Last week, rare earth miner Molycorp (MCP) announced a plan to merge with minerals processor Neo Materials (NEM.TO). The tie-up will create an integrated operation with mining, processing and production capacities across eleven countries. Intense participation on the Molycorp's joint conference call with Neo Materials management suggested investors think it is a major event, even if not a necessarily a compelling idea.
During a conference call discussing the deal, a representative of Paradigm Capital suggested it might be a "bad deal" for Neo Materials shareholders. The Wall Street Journal says the deal facilitates China hegemony over the rare earth market. The popular Motley Fool financial column called it a "bold move."
Most investors have focused on the geographic scope of the combination, the expanded portfolio of rare earths available to Molycorp and what all that means for itscompetitive position. I wonder what the happy couple will look like together and decided to construct a pro forma balance sheet as an "engagement picture."
It is a picture of dramatic increase in leverage implied by Molycorp's proposed deal financing and following right behind the drag on earnings represented by the higher interest burden. It is also a picture that makes clear the friction between the dilutive effects of common stock issuance and the company's claims the Neo Materials deal will be accretive to earnings. Choosing higher debt management is favoring risky leverage in the near-term and appears to be signaling strong cash flows down the road; a clear buy signal for stockholders.
The Molycorp Balance Sheet Today
Molycorp has a fairly simple balance sheet with $1.3 billion in total assets, which are mostly cash ($418.9 million or 33% of total assets) and the property, plant and equipment ($561.6 million or 45% of total assets). Molycorp as some debt on its balance sheet - $198.1 million at the end of December 2011 - related to a convertible note issued earlier last year. Molycorp's debt-to-equity ratio at the end of December 2011 was 0.23 - very low in comparison to a leverage ratio of 0.40 for the industrial metals and materials sector. With plenty of cash and very little debt, it is not surprising that Molycorp moves opportunistically in its market.
On the other hand, Neo Materials has a leverage profile more like the rest of the industry. Cash represents 36% of Neo Materials assets - a fact that was not wasted on Molycorp management. Molycorp CEO Mark Smith noted Neo Materials cash position during the conference call to discuss the deal.
The Balance Sheet Post Transaction
Some quick math produces a pro forma balance sheet for the combination. I used the two companies' balances at the end of December 2011, summaries of which you can see at the end of this article. Open my Molycorp and "combination" balance sheets and follow along.
The end result is a company that is significantly more levered. If Molycorp conserves all its current cash and the cash of Neo Materials for working capital, I estimate it would be necessary to raise as much as $500.0 million in new debt - or more if any of the existing debt were to be replaced with a new debt facility. This would move the debt-to-equity ratio to the neighborhood 0.55 - above the industry average of 0.40.
The Risk in Higher Leverage
Neo Materials CEO Constantine E. Karayannopoulos suggests that there would be no impediment to repatriating earnings in its China operations back to the Molycorp. If this is the case, it would be fair to consider 100% of the combination earnings as potential coverage for interest expense. If the new debt level has an average interest burden of 6%, the interest burden might be near $55.0 million. The implied "cash earnings interest coverage" would be 7.8 times ($429.0 million EBIT / $55.0 million interest burden).
Is it realistic to expect Molycorp to be successful in floating $500.0 million in new debt at a 6% interest rate? I will allow there could be some friction in my interest assumption given the resulting coverage ratio. Yet if lenders require a higher rate, the resulting interest coverage multiple would simply be lower.
Fortunately for Molycorp, there is enough interest in rare earth minerals to believe the company could find additional equity investors. That said, Molycorp management has made the point several times that the deal is immediately accretive with the 112.5 million shares expected to be outstanding after the Molymet capital raise and the Neo Materials transaction are completed. Another equity issuance would put that claim in jeopardy.
A summary of the math that created the "combination" balance sheet as well as pro forma 2011 income:
First, the deal creates some intangible assets and goodwill. Neo Materials' net assets total $466.0 million. Compared to a purchase price of $1.3 billion, a write-up of assets by as much $834.0 million may be necessary. That means a significant increase in intangibles and goodwill on the combination balance sheet.
Second, Molycorp has already said it will pay for Neo Materials with a combination of stock and cash - 71% or approximately $923.0 million in cash and 29% stock or approximately $377.0 million. Molycorp already raised $390.0 million in new capital through the issuance of 12.5 million in new shares of common stock to Chile's Molymet. To preserve all current cash for working capital purposes, I estimate the company would need to borrow as much as $500.0 million to have enough cash to complete the deal.
Third, combined at the beginning of 2011, the two operations would have produced earnings before interest and taxes of $429.0 million. This is based on 2011 earnings results and makes no allowances for costs of the combination or any savings that Neo Materials might experience as a part of Molycorp. It also does not consider the increased amortization expense which results from purchase accounting treatment.