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Molycorp, Inc. (NYSE:MCP)

Q2 2011 Earnings Conference Call

August 11, 2011 4:30 PM ET

Executives

Brian Blackman [ph] – Senior Manager, IR

Mark Smith – Chief Executive Officer

James Allen – Chief Financial Officer

Analysts

Michael Cox – Piper Jaffray

Paretosh Misra – Morgan Stanley

Anthony Young – Dahlman Rose

Paul Forward – Stifel Nicolaus

David Snow – Energy Equities

Devon Sands – National Securities Corporation [ph]

Louis Corrigan – Kingsford

Michael Scarcello – Gilmore & Company

Operator

Good day everyone, and welcome to the Molycorp Incorporated second quarter 2011 conference call. Today's call is being recorded and is available via webcast.

For opening remarks, I would like to turn the call over to Mr. Brian Blackman [ph], Senior Manager of Investor Relations for Molycorp. Please go ahead, sir.

Brian Blackman

Thank you, operator, and good afternoon to everybody. We just released our financial and operating results for the second quarter of 2011. If you have not yet seen the press release, you can find it on the Investor Relations section of our website at www.molycorp.com. This call is being webcast and a replay will be archived on the company's website for 60 days.

For those of you dialed into the call, a slide show that accompanies our prepared remarks is available on the Molycorp website in the Investors section. For those of you listening by webcast, the slides will be presented in a webcast player. Please note that you are able to advance the slides on your own.

Slide 2 has our safe harbor statement. As always, we need to advice you that some of the information discussed on this conference call will contain forward-looking statements that involve risks, uncertainties, and assumptions that are difficult to predict. Such forward-looking statements are not guaranteed of performance and the company's actual results could differ materially from those contained in such statements.

Several factors that could cause or contribute to such differences are described in detail in the risk factors section of Molycorp's quarterly report on Form 10-Q for the period ended March 31, 2011. These forward-looking statements speak only as of the date of this call and the company undertakes no obligation to publicly update any forward-looking statement unless required by law.

We also want to caution you that today's presentation includes discussions of adjusted financial measurements, which reflect how the management and directors of Molycorp analyze the business on a daily basis. The adjusted measurements segregate out certain non-cash items such as depreciation and amortization, and stock-based compensation, and certain non-recurring items. Internally, Molycorp management analyzes our business from a cash flow perspective and we want our outside shareholders to have access to the same information we use in understanding our business.

However, these non-cash and other charges are important to understanding the company's long term performance. Therefore, listeners are highly encouraged to study the non-GAAP to GAAP reconciliation supplied at the end of the earnings release.

On the call today is Molycorp's President and Chief Executive Officer, Mark Smith and our Chief Financial Officer and Treasurer, Jim Allen. Mark will provide our Project Phoenix update, review Q2 financial highlights and an update on operations. Jim will discuss the financial results, and to conclude Mark will finish with a discussion on global rare earth market conditions, as well as the production guidance for future production.

Now let me turn over the call to Mark Smith.

Mark Smith

Thank you, Brian and thank you, everybody for joining today's call. I'd like to begin on Slide 6 with an update on Project Phoenix. Our $781 million modernization and expansion project at our Mountain Pass California facility what we call Project Phoenix remains on-time and on-budget. Keeping such a complex engineering and construction project on course is a challenge for any company. The fact that this particular facility will be the world's most technologically advanced, energy efficient and environmentally superior rare earth manufacturing facility in the world underscores the importance to us of keeping on schedule.

Our team has done a truly extraordinary job of doing that and a successful on-time start-up of Project Phoenix is absolutely key to the success of our overall long-term business model.

Our highly detailed project management system for Project Phoenix tracks for the 170 different major project milestones. Currently, we've achieved 93 milestones to-date. Of the 77 remaining milestones, 67 are tracking to plan and 10 are in what we call the yellow zone. Eight of the 10 yellow zone milestones relate to building permits at Mountain Pass. Because we are constructing a unique process facility certain features of the project are not adequately covered by standard building code requirements.

We are working with San Bernardino County officials to apply a set of national standards for these permits and we have already received verbal notification of their approval. We expect several building permits to be issued this week and the remainder to be issued within the next few weeks. None of the yellow zone building permit milestones are currently impacting the overall construction schedule.

The other two yellow zone milestones relate to issuing construction contracts. We have delayed bidding of these contracts to allow resolution of several open design issues. These open issues have now been resolved and the contracting process is moving forward. Bids are due on one of the contracts this week and the other is expected to bid shortly. Neither of these yellow zone milestones are anticipated to have any impact on the construction schedule.

At the quarter's end, we announced an important contract for our new rare earth processing facility. We chose a unit of Kellogg Brown and Root or KBR to build our chlor-alkali facility. This is an important contract award because our unique asset alkali recycling technology is critical to the low cost and environmental friendliness of our future chemical processing operations, and to round things out, I am also happy to note that our CHP unit or Combined Heat and Power unit has been delivered ahead of schedule.

On the next slide, you can see variety of recent photographs from Mountain Pass, showing our steady progress with the project. As you can see construction is well underway and the new facility is beginning to take shape.

On Slide 8, I'd like to highlight the remarkable achievement and important financial milestones that we reached as a company in the second quarter. We generated nearly $100 million in revenue for the quarter as realized prices almost doubled over the previous quarter.

Our company average realized price, sales prices increased 91% to $72.10 per kilogram of rare earth oxide equivalent versus $37.73 per kilogram in the first quarter of this year. Overall, this performance represents a fully diluted EPS of $0.52 per share and a gross margin of approximately 57%.

I'd finally like to note that we successfully renegotiated a major lanthanum supply contract to allow for even higher realized prices for the company going forward. Given that we are still considered by many as a development stage company and one that generated less than $2 million in the prior year quarter, this is truly a remarkable achievement by the Molycorp family. All of this was accomplished while maintaining our Project Phoenix schedule and integrating two important acquisitions that significantly advanced our downstream integration strategy.

This leads me to Slide 10, where we will discuss our operational update. This past April, we purchased a controlling interest in AS Silmet, now known as Molycorp Silmet, which is a rare earth processor based in Sillamae, Estonia. This acquisition delivered a number of benefits to our company. First, it has helped to double our near-term rare earth oxide processing capacity. Second, it gives us a base of operations for our European market and our many customers there. Third, it has enabled us to move further downstream into the metals market, and it gives us exposure to several new markets, most notably, for high purity niobium and tantalum oxides and metals.

Also in April, we closed on the acquisition of Santoku America, Inc. now known as Molycorp Metals and Alloys or MMA. MMA is a rare earth metal and alloy processing facility located in Tolleson, Arizona, which is near Phoenix. MMA is an industry leader in manufacturing neodymium and samarium magnet alloys that are used in rare earth magnets for industries such as clean energy, high-tech, transportation, medical equipment, defense technology and others.

Also in the second quarter, we completed a convertible debt offering that raised $223 million which when combined with current cash flow from operations of $31.4 million year-to-date, provides full funding for our Project Phoenix capital plan and more.

We feel confident that we still have significant potential to raise additional capital, which could be used for acquisitions and other activities that continue to advance our downstream integration strategy. On the next slide, let me provide a quick update on our plans to advance downstream into the manufacture of permanent rare earth magnets.

This week we entered into a preliminary three-year agreement to supply Hitachi with magnetic rare earth products and lanthanum. Pricing under this agreement will be based on international market price indexes published by third parties that are commonly used by the rare earth industry.

At the same time, Molycorp and Hitachi have suspended negotiations concerning the formation of a magnet production joint venture. However, we continue to discuss various magnet joint venture possibilities. Indeed, we've been discussing such potential JV arrangements with multiple parties for over eight months, including the Hitachi discussions. The critical point to Molycorp in all of these discussions is the ability to increase value for our company and our shareholders as a result of any such JV.

Now, let's spend a moment to discuss the key operational milestones we hope to achieve in the second half as shown on Slide 12. Over the balance of the year, you should expect us to be focused on four major goals; number one, keeping Project Phoenix progressing on time and on budget. Number two, furthering the engineering of our Phase 2 expansion to achieve a 40,000 metric ton per year production capacity by late 2013.

Number three; converting 50% or more of additional Phase 1 letter-of-intent product volume into final contracts. We now have greater than 35% of the total Phase 1 production fully contracted and the rest is allocated with final contract discussions well underway.

And number four, now that Phase 1 and Phase 2 of Project Phoenix are essentially fully funded, we will continue to look at growth opportunities through acquisitions and/or joint ventures.

Let me now turn the call over to Jim Allen, our CFO, to discuss our financial results in more detail.

James Allen

Thanks, Mark and good afternoon, everyone. I'll start my discussion on Slide 14. As Mark noted, we've reached an important milestone by booking nearly $100 million in revenue this quarter. With a multi-$100 million per year revenue run rate, very strong profitability and over 810 employees Molycorp has grown into a substantial operating company. Sales for the quarter were $99.6 million as compared to $26.3 million in the first quarter of this year and dramatically higher than the year ago period.

On Slide 15 you can see where a significant portion of the sequential growth was due to our acquisitions of Molycorp Silmet and MMA. However, looking at organic growth revenue at Mountain Pass alone grew significantly at 130% sequentially to $60.3 million. That number eliminates intercompany transfers since Mountain Pass sold 159 tons of concentrates and other products to Molycorp Silmet for further processing.

Next slide please. The organic growth at Mountain Pass resulted both from broadly higher volumes and better pricing. Mountain Pass sold 829 metric tons to outside customers, a 19% sequential increase. Total volume for Mountain Pass was 988 million tons, including the 159 tons transferred to Molycorp Silmet.

Slide 17 provides greater detail of the revenue attributed to the volume sales of each of our locations. We realized an average sales price of $72.10 per kilogram compared to an average price of $37.73 per kilogram last quarter and $7.16 per kilogram in the second quarter of last year.

The majority of our lanthanum sales in the second quarter and year-to-date were under a contract for the price cap far below current market prices. We recently disclosed that the pricing on that contract was renegotiated effective July 1, and although we cannot disclose the terms of that contract renegotiation at the request of our customer, it does bring us closer to actual market pricing.

And as some of you may recall, that contract and its associated pricing ends when production at our new facility ramps up in 2012, and another supply contract with this customer then becomes effective at the recent market price.

Excluding second quarter sales on our contract with this customer, our realized pricing was $104.95 per kilogram. Revenue at Molycorp Silmet was $29 million excluding intercompany transfers. Molycorp Silmet revenue was generated from sales of 217 tons of REO products and 80 tons of rare metals.

Revenue at MMA was $10.3 million and 71% of the MMA sales were to Santoku Corporation from whom we purchased the operation. Sales to Santoku are under a contract that prices our alloys at the cost of feedstock plus a premium [ph].

Turning to Slide 18, second quarter cost of goods sold was $42.9 million compared to $16.7 million in the first quarter of 2011 and $5.6 million in the second quarter of 2010. Gross margin percentage for the quarter was approximately 57%, a sequential improvement of 20 percentage points.

The Mountain Pass standalone gross margin was 76.5%. This level of gross margin is mainly the result of strong pricing for REOs combined with some better fixed cost absorption due to volume growth. Molycorp Silmet gross margin was 37.3% in the quarter, while MMA had a negative gross margin of 8.7%. MMA's cost of goods sold exceeded revenue in part due to higher inventory cost that reflect purchase accounting adjustments to inventory as of the acquisition date as well as generally higher rare earth material costs.

Selling, general and administrative expenses for the quarter were $13.8 million compared to $8.3 million in the first quarter of 2011, and $4.3 million in the second quarter of 2010. The increase was due largely to increased business development activities with some increase also attributable to the Molycorp Silmet and MMA acquisitions.

We expect SG&A expenses to remain higher in the near term as compared to prior periods due to continued business development efforts and expanded operations.

Net income for the quarter was $48.8 million, compared to a net loss of $2.2 million in the first quarter. The more relevant measure for our common stockholders is net income attributable to common stockholders, which reflects dividends on our convertible preferred stock and net income attributable to the minority miner, Molycorp Silmet.

Our net income attributable to common stockholders is $43.5 million in the quarter or $0.52 per diluted share. This level of net income driven by a 57% gross margin demonstrates the Company's significant earnings potential, particularly following the commencement of increased production from our new facility at Mountain Pass. We must caution you that this level of earnings from our current operation is dependent on continued robust conditions for rare earth pricing, which is affected by many variables that are subject to change.

Having said that the additional cash flow from operations has further strengthened our balance sheet and provides a margin of safety on the funding of our capital plans.

Now let me discuss our capital activities in the quarter on Slide 19. Our Project Phoenix capital plan of $781 million is now fully funded. We completed an offering of convertible notes in June with net proceeds of $223 million. We now have $680 million of cash on hand and are generating positive cash flow from operations to meet the remaining capital expenditures of $682 million.

Our CapEx in the second quarter totaled $66.8 million on an accrual basis and $106.4 million for the year-to-date period.

Let me turn the call back to Mark to provide production guidance for the remainder of the year and to comment on rare earth market conditions on Slide 20.

Mark Smith

Thanks, Jim. Because rare earth prices are highly volatile, and out of our control we will not provide formal revenue or EPS guidance at this time. However, we would like to provide guidance for the operations that are under our control.

On Slide 21, we offer a table showing ranges of production in terms of REO equivalent for each of the facilities we now operate.

Now, let me also offer our insight into current rare earth market conditions and our view of the market for the balance of 2011 on Slide 22.

We expect REO prices to remain firm as the world outside of China continues to experience severe shortages of REOs. The Chinese continue to restrict global supply as they redirect domestic production to meet their own demands. Their government recently published the export quotas for the second half of 2011. If you take the face value of the full year 2011 quotas at roughly 30,000 metric tons as some observers have done, one could conclude that this quota level is about the same year-on-year as the 2010 quotas, but that's not really the case. And 2011 quotas represent yet another decline by the Chinese. This is the sixth year in a row. The reason for this is that the Chinese are including additional items covered by the quota system.

For example, ferro-alloys that contain at least 10% rare earth content, as well as other rare earth based products are now included under the 2011 export quota system. The government included these ferro-alloys in the latest round because domestic producers were adding rare earths into the metal alloys then exporting the alloys in order to work around the export restrictions. There is a lot of discussions concerning how much lower the 2011 quotas are versus 2010. When compared on an equivalent basis the 2011 export quotas are clearly lower than 2010, and let's remember that 2010 was over 40% lower than 2009.

More importantly, the Chinese export quotas are significantly lower than the rest of the world demand and they will remain this way for the foreseeable future. There are now calls by major industry leaders in China namely; Minmetals, a state-owned processor for all rare earth market participants in China to adhere to a national output quota by suspending production starting from the beginning of August. Minmetals has reportedly halted operations at its processing plants and is encouraging others to follow.

In addition, earlier this week the Chinese government launched a series of new controls over the domestic rare earth industry. These include enforcing rare earth metal production caps, tightening industry entry thresholds, suspending production by producers that operate without the quota, and enforcing greater environmental protection and safety standards on those producers with problems in these areas.

We're also seeing continuing efforts by the government to force even more industry consolidation than what we've seen in the past two years. We're obviously watching these developments very, very closely.

Slide 23 shows the recent trend in pricing for the REOs that we will be selling upon completion of Phase 1 of Project Phoenix at the end of 2012, and once again, prices rose substantially in the second quarter.

With that operator, would you please open the call to questions?

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And our first question comes from Michael Cox with Piper Jaffray.

Michael Cox - Piper Jaffray

Good afternoon guys. Congratulations on a nice quarter.

Mark Smith

Thanks Michael.

Michael Cox - Piper Jaffray

I was hoping you could maybe expand upon a little bit if I heard you correctly, the suspension of the discussions with Hitachi and rationale for that, and what other options might be out there for you right now?

Mark Smith

I'll explain as much as I can Michael. Obviously, these types of discussions are subject to nondisclosure agreement, so I have to be a little careful, but it was a joint decision by the two companies to suspend those discussions for the time being. Molycorp was very concerned about the level of value that the joint venture was going to bring to our shareholders, and we thought it better to focus on the supply contract with Hitachi right now, and maybe try to work on the other three potential joint venture magnet production potentials that we've been working on for about eight months. So, we're still very committed to the mine-to-magnets strategy. We will be producing rare earth magnets, and it's just a matter of who we produce them with.

Michael Cox - Piper Jaffray

Okay. My second question is on the Silmet production targets for the third and fourth quarters are up about 100 tons it looks like each quarter.

Mark Smith

Correct.

Michael Cox - Piper Jaffray

Could you provide a little color around that, and is there any potential to flex the volumes at Mountain Pass to capitalize on higher prices here in the back half of the year?

Mark Smith

We have a pretty solid production plan in place. We were able to work our inventory around a little bit, so that we could get more material to Silmet in the third and fourth quarters, but there's not a whole lot of room in addition to what we've shown on the table right now. Certainly, Molycorp Silmet has demonstrated a very, very high-capacity in their ability to take our materials and convert them into higher purity products, which are the products that our customers want. So we do want to make sure that we are maximizing the production out of that facility and we actually look forward to a lot of growth in that facility down the road.

Michael Cox - Piper Jaffray

Okay, and my last question is on the margins in MMA. It sounds like there were some accounting anomalies in the quarter, but I guess I'd be curious if you expect those margins to turn positive in the back half of the year, keeping pricing stable – just assuming no change in pricing?

James Allen

Yes, Michael, the situation on that is, in purchase accounting, you have to mark the inventory up to its fair value, and so that resulted in an increase in the carrying value of that inventory, which then got reflected into the income statements through cost of sales over the period. So it is higher than it would have been otherwise. Going forward, the contract that we have there is based on essentially a pass-through of the raw material cost plus a premium for processing it. So, we do expect there to be gross profit on that contract albeit not significant.

Mark Smith

But we do expect for that to be reversed as the new pricing that we had to assume as part of the purchase price accounting flows through to the customer.

Michael Cox - Piper Jaffray

And I guess just to follow-up, how long will it take to move that higher priced inventory through?

Mark Smith

We only carry two to three months of inventory at the facility, so it won't take very long.

Michael Cox - Piper Jaffray

Okay, great. Thank you very much.

Mark Smith

You bet Michael. Good talking to you.

Operator

Our next question comes from Paretosh Misra with Morgan Stanley.

Paretosh Misra - Morgan Stanley

Hi everyone.

Mark Smith

Hi.

James Allen

Hi Paretosh.

Paretosh Misra - Morgan Stanley

Just one quick question. What's your sense on any substitution risk for any of your products, especially hearing a lot from semiconductor industry and the FCC catalyst industry, those guys are getting concerned about costs, so any thoughts if they are looking for other alternative material?

Mark Smith

Well, I think, a lot of folks are looking at alternatives for rare earth Paretosh and that's not something that is new to the industry. These types of research activities have occurred for a long time. We certainly want to encourage those types of research activities. I think what's important in the rare earth industry right now because of the supply and demand situation is that we have the proper prioritization of the use of all these materials and through some recycling efforts some substitution I think that we can probably end up in a much better situation for our customers in the long run and that's really what we would want to support.

Paretosh Misra - Morgan Stanley

Got it, and maybe just one more. I know spot prices had probably – it's not very attractive to pursue XSORBX related opportunities, but any update on that and is that something like $10 to $20 per kilogram still a price you think you can get for those products?

Mark Smith

Yes, that would be the price that we would expect for what we call the waste water portion of the XSORBX use, but we're also very focused on the drinking water side of that business, which is a dry form of this product and we continue to run through all of the EPA certification tests to demonstrate the capacity of this material to remove contaminants from drinking water. Those tests continue to go very, very well and I think that we'll start seeing more and more of this material move into the drinking water markets. And of course the price for that material is actually right up there with today's spot prices for cerium. So, much better position for us to be in and obviously one that we want to capitalize on.

Paretosh Misra - Morgan Stanley

Great. Thank you.

Mark Smith

You bet. Thanks Paretosh.

Operator

Our next question comes from Anthony Young with Dahlman Rose.

Anthony Young - Dahlman Rose

Hi. Hi Mark. Hi Jim.

Mark Smith

Hi Anthony.

Anthony Young - Dahlman Rose

Thanks for taking the question. I don't know if you guys have indicated that you can't talk about the new terms of the contract for your lanthanum sales on a going forward basis, but if we were looking at it from this quarter, you realized $70.10 on average per kilogram what would that realization have been if that contract had been in place, whether the revised contract have been in place that's going to impact the remainder of the third and fourth quarters going forward?

Mark Smith

It's an interesting approach to ask the same question, Anthony, and we have to be very careful about maintaining the confidentiality with our customer. I'm afraid, if I answered that question it would be a very easy calculation for you to make. But we're happy about it. It's a fact that we have a customer who has the same values that our company does. They really want a long-term relationship with Molycorp and they were willing to sit down in a very professional way, and renegotiate a contract and there are benefits for both sides in that renegotiation. But it sure is nice to deal with customers like that who have a long-term view.

Anthony Young - Dahlman Rose

Okay, and then with respect to the Hitachi deal going forward, that is just a volume deal there is no price limitations on that one?

Mark Smith

All the pricing will be based on market-based pricing like everything else. I think we chose a longer way to say that, but it's basically market-based pricing.

Anthony Young - Dahlman Rose

Okay. And then just on the rare earth pricing side of things, just the last, obviously, we've all seen the market volatility, but have you guys seen any softening on the rare earth price side of things for the metals or the bauxites?

Mark Smith

What we have seen in the last week is that there are some price reductions in country China. We've always seen one of the rare earth that is sold outside of China that has reduced in price, and I'd hate to put too much speculation on what one week does for the business. The bottom line is that the demand for these material remains very, very strong. Supply cannot meet that demand, and if you go back to economics one-on-one, which is about all I've had, that means you're going to have impacts on prices. We anticipate prices to remain very stable and likely increasing as we head into the latter part of the year.

Anthony Young - Dahlman Rose

Okay. Great quarter guys, and thanks for the questions.

Mark Smith

Thanks Anthony. Good to talk to you.

Operator

And from Stifel Nicolaus, we will go next to Paul Forward.

Paul Forward - Stifel Nicolaus

Hi, good afternoon.

Mark Smith

Hi Paul.

Paul Forward - Stifel Nicolaus

Just going to the question on the building permits, and the two, I guess, construction contracts, little delays or you had to go from, I guess, green to yellow on your – on the project time table. It sounds like those are pretty well contained, assuming nothing surprising comes up. I was just wondering if you look at some of your other or as you look at the time table in your construction going forward over the next few quarters, is there anything that keeps (inaudible) stands out as potential other hurdles that could move into away from green and closer to yellow or red?

Mark Smith

It's a very good question, Paul, that's something that we watch literally daily. The beauty of our project management system is that we do have this green-yellow-red process, where these milestones are being tracked on a very front-end loaded basis and that means that when we get something in that yellow range, it provides for plenty of time for the company to develop alternative plans or substituted plans, whatever the case maybe, so that we can maintain that schedule. That system is working exceptionally well right now. There is absolutely nothing that's keeping me awake at night. But with that being said, I'll also keep reminding myself that this is a $781 million project. It is very large. It is very complex, there is a lot of moving parts and we have to keep our diligence and keep our focus on that project management system. So, things are going well, but we're not going to stop monitoring either.

Paul Forward - Stifel Nicolaus

Okay and you've recorded an income tax benefit in the quarter. I was just wondering if you can expand on that little bit and maybe give some guidance on what you'd anticipate tax rates would look like, let's say, for the year? And then as a follow-up, going back, one of the good points of this Silmet acquisition was the favorable taxation in Estonia. I just wondered if you could talk about, given that you've now got a quarter under your belt with Silmet, how that's played out?

Mark Smith

Yes, Jim.

James Allen

Sure, we did recognize about a $6 million tax benefit in the quarter that was primarily related to the reversal of evaluation allowance that we had established against our deferred tax assets, including our net operating loss carry forward. So, we did get the benefit of that this quarter and we'll get the benefit of that over the next two quarters as well. There is a portion of our valuation allowance that will be recognized over the remainder of the year as we recognize additional taxable income.

So for the quarter our effective tax rate was about 14.5%. Without the reversal of the valuation allowance, it would have been at about 31.5% and that results from a blend of tax in the U.S. at about 39% or so, and then the effect of the income that was generated in Estonia that is taxed at zero, there's no income tax, there's only tax on distributions [ph]. So that's where we are right now.

Paul Forward - Stifel Nicolaus

In the future [ph] Jim.

James Allen

Yes, the effective tax rate for the third and fourth quarter we are expecting to be about 27.7% with the valuation allowance releases that I mentioned to you.

Mark Smith

With that being said, Paul, I'll also indicate that we are still working on and analyzing the tax benefits that we can receive over in Estonia so we have not optimized everything just yet.

James Allen

And just to clarify on the rate, the 14.5% rate that I mentioned that is what our effective rate will be for the full year, including the benefit we recognized this quarter, which was a 16.9% benefit and then if you weight that with 27.7% in Q3 and Q4, you'll come out to an average of about 14.5%.

Paul Forward - Stifel Nicolaus

Okay. Thanks for all that detail, and just maybe one last point. I think you had talked about Molycorp still potentially considering acquisitions, or joint ventures. With the – you've got two acquisitions that you've integrated over the past quarter, and you've also got obviously the ramp up in the construction at Mountain Pass. I am just curious, does that not take all of your attention and then some and is that not a lot to think about potentially adding more to the portfolio right now?

Mark Smith

Excellent observation, Paul, and one that we're very focused on. We have increased the human resources in our company quite dramatically over the first half of this year as well. We went from a company of about 50 people three years ago, we're now a company of 815 people. So, we have increased our resources in order to handle things like acquisitions and joint ventures, and we'll continue to monitor that very closely and make sure that our manpower is as high as it needs to be.

Paul Forward - Stifel Nicolaus

Okay. Well, I appreciate it. Thanks.

Mark Smith

Thank you.

Operator

From Energy Equities, we will go next to David Snow.

David Snow - Energy Equities

Yes, hi. I see that if you had your – excluding the defense [ph] contract you had second quarter a $105, and in previous quarter about $66 per kilogram. And it looks like you got about 54% of the market price, the spot price this quarter and you got about 71% last quarter. I am wondering why that's shrinking as a relationship to the market?

Mark Smith

David, I think that one of the things that we tried to explain last quarter was what is meant by achieving market-based pricing. Most of our contracts that we have with customers are based on, if they buy something in June, it is priced based on the May metals price or metals pages or Asian metals market prices. Then when we take a look at all of the individual sales that we have accomplished, and base it on what the contract prices are we are achieving market-based pricing.

David Snow - Energy Equities

Okay. I would think that because they've been rising so fast, I see you're one month behind, but what percent are you aiming at having contracted fixed versus market related?

Mark Smith

Right now our philosophy is that we're contracting everything based on market pricing. We remain very bullish on what the prices are going to do based on supply and demand.

David Snow - Energy Equities

And how long do you think it will be before the cerium is – the XSORBX is approved and can be used for the drinking water market?

Mark Smith

It can be used already, and we do have some material being used in that market, but I just think it's very important to make sure that before we go out and sell this material that we can use things like the U.S. EPA standards and standard testing to demonstrate to our customers what the capacity of this material is. So, I want to make sure we do this right, especially when we get into the drinking water category, and I think passing this U.S. EPA standard test is a really outstanding way to demonstrate that. All those tests are ongoing. Almost all of them have been complete now. Then the results are in and they are very good. I think you'll start seeing much more of this material moving into the marketplace, likely in the places like India very soon.

David Snow - Energy Equities

Okay, now does India require or benefit from the EPA certification?

Mark Smith

They don't' require it, that's for sure, but it's one of those things that I think the values in our company suggest that we want to make sure we do things right. And I think it's just a safer approach for us and for our shareholders to make sure that we have very high level of standards that we are meeting, and can demonstrate before we sell products into a market area like drinking water.

David Snow - Energy Equities

And then I thought your other applications for XSORBX got a price somewhat higher than what was mentioned. I thought you got closer to $60.

Mark Smith

Yes, it depends on which market area we are in. We've got three primary markets that we're focused on for XSORBX. One is just waste water treatment, that's really for all practical purposes, processed water in manufacturing facilities which would have the lowest price associated with it. The second area that we're focused on is recreational water that would be for things like fountains at Bellagio or swimming pools or hot tubs.

And then the third category is, of course, the drinking water uses and we do see different prices in each of those market areas. The beauty of XSORBX and one of the reasons why we were so excited about it is that XSORBX is priced based on its water treatment efficacy, it is not priced based on its rare content. So, the pricing of those materials is really based upon comparative materials that are otherwise used in those markets.

David Snow - Energy Equities

Okay, and I was just curious as to what your supply arrangement is for the two rare metals that you are reporting now?

Mark Smith

The tantalum and niobium we have outstanding supply sources for those that have been very reputable and very dependable for some period of time, but it is one of those areas that I have asked Molycorp Silmet to take a look at in terms of assuring this for an even longer term than what they have in place right now, just a good business measure.

David Snow - Energy Equities

You get a fixed price on the sources delivering to you or is it a market based?

Mark Smith

It's a blend of both and it highly depends on where the source is coming from and what it has in it for other minerals that have to be removed as part of the purification process.

David Snow - Energy Equities

Okay. I guess that will hold me for the moment. Thank you very much.

Mark Smith

Okay, David. Thank you.

Operator

(Operator instructions) And we will go next to Dan [ph] with Alert Advisors [ph].

Dan - Alert Advisors

Hi, my question has been answered. Thank you.

Mark Smith

Thank you Dan.

Operator

Our next question comes from Devon Sands with National Securities Corporation [ph].

Devon Sands - National Securities Corporation

Hi, I just want to congratulate you guys on an excellent quarter, and I really like the way you are taking the company, and I really appreciate it because I am an individual who actually owns a stock by clients [ph]. You guys are doing a great job.

Mark Smith

Thank you Devon, we appreciate your support.

Devon Sands - National Securities Corporation

Yes, for sure. I am in there for the long haul. My question was when you guys come to the market where it seems to be 20,000 tons worth of rare earth elements. You guys are going to make a big splash, right? I mean how you're going to, let's just say, not disrupt the supply and demand curve there, and inside [ph] prices and let's just say keep them from dropping, are you going to make them solely [ph], because you guys are going to have a bunch and a heap of rare earth elements getting out, and I don't know if that's going to negatively impact prices. How can you prepare a hedge for that?

Mark Smith

Well, when we take a look at the supply and demand situation, right now Devon, it would suggest to us that even with Molycorp coming on with its Project Phoenix Phase 1 and Lynas coming on with their project Phase 1 levels that that would be barely enough to fill the supply and demand gap today, and of course, by the time we come on that market demand will increase 5% to 10% more.

So, we actually anticipate that although the gap, maybe lessened that there will still be a gap. The other item that we would throw out for consideration is that there are lot of people speculating on when the Chinese may become net importers of this material as well, their demands are growing astronomically as well, and we think it's an interesting question, which just supports the fact that this production is needed and these alternative supplies need to come online.

Devon Sands - National Securities Corporation

Yes, I mean right now what we are like 180,000 and we're looking at 300,000, they're going to be necessary by the year what 2013, does that sounds about right?

Mark Smith

No, that's a little high, probably about 180,000 by 2014 or '15 and over 300,000 is being forecast by 2020, but it still is a very, very rapid growth rate on that demand?

Devon Sands - National Securities Corporation

Yes, that's going to be huge and one other thing I was curious about, I mean how much validity is to that digging these rare earth elements out of the Marianas Trench, and I don't know if you've heard about them pumping it out of the ocean there, 20000 leagues under the sea and being very easy to separate. It doesn't sound very feasible, but I don't know if you've read that story I heard about it.

Mark Smith

We certainly did read the story, and we have a lot of questions in our mind concerning the economic feasibility of that. You start out with the depth that you have go through the ocean waters to get there, which is – it's in the neighborhood of the deepest deepwater wells that the oil industry is drilling today. They have billion dollar platforms that they put into place.

Devon Sands - National Securities Corporation

And that is the first thing that came to mind, the first thing that came to mind. (inaudible)

Mark Smith

The only thing we look at, Devon, is the odd rates that are being reported at those depths in the ocean, and those odd rates are very, very low. It just doesn't take a whole lot to run a calculation on any odd rate there is and then make a lot of assumptions, and then all of a sudden, you have something very massive out there that attracts a lot of attention. What I'll say is, I'm glad that we are the owners of a world class rare earth deposit that is proven. It's proven its production capabilities for over 20 to 30 years now, and I like where Molycorp is. I'll tell you that much.

Devon Sands - National Securities Corporation

Yes, just to touch upon, (inaudible) 1965 to 1985, if I have my dates correct, when this actual mine that you guys are working on, it was the largest producing mine in the world, am I right?

Mark Smith

For rare earth, that's actually correct. It actually started up operations in 1952 and really was the largest rare earth resource in the world, probably through the late 80s.

Devon Sands - National Securities Corporation

Knowing that you being in control of the company, what led to the demise of this company and it being overtaken by the Chinese and what things are you doing, countermeasures you are putting in place so history doesn't repeat itself or not reading about Molycorp [ph] from 2012 to 2025, until someone else came in, and that's the last thing I would want to see.

Mark Smith

Let me answer that really quickly by saying that we took a hard look at our 50 years of history, eight years ago, and one of the things that that was very, very apparent to us in terms of moving forward and ensuring the success of this company was that we absolutely had to be the low-cost producer in the world and that's what our new process technologies have been able to achieve. We will be the lowest cost producer in the world. What I'd like to suggest, Devon, if it's acceptable to you is why don't we set up a separate phone call so that you and I can go over any or all of these questions, and we can keep the other people that have questions moving into the queue?

Operator

Our next question comes from Louis Corrigan with Kingsford.

Louis Corrigan - Kingsford

Hi, thanks for taking my call. I have a couple of quick questions, on the tax rate, is it right to assume that the effective rate is around 27.7% and then it sounds like the reversal of the evaluation allowance benefited Q2 and will benefit the second half but essentially if we want to kind of mentally back that out, the ongoing tax rate should be around 27.7%?

James Allen

That is close. Basically, if we looked at the tax rate for 2011 on an annual basis without reversal of the valuation allowance it would be more in the neighborhood of 31% to 31.5% or so. It's because of the reversal of the valuation allowance that's driving it down to the 27% to 28% level in Q3 and Q4, which again will go to offset the benefits – more significant benefit that we recognized in the current quarter, the second quarter.

Louis Corrigan - Kingsford

Okay, and I had a question about the supply contract that you signed with a major customer for lanthanum, it looks like from your 10-Q I am assuming that this customer that you may not want to name was the one that bought a lot less from you in Q2 than they did in Q1 and I assume that that was your choice to sell to other customers who were willing to pay more like a market price. Is that probably true?

Mark Smith

Not true, Louis. I think that all that you're really seeing there is the nature of product flow under contract like this over the course of the year. You'll get one quarter that's a little higher, one quarter that's a little lower, but what we look for is the average annual amount and we don't anticipate any less material going to this customer over the course of the year.

Louis Corrigan - Kingsford

Okay, I guess, I am just trying to get some clarity, was it your decision not to sell to them just because you could get a better price for your production from other customers?

Mark Smith

No, what we have is an arrangement with them where on a periodic basis they send us what their transportation schedule is, their needs are for product and then we build that into our logistic system and make sure that they get what they need, but they do have an obligation to purchase these materials at the stated rate, and it will occur over the course of the year.

Louis Corrigan - Kingsford

So, should we expect that there are kind of unit demand that get back to something like Q1 levels on the second half or not?

Mark Smith

Well, I don't know what the exact number is off the top of my head, but they will purchase all the materials that they're supposed to purchase before the end of the year, and I guess the positive thing from the analysis that you've done is that they ordered a little less in the second quarter, which means they'll be ordering more in the third and fourth quarter and it will be under the new contract terms.

Louis Corrigan - Kingsford

Okay, thanks very much.

Mark Smith

You bet Louis.

Operator

And our last question comes from Michael Scarcello with Gilmore & Company.

Michael Scarcello - Gilmore & Company

My question is regarding Molycorp's long-term plan regarding heavy rare earth. I know that you have an impressive portfolio of light yield [ph] given the other critical materials, but what my concern as a shareholder is the perceived lack of heavy particularly in yield – particularly dysprosium, terbium, europium. My question is what are your long-term plans to secure a supply of those materials, in particular?

Mark Smith

Thank you for the question Michael. First of all let me reiterate from prior calls that Molycorp will be producing 10 rare earth elements, once Project Phoenix Phase 1 is up and operating, and we will be producing heavy rare earth metals as part of that production. We'll also be obtaining some heavy rare earth production as a result of our ownership of the Molycorp Silmet operation.

They'll be pulling those materials out and we'll be processing those into final sellable products. Molycorp has about four different tactics that it uses to handle what we call the dysprosium issue. The dysprosium issue, which is, I guess, linked to terbium as well is really related to the rare earth magnet business because without dysprosium, of course, these neodymium-iron-boron magnets will not be able to operate at the higher temperature capacities without that dysprosium.

So, in order to address that our first approach is we will be producing materials from both Mountain Pass and Molycorp Silmet. We're also in the process of evaluating several new resources that appear to have a slightly different natural distribution, in other words, they offer more dysprosium and/or terbium for production. We're also engaged in two other tactics; one is, recycling programs where we can recycle the rare earth permanent magnets that have the dysprosium and/or terbium in it, as well as compact fluorescent light bulbs, which could be an outstanding source of terbium for the future.

The fourth tactic that we're pursuing is an interesting one where there are several new technologies being developed as we speak, which significantly reduce the amount of dysprosium needed in these permanent rare earth magnets, and in one case we've actually found a use for these magnets that would normally require very heavy concentrations of dysprosium, say, 7% to 10% in the magnet – and in the case that we're talking to with the company that would actually require zero dysprosium in that magnet. So, we've got four very strong approaches that we feel very confident will bring the results we need to make sure we can produce the magnets that we need to in our supply chain approach.

Operator

Ladies and gentlemen, that does conclude the question-and-answer session for today. At this time, Mr. Blackman, I will turn the call back to you for any additional or closing remarks.

Brian Blackman

Thank you, operator. We want to make investors aware of several upcoming events. Coming up this September, we will be presenting at the ThinkEquity G8 conference in New York on September 14, and on September 26, we'll be at the Oppenheimer 6th Annual Industrials Conference, and also at the Credit Suisse Future of Energy Conference on September 27, also in New York. Once again, I'd like to thank everybody for joining us on today's call. We look forward to reporting our progress to you again next quarter.

Operator

Ladies and gentlemen, that does conclude today's presentation. We thank you for your participation.

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