Molycorp.Inc. (fka MCPIQ)

[RareEarths]

RW Baird, Dec 2013 Initiate coverage, $10 target:

We are initiating coverage with a Neutral rating and $10 price target. MCP is completing Phase I capacity expansion at Mountain Pass, one of the only producing rare earth mines outside of China. It has made several acquisitions across the value chain helping to increase pricing power and capture margin. While we favor MCP’s
progress at the mine and transforming its business into a specialty chemical and material company, we remain on the sidelines until sentiment and liquidity position improves.

¦ Expansion at Mountain Pass will make MCP one of the largest rare earth producers in the world. MCP is in the process of completing a $1.25B modernization project at the Mountain Pass rare earth mine in California, which will make it one of the largest producers of rare earths in the world. Once ramped, Mountain Pass will be the only active rare earth mine in the United States and the largest in the Western Hemisphere.

¦ Technology innovations position MCP as one of the lowest cost rare earth producers. At full-scale production at Mountain Pass, MCP estimates it can produce finished oxide at $3-$6/kg, with its concentrate costs being even lower.

This compares favorably to the $20-$25/kg price that MCP's processing facilities currently pay today to buy feedstock from third-parties. MCP's cost advantage will allow thus it to capture meaningfully higher margin at its downstream operations.

¦ Vertical integration allows MCP to control the value chain and sell higher-margin end products. MCP has acquired downstream facilities that allow to produce high-purity oxides, metals, alloys, and magnetic components. By moving down the value chain, MCP can further differentiate its products thereby increasing its pricing power and margin potential.

¦ Recent CEO change could help improve credibility. Cost overruns and the poor handling of an SEC investigation disclosure had damaged MCP's credibility recently. The management change gives MCP a cleaner slate, but it may take time and solid execution to reverse sentiment.

¦ Limited margin for error in 2013 in terms of liiquidity - could be concerns of a funding gap until MCP secures additional liquidity sources. We estimate MCP’s liquidity buffer for 1H:13 as it funds the remaining CapEx at Mountain Pass to be slightly over $20M. Securing a credit revolver or equipment leasing
could alleviate concerns.

¦ $10 price target. Based on an EV/EBITDA multiple of 8x our 2013 estimate. Premium to specialty chemical comps (6.5x) due to scarcity value as a rare earth pure-play offset by scale-up risk and falling prices.

Despite operating a mine, MCP is effectively a specialty chemicals company with extensive overlap with our existing Energy Technology & Resource Management coverage. At first glance, MCP appears to be a mining company given it is in the process of ramping up one of the world’s largest rare earth mines. However, MCP has integrated extensively down the value chain to give itself the capability of producing a variety of high-purity refined oxides, alloys, and magnetic materials necessary to a wide variety of industrial processes. Given the significant value-add from downstream processing as well as the potential for meaningful product differentiation, we view MCP as a specialty chemical company with mining operations as opposed to a pure-play mining company.

Additionally, many of its rare earth products are used in Energy Technology applications, including wind turbines, electric motors
for EVs, batteries for hybrid cars, as well as catalysts used to improve yields and reduce emissions in petroleum refining.

Technology innovations and scale can potentially position MCP as one of the lowest cost rare earth producers in the world. Molycorp has developed a number of proprietary processes to reduce the costs of rare earth processing. One of the most important is its solvent extraction technology, which allows the company to use
less inputs than traditional processes. MCP estimates that hemical reagents comprise 60-70% of the cost of production. Once its chlor-alkali facility is online, MCP will have the capacity to capture salt water used in its process and recycle it to produce new chemical reagents, significantly lowering its cost of production. Today, Molycorp Canada (formerly Neo Materials) procures feedstock from Chinese sources at a price of ~$20-$25/kg. With the cost reductions derived from its chlor-alkali facility and its co-generation unit as well as the economies of scale from
operating at Phase II production at Mountain Pass, MCP estimates it will be able to produce finished oxides at a cost of $3-$6/kg, with its concentrate cost being even lower. This will allow it to capture meaningfully higher margin at its downstream operations.

Vertical integration allows MCP to control the value chain and ultimately sell higher-margin end-products. While the Mountain Pass facility forms the bedrock of its business as its source of raw materials, MCP has aggressively moved to expand its capabilities down the value chain via acquisitions. In 2011 it acquired downstream capabilities in high-purity oxides and metals & alloys through its purchases of two rare earth processing facilities.

Most recently, in June of this year, the company completed its $1.3B acquisition of Canadian rare-earth processor, Neo Materials, which significantly expanded its downstream capacity and added a large portfolio of magnetic component products. Today, MCP has the ability to produce the entire value chain of rare earth products from concentrate all the way to permanent magnets. Progressing further down the value chain gives MCP the ability to add
increasing levels of differentiation to its products, while also getting closer to the ultimate end-products into which its
offerings are incorporated. As such its pricing power and margin potential subsequently increase. Additionally, the strategy helps to reduce MCP’s exposure to input price volatility and allows it to leverage cost reduction efforts at Mountain Pass to drive margin expansion in its downstream products.

Recent CEO change could help improve credibility but it will take time and improoved execution. In our view, the recent appointment of Vice Chairman, Constantine Karayannopoulos, as MCP’s interim President & CEO should help improve investor sentiment around the name. We believe the company’s credibility had taken a hit over cost overruns related to Project Phoenix and the poor handling of the disclosure of an SEC investigation into the company’s most recent equity raise. While MCP will now have a chance to operate with a somewhat cleaner slate, it will likely take time and solid execution to reverse sentiment. Additionally, there will be some overhang until a permanent CEO is identified, particularly given the importance of this period as MCP ramps its Phase I and Phase II expansions at Mountain Pass.

While we think MCP can fund its remaining capital needs through 1H:13 with its cash on hand and operating cash flow, there will be limited margin for error – we think the market could have concerns of a funding gap until the company secures additional liquidity sources. MCP expects to recognize ~$180M in cash CapEx during
the fourth quarter, of which $170M is related to Mountain Pass. Additionally, it will pay $305M in cash CapEx in 1H:13, of which the majority is payables under CapEx accrued in 2012. Based on an expected full-year maintenance run-rate, we also assume 1H:13 capital requirements for maintenance activities of ~$20M. Based on MCP’s cash balance as of September 30, 2012 of $436.0M and our Q4:12 and 1H:13 EBITDA estimates, we believe MCP has adequate liquidity to fund its capital requirements. That said, we project its liquidity buffer to be small at slightly in excess of $20M, so its margin for error is somewhat thin at these levels, as any hiccups across MCP’s various operations or overruns on its capital needs could jeopardize this balance. We think concerns could pop up in the market place in regards to a funding gap, which MCP could help alleviate by securing access to additional sources of
liquidity such as a credit revolver or equipment leasing.

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