A follower recently added a comment to an article I wrote in March 2012 as the rare earth miner Molycorp (MCP) was poised to merge with Neo Materials Technologies, a China-based rare earth materials company. That deal is done now and there have been a few additional developments. The company recently raised capital through the sale of common stock. Losses have deepened as weak selling prices have eroded sales prospects. There has been little in the way of good news for Molycorp and the stock price seems unable to find a low point. Some have even questioned Molycorp as a going concern.
It is time to take another look at MolyCorp's balance sheet.
This time let's use the Nobel Prize winning economic measure, Tobin's Q. This simple ratio compares the market value of a company's common stock to the replacement cost of its assets.
If strong profits or even just the promise of future profits drive market value to a level higher than the cost of replacing the company's assets, Tobin's Q ratio will be greater than 1.0. This is a signal that additional investment might be in order. However, a ratio of less than 1.0 suggests that the company's assets are not being used to the best advantage. That is to say, market value is depressed because assets are not generating the kind of profits that drive stock price. Any assets that cannot be used to generate a profit should be sold. Historically, the average Tobin's Q across all industries has been 1.35.
Certainly everyone who has a stake in MCP would like to get this simple, thumbs up/down guidance.
Alas, Tobin's Q is an elegant little tool in theory, but considerably more difficult to deploy. The calculation is vulnerable to measurement error. Finding replacement value is a time consuming and subject to considerable subjectivity. Consequently, it has become common to use the following ratio:
Equity Market Value + Liabilities Market Value
Equity Book Value + Liabilities Book Value
We can make a pro forma adjustment to Molycorp's balance sheet at the end of September 2013, to reflect the $247.5 million capital raise in October 2013. If we let's use a stock price near $4.60, the ratio might be as follows:
$1.11 billion market value + $1.57 billion liabilities* market value
$1.58 billion pro forma equity book value + $1.70 billion total liabilities book value
Tobin's Q for Molycorp reads "throw in the towel."
Admittedly, this proxy for Tobin's Q is subject to criticism. So before shareholders begin sending me hate mail, let's review Molycorp's market value and assets. Market hype of one kind or another can influence the numerator in the ratio by driving up market value (bulls running amok, predicting extravagant future profits) or driving it down (short sellers holding sway in social media sending prices downward). In Molycorp's case we know there has been considerable give and take about the company's prospects and management's motivations. I will leave that argument for another day.
A more important discussion is the influence that balance sheet values might have on our Tobin's Q ratio. Book value can be far different from fair value and differ even more from replacement value because most assets are reflected on the balance sheet at their cost. Intangible assets and goodwill get created when a new patent gets put on the balance sheet or when an acquisition is completed. Yet, what about the assets a company creates but are never added to the balance sheet. These could come in the form of process knowledge or unique protocols and configurations a company creates over the years and deploys competitively. Such value is real but does not get recognized under GAAP accounting rules.
Are there assets on Molycorp's balance sheet that are not represented at fair value?
At the end of September 2013, Molycorp had $2.3 billion in real assets on it's balance sheet. Today let's assume current assets and certain long-term assets are reflected at fair value. (There is a lengthier explanation at the end of this article.)
This leaves a discussion of property, plant and equipment (PP&E), which totaled $1.8 billion net of accumulated depreciation at the end of September 2013. Gross PP&E is not much greater, because most of the assets have been acquired in the last three year, leaving time to accumulate only $86.0 million in depreciation.
The majority of PP&E - $1.0 billion - is classified as 'construction in progress' related to the improvements underway at the company's Mountain Pass facility in California. Since these are costs that the company has paid over the last three years, we can assume they are as near to fair value as possible. Indeed, the $1.0 billion in construction in progress could be considered 'replacement value.' Since this is 55.6% of total PP&E, we begin to have a more confidence in the denominator of our Tobin's Q ratio.
Of course, until all the upgrades and enhancements are completed, there is some question about the full viability of Mountain Pass, at least in terms of performing as management has promised. The company has made much of its plans to add a chloralkali plant to the Mountain Pass operation so as to reduce production costs to a level competitive with low-cost producers in China. Chloralkali technologies make it possible to recycle water and regenerated chemical reagents, thereby reducing supply costs. While all steps in rare earth production have been completed at Mountain Pass, the very element that could ensure the competitive rigor of the company's production has not been commissioned and put into operation. More about this situation below as we discuss Molycorp's version of vertical integration.
Does Molycorp have intangible assets that are not represented on the balance sheet, indeed assets that other rare earth producers do not have?
Now comes the hard part - analyzing intangible assets and goodwill. In June 2012, the acquisition of Neo Materials Technologies resulted in the addition of $482.2 million in intangible assets and $494.8 million in goodwill to the Molycorp's balance sheet. However, before the year was over, the company was forced to write off most of $256.3 million of the goodwill and $6.0 million of the intangible assets related to patents. Estimates of future cash flows at new, lower prices for Molycorp's principle rare earth materials and products were not sufficient enough to support the stated book values of associated assets.
There remains $239.7 million in goodwill on Molycorp's balance sheet. Net intangible assets now total $450.9 million, of which 73% related to customer relationships that belonged to Neo Materials Technologies. From the perspective of the Neo Materials assets and the revenue they could produce, intangible assets and goodwill are still vulnerable to future revaluation.
Let's just think logically about what Molycorp's acquisitions mean for Molycorp competitively. Principally, the combinations have created a unique multinational production and distribution network. The Silmet deal gave Molycorp a place to plant a flag in Europe at one of two rare earth processing facilities in Europe. Buying Santoku America gave Molycorp control over the only producer of rare earth alloys in the U.S. Then the Neo Materials Technologies deal added a number of downstream processing and advanced materials production facilities to the mix. At least theoretically these provide a captive distribution channel for Molycorp's rare earth oxides.
What is more, Neo Materials Technologies has developed a plum relationship with Mitsubishi and Daido Steel, which jointly have access to patented technologies related to neodymium (NdFeB) magnets. 'Neo magnets' are particularly useful in hard disk drives and fasteners among other products. Now the IMJ joint venture in Japan is part of the Molycorp mix, giving the company access to an important distribution channel in Japan for the company's neodymium materials and alloys.
Integrating forward into intermediate and finished rare earth products should add to competitive strength. At the end of 2012, the company estimated between 4,000 and 7,000 metric tons of the rare earth materials production at Mountain Pass could be allocated to its captive downstream subsidiaries. That represents 21% to 37% of the Mountain Pass initial production capacity of 19,050 metric tons per year.
However, it does not appear that investors have given Molycorp any credit for the accomplishment. Granted there has been little in the way of sales and improved margins to suggest that any sort of integrated structure is working for Molycorp. At the end of 2012, the company revealed 8% of production at Mountain Pass had been allocated to support production at facilities in Korat, Thailand and Tianjin, China producing Magnequench branded magnetic powders. This suggests the reality of an integrated operation so far has fall short of plan.
There is also some concern that Mountain Pass production, which is skewed toward lower-priced light rare earth materials such as lanthanum and cerium, is not delivering enough of the coveted heavy rare earth materials such as neodymium that are needed at its various downstream subsidiaries. What is more the Mountain Pass facility has yet to transform itself into a low-cost producer. Its chloralkali plant is just now being commissioned and put into operation. Downstream captives such as the Magnequench facilities in China and Thailand and the Santoku facility in Tolleson, Arizona are better off sourcing competitively priced materials elsewhere.
If Molycorp fails to fully take advantage of the opportunities inherent in its acquisitions, there is no justification for the premium price it paid for Neo Materials Technologies. Ignoring the intangible assets and goodwill created by that deal, the Tobin's Q ratio for Molycorp would be 1.03. Thus it looks like investors have already discounted the promise of an integrated operating structure.
Now we finally get to a real issue with Molycorp….management.
The potential for the company to realize the value in its unique combination is largely in the hands of management. There have been some complaints registered among investors that management is self-dealing and opportunistic. Investors have criticized management for realizing personal profits in the combination. I reference comments to articles on MCP posted on the Seeking Alpha platform over the past year. Articles posted on October 3, 2013 , November 4, 2013 and November 9, 2013 are the most recent examples. Perhaps the greater concern should be whether management has the skills needed to bring profitability to the integrated operating structure they set up.
Constantine Karayannopoulos has been acting CEO of Molycorp for the last year. He is an engineer by training and has accumulated quite a bit of experience in business development. What we do not see in his background is significant multinational operating experience. In the company's 2012 10K filing the biography of CFO, Michael Doolan, claims he has experience in mergers and acquisitions. Since I do not see any experience in operations, I suspect he is good at finding the money to pay for a deal but expects someone else to make the various operations work together.
That someone else is Geoff Bedford, who had been with Neo Materials since 1999, and was most recently COO for the company. He will take over the reins as CEO at the beginning of December 2013, continuing whatever integration plans he has had in place over the last year. Karayannopoulos will remain on the Board of Directors.
Still no one on the management team has experience in managing an operation with as many moving parts as now found at Molycorp. I wonder, for example, if any one on the management team has asked whether the company really needs 2,700 employees in 27 different locations. Revenue per employee was $218,815 in the most recently reported twelve months (based on the 2,700 employees reported at the end of 2012 and trailing twelve months revenue). Are employees working together to increase that sales or are they isolated in 27 different silos?
Two, Four, Six, Eight. When is Molycorp going to integrate?
There is a clear relationship between a company's Tobin's Q measure and its competitive structure. Combinations like Molycorp's may not realize an increase in market power just by joining together. They also need to create barriers to entry or at least hurdles for their competitors. For Molycorp the hurdle is in the form of low cost production coupled with access to intermediate or end markets. In Molycorp's case we have heard the plans of an integrated operation but have yet to see the reality. Sales have actually decreased as lower selling prices have not been offset by capture of market share or more numerous customer relationships. Granted the Neo Materials deal closed in June 2012. It does not seem plausible that the full potential of the combination could be realized in just one year.
Instinctively, investors have pointed the finger at management. However, the accusations have been for all the wrong reasons. In my view, what Molycorp needs today is some good old fashion blocking and tackling to thoroughly integrate its operating structure. Karayannopoulos and his team may have led the charge to legally combine Molycorp with Neo Materials, but they may need to recruit new hands to realize the new company's full value.
*Market Value of Liabilities Adjustment
A few of the liabilities resulting from accounting treatments and not requiring cash payment by the company were eliminated from the market value of liabilities.
**Discussion of Fair value of Assets
Cash ($173.9 million plus $247.5 million from recent capital raise), deposits ($26.0 million) and investments ($58.7 million) are arguably represented near fair value. Likewise, net trade accounts ($58.2 million) could be considered represented at fair value as well.
Note that investments are composed of the company's stake in various rare earth materials, rare metals refining, magnetic materials manufacturing operations that were a part of the Neo Materials Technology deal. The two largest positions are 1) $20 million in convertible preferred stock in Boulder Wind Power and 2) the Intermetalico Japan Joint Venture (IMJ) which is on the balance sheet as $25.3 million after $2.4 million in losses were trimmed from the total investment of $27.7 million. Investments are evaluated frequently and are at fair value, but all are vulnerable to write down if cash flows appear impaired. For now we will accept the book value of investments as fair value.
There is a plausible case for altering the value of short- and long-term inventory ($183.4 million and $24.3 million, respectively) as the price of rare earth materials changes. Molycorp has already reduced inventory by $74.5 million in 2013 even after having recorded $83.0 million in inventory write-downs in the year 2012. Thus it seems that the inventory values on Molycorp's balance sheet are near fair value.
All balance sheet values are from the 2012 10K and 2013 3Q financial filings with the SEC
Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.