Estimating the Value of Molycorp's Grace Rare Earth Contract

Includes: GRA, MCPIQ
by: Engineer Broker

There are only nine trading days left until Molycorp’s (MCP) Q2 earnings release. Approximating the effects of the Grace (NYSE:GRA) Lanthanum contract renegotiation could mean big money to investors.

No material information has been provided about the new contract. As such the most prudent thing to do is evaluate the effects across a range of potential outcomes. I will attempt to provide investors with a range of potential earnings effects so that they can determine their own opinion.

To begin the evaluation we will use Molycorp’s published production estimates from the last earnings call for each of its three facilities. One key piece of information to remember is that the company only has a finite supply of stockpiled material and that it currently has more processing capability than material. In my opinion this means that it will hit the top of its ranges. Unlike a company that is production constrained, if one of the facilities hits a snag then they can just ramp up production in the other plant or even make up production once they come back online. FYI, a smart investor can look at the original stockpile and the production rates and determine when it will run out. Knowing that the company would like to keep the pilot plant and Silmet running helps tell investors that project Phoenix is on schedule based upon the stockpile drain rate. This however is the topic of a future article. In an effort to be conservative we can use a rate of 4100 mt/year in the calculation to estimate the contract's financial effects. Please review this chart, it will be explained below.

(Click chart to enlarge)

EPS Estimates

The current Grace contract is in effect for approximately 75% of the Lanthanum production that Molycorp produces from the pilot plant until the new plant comes online. At that point Grace had another contract that was set at market prices, but also included a floor price to protect Molycorp.

Based upon past data, Out of the 4100 mt/year Molycorp would produce about 58.7% of Lanthanum oxide. We can then multiply the total rate by the Lanthanum percentage to get the estimated Lanthanum rate. Knowing that Grace gets 75% of this production shows us that Grace may receive 1805 mt/year of Lanthanum at the low fixed price of $13.71.

The fixed price has never been published that I know of, but by back calculating from past earnings results the fixed portion can be determined and the price approximated with a high degree of accuracy.

For multiple reasons the spot price that Molycorp receives is lower than the average spot price and has run at approximately 84% of the average quarterly price publish for REEs. Most of this is probably due to accounting and the date the product was sold versus the dates that the sale is recorded in the books. In a rising market this would cause a slight decrease until the market flattens out. Other small charges may also be incorporated into the sale and transport, which lessen the money received versus the spot price. As such we will use the received price versus the spot price to determine the new contract's value. By doing this we can see that the maximum potential that this new contract could add is $103.89/kg of Lanthanum sold to Grace.

Now comes the hard part. Grace did not just give away $100 million dollars. First let’s determine just how much the contract adjustment is worth for every 10% increment of increase toward current spot prices. As seen above, the new contract could be worth $.22 to $2.23 in full year EPS to Molycorp. Taking the midpoint and assuming a P/E of 15 this just added $16.80 in value to Molycorp stock from this announcement alone.

Since Grace had a contract in place, it needed something to pressure the company into reopening this contract. It either wanted more supply now or in the future, or were offered less current supply (I will explain this later). Just this week Grace reported outstanding earnings that blew away estimates. Back when the market collapsed a few years back Grace went into bankruptcy. Now that the global economy is recovering it has been posting results for many quarters that have beat estimates. It is very likely to want more future production and is willing to pay up in the short term in order to lock in rights to more Lanthanum in the future. In contract negotiations you usually start by splitting the difference and then moving in the direction of the stronger hand. Since we do not know whose hand was stronger, assuming that the difference was split may be the best option.

There is one other way that Molycorp may have been able to get Grace to reopen the contract. A few months ago I sent the company a note asking why the company would keep running the pilot plant at such high rates if it had more room in the Silmet plant and could get spot prices for all the material from the Silmet plant. The original contract was signed with the assumption that the pilot plant rates would be up to 3000 mt/year. Since then Molycorp has debottlenecked the plant and increased rates drastically in a short time. The company may have informed Grace that if it would not reopen the contract that it would shift over production to Silmet up to the point where it would be running the pilot plant at 3000 mt/year. Going any further could open up legal questions, but shifting production up to the maximum at the signing of the contract should not. Since Grace is doing well and in need of Lanthanum, it may have agreed to pay the original fixed prices for production up to the original assumed pilot plant rates and then pay spot prices for the production after that amount. Molycorp’s position would be that the 3000 rate was all that was assumed in the original contract. Doing the math, this would show that the average price paid by Grace would be 40% higher than the old fixed price.

Both lines of reason take us into the 40-50% price increase range. While Molycorp revealed no information, I believe that the likely value of this contract is an instant $1 per share in the next four quarters.

In my last article I calculated Molycorp’s 2Q EPS. The result was above the analyst’s average estimate. That calculation was done at the beginning of the quarter before actual rare earth spot prices were known for the quarter. Since that time the prices of Molycorp’s products have risen faster than my estimate. Molycorp should beat the estimates handily when it reports on August 11th.

Investors should review all of the potential positives out there to determine their path forward. If the general market gets a relief rally after the debt ceiling is resolved Molycorp could add 5-10 points. This contract has added 5 points so far, but if these assumptions are correct there is room for an additional 10 points. Once great earnings get posted many investors short this stock will begin rethinking there position now that the company is posting significant real earnings. This could cause a large and rapid short squeeze. If earnings beat like I expect the future earnings will get adjusted, which will add another round of upgrades and even more stock momentum and television coverage, which will attract the fast money. In the end the stock would inevitably run up too far too fast, but we may just blow through the $100 mark in very short order.

Disclosure: I am long MCP.