For the convenience of Seeking Alpha readers, we have divided this report into three parts:
- Our Macro Perspective on the REE Sector
- Molycorp: Understanding the Misunderstood
- Valuation: Putting it All Together
Base Case Model Snapshot
Our analysis suggests that Molycorp is conservatively worth $139/share on a net present value basis at the end of 2012. This is derived from our base case scenario outlined in this report. We have also ran a severely bearish scenarios to illustrate why even if we adopt a more conservative price deck, Molycorp is undervalued. In both scenarios, we have assumed the acceleration of Project Phoenix does not occur and that the original time table (Phase I commence Jan. 2013, Phase II commence Jan. 2014) occurs but have included the acceleration CAPEX in our model.
NPV Sensitivity to Discount Rate in the Base Case Scenario
We assumed in all scenarios that Phase I production commences on January 1, 2013 (3 month delay) and Phase II production commences on January 1, 2014 (6 month delay). We have included however the acceleration CAPEX along with all other development CAPEX as occurring in 2012.
Contrary to the market and punditry focus on cerium and lanthanum, the value of Molycorp is most sensitive to changes in the price for neodymium iron boron alloy and the market penetration of XSORBX.
Bearish Pricing Scenario
While some will immediately point to our premium price deck in 2013-2015 as the reason for why our estimate for net present value is over five times the current share price, we would argue that even in the most bearish but rational long term pricing scenario, Molycorp would have to rise over 20% to be trading at net present value. We ran end of 2011 domestic Chinese prices with a 25% discount across the board and zero dollars for cerium and lanthanum (oxide and metals) through our model at a 15% discount rate (higher than the discount rate used by JP Morgan (12.50%), Morgan Stanley (11%), Dahlman Rose (10%), and in line with Bryon Capital Markets – the most bearish sell side analyst), Phase II production capacity never being utilized, and the result was a net present value of $32/share, or 34% higher than the year end 2011 share price.
Environmental reforms of the rare earth mining industry inside of China have resulted in significantly higher costs of production (see our earlier point about Lynas management telling analysts new paradigm in China is $20-$25/kg REO production costs), and as a result, our view at The Strategist is that current domestic Chinese prices represent the new long term prices for rare earth elements.
Given the results from this extremely bearish scenario, we have to wonder if perhaps investor pessimism as swung too far to the negative on Molycorp. It is completely rational to argue the stock should trade a discount to net present value until we see the results of the first quarter under Project Phoenix, but the current valuation simply makes no sense to us. While its purely speculation on our part, we think this ties back in part to our point in the section on why the market is inefficient on REE miners.
Based on current reserves, and not accounting for any production from the NI 43-101 compliant measured & indicated resource at Mountain Pass, over 75% of mine life revenue will come from NdFeB alloy and XSORBX production.
The current share price of Molycorp makes absolutely no sense relative to fundamental valuation. There is a massive misconception in the market that the key to Molycorp’s valuation is cerium and lanthanum prices, but this does not give an accurate depiction of where the revenue will pre-dominantly come from once production at Mountain Pass achieves a steady state. The truth is that over the mine life of the Mountain Pass main ore body, over 64% of Molycorp’s revenue will come from NdFeB alloy. The second largest contributor to revenue will be from the XSORBX water filtration system at approximately 15%. We see less than 25% of revenue coming from rare earth oxides, metals, and concentrates. Lanthanum metal and oxide are the largest component of this segment at approximately 7.6%.
This is not only a rare earth mining and oxide company but also a company focused on the downstream higher valued use of rare earth including the growth in demand for neodymium alloys and magnets as well as becoming a supplier of cerium-based water filtration systems. We would highlight that we have assumed XSORBX does not penetrate the higher price point drinking water market (where it would fetch the cerium oxide equivalent price of $80/kg). Successfully penetrating this market would multiply the revenue impact from XSORBX. We have modeled XSORBX to initially penetrate the waste water and recreational/spa water treatment markets only.
Beyond improved recovery rates (allowing greater production at the same total cost), the valuation of Molycorp is most sensitive to neodymium prices first and foremost. If we are incorrect about premium neodymium pricing be realized in the 2012-2015 time frame, we would note when we moved our neodymium oxide price from $40/kg to $80/kg (over 20% discount to domestic China prices) which is below the economic cut-off price of $100/kg Nd Oxide that makes rare earth inputs into wind turbines economic, the increase in net present value is greater than the current market capitalization.
The valuation discount is so great at present that even if we have been too optimistic about rare earth prices in the medium term and long term, it does not push net present value below the current market capitalization as evidenced in our bearish price scenario.
We have not included four potential blue sky positives for the value of Molycorp.
1) We have assigned zero value to the magnet joint venture with Daido Steel and Mitsubishi. As we have shown in our analysis with the value add from Molycorp’s future NdFeB alloy production, the downstream is a huge upside driver of intrinsic value. As a result, we view the results from the magnet joint venture as a potential upside catalyst. We have high conviction the joint venture will be an upside driver to net present value.
2) We have assumed XSORBX does not achieve a price point exceeding $40/kg on a cerium oxide equivalent basis which is approximately the recreational/spa water treatment price point. We have mild conviction that higher price point will be achieved and materially improve our net present value, but there is no reason for us to get greedy.
3) We are assuming no gains from the venture investment Molycorp made in Boulder Wind & Power in 2011. We have no expectation of any gains from this investment in the long term.
4) We have not accounted for any production or value add from the Mountain Pass HREE prospect. We will wait until drill results are made available before we determine if the prospect will be a positive catalyst to net present value.
Compared to when we first looked at Molycorp in July 2010 prior to the initial public offering, we have a lot more clarity on the rare earth industry thanks to over a year of research and due diligence. Fundamentally, Molycorp is worth well north of $100/share, and we think the company will finish 2012 in triple digits. The obvious catalyst are an on time (April 1st) start to the sequential Phase I start up and an on time commencement (October 1st) of Phase I production through the oxide stage. Once Molycorp has achieved Phase I production, investors will hear in March 2013 about the first quarter in which Molycorp is operating under Project Phoenix. Our analysis suggests Molycorp has $8.75 EPS potential in 2013 (not including Phase II production in 2H13), over $25 EPS potential in 2014, and steady state EPS of approximately $19. As such, we see the market giving Molycorp a full valuation by the end of 2014 once the company delivers on its earnings potential and the market assigns a mid to high single digit P/E on its long term earnings power of approximately $20/share.
Simply put though, the current valuation of Molycorp significantly undervalues the company. The shares are currently pricing in rare earth prices returning to levels seen over the second half 2007 to first half 2010 time frame even though marginal production costs in China have gone up significantly due to environmental reforms. We think fundamental growth and value investors have been given a gift by the stock market as short sellers, and the complete absence of speculators and momentum investors, has driven Molycorp’s share price into the ground. Investors who did not understand the rare earth element industry in July 2010 when Molycorp went on the road for its initial public offering (and was forced to price below the guided price range) have been given opportunity to take a second swing at the exact same pitch and invest in the company at an absurdly cheap valuation.
In its current form, Molycorp is a “show me” stock. If the company executes Project Phoenix on time and without cost over runs, the potential is there for significant investors gains. There does remain the risk that investors will not believe in the pricing environment and will therefore always price Molycorp at a discount to net present value. We believe that the discount to net present value will compress as certain milestones are achieved such as the April 1st commencement of the six month sequential start up of Project Phoenix Phase I.
Bottom line, we consider Molycorp a STRONG BUY which we say with our highest conviction as it is the largest liquid position in our editor’s portfolio (cost basis in the mid-thirties per share). As the REE business outside of China matures and Mountain Pass Phase I & II production hits profitability and sales targets, we expect the P/NPV ratio to approach 1.0x over the course of the next 3 years as major buy side institutions come around to our thought process on REE companies and specifically Molycorp.
 See Revenue Distribution section
Molycorp press release November 29, 2011: http://us1.campaign-archive2.com/?u=a9e8676e87fad805702b98564&id=3fb697d81e&e=d068c915e8
Additional disclosure: The facts in this newsletter are believed by the Strategist to be accurate, but The Strategist cannot guarantee that they are. Nothing in this newsletter should be taken as a solicitation to purchase or sell securities. These are Mr. Evensen’s opinions and he may be wrong. Principals, Editors, Writers, and Associates of The Strategist may have positions in securities mentioned in this newsletter. You should take this into account before acting on any advice given in this newsletter. If this concerns you, do not listen to or consider our opinions. Investing includes certain risks including potential loss of principal. The commentary of The Strategist does not take into consideration individual investment objectives, consult your own financial adviser before making investment decisions.