Molycorp (MCP) is up 400% from its August IPO, boosted in part by news that China will further restrict exports of rare earth metals (REEs) to meet domestic demand. Given the fact that China controls over 95% of world REE production, the frenzy over new REE sources is understandable, particularly in light of the growing demand from consumer electronics and green technologies. But can this company, which doesn’t even expect to restart mining operations at its Mountain Pass mine until late 2012, really be worth $4.7B?
Call me old-school, but in my book, the value of a business is the present value of its expected future cash flows. Below is a simple discounted cash flow model of this business. It suggests Molycorp MIGHT be worth nearly $1B IF management successfully executes AND REE supplies remain tight for the foreseeable future.
click to enlarge
Let’s examine the assumptions to consider what you would have to believe for $1B to be a reasonable valuation:
Revenue: Shown below is management’s projected 2013 production capacity and prices, which suggest $500M in revenue is possible. The revenue then doubles by 2016 to reflect management’s belief that they can double capacity if warranted.
Management 2013 Capacity and Price Projections
The Big Question: What will REE prices look like in the short and long term?
On the one hand, these 2013 forecasted prices are double the prices Molycorp is currently getting. According to the most recent 10Q, Molycorp is selling lanthanum oxide for only $3.46/Kg. Similarly, their Q3 weighted average price is $3.30/kg (versus the forecasted 2013 price of $20.41/kg).
On the other hand, spot market prices for these materials spiked in late 2010 (see below).
Source: Lynas Corp.
Here are some reasons why I believe prices (and thus, Molycorp’s revenue) will not be as stratospheric as Mr. Market seems to believe:
1) Supply Contracts: Molycorp has already entered into supply agreements for much of its capacity. This will likely result in stable but lower than spot market prices. For example, on November 5th, Molycorp committed over 75% of its lanthanum production to WR Grace for the next 5-8 years. Similarly, Sumitomo has also locked up a good chunk of Molycorps’ capacity for the next seven years.
2) Hitachi Metals JV: Nearly 60% of Molycorp revenue is projected to be in NdFeB alloys and magnets. On Dec 21, the company announced it was entering into a JV with Hitachi Metals to make NeFeB alloys and magnets. While this will likely reduce the risk of the venture, I suspect a significant share of the economics will flow to the JV partner.
3) New Supply: Rare earths are not rare. In fact, the USGS indicates there are nearly 800 years of supply in known reserves alone (see below).
The supply constraints stem from China’s two decade effort to dominate this business, in part via lax environmental laws and low cost labor. As the Chinese subsidized our consumption, non-Chinese miners (including the former owners of Mountain Pass) exited the business. With prices finally attractive, new supply is on its way. DOE’s latest study (.pdf) suggests production will increase roughly 50% by 2015 as new mines ramp up.
Most of this capacity is projected to come online well before 2015. For example:
Arafura’s Nolans Bore in 2013 (20,000 tonnes of REOs) and additional mines in 2014
Furthermore, Mountain Pass doesn’t even have meaningful quantities of the Heavy REEs that are expected to be in tightest supply (Dysprosium, Terbium, and Europium).
4) Substitution: The demand for rare earths is not inelastic. Technologies are maturing that will reduce our reliance on rare earths. For example, the world is rapidly moving from NiMH batteries (which use large volumes lanthanum and cerium) to Lithium-based battery chemistries (as seen in the Chevy Volt, Teslas, and the Nissan (OTCPK:NSANY) Leaf). Even Honda (HMC) has committed to shift from NiMH to Lithium. It is no longer a question of IF but rather how fast the world shifts from NiMH to Lithium-Ion. Similarly, nanoparticles such as quantum dots (made by companies like Nanosys and Nanoco Group) are now being used in volume as an alternative to rare earth phosphors (Yittrium, Europium, and Terbium) in LEDs, flat panel displays, and lighting applications. These two applications alone represent close to half the REE market by value according to IMCA (see below). Additional efforts are underway to engineer nanocatalysts and permanent magnets that also reduce the need for rare earth elements.
For all of the reasons noted above, it is my opinion that supply will be adequate to prevent sustained high REE prices. Nonetheless, even if REE prices doubled from those in the DCF, the present value of the business would still only be $2B (or one half its current market cap). As another frame of reference, Libertas Partners recently forecast the REE market to be $1.9B in 2014. So the DCF implies Molycorp would have 34% of the market with its ~ 15% of the capacity?
Here are some of the other important considerations:
Margins: The histogram below shows operating margins from Google Finance for the 231 listed materials companies, including mining. The median is 10%, the top quartile is 18%, and the mean is 13%. The DCF assumes 50% operating margins, which would place them among the top 3 most profitable mining companies. According to the DOE (see page 7 of the full report), REE refining is significantly more complex than common smelted metal sulfide ores like silver, so 50% operating margins appear generous.
Comparable Operating Margins
Source: Google Finance 1/2/11 (Basic Materials Companies)
Discount Rate: The DCF uses a 15% discount rate, which in my opinion would be an appropriate cost of capital for a more mature, profitable company. Molycorp is unprofitable and faces significant risks in execution, financing, regulation, and competitive supply. In case you don’t agree with that rate, here is a sensitivity table showing how different discount rates and terminal growth rates would impact the value.
Terminal Value: 93% of the value is in the terminal value - seven years from now when even more mines come online
Future Dilution: The Company will likely need more capital on top of the dilution coming from the Sumitomo investment. Plus any debt they raise should be deducted from the valuation to arrive at the market cap.
Chinese Capacity: Who really knows what the REE production capacity is in China? They have plenty of reserves. If the Chinese can build a 15 story hotel in 6 days they can probably add REE capacity. I suspect they are limiting exports partly to nurture domestic industries further up the value chain (instead of buying neodymium oxide from China we’ll be buying permanent magnets).
Haven’t we seen this movie before?
This reminds me of the polysilicon frenzy of 2007 and 2008, when prices skyrocketed with the global deployment of new solar panels. Like every good bubble, investors saw opportunity and poured $1B a pop into new polysilicon facilities (even larger scale than REE mines) thinking they were immune from the laws of supply and demand. Guess what happened? As shown below, polysilicon prices collapsed back to pre-“shortage” prices (where they remain today). And along the way, the polysilicon vendors went from earning 30-40% operating margins to operating losses.
Source: Green Rhino Energy
Maybe there is short term money to be made waiting for supply to come online (or via the greater fool theory), but I predict a rush for the exits when the 65% of outstanding Molycorp shares come out of lockup in early February. Interestingly, Goldman Sachs used to be an investor, but apparently sold its stake prior to the IPO.
My prediction: $25 MCP price by the end of 2011