Is Molycorp a Falling Knife?

Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There is an old adage amongst traders that states “don’t try to catch a falling knife.” In case it is not abundantly obvious, knives fall blade first, meaning that unless you just happen to get lucky, the attempt will probably result in you getting cut. Of course, Warren Buffett is on record as saying that the best time to buy is when there is blood in the street – after the carnage has been done, the greatest opportunities emerge. Aside from the philosophical interest that considering the interplay between these two proverbial pieces of advice present, in the case of Molycorp (NYSE: MCP), you must decide if the company is a falling knife or a gem that lies bloody in the streets, waiting to present opportunity to whoever picks it up.

Recent Developments

There are two primary news items to consider when evaluating this stock: the recent earnings release and the fact that the company is currently the subject of an SEC investigation regarding the accuracy of its regulatory filings. News of the investigation surfaced on Friday – it was buried in the company’s earnings release – and took the stock down from up nearly 7% on the day to a close nearly 14% off the previous day’s close. The fact that the investigation was initiated in August and had not been disclosed by the company severely compounded the negative impact of the investigation’s very existence.

As long as we are talking adages, two that might be added to the list are: “run when a company is under investigation by regulators,” and “run when the company demonstrates that it is no longer your best source of information about its inner workings.” While it may be too soon to conclusively convict Molycorp, the fact that it did not make investors sharply aware of the investigation does not cast the management team in a very favorable light.

SEC investigations are cases in which the best defense is to control the story and do damage control early. If there is no story, meaning the company has a good faith belief that the investigation will not reveal any willful wrong-doing, getting ahead of the news is always a good idea. Furthermore, and not to be glib or minimize the importance of the work done by our dedicated regulators, the SEC is still rebuilding its credibility after missing Madoff, Bear Stearns and Lehman.

On the positive end of the spectrum, Molycorp announced that even though it missed analyst expectations and saw net income turn negative on the quarter, revenue surged by nearly 50%. Additionally, the company says it is 80% complete with Phase 1 of the Mountain Pass expansion project and expects to be running at a production rate north of 19,000 metric tons by year end. The earnings problems stem from the continuing deterioration of the supply and demand relationship; supply is increasing faster than demand causing prices for the company’s production to fall.

The Industry

Along with competitors like Avalon Rare Metals (NYSEMKT: AVL) and Rare Element Resources (NYSEMKT: REE), the industry has gone from being one of the most highly watched to a source of total stagnation. Where Molycorp has generally been considered the best-in-breed in the space and the standard bearer for rare earths, it is hard not to wonder if either Avalon or Rare Element Resources can capitalize on the PR problem to gain attention for itself. However, as the Foolish Travis Hoium suggests: “If Molycorp can't make money, there's no way these companies can.”

Answers

Molycorp certainly has all of the hallmarks of a falling knife, having gained several as a result of its own mishandling of the SEC situation. The fact the stock is trading essentially at its 52-week low makes me want to like it, as I believe in the long-term story for rare earths, but there is so much negative to overcome. There is blood in the streets around this company, without a doubt, but I think there is likely more carnage ahead. As a highly speculative play, I have not abandoned the multi-year Molycorp story, but any share buying should be done with extreme care, particularly until more color is achieved on the nature and depth of the SEC probe.


Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.

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