operations, and we took a big chunk of that out. Whether it’s all? I think it was a very painful process. and as I said in my comments, the results are significantly better than what we expected. I think we are seeing sort of a cultural change around the company. People are watching dimes. We’re not spending the way we used to spend, so this is very gratifying.

Now, in terms of our assets, the asset base of the company has been put together on a very deliberate basis. and there are strong strategic reasons why all the assets are where they are. However, things are changing constantly, markets are changing, product lines are changing. We are always looking at what assets are productive and what assets are not. And I’m not saying this is what we’re going to be doing, but we should not – you should not be surprised, if you find out that in the next few months. as our ongoing evaluation continues, we are slowing down, shutting down or disposing of assets.

Having said that, this is clearly not my top priority right now, as I said, Mountain Pass and cash flow are our top priorities. but even during the good times, we have to take a look at our asset base and make sure that it is what we needed to be. But I’m not saying that we will be doing that, but in our continuous evaluation, we are always taking a look at those options.

Ben Joseph Kallo – Robert W. Baird & Co. Equity Capital Markets

How much restrictions are there on a covenant perspective maybe Michael, just for doing anything like that?

Michael F. Doolan

Well, certainly, the ones that are under the – it seems like the 10% notes are all flat. So, which is really the, let me see, Molycorp assets, and you have to use that to – any proceeds remaining that we were to do, will have to be used to retaining those.

Ben Joseph Kallo – Robert W. Baird & Co. Equity Capital Markets

Okay. And then my last question, you touched on a lot about the chloralkali. and then the brine purification and where you stand in that. I guess I’ve always wondered what type of technology hurdle is there or is it just a time hurdle in your construction or is there some actual technology that needs to be worked through?

Constantine Karayannopoulos

Yeah. the technology is relatively standard. it’s state-of-the-art membrane technology for chloralkali production. The way I see it, there are two main challenges here. The first challenge is for a chloralkali plant of this complexity to operate properly, we need to have proper brine feed to the systems, to the electrolyzers. that’s why brine purification is critical. So we need to get this right. I don’t think it’s rocket science, it’s not magic, it’s just a very deliberate approach that we’re taking and we’re very confident that we know what we’re doing. I don’t expect surprises there. The other major concern here – the thing that if there is one thing that sort of August-September of this year will be keeping me up at night is the safety aspects around the chloralkali plant.

Again, I’m a chemical engineer, but I’ve never been around a chloralkali plant. Our team at Mountain Pass have spent their entire professional lives putting chloralkali plants together and working them. My concern is when you see how one of these things works, those hydrogen gas and chlorine gas being produced then I want to make sure that our safety systems are topnotch and do not leave any sort of risks that are not addressed adequately. Again, it’s been done before; it’s been done many times. We’re not breaking new ground on the chloralkali front. So as long as good people are doing their jobs right, we’ll get there. There might be some timing issue around the commissioning, if something unexpected happens, but there’s not any real big sort of hairy uncertainties out there.

Ben Joseph Kallo – Robert W. Baird & Co. Equity Capital Markets

Okay. My final question, just a blast from the past here The M&K Chemical Engineering lawsuit, is that still out there? Should we be watching for anything in that?

Constantine Karayannopoulos

Yeah, it’s still out there. Our lawyers are talking to their lawyers. Again, for me, it’s a matter of priorities. I haven’t – to tell you the truth, I haven’t spent an awful lot of time in the last couple of quarters on this. I ask our new Chief Counsel, Kevin Johnson about it. He tells me that there are negotiations continuing. So I leave it at that. I mean, it’s something that’s important clearly, but at this stage, we have more important things to do. But we’re not forgetting about it. Our legal team is engaged with this and the process is continuing.

Ben Joseph Kallo – Robert W. Baird & Co. Equity Capital Markets

Thanks guys.

Constantine Karayannopoulos

All right. thanks, Ben.

Operator

Thank you for your question. Our final question is from the line of Mike Ritzenthaler of Piper Jaffray. Over to you please.

Michael Ritzenthaler – Piper Jaffray

Good afternoon guys. A little nuance or maybe a clarification on some of the previous questions on the bottlenecks, you mentioned the filtration and you mentioned the chloralkali at length. But I guess the rest of the process downstream of filtration within leech and crack; have all those unit ops been run and is that what’s giving you the conviction that various bottlenecks have been taken care of?

Constantine Karayannopoulos

Mike, we’re really running big a big risk here, because you’re talking to a gearhead and I could speak about it for hours. So we have to finish with the call. But no, we have run – what happens – clearly we had very large filters, filtrate and rotary filters in place. But the way that the design and the startup came together, we started with the forming issues that we did not expect to see at the level we saw. We addressed those and then forming and the nature of the material finally meant that our filters that we’re in place against state-of-the-art, large continuous were not the right machines for the task. So we tried to – it was hand-to-hand combat there during January and we came to the realization that we’re fighting a losing battle. So we made a decision in February to replace those filters with much more conventional, very large plate and frame pressure filters.

So then what we’ve achieved there in the last couple of months is monumental. We got tanks in place. We virtually built almost a new plant dedicated to filtration out of our leach and crack. Now so, we’re there. We’ve repurposed and commissioned an existing filter press, it’s working really well and we have – our problem now is that we can’t keep up with a downstream. The downstream units are working really well and we’re not seeing any bottlenecks. So I think the key to the next month will be ramping up leach and crack, which as I said, we’ve run the systems at 10,000 tons over the last couple weeks. And we know, we’ve also run the separation, the solvent extraction units, the divalent metal removal units, all at much higher throughputs and we’ve tested the limits of Phase 1 capabilities and even we’ve in some cases, we got carried away, we pushed into Phase 2 capability.

So, will there be problems, absolutely. I mean it’s the nature of the beast. There will be pumps that fail, there will be valves that leak, there will be packings that will have to be replaced, there will be lines that spring leaks and mistakes made. But again, these are not fatal flaws and it’s sort of the fact of daily life in any processing facility. The plan is now looking and feeling like an absolutely topnotch chemical processing facility attached to a mine.

So, I have a very high degree of confidence that this name is going to work the way. It’s expected, but until, sort of the middle of the year, the hand-to-hand combat will continue and there is an exemplary group of very good people at Mountain Pass and they’ve been solving every problem that’s been springing up and they will continue to do that. So I don’t see again any, I use the same expression, for the chloralkali, I don’t see any big hairy surprises or concerns lurking around the corner here. It’s sort of shoulder to the wheel and solving one problem at a time.

Michael Ritzenthaler – Piper Jaffray

Okay. I want to be (inaudible) just one last quick one on SorbX, can you quantify for us how many trials are going on or are there any other details beyond what was on that slide?

Constantine Karayannopoulos

Yeah. the current schedule is for three municipal waste water trials. We’ve completed one. We’re in the middle of the second and we’re starting the third closer to the end of the month. and we are still trying to choose the next industrial waste water facility. So we completed one, one is going on, another one coming, and this does the industrial trial that we want to complete before the end of June.

Michael Ritzenthaler – Piper Jaffray

Got it. Thank you.

Constantine Karayannopoulos

All right.

Operator

Thank you for your question. We have no further questions. and with that, I’ll hand it back over to Mr. Blackman for a closing remark.

Brian Blackman

All right. Thank you, operator, and just a quick wrap up. I’d like to thank everybody for joining us on today’s call. We certainly look forward to speaking to everyone again to report our second quarter results for 2013. Thanks and have a great day.

Constantine Karayannopoulos

Thanks, everybody

Operator

Thanks to your presenters. Ladies and gentlemen, your conference call now comes to an end. You may now disconnect. Thank you very much for joining.

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