It appears that there may be no effect on Molycorp’s (MCP) earnings due to recent lower rare earth prices. Even more ironic is that there should be no effect on 4Q earnings. How can this be? Timing is the answer. It appears that the secret is in the timing from the actual day that the orders have been placed until when they get recorded.
Have you ever noticed that every time there has been an earnings conference call there is one question that Molycorp’s CEO seems to get perplexed by? That question is “How come you are not receiving market prices for your REE’s?” He always assures the asker that Molycorp is receiving market REE prices, but there is always a hint of something in his voice during this explanation. When listening to it I feel like I am hearing a bit of shock that people keep asking this same question and not understanding the answer. It seem like he is perplexed that the analyst just don’t get it. Sometimes it can be hard for people to answer simple questions because they just assume that the audience knows enough of the details to draw the proper conclusion from the information that is revealed.
While not everyone is Mr. Smith’s fan, it does appear that the operation and project are falling into line with past presentations and that the company is meeting or exceeding all published comments. Given this track record and the honest tone of his verbal responses I have tried to dig into the pricing issue and determine just how he could be right when the prices were always significantly lower than the average quarterly market prices. In my earlier models I recognized this situation and just applied a reducing factor based upon past results. If what has been discovered is true, then investors may be getting some surprises for the next few earnings quarters. This is especially relevant given the recent pullback in REE prices, the new Grace (GRA) contract, and any potential price rebound that could occur.
It has always appeared that there were some accounting delays in the system. After analyzing the past REE price data the significance of the delay could be seen. It appears that there is approximately a 70-day delay. The assumption would be that an order is placed (at market value) and then there is processing time, shipping time, and once received that the customer gets a 30-day billing grace period before the sale is actually paid for and recorded in Molycorp’s books. If this is true then this drastically skews everything because the REE market has been so volatile. If prices were relatively stable then it would not matter, but in this market this information can be used to gain a real advantage going into earnings. Over time everything will average out, but in the short term an investor can figure out which earnings numbers will likely fail or beat expectations.
So how does this pertain to the Grace contract? Who really knows because they did not release the details. The contract was announced at the end of July and implied that it would be for prices going forward. Most likely it would have been for new orders. It is unlikely that there will be any increased earnings during 3Q given the assumed receivables delay of 70 days. The good news however is that in 4Q this could be a mega surprise pop that most people have forgotten about and which helps to smooth out earnings after the REE price decline that we have seen recently.
Now let’s look at how this pertains to the 3Q earnings outlook. After a big run up in REE prices and then a correction Molycorp would have originally appeared to receive just slightly better pricing for 3Q. If the delayed accounting is correct then it looks like there could be an 18% increase in REE price received.
When everything is put together it looks like Molycorp will post earnings of just over $.80 per share in 3Q. This number could come as quite a shock to some investors who thought the wheels were falling off the company when prices declined. If REE prices stabilize or start to recover by the time earnings get here then people might become a bit exuberant. If this accounting delay is true then the 4Q realized REE prices would end up being almost the same as the 3Q realized REE prices. In addition there would be slightly more production and the new Grace contract benefit, which I have estimated as $.20 for 4Q. If REE prices stay down and this is all true then many people could be surprised when MCP posts over a $1 per share in 4Q. And even more would be shocked in 1Q when the delay in lower prices reaches the earnings statement and a lower quarter is recorded.
We will have to see if prices rebound, but if not then both long and shorts will have some exciting trading times in the near future. When the data are delayed and the earnings come in as a surprise to the current view it can lead to some volatile trades. A proper short could easily think that since prices crashed in September that it would be recorded in this earnings result. By beating earnings in a down price environment the shorts could get blown away and have to cover fast leading to a covering rally. If prices recover then all is well and the rally will really be on, but if they do not recover then the Grace contract could help to hide what is really happening in 4Q and help to extend the rally. If prices have not recovered then the 1Q 2012 earnings results will be the first earnings results that take into effect the full scale of the decline but it would be mitigated by the higher Grace contract price. Since investors would have seen great earnings despite lower prices they could get shocked by the earnings dropping while it appeared that prices had been stable for a while, or even more shocked if prices started rising but none of this rising was reported in 1Q.
Disclosure: I am long MCP.