Avoid Molycorp Until Its Liquidity Position Improves

Aug.29.12 | About: Molycorp, Inc. (MCPIQ)

Rare earth metals had seen continued price rallies until 2011, due to augmenting demand and China's supply control measures. However, manufacturers switching to alternatives and the global macroeconomic meltdown has caused a dip in rare earth metals' prices.

Molycorp Inc. (MCP) is a U.S.-based miner and processor of rare earth metals, and has the largest rare earth deposits outside China. The company is aggressively developing its California mine, which has recently started operations. However, the company has to resort to equity financing to fund its rising capital expenditures and is suffering from poor operating performance and declining rare metal prices. These factors prevent us from recommending a long position, despite its cheap valuation, given that the stock has dropped by more than 60% this year and is trading near its 52-week low. We advise investors to stay away from the stock until its liquidity position improves.

Rare Earth Metals (REMs)/Rare Earth Elements (REEs)

According to the classification of the International Union of Pure and Applied Chemistry (IUPAC), rare earth metals (REMs) comprise seventeen chemical elements of the periodic table, fifteen of which are collectively called lanthanides, while the other two are scandium and yttrium. These elements are not rare in abundance, but have the common feature of being extracted from uncommon oxide-type minerals.

These chemically similar elements have a multitude of uses, including hybrid cars, magnets, flat-screen TVs and Apple (NASDAQ:AAPL) iPods. To get a detailed idea of the uses of each of these metals, please click here.

Industry Dynamics - Demand, Supply & Prices

According to a recent MIT study, the demand for two of these REMs, neodymium and dysprosium, is expected to increase significantly in future, as the world transitions to renewable energy sources. This is because neodymium is an essential ingredient of magnets used in wind turbines, while dysprosium is used in some electric vehicles' motors. The research predicted that the demand for neodymium and dysprosium is expected to increase by as much as 700% and 2,600% over the next 25 years. While these raw materials are abundantly available in the ground, their supply needs to be paced up so as to match the rate of increase in expected demand. However, the development of a mine takes a decade or more, and unless noteworthy steps are taken in the short-term, such as new mines' development and recycling, a bottleneck will very likely lead to severe price hikes in future.

The prices of rare earths touched record levels in 2011, but dropped by more than half this year as consumers have sought alternative materials or decreased purchases. Moreover, the global economic malaise has added to the problems of this industry as it has hampered the metals' demand from their end markets.

China supplies 90% of the world's REMs, and so the country has a crucial role to play in this market. It has taken some steps, such as export and production quotas, crackdown on illegal mining, and cutting of mining rights, to restrict the supply growth of rare earths. This was to support declining metal prices, protect the environment and conserve resources. However, the restrictions prompted the U.S., Japan and the European Union to complain to the World Trade Organization (WTO) citing "harmful disruptions and distortions in global supply chains .

Consequently, China eased restrictions for the first time since 2005 by recently increasing export quotas. However, the move comes too late as manufacturers are trying to divest away from Chinese-produced minerals by starting their own mining operations. China's rare earth exports have dipped by 36% in the first seven months of this year as compared to the last year.

Molycorp Inc.

MCP reported its recent quarter earnings on August 2 when it posted a loss of 71c per share relative to last year's gain of 53c. This poor operating performance was primarily a result of softening rare metal prices and customer de-stocking activities, which resulted in lower cash flow from operations.

The Colorado-based company is aggressively trying to boost production at its Mountain Pass mine in California so as to become one of the most integrated producers of rare earth products in the world. However, this expansion project at Mt. Pass has resulted in a significant increase in its capital spending needs. In addition, MCP acquired NeoMaterial Technologies Inc., now called Molycorp Canada, in June 2012, which loaded it with heavy debts. MCP became responsible for the financial obligations of the acquiree, $230 million of 5% convertible subordinated debentures. Still, this acquisition helped MCP to record a 5% YoY increase in revenue due to more sales volume.

MCP has tried to address a potential liquidity shortfall by issuing $120 million of common equity and $360 million 6% convertible notes. The company will use the raised proceeds to fund capital expenditures at Mt. Pass and potential cash payments to holders of NeoMaterial's notes, which have the option of even being put back to the company.

Yesterday, the company announced the start-up of its heavy rare earth concentrate operations at the Mt. Pass ore by the name of Project Phoenix. The concentrate will be produced from this ore and then processed into rare earth products at the company's global production facilities. This concentrate contains dysprosium, europium and other rare earth metals, and will be processed into rare earth oxides, alloys, and metals, which are then used in electronics, wind turbines, and hybrid vehicles. This project also features a Combined Heat and Power (CHP) plant, which will be producing steam and electrical power for its Project Phoenix facility from this week onwards.

However, we have serious concerns regarding MCP's liquidity condition in case the market weakens any further or there are any additional operational shortfalls. The company's high Capex requirements and volatile earnings further add to our concerns. Moreover, China's control on the supply of REMs, probable synergies' failure at Molycorp Canada, and overdependence on a single mine to drive future performance, make us wary on the stock.

The company's stock performance has followed a downward spiral as the stock is down 60% on a YTD basis. It is trading close to its 52-week low, but still, the potential risks associated with the company, especially related to liquidity, are making us cautious about the stock. The following chart shows the YTD stock performance of MCP relative to Market Vectors Rare Earth/Strategic Metals ETF (NYSEARCA:REMX). We feel REMX is a better option as compared to MCP for those investors who want to play a rebound in rare earth metals' prices.

Click to enlarge

Source: Google Finance

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Materials Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.