I sometimes think Molycorp (NYSE:MCP) shares much in common with Charles de Gaulle's observation about Brazil: "Brazil has a great future, and it always will have." Moly has often been right on the edge of delivering but just couldn't close the deal.
While there will always be "many a slip 'twixt cup and lip," I think this time they may have bumbled and backed into positioning themselves for dominance. This is still a speculative company. Readers need to be alert to the possibility they could see this stock soar from its all-time low of 9.61, reached a few days ago back to its all-time high of 75.18, achieved just 16 months ago in April 2011 - or it "could" crumble to zero.
Since I view the odds of that latter event as remote, I am again buying both MCP common shares and the Molycorp Convertible Preferred A.
Why do I like the industry?
Without rare earth elements (REEs,) our national security strategy is untenable. Some of the applications for these REEs are illustrated below. While all are credited to the originator of the source data, I first saw them in a paper published by Valerie Grasso of the Congressional Research Service titled, "Rare Earth Elements in National Defense: Background, Oversight Issues, and Options for Congress," which I recommend if you'd like to really dive into the weeds and understand this sector.
If rare earths had no application beyond those used in defense systems, they would be extremely valuable. In addition to being used for specialized aircraft coatings, for state-of-the-art and next generation radar systems, to provide luminescence, brightness and quick-reaction displays inside aircraft cockpits, and to allow jet aircraft to function at higher temperatures, REEs are also absolutely necessary for current and future PGMs (Precision Guided Munitions,) lasers, mine detection, optical equipment, NVGs (Night Vision Goggles,) Sonar, GPS, and certain ECMs (Electronic Counter Measures.)
But REEs' benefits go far beyond this. There are all the non-defense applications that rely upon REEs for greater efficiency as well. Lighter weight, lower cost, and so on: Clean energy technologies like hybrid and electric vehicles and wind power turbines; consumer electronics like iPads, smart phones, and laptops; energy-efficient lighting systems; fiber optics, lasers and hard disk drives, advanced water treatment technology for use in industrial, military and outdoor recreation applications; and medical devices and other health care technologies.
Why Molycorp, Why Now?
Molycorp is US-based. Currently, China produces some 97% of all rare earths. I believe that situation is untenable for the security and success of our nation.
Molycorp is the only US-based firm with sizable DoD contracts to supply the rare earth minerals that are absolutely essential in satellite communications, pulsed/continuous wave radar amplifiers, and other communication links at the level we need them to be for advanced defense applications.
They are vertically integrated thanks to their purchase of Neo Materials. Their strategy is to mine REEs, concentrate them, process them, and distribute them around the world.
None of this means that Moly must be among the survivors in this business - but at least what they make is not yet another video game or social networking site we can live without. Like oil companies, copper companies, and timber companies, Molycorp owns real tangible "stuff" that provides value even if they were to screw everything up. A buyer might pay 10 cents on the dollar if they screw up badly, but there is always the stuff, sitting there waiting to be extracted.
Their products underpin the technologies we depend upon to save American lives in combat and keep tabs on our enemies, as well as to communicate with each other, conserve energy, and increase the power of our computers while reducing their weight and size.
On the surface, there is little in their numbers to like. They just declared a loss this quarter as they under-estimated the capital savings from and costs associated with their acquisition of rival Neo Materials (now called Molycorp Canada.)
They just announced the start-up of their new Project Phoenix heavy rare earth concentrate facilities at Mountain Pass, California, which will produce heavy rare earth concentrate from freshly mined Mountain Pass ore that will then be processed into high-purity, custom-engineered heavy rare earth products in what they call "Molycorp's globally integrated production facilities." What they mean is, given that our national leadership has been asleep at the switch on this issue, they will have to send them for processing to their (newly-acquired via Neo Materials) processing plant in China, then re-import them back to the USA.
Another question mark with Molycorp is that, in order to bankrupt or cripple every foreign competitor, China first flooded the markets, then effectively controlled prices via their monopoly on production. They will do their best to keep prices high enough to make a great profit but not so high as to create viable competitors. Can Molycorp or our other REE favorite, Lynas, or anyone else, compete with this monopoly today? I say "today" because, while China controls 97% of all production, they are themselves fast running out of the actual REEs. Most estimates give them only another 12-16 years of reserves.
Lots of companies did poorly this quarter. But Molycorp provided a double whammy. First, they made less money than they thought they would because the acquisition was more costly to integrate, then they decided to raise money during a time when most companies raising money are doing so to survive. The stock hit a new low, down some 85% from its 52-week high, and the preferred dropped to half its former high.
And yet, for all the hair-on-fire selling of MCP and its convertible preferred, the company is not in bad shape. With the acquisition of Neo Materials they have captive processing capability for the rare earths they mine and a toe-hold in China, as well. The cash flow from these operations isn't enough to fund major expansion, but certainly doesn't doom them to also-ran status, either.
And their Altman Z-Score, a measure of financial viability, is 4.12 - higher than many blue chips. (For comparison, the Z-score, which has shown an excellent capability to predict near-term financial distress, for General Electric is just 1.32 and defensive dividend aristocrat Proctor & Gamble is just 3.36. Anything less than 2.99 places a company in the gray zone, anything below 1.81 portends difficult times financially.)
Yes, MCP is raising money, but not because they are hemorrhaging. They are raising, via the convertible senior notes and common stock offering, some $480 million to expand their capabilities, finish their Phoenix rejuvenation, and secure additional resources. Raising money to make more money used to be seen as good business. If the business is solid, it still is, though I would caution that Moly is paying 6% on this latest round of financing so they must quickly conclude their capital infrastructure projects and get actual product into the pipeline. While the current 5.5% preferreds can be converted to common (highly dilutive, of course) the nearly $22 million in annual interest on the new bonds must come from cash flow.
I think what MCP does, and where they get their raw materials from - California, not Canton (Guangdong ) - augurs for their success. As a national resource, like home-grown natural gas versus imported oil, or US agricultural products rather than imported ones, I give Molycorp the edge over any other competitor.
The only other major fly in the ointment is the currently low price for almost all REEs. If you believe, as I do, that energy-saving transportation options, greater use of electronics and precision in warfare, more wind and solar, and more, not less, individual consumer electronics are in our future, then you might also believe that the current pricing is bound to rise. The demand is rising, the supply is not.
MCP common and preferred are our largest rare earth holdings. Our other, Lynas, has been a disappointment thus far. It has been unable to secure an operating license for its behind-schedule materials processing facility in Malaysia. There are those who believe they see China's hand in this, as well. The more they can pressure Malaysia to throw straw men against the plant or organize local resistance, the less likely they will have a real competitor on their doorstep. Whatever the reason, Lynas languishes. But China has only 15 years or so of rare earth reserves. For the survivors, and I count Molycorp and Lynas first among equals, every year their resource base becomes more valuable.
Molycorp's common offers the greatest leverage. But conservative investors might favor the preferred rather than the more highly-leveraged common stock as the way to go to secure a floor beneath which the investment is unlikely to fall in the short term.
A caveat, however. This preferred is mandatorily convertible on 3/1/2014 into a variable number of Molycorp common shares. The conversion settlement rate will be 1.6667 shares per unit if the then market price of the common stock is equal to or greater than $60.00 and 2 shares per unit if the market price is equal to or less than $50.00. With MCP at $10, that would today make the preferred worth just $20 upon conversion. Add in the annual $5.50 per share in dividend income and it still only gets us to just under $30 in preferred share value by March 2014. If you agree that the MCP selling is overdone, and can imagine a price of $20 on the common, which it sold for as recently as July 11th, that makes the preferred worth $40, its current price. The 13.5% yield for the next 18 months would be gravy. If, dare to dream, MCP common reaches 30 in the next 18 months ( which it did as recently as April 20th of this year) the MCP preferred would be worth $60 - plus that 13% yield.
This investment is for the risk portion of your portfolio only. Maybe the common, currently selling at its low for the year, won't budge, in which case we'll see a 25% loss on our investment (but we'll own common shares, via the mandatory conversion, in a company I believe will one day recover hugely.) I don't see the company going out of business and I do see them getting funding to complete their plans. I don't see the demand for what they have slacking off any and I do see the prices firming.
If the common merely recovers to 20, we've made 13% annually and will then, via mandatory conversion, be forced to buy shares in a company which is the market leader in a key strategic materials sector that the nation needs to see prosper. I can live with that. If you can, too, and like the idea of an investment floor based upon the dividend stream alone, you might want to perform your own due diligence and join me in this purchase.
Disclosure: While we remain hedged in this volatile market, we are always on the lookout for a special situation where we believe the selling has been overdone. For this reason, we are now long MCP and MCP pr A.
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