Tuesday, December 28, 2010

Rare Earth, Rich Price

In the “Rarest of Them All” post on October 22, 2010, we introduced several rare earth mining companies. In recent weeks the financial press has seized the rare earth topic as if there were no other economic or financial issue of any importance. Along with some well-timed, accurately aimed rumors, the publicity has helped drive the stock prices of all of the companies we mentioned.

The October posted noted our expectation that U.S. producers would eventually benefit from the renewed emphasis on U.S. domestic production or rare earth minerals. The likely winners we named were MolyCorp, Inc. (MCP: NYSE) and Rare Element Resources, Inc. (REE: NYSE). Both are in the Materials Group of The Mothers of Invention Index.

MCP closed at $31.69 on the day of our first pos and has appreciated by 56.0% since then. The only way to justify such meteoric price appreciation is either the correction of gross undervaluation in the first place or some sort of unexpected fundamental breakthrough.

As a developmental stage company with not a penny of profits to claim, it is difficult to hold our MCP as undervalued. Molycorp is estimated to produce approximately 1,700 metric tons per year in rare earth minerals, but the company reported a net loss of $50.3 million on $15.4 million in sales in the twelve months ending September 2010. Of course, Molycorp is investing heavily in expanding production. Nonetheless, during the road show for its July 2010 IPO the Company has been cautious in describing its timetable for bringing ore up from its Mountain Pass Mine in California. First production is still not expected until 2012. MolyCorp is making progress and appears to be on schedule, but nothing exceptional has developed in the past two months to justify the big move in its stock price.

In its S-1 filing with the SEC earlier this year Molycorp claimed that with its modernization and expansion plan the company would have the ability to produce 19,050 metric tons of rare earth metals per year. Given the run up in rare earth minerals prices, that level of production could drive revenue to dramatically higher levels. For example, neodymium prices have risen to levels near $170 per gram in recent weeks compared to $55 per gram in the first quarter 2010. Neodymium is used in magnets that are important in computer hard-disk drives, hybrid-electric vehicles and guided missiles, among other products you actually use every day. Just for perspective, your cell phone includes approximately 2/10th of a gram of neodymium.

Before you plug $170 into your calculator, consider that market prices are likely to decline as new production comes available. It is also important to note that one ton of ore yields a combination of the fifteen of the rare earth elements through processes involving some potent acids and heavy water applications. More complicated processes yield two more of the metals. Has anyone mentioned that rare earth ores are commonly radioactive? It is a complex, high-cost business.

According to Thomson-Reuters, the consensus estimate for Molycorp is a loss of $0.30 per share on $53.6 million in sales. There appears to be quite a divergence in opinion on the year as the revenue estimate range from $30.0 million to $85.0 million and the loss estimates range from a loss of $0.47 per share to a loss of $0.18 per share. We do not expect a profit in 2012 either, but if the company is able to ramp production, the year 2013 may be Molycorp’s time to shine.

Molycorp’s CEO David Smith has cited an estimated world demand of 205,000 metric tons by 2015, including China’s domestic demand. This seems like a plausible figure given that recent demand was estimated by the Congressional Research Service (CRS) at approximately 134,000 tons per year. The CRS estimates 2012 demand could reach 180,000 tons. World production is estimated at approximately 124,000 ton per year, leaving a shortfall of about 10,000 tons. China has set an export quote of 35,000 tons per year through 2015, suggesting that PRC planners are not operating off Smith’s or the CRS figures for that matter.

The exact numbers may not matter from the perspective of whether Molycorp is able to reach profitability. Aggregate demand and consumption trends appear sufficient to support Molycorp’s incremental production. The real question is whether investors can get a return on MCP at the current price level.

To answer that question we went through a back of the envelope valuation. A $49.44 stock at a multiple of 30 times earnings (current metals mining industry price/earnings multiple of 23.0 plus a 7.0 premium), implies a 2013 EPS figure of $3.60 (assuming a discount rate equal to the earnings multiple). To derive the required 2013 revenue to produce such earnings, we will apply the mining industry average net profit margin of 5.5%. The exercise results an estimate of $5.3 billion in revenue in 2013, or at full production of 19,050 tons per year, approximately $282,800 per ton in revenue. What does you common sense tell you?

In this post we also want to mention a few more companies involved in the rare earth element market. Quantum Rate Earth Developments Corp. (QRE: TSX). is exploring deposits in southeastern Nebraska. Lynas Corporation (LYC: AUS) in Australia is developing the Mount Weld deposit in Western Australia, which is among the richest rare earth deposits in the world. Lynas is also involved in rare earth metals processing at tis Lynas Advanced Materials Plant in Pahang, Malaysia. Avalon Rare Metals, Inc. (AVL: TSX) is a Canadian mineral exploration and development company with a project in Nechalacho deposit in the Northwest Territories of Canada. All three have been added to the Rare Earth Group of our Mothers of Invention Index.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.


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