By Carl Delfield
I just published a 50-page special report on China aimed at institutional investors. An Inconvenient Truth About China: Seven Troubling Trends describes how its semi-market state capitalism model is in need of significant reform. But no matter what happens with China's economy, one truth will remain: The country has a lot of leverage over rare earth production and prices. It produces 90% and controls 95% of the export market for the 17 metals considered "rare earths."
This is a big deal because many emerging industries rely on these rare earth metals and elements. A Toyota Prius contains about 10 pounds of lanthanum. Smartphones, tablets, night vision goggles, jet engines, giant wind turbines, GPS, fiber optics and missiles are just a few other examples.
China made headlines in late 2010 when it suspended exports to Japan as negotiating leverage during a territorial dispute with Japan. The tactics led to alarm and a surge in rare earth metals and stocks through the summer of 2011. Since then, you may have noticed that rare earths have largely disappeared from headlines and stock prices have come back to earth. Meanwhile, the industrial uses of these elements has increased, while there are also indications that the high prices during 2011 led to a ramp-up of mining activity.
Take Advantage of the Pullback
Weighing all this, I believe it's time to take advantage of this sharp pullback and make a value-driven move on rare earth stocks. My top pick is Denver-based Molycorp (NYSE: MCP), whose stock is down 66% in the last year.
Molycorp, founded in 1946, mines rare earth minerals and elements at its fully integrated mine in California and runs processing facilities in Arizona and Estonia. In addition to producing rare earth oxides at its rare earth mine and processing facility at Mountain Pass, California, the company produces rare earth metals, rare earth alloys (such as neodymium iron boron and samarium cobalt alloys) and rare metals such as niobium and tantalum.
In 2011, the company announced a partnership to produce high tech magnets in Japan. A bigger deal was the acquisition of rare earth producer Neo Material Technologies for $1.3 billion announced in March of 2012. This deal is significant because the 2011 results of the combined companies on a pro forma basis show a tripling of revenue and gross profits, while the holding of Molycorp shareholders will be diluted by only about 15%.
Looking forward, the combined Molycorp and Neo Materials is forecast to produce $1 billion of revenue and $3.80 per share of net income in 2013 when the merger is fully completed. If the combined enterprise gets into the ballpark of these projections, the impact on its share price should be sizable.
It was during 2011 that Molycorp's rare earth business exploded with revenue, going from $35 million in 2010 to $362 million leading to an EPS of $1.27. The company also posted a solid first quarter in 2012, marginally beating consensus earnings per share estimates with quarterly revenue up 222.5% year over year.
The combination of the sharp pullback in share price, the acquisition of Neo Material Technologies and the recent reassuring earnings report are all catalysts pointing to a sharp rebound for Molycorp. I have also noticed an uptrend for the stock since the earnings were released.
If you prefer a broader shotgun approach, take a look at the Market Vectors Rare Earth/Strategic Metals (NYSE: REMX). It's a basket of 30 companies from around the world that are engaged in mining, refining and manufacturing of rare earth strategic metals. This ETF offers a 5.4% dividend yield, and roughly 60% of its holdings are small and mid cap stocks from all over the world - but mainly concentrated in the United States and Australia. Surprisingly, only 10% are based in China. Launched in late October 2010, it caught some of the rare metal surge through the summer of 2011, but ended up down 39% for the year.
Though you should expect some volatility, I recommend pairing a small stake in MCP and REMX to take advantage of their out-of-favor status while you have the chance.