Molycorp: A Prime Short Candidate

Molycorp, Inc (NYSE: MCP) has been on a wild ride the last 18 months. With its production set to ramp up in 2012, how is it positioned in the current market? I analyzed the company looking at both fundamentals and the market environment. Here is what I found to be in store for Molycorp:

Molycorp's share price stands near $29 which is at the bottom zone of its 52-week trading range of $23.05-$79.16 and it boasts a market cap of $2.7 billion. Its earnings per share is $0.94 for the trailing twelve months for a price to earnings ratio of 34 and a price to cash flow of 33. It is priced as a growth stock and in fact it is buoyed by blossoming earnings which have rocketed up over 190% during the last twelve months. One of the company's competitors is Freeport-McMoRan Copper and Gold (NYSE: FCX).  Freeport is the world's largest producer of molybdenum and operates much of its mining through its subsidiary, Climax.  This subsidiary has positioned itself as an innovator as it has garnered a metals processing patent portfolio including a method patent tailored toward selling the metal to steel-makers.  Both Molycorp and Freeport can coexist successfully in precious metals mining and selling because of specific needs and steady demand for metal oxides in the steel-making industry.

The market the company operates in is convulsing as conflicting forces play chicken with each other. The Rare Earth Oxide (REO) mining niche is small and the last two years have seen a series of quantum shifts. REO is used for a lot of tech applications from magnets to lasers. They are also used in a range of green energy applications, such as hybrid and electric vehicles and wind power turbines. They are incredibly important, but are only used in miniscule amounts. So despite the importance, total world production is a tiny fraction of more basic materials like copper, gold or diamonds.

Back in 2002 the market in REO was a wasteland. China was able to dominate the tiny market, producing rare earths at a much lower cost than competition. Many mines closed around the turn of the millennium and China became the dominant producer. Then in 2008-2009 two changes came to the market: China began a series of production cuts and the country's restriction of its exports sent prices higher. Additionally energy markets were repelled by $100+ oil and started looking towards green initiatives, lead by the green energy programs backed by US President Barrack Obama. With a finite supply and broadly expanding demand expected, prices in REO soared. Miners like Molycorp scrambled to reopen old mines and increase production capacity to take advantage of the new paradigm.

Molycorp's entry was the Mountain Pass mine, which used to provide a large portion of the world's rare-earth oxides until the mine closed in 2002. Molycorp's  stock soared on the plans that its production would increase supply by 40,000 metric tons - more than all of China exported. Investors had sweet dreams of Molycorp dominating a new market landscape. REO revenue and Molycorp shares were priced for higher demand and profits.

The shoe dropped in December 2011 when China announced a reversal of policy. Instead of continuing to decrease exports it announced it would increase by 3% to 31,130 metric tons for 2012. Investors panicked as REO prices plummeted and Molycorp lost 14% of its share price in a single day.

In fact, China's announcement meant little from a practical standpoint, but it made investors reassess the situation. Molycorp and its peers are going to increase worldwide REO export production by over 100%. Also the green initiatives of 2008-2009 are drying up as government budget woes make cutting green subsidies necessary. In as small a niche market as rare earths are, the market is on target to go from a shortage to a massive glut in 2012. Rare earth prices as a whole have dived 45% already and as more production capacity becomes available it can only fall farther.

This means squeezing margins at Molycorp and its peers. How bad it gets will depend on a lot of things, including what China does in channeling its export quotas through 2012 and the state of the economy in embracing those green initiatives that need rare earths. In the end, Molycorp should come out well. It has an admirable balance sheet with over $315 million cash and no long term debt. Molycorp is set up so that it can survive a price war until weaker competition falls away or the market for REO expands. However that will be a long, brutal contest and near term it does not look good for company share value.

The wildcard to this is that the events since China's increased export announcement could motivate some players to halt their plans for production expansion, thus reducing the coming market oversupply. China could also return to their previous trend of decreasing exports which could have the same effect. Any of those events would require everybody to recalculate what any such move would mean to world supply.

Such a future shock aside, near term Molycorp could fall another 50% to around $16 as the reality of a market glut filters down to the bottom line and to investors. I consider Molycorp a prime short candidate if you can get in above $28.