Index Member Comment - September 20, 2011: Molycorp takes market hit after JP Morgan analyst notices lower REO prices
Molycorp Inc lost 20% of its market capitalization and traded more than $1 billion worth on the NYSE on September 20, 2011 after JP Morgran reduced its target price from $105 to $66. JP Morgan analyst Michael Gambardella appears to have recognized the folly behind using FOB spot based basket prices in his valuation of Molycorp's Mountain Pass operation. On June 20, 2011 JP published a report setting a price target of $105 for Molycorp based on a medium term basket price of $85/kg REO from Mountain Pass. The FOB spot basket price at the time was $175/kg while the domestic spot basket price was $62/kg compared to $7/kg amd $4/kg respectively in 2009. Given the sharp runup in FOB spot prices since July 2010 when China first slashed the export quota, and the sharp runup in domestic spot prices since March 2011 when China's crackdown on illegal and polluting operations started to gain traction, one could regard the choice of an $85/kg basket price as aggressive and naively optimistic, even if it reflected a 50% discount from FOB spot prices. Mountain Pass FOB spot basket prices have retreated 43% from their subsequent $194/kg peak to the current $111/kg level, while domestic spot basket prices have retreated 27% from their $64/kg to the current level of $47/kg. (Keep in mind that the basket price refers to the mix of individual rare earth oxides in each recovered kg of TREO, and as such will vary for each project.) The exponential price increase during Q2 of 2011 was helped along by speculative Chinese hoarding which is now reversing itself, though how far is uncertain in light of recent comments that Baotou Steel plans to purchase rare earth oxides at a premium to market prices to stabilize the pullback.
The recent pullback reflects dis-hoarding in the face of evidence of a global economic slowdown, capitulation by non-Chinese end-users in moving their rare earth dependent production to China, and demand destruction as end-users either abandon rare earth dependent technologies or engineer low or zero rare earth usage solutions. During a recent Metal-Pages conference in Beijing IMCOA's Dudley Kingsnorth poured further water on the party by reducing his 2011 rest-of-world demand projection from 60,000 tonnes to 40,000 tonnes, though I suspect this reflects the reality that only 30,000 tonnes are available for export markets via quotas, China's domestic demand is approaching 90,000 tonnes, and this time around the authorities appear to be having much better success in enforcing their 90,000 production quota. While Dudley relishes being a sourpuss about the rare earth sector, his pronouncement is not quite the pooh-poohing of rare earth demand that the rare earth bears would like to spin it as, and is more a reflection of the consequence of strategic blindness by end users. On September 21 Molycorp's CEO Mark Smith testified to Congress that "China has no intention of remaining the world's major supplier of rare earths and gradually shift focus to domestic demand...and that tight supplies of rare earths represent an irreversible trend". This implies, as we have already argued, that China is headed towards a zero export quota unless there is a miraculous expansion of Chinese rare earth supply, and that, WTO rules not withstanding, demand from end-users outside of China has nowhere to go except away unless non-Chinese rare earth supply is developed. The ensuing evaporation of demand will have a negative impact on spot prices, which is actually a good thing for the rare earth juniors because a retreat to more reasonable sustainable levels will restore demand from end-users who ultimately are better off using rare earth inputs instead of inferior or complex workarounds. But this is not good news for analysts who use anything higher than the Chinese domestic spot prices for their cash flow models. All of this seems to have been a rude awakening for Gambardella, who has now decided to use a lower basket price of $48/kg in his valuation model, which results in a $66 price target and neutral rating for Molycorp. The shorts rejoiced by hammering Molycorp afresh, with predictable collateral damage in other advanced rare earth juniors.
JP Morgan's new basket price of $48/kg is very close to the domestic spot based basket price of $47/kg for the Mountain Pass output which is dominated by the light rare earths. Interestingly, the FOB 3 year average basket price is now $45/kg, though the domestic 3 year average basket price is still lagging at $14/kg. Thanks to the exponential price rises during the past year these three year averages will be rising higher for some time, leaving the miserable $7/kg FOB and $4/kg domestic basket prices that prevailed in 2009 while the world was still struggling to recover from the 2008 Crash as relics of a distant past. Given that Lynas and Molycorp are both scheduled to add 60,000 tonnes of largely light REO supply during the next couple years, one could argue that JP Morgan is still being too optimistic in its revenue assumptions and will have to publish further downward revisions as the domestic price for the Mountain Pass basket drifts lower.
The chart below shows what the rare earth supply profile will look like in 2016 if all the major advanced projects come on stream as expected. The numbers to focus on is the $39 billion value of the 232,573 tonnes of production at FOB spot prices, and the $19.5 billion value at domestic spot prices. Compare that to the estimated $1.5 billion value of the 125,000 tonnes produced in 2009. This price escalation is what the end users are balking at, and you don't need to be a rocket
scientist to realize that these levels are not sustainable, even at domestic prices. A further 50% fall, skewed toward the more abundant lanthanum and cerium, bringing the annual production value down to $10 billion by 2016 (Kingsnorth estimates 2010 production at $4-$6 billion), should be factored into pricing assumptions.
The graphic below depicts the after-tax sensitivity of the Mountain Pass operation at full capacity to various basket prices ranging from the domestic 3 year average of $14/kg which points toward an $18 price target for Molycorp, to the hopelessly unsustainable FOB spot basket price of $111/kg which implies a price target of $232 for Molycorp. This model is a simplification of Molycorp's mining and processing plan, and is less conservative than JP Morgan's model whose details are not published. At the $45/kg three year FOB average basket price the Molycorp price target using a 10% discount rate (rather than 12.5% as used by JP Morgan) is $86, bumping up to $91 using the $47/kg domestic spot basket price. Using JP Morgan's new $48/kg basket price forecast the stock price target would be about $93 per share. I am not proposing a debate about whose discounted cash flow model is better constructed; in offering this comparison I am only trying to point out that if I use the $85/kg basket price JP Morgan used to support its $105 price target for Molycorp last June, my model generates a price target of $175 per share.
JP Morgan's downgrade of Molycorp from Buy to Neutral with a price target lowered from $105 to $66 was just what the bears needed to flush out the longs so that they can start covering their shorts. Not surprisingly, other advanced rare earth juniors such as Avalon, Rare Element and Quest were also hit by selling, even though their market prices had not been puffed up by foolish analyst REO price assumptions.
The basket price chart below for the Strange Lake project of Quest Rare Minerals Ltd shows that the FOB spot basket price for the BZone peaked at $347/kg on July 28, 2011 while the domestic spot price peaked at $190/kg on July 21. Both the FOB and spot domestic basket prices are significantly higher than the Mountain Pass basket prices because the Strange Lake output mix has a substantially higher proportion of the less abundant and more expensive so-called heavy rare earth oxides. China's output of heavy rare earths comes primarily from the ion adsorption clay deposits in southern China which are viewed as headed for depletion within 15 years and are currently the target of rationalization and consolidation by Chinese authorities. At current domestic spot prices for light rare earths there are plenty of deposits around the world which on paper are economic, which implies that in the long run spot prices for light rare earth oxides will end up lower than current domestic levels unless their is phenomenal new application driven demand growth. But deposits with a significant proportion of heavy rare earths are less abundant, typically have lower overall TREO grades, often have complex mineralogy, and have a penchant for being located in remote, infrastructure challenged regions. Assuming engineering is not successful in securing the functionality offered by the heavy rare earths through cheap, non-rare earth means, prices for the heavy rare earths will not suffer quite as bad as the light rare earths in the long run. At $265/kg the FOB spot basket price for Strange Lake is down 24% from the peak, while the domestic spot basket price is down 26% and showing signs of bottoming.
Although the basket price for Strange Lake has also retreated from the July peak, the market has never used basket prices in its valuation of Quest anywhere near peak FOB and domestic levels. The chart below presents the after tax net present value per share sensitivity of the proposed Strange Lake operating plan to various basket prices. Quest published a preliminary economic assessment (PEA) in late 2010 which did not include a separation stage. I have modified the PEA by adding a speculative capital and operating cost for this extra separation stage which need not be located at Strange Lake, so view this model less as an absolute depiction of economic value and more as an illustration of relative value. The junior is working on a pilot plant scale metallurgical study which Peter Cashin believes will allow him to publish a prefeasibility study (PFS) calibre flowsheet in Q4 of 2011. In fact, he has even threatened to be in a position to declare that the study has generated several hundred kilograms of mixed oxide concentrates. If he actually delivers this, it will be a huge milestone that pushes Strange Lake well ahead of other heavy rare earth supply contenders, including Avalon's Nechalacho project. Of course, if Hazen spent a fortune generating this concentrate, it will prove to be merely a scientific rather than an economic success. We will discover which it is when Quest publishes its PFS which will document the costs associated with the recoveries achieved by the metallurgical flowsheet. While it would be nice to see the PFS published before the end of 2011, Quest's history of delivering key milestones just as market windows are closing suggests we not hold our breath. At this stage the DCF model on which my NPV sensitivity analysis is based has huge uncertainties, but it is useful to illustrate how uncharitable the market has been towards Strange Lake, and why it is ridiculous that Quest should be punished because a Wall Street analyst screwed up with his basket price assumptions for a company which at one time boasted a market capitalization in excess of $6 billion.
For example, this DCF model generates a $253 price target for Quest using the FOB spot basket price of $265/kg, a far cry from the current trading price of $3.40 per share. The model generates a $128 price target using the domestic spot basket price of $141/kg. Keep in mind that JP Morgan is now using a forecast basket price that is very close to the domestic spot basket price for Mountain Pass. Where Strange Lake really starts getting interesting is when we apply three year average FOB and domestic basket prices to the model. The 3 year FOB basket price is $72/kg, more than three times the $22/kg FOB spot basket price that prevailed in 2009, which generates a price target of $59 for Quest. The 3 year domestic basket price of $38/kg, which is 171% higher than the $14/kg domestic spot basket price in 2009, generates a price target of $24 for Quest. These numbers are not quite comparable to the Molycorp numbers because Strange Lake will not be in production before 2016, while Molycorp should be in commercial production by 2013. So we should apply a further 50% discount to these price targets under the various basket price scenarios, which still leaves far more room on the upside for Quest than to the downside from the current price. What this sensitivity chart is telling us is that the market thinks Strange Lake has zero chance of becoming a commercial rare earth mine. And that is exactly what JP Morgan's Michael Gambardella implied when he declared "most announced rare earth supply projects beyond Molycorp and Lynas will not enter the market on schedule or if ever due to financing and permitting hurdles". The fact that he did not use the word "all" suggests that the purpose of the downgrade is less to correct an error than to shaft the rest of the rare earth sector so that Molycorp will be better positioned to embark on a lucrative mergers and acquisitions program.
Quest has been silent since its last news release in May amidst a flurry of insider sales which didn't exactly make any of the insiders rich, but which did portray them as a bunch of tone-deaf amateurs oblivious to the impact their petty actions have on the confidence of a shareholder base constantly buffeted by a chorus of naysayers. Quest has started to attract research recommendations from Bay Street analysts whose understanding of the rare earth sector has become quite sophisticated, which suggests that my work is nearly done. We are at a transition stage where the bottom-fishers and spec value hunters are feeling the urge to move on to other stories with a livelier news flow, while the mergers and acquisitions players are sniffing around, doing what they can do trigger a flash crash to flush out the earlybirds at cheap prices. We are 3-4 months away from seeing a prefeasibility study that will allow us to better quantify the economic potential of Strange Lake, and whose content will reveal that Strange Lake is a very real and serious endeavour. By then we should also have a better picture of where China is taking its rare earth policy (for those to whom it is not already painfully obvious), and maybe Peter's timing will finally coincide with a new rest-of-world panic characterized by an extreme urgency to guarantee real solutions. I keep hearing that major end-users are engaging in secretive discussions with the advanced juniors, and I suspect they will act when the juniors demonstrate that they have a plausible flowsheet nailed down and a decent handle on the processing costs. I initially planned to close out the entire 2009 Bottom-Fish Edition at the end of 2010, but the dearth of good candidates for a 2011 Edition persuaded me to extent the 2009 Edition to the end of 2011. Some 2009 bottom-fish I will close out explicitly between now and the end of the year, such as I did with Peregrine Diamonds whose timeline for major developments is no longer suitable for bottom-fishers. The rest will be automatically closed out on December 30, 2011 at the closing price for the year. Quest stands to benefit from at least one more milestone, the pilot plant study by Hazen Research, and possibly the PFS before the end of the year, so I am keeping the Spec Cycle Hold 100% recommendation intact for the bottom-fishers, and reiterating that Quest remains a Good Relative Spec Value Buy at current prices. An upgrade to Good Absolute Value hinges on the outcome of the PFS and where the market has pushed the stock price when the PFS has been delivered. If these milestones do not disappoint, they will provide the foundation for a stock price at $5 and heading higher as Wall Street analysts tired of monkeying with the Mt Weld and Mountain Pass basket prices seek out large scale supply contenders for 2016 and beyond such as our dysprosium champion Quest.
In his Congressional testimony Mark Smith declared "that there may always be some rare earths that the US will need to import from other nations", and that "we expect to share some of our rare earths with other nations - particularly our allies in Japan and the EU". He then went on to declare that Molycorp "will produce all of the 10 rare earth elements - lights, medium and heavies - that have commercial applications", but as the production profile chart above for Mountain Pass demonstrates, which assumes uniform recovery of the natural REO distribution within the bastnaesite ore targeted for production, even at full capacity Mountain Pass will produce a piddling amount of heavy rare earths, europium excluded. Molycorp will be trying to unload its surplus of light rare earths on Japan and Europe, not its non-europium heavy output. I should point out that the production profile chart above is theoretical, meaning that this is the output possible based on the natural REO distribution. The actual recovery of heavy rare earths from Mountain Pass will be zero because it simply does not make economic sense to build a facility which can separate a mere 162 tonnes of heavies ranging from gadolinium through ytrrium from 40,000 tonnes of mixed oxide concentrates, especially given that the heavies are more difficult to separate than the lights. The significance of Smith's comments is that based on Molycorp's assessment of Mountain Pass and other American based deposits, of which Ucore's Bokan is the only one with heavy rare earth content undergoing meaningful development, the United States cannot achieve self-sufficiency in certain rare earths, which by deductive reasoning are the heavy rare earths. Naturally this would cause one to think that Molycorp would use its generous market valuation to make takeover bids for advanced projects outside the United States which have a significant heavy rare earth component, such as Avalon's Nechalacho or Quest's Strange Lake, but management is still actively denying the wisdom of such strategy and does its best to discourage the market from bidding up such heavy rare earth supply contenders. This is evident in its recent decision to invest in the equity of Boulder Wind Power which has developed a new type of direct drive rare earth magnet based wind turbine that does not require dysprosium. The designs for competing large direct drive wind turbine motors do require dysprosium, and the owners of these designs are not going to shelve their technologies and cede the field to Boulder Wind Power. The demand for dysprosium, assuming it can be delivered by parties which most certainly exclude Molycorp, will not disappear as Mark Smith appears to suggest.
*JK owns shares of Quest