Index Member Comment - August 3, 2012: Molycorp punished for buying Neo Material at the top
Molycorp Inc was pummeled on August 3, 2012 after revealing on August 2, 2012 that it will need to raise additional capital to complete development of its Mountain Pass rare earth facility. This surprise comes in the wake of the $1.3 billion takeover bid for Neo Material Technologies Inc at CAD $11.30 per share on June 11, 2012, of which 71% was paid for by cash and the rest by the issue of 0.122 Molycorp shares for each Neo share. The friendly takeover was announced on March 8, 2012 with a price of $11.30 to be paid with a combination of stock and shares, with Neo shareholders allowed to specify the mix. However, by the time the deal closed so many Neo shareholders had opted for cash that Molycorp had to enforce the cash payout limitation by pro-rating the payout on the basis of $8.05 cash plus 0.122 Molycorp shares. Despite the vote of non-confidence from Neo shareholders, I believe the merger is a strategic no-brainer in the long run because it marries Molycorp's Mountain Pass rare earth supply with Neo's downstream processing and fabrication business which will allow Molycorp to evolve into a critical metals powerhouse. Meanwhile, however, Molycorp may make it onto the 2012 Bottom-Fish Edition.
Molycorp's timing does not appear to have been as good as that of its shareholders, RCF, Pegasus and Traxys, who blew out nearly $1.4 billion worth of Molycorp stock at $50-$51 during February to June of 2011 through secondary offerings managed by Morgan Stanley and JP Morgan. This was at a time when China's export quota policy had sent FOB rare earth oxide prices into the stratosphere, and its industry consolidation and environmental cleanup strategy had unexpectedly, much to the dismay of China based manufacturers, pushed up domestic rare earth prices 5-10 times their averages for the past decade. At the time Mark Smith described the secondary offering as a just reward for these big risk takers who paid $1-$1.25 for their stock in 2008-2009 when their consortium outbid other groups for ownership of Mountain Pass which Chevron inherited when it was shanghaied by Congress to stop CNOOC from acquiring Unocal's foothold in southeast Asia, a region China sees as an extension of itself. I do not have a problem with this concept of selling cheap but initially risky stock at high prices when the market wants it, but I do think these founding shareholders, who as late as March 2010 told me they were not considering going public for at least several more years and had no interest in Neo, should have loaded Molycorp's treasury first before pocketing a windfall profit on such a large scale for which Chinese rare earth policy was entirely responsible while management's contribution prior to the IPO had been to petition the US government for handouts. I have significantly diminished respect for RCF as a result, one that will worsen if Molycorp ends up foundering, though I know that in certain other camps RCF is now viewed in high esteem.
The Q2 2012 financial report includes less than a month of Neo income, so these financials bordered on useless, but Mark Smith did warn that the deteriorating market for rare earth based products, linked to the global economic slowdown, would negatively impact cash flow during the rest of the year. It has been no secret that Molycorp bought out Neo at the top of the latter's business cycle, but the market's harsh reaction reflects Molycorp's indirect admission that it had counted on Neo's cash flow to provide the capital it needs to complete the Project Phoenix expansion to 40,000 tonnes of annual rare earth output. Project Phoenix was claimed to be fully funded last year, but it appears that Molycorp raided the cash earmarked for Project Phoenix in order to make up the cash portion of the Neo buyout not covered by the $650 million secured note sold in May 2012. The next shoe to drop will be news in early 2013 about how joyously Beijing embraced the arrival of Molycorp as the new owner of a major downstream fabricator of rare earth based products which, until Mountain Pass comes on stream, has been entirely reliant on the benevolence of Beijing. In my view, however, this has always been the price of repatriating Neo Materials, which transferred American technology to China during the late nineties, but did build a significant company whose subsequently developed brain trust can now seep back into America.
Some of the market backlash has to be a vindictive reaction to the rare earth pricing assumptions used by research analysts to facilitate the blow-off by Molycorp insiders last year. At Kaiser Research Online we treated FOB prices as a joke, marveling at the outlandish NPV per share prices generated when we plugged them into the discounted cash flow models for major rare earth projects, and focused our attention on what would become the new long term reality for domestic rare earth prices once the supply squeeze subsided. We knew they would be lower than the peaks during July-August 2011, and figured the new reality would be 2-4 times the historical averages just as had happened to base metals such as copper, nickel and molybdenum. The composite chart above shows that for both the FOB and domestic prices their three year averages are now near the spot price, with a crossover taking place over the next year just as it did for copper and nickel. Price trackers such as Metal-Pages continue to report soft demand as end-users resist restocking in the face of a global economic slowdown led by Europe, and play a waiting game to see how low producers will allow their offers to drop. However, unless the Chinese enforcement of environmental standards and the consolidation of producers and processors into a much smaller group are pure media fabrications, we are very likely at a bottom for domestic rare earth prices. And if this bottom is not already in place, I suspect that Chinese strategic stockpiling plans will soon enough build a floor at current levels.
In the chart above I show how much the FOB and domestic prices for individual rare earth oxides are above the prices that prevailed at the end of 2009, which was before China slashed its export quota in mid 2010. Domestic prices now range from a 164% gain in the case of lanthanum to 550% for dysprosium, the heavy rare earth whose future supply is a problem for China itself. For FOB spot prices the gain ranges from 242% for lanthanum to 1,400% for samarium and gadolinium, rare earths with relatively small overall supply but which are critical to the high performance samarium-cobalt magnets Great Western's UK subsidiary Less Common Metals fabricates for defence contractors to whom they can pass through the input price. The average FOB gain for spot prices from December 29, 2009 is 643% compared to 290% for domestic prices. This average is not weighted because I do not have reliable estimates of China's output by individual rare earths. I suggest ignoring the FOB spot price and focus on the domestic spot prices, whose average is not distorted by a couple of the less important rare earths.
The chart above shows that except in the cases of yttrium, samarium and gadolinium the premium of FOB prices over domestic is generally less than 100%; a 25% premium reflecting export duties would imply parity between FOB and domestic spot. As Mountain Pass and Mt Weld come on stream over the next couple years we can expect the FOB premium to disappear. Anybody who uses FOB prices in the analyses instead of domestic prices is a charlatan. What is interesting is the chart below which shows that except for cerium, europium and erbium the domestic spot prices are now very close to the 2016 price deck Toyota recommended Matamec use for its Kipawa PEA. I have argued that the dynamics of rare earth supply and demand is very complex because the rare earth supply comes as a batch whose makeup depends on the deposit type, while the demand applies to individual rare earths based on their unique properties and the applications that require them. With policy and innovation serving as application derived demand drivers, it is impossible to predict future rare earth prices with any degree of confidence. I suspect what Toyota has done with its 2016 price deck is signal the price levels its downstream applications can live with. As far as domestic rare earth spot prices are concerned, I believe they have in most cases bottomed. So the question now becomes, whose non-Chinese rare earth project is feasible at current domestic spot prices?
It is reasonable to expect that the slump in Molycorp's stock price will hurt the valuations of rare earth juniors with less advanced projects, but that would be to ignore the fact that Molycorp's current problems are of its own making. Management has been dismissive of other rare earth projects, but is now facing a cash crunch in a difficult market just as it heads into the critical commissioning stage of its new Mountain Pass facility. At 99.7 million shares issued Molycorp's stock price of $11.49 implies a value of $1.14 billion for Mountain Pass compared to $97 million for Tasman's Norra Karr heavy rare earth project in Sweden and $86 million for Quest's Strange Lake heavy rare earth project in Quebec. The company most likely to be hurt by Molycorp's slump is Great Western Minerals Group whose Steenkampskraal project in South Africa still commands a lofty $276 million implied value and whose Less Common Metals rare earth alloy fabrication business is going to suffer the same revenue and margin pressures as Neo Material's business. Great Western does not plan to produce anything bigger or better, or for that matter, remotely close to what Molycorp hopes to produce during the next year, so it is a sitting duck for collateral market damage. The same goes for most of the light rare earth dominated juniors, but large full spectrum deposits in secure jurisdictions (definitely not countries whose names end with "stan") need not suffer any market fallout from Molycorp's temporary consignment to the penalty box. Molycorp is for now a chump because its key backers chose to line their pockets with short term gain instead of thinking clearly about the nature of the 2011 market boom and taking steps to maximize the long term interests of Molycorp shareholders.
Quest and Tasman, currently the only rare earth juniors for which Kaiser Research Online has open Spec Value Hunter recommendations, a Buy in the case of Tasman and a Hold in the case of Quest, have something that Molycorp does not have, and which China will eventually want, namely a significant portion of heavy rare earths. Molycorp has conceded that its exploration efforts on a heavy rare earth target at Mountain Pass have been abandoned due to low grades, but claims it is looking at other prospects elsewhere in the world. The company no longer spouts misleading statements that every deposit, including Mountain Pass, has heavy rare earths, a statement that is trivially true but not so in economic terms, especially at Mountain Pass. Nevertheless, it will take at least a year before Molycorp will have the gumption to clean out projects such as Strange Lake and Norra Karr which so obviously fit into its future, assuming it has one.
I have run my discounted cash flow models at the current rare earth basket prices to see what happens to the 10% discount rate based NPV per share targets. At the domestic spot basket prices, which are now slightly higher than the three year domestic average, the mining scenarios outlined by the Quest and Tasman PEA's suggest targets of $33 and $20 per share respectively (targets in the sense of what the project would be worth on a debt financed post feasibility study basis). Their current stock prices of $1.25 and $1.50 are so low that the market is in effect saying these projects will never be developed. Both projects are now at the prefeasibility stage where everything takes longer, costs more, and generates outcomes less robust than presented by the PEA. Despite these negative circumstances, both projects are moving forward. Now that Toyota has effectively absorbed Matamec's Kipawa project, Strange Lake and Norra Karr are the only serious contenders left with the potential to serve as a meaningful primary source of heavy rare earth supply outside of China and to China once it depletes its ion adsorption clay deposits. Avalon has made important progress in buying out pesky royalties and and coaxing First Nations groups onside, but the jury is out on Nechalacho until Avalon completes pilot plant studies with positive results. Although Quest and Tasman have no fundamental reasons to trade lower, that does not mean their share prices cannot drift lower while the economic outlook remains glum. What makes me reluctant to turn Quest and Tasman into market cycle sells that can be bought back cheaper later in the year is that both are proxies for a strategic geopolitical discourse that could turn red hot with very few alternative proxies at any instant. Both have AMEX listings and both are poised for rapid turnarounds which could happen while Molycorp and Lynas, the leading potential suppliers, remain stalled in the market. Molycorp and Lynas have something the rest of the world needs and which China has decided to dole out acording to internalo agenda; Quest and Tasman have that plus something China itself needs.
What could be the trigger for a revival of interest in the rare earth sector? An interesting recent development is the bankruptcy filing in a Dutch court (F.12/210) of Netherlands based Atlas Magnetics Holding Bv, owner of Altas Magnetics, a fabricator of customized rare earth magnets for end-users around the world which sources its rare earth inputs in China. The media has not noticed this yet, but no doubt it will cause serious problems for end-users who relied on Atlas for components critical to complicated technologies assembled in facilities outside of China. Atlas has a subsidiary based in China which presumably procures its raw materials from local suppliers and processes them into an exportable form. China's rare earth policies have been interpreted as self-serving in a manner that is hard to quarrel with; it is curtailing supply by refusing to be the cost dumping ground for the rest of the world's cheap rare earth supply, and protecting its domestic end-users by allowing export quotas to create a two-tier pricing system that punishes foreign based users of rare earth inputs. The obvious option is for western end-users to move their operations to China and expose their intellectual property to Chinese thievery, though if a recent Bloomberg article (July 26, 2012) is to be believed, nobody's IP is safe from Chinese hackers regardless where based. Pragmatic end-users have been considering capitulation to the obvious solution to their problem, though Japan's Trade Ministry recently warned its magnet makers not to relocate operations to China. But what if evidence emerged that the pressure to relocate to China is not a coincidental by-product of China's legitimate rare earth policies, but instead has taken a deliberate, calculating form that represents economic warfare? This is the story Ucore trumpets everytime its shareholders pester Jim Mckenzie for a Bokan progress report, a story nobody takes seriously. Standard thinking is that Atlas Magnetics simply mismanaged its affairs and is paying the bankruptcy price. But I have heard rumblings that there may be much more to this bankruptcy than meets the eye, which, if true, turns Atlas Magnetics into a smoking gun with which the broader media will be able to run a long way, especially if Chinese squabbles with its neighbors over sea territory spin out of control as the US military continues its grand pivot to Asia. The time is ripening for major heavy rare earth plays such as Tasman and Quest, and possibly Avalon, to diverge from the market trend defined by Lynas and Molycorp, both of whose trends are bogged down by company specific issues, and neither of which has a solution to the bigger problem of assured full spectrum rare earth supply. At current prices Quest continues to be a Fair Relative Spec Value Hold and Tasman a Good Relative Spec Value Buy, though to get an uptrend while they labor on prefeasibility study work, we will need to see a turnaround in the global economic outlook, or an escalation of the strategic narrative for which I think Atlas Magnetics will prove to be the thin edge of the wedge.
*JK owns shares of Quest and Tasman