It is unfortunate to see educated people argue that a stock is "overvalued" or "too expensive" merely because it currently trades a lot higher than where it IPO'ed. This is an argument I have heard applied to Molycorp (MCP) time and time again, including Jim Cramer on Friday's lightning round, as "they have hardly sold anything, it is way overvalued."
Yet I am sure the same individuals would not be so quick to call a biotech on its way to a landmark drug which "hasn't sold much of anything" overvalued. P/E, P/S and other valuation metrics are only part of the story, particularly for a new company in a new industry.
In the case of Molycorp, the way to value the company is not by P/E, P/S, or other such metrics, but rather a discounted cashflow analysis based on:
- An estimate of when it will begin seeing cash from the sale of the rare earths it produces (therefore it is very important to ascertain when the mine will become operational).
- The price we would expect to receive from said rare earths when MCP actually begins selling them.
- How much rare earths it can pull out of the ground and sell.
- An appropriate discount rate.
The type of analysis I am talking about -- a net present value analysis (NPV) -- has been conducted by both Morgan Stanley (MS) and JPMorgan (JPM) with some startling results.
JPMorgan explains its current $65 price target as follows:
We are maintaining our Dec 2011 price target for MCP of $65. Our price target is based on a NPV of $65, which assumes pricing from mid February spot levels (for a basket price of $48.50/lb as shown in Figure 2 below) for the next several years, gradually decreasing to a long-term average price of $21/lb (a 66% decline from current levels of $60.50/lb) for MCP’s basket starting in 2019 (a long-term price that we believe will generate attractive enough returns to allow new projects to eventually come on line). The NPV also assumes the company's planned expansion to 40k tonnes starting in 2014, the costs outlined in MCP's engineering study, and a 12.5 discount rate.
But JPMorgan also indicates there is room for much greater upside if rare earth prices continue to rise and do not ultimately fall:
While we are maintaining our price target of $65 for MCP, we do think that rising rare earth prices should be a catalyst for MCP’s stock and push it higher as investors get a better understanding on the impact that these higher rare earth prices have on various valuation levels for MCP. While we are holding MCP's mid February basket price of $48.50/lb constant for the next two years before having them start to decline, we would note that MCP's basket price now stands at $60.50/lb. Table 3 below shows the sensitivity of MCP's NPV to our long-term basket price assumption of roughly $21/lb for MCP. If this long-term price were to be 50% higher than our forecast (or roughly $31.50/lb) our NPV would increase to roughly $84. While this 50% increase sounds like a relatively large step-up, we would note that it is only 52% of MCP's current basket price. Additionally, if we assumed current rare earth prices stayed flat over the life of the mine, our NPV would increase to $215/share and our 2014 EPS would be $38.
So there you have it: A well-thought-out valuation analysis that more than justifies a price target for Molycorp that is almost 50% higher than current prices, as well as a fairly reasonably argument for a scenario whereby Molycorp would be worth 500% higher than its current trading price. JPMorgan's $65 price target assumes that MCP will fetch rare earth prices lower than we are currently seeing, and that over time those prices will decrease even further.
But don't take one source's word for it. Here is what Morgan Stanley has to say:
Our base case valuation is $63. We assume 19 kT REO production in 2013, 30kT in 2014, and 40kT in 2015. Our base case valuation implies 4.0x 2015e EV/EBITDA and 5.8x 2015e P/E, at 40kT production. Our average realized price is $31/kg and 2013 EBITDA of $675 mm, rising to $1.4 bn in 2015. Our bull case valuation is $140. REO production profile similar to the base case and REO prices 90% of spot. We estimate MCP’s average realized price at $81/kg, benefitting from enhanced value due to downstream integration, and 2013 EBITDA of $1,458 mm.
So both Morgan Stanley and JPMorgan use very reasonable NPV analysis to justify price targets in the $65 range. CIBC has a price target of $80; Piper Jaffray (PJC) raised its target after earnings to $55.00, and Dahlman Rose increased its price target to $85 after earnings. I am certain they all used similar valuation methodologies to come up with a price target for Molycorp.
I would love to see the valuation methodology by which Cramer and the other naysayers come up with their estimates for Molycorp. Unfortunately, I don't think any of them have done a more rigorous analysis other than "it's gone up a lot" -- which is, of course, no real analysis at all.
Molycorp traded up after the earnings announcement Thursday morning to $51.00 before trading back down to around $49.00. This reversal was likely the result of Thursday's overall market weakness. Molycorp still ended up while the market as a whole traded sharply down. Friday was a worse day for Molycorp, however, trading down nearly 4% with the market up.
What explains this activity? Technically Molycorp ended under the 50dma and a bit under the 20dma, and technicals were not good for Molycorp on Friday. But I think the explanation for Molycorp's post-earnings trading activity was much more innocuous than that.
Molycorp traded down because Japan had a massive earthquake. Japan is a key user of rare earths. It was unclear on Friday how much damage was done to Japan's industry. Over the weekend, while we have gotten some awful news out of Japan (including nuclear meltdowns), we also have word that Japan's industrial center was largely spared, being some 200 miles south of the quake's epicenter.
Barring a substantial decrease in rare earth prices, Molycorp is nothing less than a screaming buy. Molycorp will be the second rare earths producer outside of China to come on line. (Lynas (LYSCF.PK) of Australia will be the first, but other producers are many years behind Molycorp.) According to Molycorp, China may become a rare earths importer by 2015, thus making the demand for rare earths even tighter. I can see little justification for calling Molycorp "overvalued" in this scenario.
Disclosure: I am long MCP.
