Molycorp: Digging its Way Out of the Ground
Molycorp’s share price has fallen more than 32% in the last one year alone; however, higher revenues and depleting customer inventories point towards a turnaround for US’s largest rare earth producer
Molycorp, Inc. (MCP) is one of world’s largest rare earth and rare metal producers. The Colorado-based company, which was founded in 2008, has production facilities in North America, Europe, and Asia, and one rare earth resource in Mountain Pass, California. Deriving almost 17% of its revenues from its Resources segment, the company reported revenues of $28.9 million in fiscal year 2012 (FY12), which ended December 31, 2012.
The company expects production from its Mountain Pass mine to reach full capacity (19,050 metric tons) this year, which puts it at a distinct advantage against greenfield projects that are expected to take at least five to 10 years to be fully developed.
Despite the said developments in production, Molycorp's stock shed 32% of its value during the last twelve months. This was primarily due to falling average selling prices (ASPs), an early decision from the company to delay production from its Mountain Pass mine in California, stringent development timelines, and lower revenue guidance for 2013. The stock underperformed the S&P 500 (SPX) by more than 16% during the same time frame.
Molycorp’s share price rose by more than 520% form the last quarter of 2010 to May 2011, as REE ASPs increased sharply. But after the bubble burst in the second half of 2011, the share price declined by almost 94%, and Molycorp stock hit a low of $4.53 in December last year.
Revenues for the company, on the other hand, registered an increase of 7% year-over-year (YoY) in the last twelve months due to acquisitions, and higher volume sales in all of the company’s segments except the Resources segment.
The increase in revenues, coupled with an expected increase in demand from Molycorp’s customers as their inventories fall, signals a turnaround for the company.
Molycorp reports its revenues in four business segments, namely: Resources, Chemicals and Oxides, Magnetic Materials and Alloys, and Rare Metals. The Chemicals and Oxides division contributes the most towards the company’s revenues (37% as of FY12), followed by Magnetic Materials, which contributed 32% in the same year.
The Resources segment generates almost half of its revenues from the sales of Lanthanum, Neodymium, and Praseodymium products. The segment is highly dependent on a few companies for its sales; in FY12 the segment earned 81% of its revenues from just five companies, with Hitachi Metals LTD S (HMLTY) being its largest customer.
Average selling prices (ASPs) declined in the segment, mainly due to changes in the product mix over the years.
Chemicals and Oxides
This segment’s operations include selling rare earth oxides, zirconium-based engineered materials, and mixed rare earth oxides. The main product of the division is Cerium, whose sales comprised 15% of the business unit’s revenues in FY12.
Operations are mostly conducted under the segment’s subsidiary, Molycorp Canada, which was acquired on June 11, 2012. Molycorp also conducts operations out of Sillamäe, Estonia, through a subsidiary called Molycorp Silmet, which was acquired in 2011. The segment also has facilities in a number of provinces in China.
The Chemicals and Oxides division is also dependent on a few customers to generate most of its sales; the segment’s top five buyers accounted for approximately 41% of the segment’s revenues in FY12.
Magnetic Materials and Alloys
Magnetic Materials and Alloys saw its sales increase 215% YoY in FY12, which made the segment one of the fastest growing businesses of the company.
The segment is primarily involved in producing magnet powders of neodymium-iron-boron (NdFeB), whose alloys’ sales made up 11% of the segment’s revenues in FY12. Revenues from selling magnet powders, or Neo Powders™, made up 25% of the segment’s total sales.
Falling ASPs are also a major concern in the Magnetic Materials and Alloys segment, as the price of neodymium, the main driver of Neo Powders™, fell approximately 26% in the second half of 2012. However, the segment’s demand is expected to register an increase moving forward due to strong growth seen in the product’s end markets.
The company’s acquisitions of Molycorp Canada and Molycorp Silmet led to the creation of the Rare Metals segment. The business unit’s ASPs, which were driven by scarce supply of heavy earth metals, increased more than 21% in FY12.
Rare metal products are also helping the company hedge itself against the shift towards using LEDs instead of LCDs, which use a large quantity of rare earths in its production. The segment’s end markets are showing strong growth, which will help the segment’s sales increase this year, and in 2015.
Supply and Demand
Molycorp’s customers were destocking, which led to a drop in fresh demand, and consequently a fall in ASPs. Destocking, along with the shift to LED applications, resulted in weaker demand in the phosphor market this year. However, we anticipate that moving forward the restocking of inventory levels by the company’s customers will help boost demand for Molycorp’s products.
In addition, The Inner Mongolia Baotou Steel Rare Earth Group, China’s largest producer of rare earth elements (REEs), has recently acquired nine regional mining companies. The acquisitions are in line with a Chinese government master plan to consolidate the sector and support it.
China’s plan was executed after rare earth prices started declining in 2012, following which the country’s government and rare earth producers decided to control supply and production to maintain their pricing power. It was decided that Beijing would encourage exports of high-value downstream products and limit the export of raw materials.
Export quotas and export duties imposed in 2010 led to an increase in prices but then the bubble burst and REE ASPs began falling. However, a state-sanctioned crackdown on illegal mines in the country, along with the consolidation in the Chinese rare earth industry, is expected to result in a rebound in REE prices in the future.
Rare Earth End Markets
Shifts in the Industry
REEs are crucial raw materials used in the production of many products we use today. They have broad applications across a number of industries, and rare earth products are considered important components of the global industry. REEs are used in clean energy technologies, high-technology applications, critical defense applications, and advanced water treatment. These industries have huge growth potential, which will help boost the demand for REEs.
China accounts for more than 95% of the rare earth minerals supplied globally each year, according to the US Geological Survey (USGS), and holds an estimated one-third of global REE reserves. The country’s dominance as a global rare earth producer grew in the 90s when it increased production of rare earth elements from 16,000 metric tons at the start of the decade, to 73,000 metric tons by the time it ended. During the same period, rare earth production in all other countries declined from 44,000 metric tons to 16,000 metric tons. Taken together, global output increased more than 50% to 89,000 metric tons during the period.
The US had been a major player in rare earth production before China increased mining of mineral deposits in the country. The erosion of the US’s market share and a gradual fall in output coincided with China’s rise.
As more applications for rare earths were found across many different industries, production continued picking pace and increased to 132,000 metric tons by 2009, of which 129,000 metric tons was supplied by China alone.
To control its heavy production of rare earth elements and halt the resultant fall in prices it had caused, China imposed production quotas and increased export duties on rare earth exports in 2010. The moves resulted in a sharp rise in the prices of rare earths.
But even though rare earth oxide prices rallied through 2010 and the first half of 2011 following China’s export control measures, they fell sharply in 2012, indicating that the REE bubble had burst.
The Resources segment used to be biggest revenue generator for Molycorp up until FY11; however falling ASPs of rare earth resources led to a big loss in revenues generated from the segment.
Apart from the fall in revenues in the Resources Segment, we also notice a shift in the demand of products. Back in 2010, catalysts used to drive the majority of demand for rare earth elements in the US (generating almost 60% to the segment’s demand), but all this is due to change. The Industrial Minerals Company of Australia (IMCOA) estimates that by next year, magnet powders would witness the largest increase in demand in the US, which is expected to increase from 3.3% of total demand to 13% by the end of FY15.
The IMCOA estimates the demand for rare earth oxide products will increase at a compound annual growth rate (CAGR) of 9% to 162,500 metric tons by 2016. The Chinese Secretary General of the Rare Earth Industry Association, Wang Caifeng, has more optimistic estimates for global rare earth demand though; he thinks global rare earth demand will rise to 210,000 metric tons by next year.
The IMCOA estimates that demand will further increase at a CAGR of 8.75% from 2013-2020 to 225,000 metric tons by 2020. The IMCOA estimates Chinese consumption to be the main driver for REE demand (the firm believes that 65% of the estimated supply of 180,000 tons will come from China by 2016), expecting it to increase from 70,000 metric tons in 2011 to 105,000 metric tons by 2016.
According to the US Geological Survey (USGS), demand for rare earth elements is also expected to rise in the US, driven by the increased production of magnetic materials that are used across industries. Annual demand for rare earth elements used to make magnets is estimated to rise 10-16% each year in the next few years, while REEs used as catalysts in various industrial processes will also witness an annual increase of 6-8% in demand for the next couple of years.
The shift in demand can be seen from the increase in demand from China and Europe. China is poised to be the biggest market for rare earths, as smartphones are increasingly produced in China. A rise in the demand for smartphones for the past few years has been a major driver of REE consumption. Although the usage of rare earths in smartphones has almost halved from what it initially was, the increased shipment of smartphone devices has offset its impact on REE demand. According to Barclays, smartphone shipments are expected to increase 30% year-over-year (YoY) this year, 17% in 2015, and 10% in 2016. This indicates that the demand for REEs will continue to remain strong for the next three years.
Furthermore, China has overtaken the US as the biggest smartphone market in the world. Demand for smartphones in China still has a lot of room to expand; the smartphone penetration rate in China was only around 25% in 2012, but is expected to rise to 79% by 2015. Smartphone sales have hit their highest in the country, and currently account for every nine out of 10 devices sold. Given that trend, and considering that Chinese smartphone manufacturers like Xiaomi Inc. are introducing their own high-end devices to compete with companies like Apple (AAPL) and Samsung (SSNLF), expect China to divert production to local companies to give them a pricing edge over their international counterparts.
Molycorp’s global exposure has become more diverse. Acquisitions in China and growth in the smartphone industry have led to the region contributing 22% of total revenues, and we expect the company will report that the country’s revenue share increased in FY13.
Investing in Molycorp
Molycorp’s revenues have increased more than 33% YoY in FY12, higher than the industry’s average revenue growth of approximately 14% for the same time frame. The company’s revenues have risen by 7.7% during the last twelve months. Though Molycorp currently has negative gross margins, they are expected to become positive this year as the company’s new Mountain Pass cracking facility helps lower production costs.
Molycorp has a net debt-to-equity ratio of 90.5% and a total debt-to-equity ratio of 41%; none of the company’s debts are due to mature until 2016, by which time the company would be generating significant cash from operations. The company has to pay debts worth $230 million in 2016, and payments will continue till 2018. Its largest debt payment, worth $650 million, is not due to mature until 2020.
Though the company has negative cash flows from operations (CFO) of $140 million in the last 12 months due to extensive capital expenditure, we believe that CFOs will become positive by 2015 as the company enhances production capacity this year, which is expected to reach 19,050 metric tons.
Molycorp stock is currently trading near its 52-week lows of $4.53 per share, and we believe it is a good stock to go long on at these price levels. Shares are currently trading at a one-year forward EV/EBITDA* multiple of 21.5x, at a premium of 164% to the industry’s average multiple. The return on assets (ROE) and return on capital (ROC) ratios are -21.2% and -44.3% respectively, and both are significantly lower than the industry’s average ROE and ROC ratios. The company’s bottom line is expected to become greener moving forward. There are projections that the company’s price-to-earnings multiple will drop from 110x for 2015 to 13x for 2016.
* (Enterprise value / earnings before interest, taxes, depreciation and amortization)
We recommend Molycorp as a pure play on future REE prices, and recommend investors add it to their portfolio for solid capital gains.