Molycorp: Overpriced on Rare Earth Excitement

Oct. 7.10 | About: Molycorp, Inc. (MCPIQ)
Molycorp, Inc. (MCP) is a company based just south of Denver, CO engaged in the exploration of production of Rare Earth Oxides ("REO"). For the purposes of this article, I will assume you either know what REO(s) are or if not, see here for a fulsome explanation by the Company.
The Company went public in late July in a broken IPO in which the price had to be chopped from the originally marketed $15-17 range to $14/share ($394MM) based on lack of interest in the offering. Since the IPO, shares are up over 100% to ~$29 as of writing this article, or a market cap of ~$2.4Bn dollars. The proceeds of the offering will be used to to refurbish equipment and facilities in it's open pit mine in Mountain Pass, CA - the company's only mine. Mountain Pass was formerly a property of Molybdenum Corp. of America, which was purchased by Union Oil of CA, which was subsequently purchased by Chevron in 2005. Operations at Mountain Pass were suspended in 2002 due to softening prices in REO and a lack of additional tailings disposal (waste from the production process). The mine was formerly the largest producer of rare earth minerals in the world before operations were suspended and now still has large deposits of the minerals, although MCP will not be fully operational to mine them until at least late 2011/early 2012. You may ask then, what are they doing in the meantime to warrant a multi-billion dollar valuation such as this? Well, quite a bit, but with still over a year of work in front of them before the market can really discover if they warrant this valuation, it's hard to justify a long at these levels and for the reasons below, I would propose a short of MCP.
Click to enlargeFirst, valuation is getting lofty based on the mine assessment done by SKM (which can be seen on pages 72-76 of their S-1). By looking at the proven and probable reserves that could be pulled out over the life of the mine, assessing costs and pricing assumptions, SKM came to a net present value of $2.02Bn for the mine, or approximately 20% below the current market valuation of MCP. Prices for rare earths have run up further since this assessment was priced on June 15, but at the current market cap, one would need to assume that MCP could a) fully extract the proven reserves to meet that NAV and b) that no other REO capacity was to come on line and cut pricing back to a more normalized level.
Second, the market does not seem to be assessing the risk of the operation currently. While the government has made it clear these rare earth metals are extremely important to national defense and I believe will do all in their power to get this mine running again, there is still a lot to be done in front of operations beginning again. This is basically a greenfield project that is being provided a brownfield base on which to start.
Third, they are spending (A LOT) to refurbish the aged, rusted and unusable equipment currently at Mountain Pass. They are also buying new equipment and in the process of building a plant on-site to produce chemicals (used in production process) and a co-generation facility to provide natural gas power to the operations. The Company has said they will need in the range of $500-600MM to bring the facilities on-line, which is likely a conservative estimate given they expect to only spend $53MM of that in 2010. There are also numerous environmental costs before production can begin as well as ongoing after operations commence. The Company plans to spend $187MM alone on environmental-driven capital projects between now and 2012.
Fourth, they are not earning any material revenue. MCP is currently only earning revenue by selling remaining stockpiles of rare earth that they have at the Mountain Pass mine, although they are generating a minuscule amount in comparison to their market cap - $14MM since inception in June 2008. They currently have a two customer concentration of 89% of revenues for the six months ended 6/30/10 and generate 90% of sales from two products: lanthanum concentrate and lanthanum oxide. MCP is also burning through cash, not at an alarming rate currently, but they have only begun to refurb their operations, which will greatly accelerate the cash going out the door.
While the share price run up since the IPO has been due partially to the market's realization of the value of the FUTURE OPERATIONS of the mine, primarily I believe the move is based on a large retail presence (and here) in the name, spurned on by the constant front page headlines regarding China's not-so-generous trading of their rare earth resources (of which, they have about a 97% market share on all rare earths currently produced). If you are not convinced of this being any sort of retail led run up, type "china rare earth" into Google and see the number of articles that have been written on the subject in the last two weeks. You could also watch the erratic nature in which the stock trades, many times taking 4-6% round trips more than once a day and a 40% round trip last week (down 20% Monday to mid-Wednesday and returning to almost flat by Friday). We will see for the first time in this quarter's 13-F filings if there are many hedge funds in the name, although I don't suspect that will be the case.
The issue the bulls make here is that rare earth elements are very important to a number of industries including green tech, mobile telephony and defense. The Mountain Pass mine is currently a front runner in meaningful production outside of China given its history as a producing mine and the remaining resources available there. The US government wants to see this mine begin operating and will do what it can to make that happen, including a $280 million loan guarantee which has not yet been provided, but will likely go in their favor. When this mine gets up and running and if Molycorp proves it can be one of the lowest cost operators in the industry and in fact extract the proven reserves in Mountain Pass, there can be a case made that their current valuation is not even excessive and according to their margins may be downright cheap as seen below (click to enlarge):

But until that can happen, I see a lot of mines in the field before MCP finds the clear path to the finish line. Becoming fully operational is clearly the biggest and first hurdle. Past that, demand and pricing needs to stay high to realize the revenue and profits to justify their valuation and finally, competition outside of China needs to stay low. The final point is going to be tough given that "rare" earths are not actually as rare as the name would lead you to believe and based on the economics of the situation, others are beginning to get wise (and here). Japan has even found a solution of recycling the rare earths out of electronic goods and other items.

The bottom line is that while MCP will likely eventually be a fully operational rare earths producer, the market is not currently pricing in the risk that goes along with what is essentially a greenfield mining project and the hype around the company and it's products is at a fever pitch right now. While the momentum trade may continue to take MCP a little higher from here, there is a lot of risk to the downside if you get caught up in the hype. We may look back in 2 years and realize that adding "rare earths" to a company's mining credentials was like adding a ".com" to a company in 1999. The result for shareholders could be the same as well.

Disclosure: Author is short MCP