Editor's Note: Here at StreetAuthority, we've been talking about the best way to profit from critical elements that are in short supply while demand is exploding. Gold, commodities, energy, rare earth elements -- these scarce assets are some of the best investments on the planet. With this in mind, we decided to offer two opposing takes on Molycorp, a high-profile rare-earth miner. After you read both takes, tell us what you think (firstname.lastname@example.org). Is Molycorp worth a place on your radar?
The Case For Molycorp
By: Joseph Hogue
When it comes to fundamentals, I will be the first to admit that Molycorp (NYSE: MCP) is not what I usually look for in a stock. Earnings for this once-thriving miner have been negative for the last two quarters and management guidance for production puts 2012 fourth-quarter sales as low as $145 million, 30% below sales of $206 million in the previous quarter.
But investors only looking for "Forever Stocks" with great balance sheets and cash flows may also miss out on huge investment opportunities to make double- or triple-digit returns in less than a year.
And Molycorp could be one of these opportunities...
The market for rare earth elements
China supplies more than 90% of the world's rare earth elements, largely because the most populous country in the world has had an aggressive mining program since the 1990s -- at the expense of the environment.
[See also: "As Shortage Grows, These Rare Metals Grow in Value"]
Prices of rare earth elements soared in 2010 when the country cut its export quota of metals to 40% of production, bringing many new companies to market. It was during that time that Molycorp started trading as a public company.
When China resumed higher exports, prices of rare earth elements came down significantly. As a result, miners worldwide took a hit, with many stocks underperforming the market since. Molycorp, for example, is down an astonishing 73% during the past year, underperforming the Market Vectors Rare Earth Strategic Metals ETF (NYSE: REMX), an exchange-traded fund that tracks the rare earth metals market, with a slide of 31% during the same period.
But things could change soon...
China recently started imposing stricter environmental controls on the industry. First to confront a growing pollution problem in the country, which caused the near shutdown of Beijing in January, but also to be used as a geopolitical bargaining chip for the country, as China would be able to cut off the industry and the supply of needed resources when it doesn't get its way.
[See also: "Is China on the Verge of a Comeback?"]
In addition, despite current weakness in prices and high extraction costs, demand for these elements is only going to increase as more new products, including smartphones, tablets, electric vehicle motors, military drones, wind turbines and solar panels, need them in order to function. Increasing demand and the possibility of political turmoil are good news for miners like Molycorp.
Already priced for the worst
In January, management released a plan to offer $200 million in stock and $100 million in convertible debt, both of which diluted shareholder value. The company has already warned of a $250 million cash shortfall due to cost overruns at the Mountain Pass complex in California, where Molycorp plans to spend up to $1.4 billion to increase output to 40,000 tons of rare earth oxide equivalent per year.
And while those bad news were not unexpected, shares still plunged 22.7%. The good news is, it's likely only to get better from here. And this is why now is the worst time for investors to get out.
First, because the stock and debt offering will shore up the company's balance sheet and provide financing for at least this year, giving the miner the rest of the year to finish development, increase production and watch for higher prices.
Second, because shares are becoming scarcer as short sellers focus on them and institutional ownership is increasing at a fast pace. Short sellers have accumulated 33.5 million shares, about 24.3% of the total shares outstanding. It has been a winning bet so far, but one that could change very quickly. After all, institutions and company insiders have a different idea about the stock.
Molymet, a Chilean holding company and second-largest owner of Molycorp, bought 15 million shares for $90 million on Jan. 30, doubling its holding to 18.3% of the company. Molymet is engaged in the treatment and processing of molybdenum, a common steel additive, so the stake increase in Molycorp is more likely a way to lock in resources from a supplier.
On that same day, Molycorp CEO Constantine Karayannopoulos doubled his holdings with a purchase of 16,667 shares for about $100,000. In fact, in the past year, insiders have bought more than 2.7 million shares, with nobody selling.
The takeover chatter has been hot since these two deals, causing the shares to almost double from $6.06 in November 2012 to $11.56 this year, before coming down after the news of capital needs. While a buyout would face tough oversight by regulators as a strategic national resource, there is a good chance for further strategic investments like the one from Molymet.
Total insider and institutional ownership is at 73.6%, according to Thomson Reuters. Much of this is related to strategic and long-term investments, so the stock will not likely be sold any time soon. This leaves barely enough shares, 36.4 million, available to cover the 33.5 million short-sellers have borrowed.
Daily trading volume has spiked more than 20 million shares 10 times during the past six months. With funding needs met for the rest of the year and the stock already priced for the worst-case scenario, any positive development could send the shares skyward as short-sellers get squeezed.
Risks to Consider: Cost overruns and lower revenue, along with headline risks from the SEC investigation into the company's reporting, could weigh on the shares. Investors should only risk a small amount of their overall portfolio for this highly-speculative position.
Action to Take --> The shares are priced for the worst at just 0.66 times book value, even though funding needs for the year have been met. Any good news, or even a stabilization in the sector and subsequently the stock price, could force short-sellers into the market to buy shares that may not be available without a surge in share-count.
Investors willing to stomach some risk should definitely consider buying this stock.
The Case Against Molycorp
By: James Brumley
Two years ago was the perfect time for Molycorp (NYSE: MCP) to get back in the business of mining for rare earth metals, after a hiatus of eight years. The price of rare earth elements was skyrocketing and China had announced plans to cut its export of these metals, which are used in everything from disk drives and hybrid cars to LCD screens.
Investors agreed with the decision, too, and backed it up with dollars. Shares rallied from their July 2010 IPO price of $14 per share to highs of $79 by May of 2011, hand in hand with what ended up being more than a 200% price hike for rare earth elements.
As is too often the case, however, the market made a long-term assumption based on what was only a short-term situation. Prices for rare earth elements didn't remain at the high levels that drew Molycorp back into the business in the first place. And with prices of rare earth minerals back to pre-bubble levels, Molycorp appeared to be right back in the same situation that had driven it out of business before.
It leaves an investor wondering whether there's actually a fruitful future here... And I think there is.
That was then
The year 2010 was something of a perfect storm for miners of rare earth elements. Electric vehicles -- which require rare earth metals like lanthanum and neodymium to power them -- such as the Chevrolet Volt and Tesla (Nasdaq: TSLA) Roadster had become a reality. Wind energy turbines, which also need rare earth magnets to create power, were popping up in more places then ever. And, though LCD screens were already common, the advent of tablets and smartphones with interactive touchscreens further drove demand for rare-earth minerals.
As proof of that swelling demand, neodymium, which happened to be Molycorp's chief product, and its end-product neodymium oxide saw a five-fold surge in prices during that time. Specifically, neodymium oxide soared from $15 a pound in July of 2010 to $114 a pound by mid-2011, supporting the case for Molycorp to reopen its primary mine in 2010.
When it was all said and done, Molycorp sold $396 million worth of rare earth elements in 2011, at an average of about $35 a pound, and turning a per-share profit of $1.26. In that light, the $500 million from the 2010 IPO in addition to $1 billion worth of private-equity funding was a brilliant investment.
It wasn't to last, though.
This is now
Since then, neodymium -- which is a popular additive in glasses for its fluorescent effects -- has fallen back from its peak price of nearly $227 a pound to less than $45 a pound. Neodymium oxide is now trading at $41 a pound , more than 60% below its peak price. As it turned out, speculation drove the price runup more than actual consumption.
This weak demand has taken a toll on Molycorp's numbers, too. Though revenue for the past four quarters has grown to $527 million versus $286 million for the four quarters before that, operating profit has fallen to only 51 cents per share compared to an operating profit of $1.10 per share during the preceding four-quarter period. That's a 53% decline in earnings on an 84% increase in revenue, reflecting the underlying plunge from neodymium prices and all rare earth element prices for that matter.
The company's average selling price for rare earth minerals has fallen from $35 a pound to about $20 a pound. Moreover, with older sales contracts expiring and new ones replacing them at lower prices, income is projected to keep falling into the red at least for the next couple of quarters.
And that may be the least of the company's woes.
Underestimated costs/overestimated demand
The rise and fall of Molycorp's results is a microcosm of the rise and fall of the entire rare earth industry. Although prices reached levels in 2011 that convinced Molycorp and several other miners to get into the business, that steep price ascension was a bubble that won't likely re-inflate again -- at least not to the extent we saw two years ago.
There are a few reasons why. One of them is the fact that the higher rare earth prices go, the more willing (and able) its users are to find alternatives. Take Toyota (NYSE: TM) as an example. In 2011, when neodymium prices were through the roof, the company announced it had begun work on a hybrid engine that doesn't require any rare earth elements to function.
An alternative may be the least of Molycorp's stumbling blocks, however.
Though the intent for most of the $500 million the company raised in its 2010 IPO was to restart mining operations at its Mountain Pass mine in California, Molycorp recently announced it needs another $1.25 billion to ramp up that mine's productivity to originally-planned levels. The cost of reopening the mine has exceeded initial estimates, yet one has to wonder whether that extra $1.25 billion would be enough to crank the mine's output up to the initial target of 19,050 metric tons of rare earth elements per year. After all, the company was wrong the first time around.
And therein lies the bigger-picture. As prices of rare earth elements move higher, the more demand falls. As prices move lower, the less profitable they become for miners, up to and including operational losses.
That's where Molycorp found itself a couple of quarters ago. But after two years of being back in the business, it's starting to look like there is no happy medium between "sustainable" and "profitable" for Molycorp.
Risks to consider: None of this is to say Molycorp's shares can't or won't move higher at any point in the future. Sentiment, buzz and a herd mentality can drive stocks upward for a flimsy reason, or even a non-existing reason. It's just that the current math implies there's nothing to sustain strong prices from this stock.
Action to take --> Simply put, long-term investors should steer clear of Molycorp, at least until prices of rare earth elements stabilize and Molycorp can prove it can mine in a cost-effective manner. After two years of inconsistency on both fronts, however, that could be a long wait.