Molycorp's Pain Is Grace's Mega Million Dollar Gain

 |  Includes: GRA, MCPIQ
by: Engineer Broker

If you want to win big and know where a stock is going you need to follow the money. Last year when rare earth prices were a fraction of today’s value Molycorp (MCP) and Grace (NYSE:GRA) entered into a rare earth supply agreement that had a fixed price ceiling. What appeared to be a balanced agreement at the time has turned out to be completely lopsided as rare earth prices have skyrocketed since the agreement was signed.

The supply contract that Molycorp entered into was to supply Grace with 80% of Molycorp’s Lanthanum production. This contract is to be in place until Molycorp’s new facility is up and running in mid 2012 and would be subject to market prices along with a ceiling and floor price. It would appear that the Lanthanum price ceiling is around $13.71/kg. This value was determined by back calculation from Molycorp’s 3Q and 4Q 2010 earnings releases.

The effect of this contract is that a large portion of Molycorp’s production is being sold for 11% of today’s spot prices. For Grace this contract is a boon as they will be able to sell products in the market at today’s prices, but their raw materials will be a fraction of their competitors. In 2011 this could be a $100M dollar swing from Molycorp’s pocket to Grace’s. To put this amount into perspective it could add over $1.00 to Grace’s full year earnings and raise them from an estimated $2.97 per share to over $4 per share. The reasoning behind these projections is as follows:

In 4Q10 MCP appeared to receive pricing at 84% of cerium and lanthanum spot prices due to shipping, product quality, and market timing. If Molycorp is producing 3000 mt/yr of total rare earth oxides then they should be producing 329 mt of lanthanum per quarter. 80% of the lanthanum production has been contracted to Grace which makes Grace’s share 263 mt in 1Q11.

Next, the average spot price of lanthanum in Q1 was determined ($87/kg) and factored down to 84% of the spot prices to reflect actual expected pricing of $72.78/kg. At spot price minus costs, Grace would have been expected to pay $19.1M for the 263 mt of lanthanum, but due to the contract they should be paying around $3.6M.

This results in a savings of $15.5M on Grace’s raw material costs for 1Q11. On a per share basis this could add $.21 per share to Grace’s profits in Q1. Most likely this number will be reduced as some of the products sold are quoted at quarterly prices and Grace may not have yet realized all of these gains. Gains that are not realized in this quarter should be realized in the next quarter as forward sales pricing is adjusted to reflect current rare earth pricing conditions.

Going forward, the additional revenue for Grace should even increase. Currently the 2Q spot pricing of lanthanum is 51% higher than it was on average in 1Q. If these price levels hold Grace will receive $25.3M in additional revenue potential in 2Q. Pricing only has to increase the slightest amount from today’s levels for Grace’s total year 2011 benefit to be at $100M due to this contract. Late last week investors began piling into Grace before next weeks earnings release on Tuesday. This is a sizable hit to Molycorp, but it an even larger boon to a small company like Grace.

Disclosure: I am long GRA and am hedged (both long and short) MCP