Why You Should Avoid This Miner Like the Plague

In 2005, global smartphone sales were 39.4 million. By 2017, that number is expected to rise to 1.579 billion, representing 36% compound annual growth over a 12-year period.

Tablet sales have grown from 66.6 million in 2011 to a projected 242.3 million in 2015, representing 38% compound annual growth. 

A new study by ABI Research predicts sales of electric cars will increase 48% annually through 2020 when 2.4 million EVs will be sold. 

What do these three trends have in common? Heavy use of rare earth elements. For instance, a Toyota Prius' battery pack contains 20 pounds of them.

With such an explosion in demand it seems logical to invest in rare earth miners such as Molycorp or Australian miner Lynas . After all, the suppliers of the pick and shovels make the most during a gold rush, don't they? Well as I'll now explain (using Molycorp as a case study that also applies to Lynas Corp), rare earth mineral miners are likely to lose investors nearly all of their money. 

Why Molycorp is doomed

MCP Chart
MCP data by YCharts

That spike in Molycorp stock resulting in a peak of $79.16 came after a perfect storm of events. In 2007, China, which mines 90% of rare earth elements, began imposing quotas and export restrictions. In 2010, geopolitical tensions with Japan caused the price of these metals to soar to all-time highs, resulting in Molycorp's peak (and subsequent raising of $816 million in stock and debt offerings).

But today a perfect storm of factors in the opposite direction is resulting in a collapse in rare earth prices and a downward spiral from which Molycorp investors will likely never recover.

MCP Chart
MCP data by YCharts

This perfect storm is a result of three things.

First, the recent sky-high prices of rare earth elements caused industries to find alternatives, which means demand isn't growing as fast as consumer products listed above. Second, new mines were opened creating a surplus of supply. Finally, the World Trade Organization recently ruled that China's restrictions on rare earth exports are in violation of its policies. With rare earth prices falling 50%-70% from their highs prior to this ruling, prices are likely to continue falling, further reducing margins for miners such as Molycorp. 

Which brings me to three specific reasons why investors should avoid Molycorp.

First, it's hemorrhaging cash, having reported a Q1 loss of $86 million, a 125% increase from last year. Molycorp's average price for its products fell 25% from $44.71/kg to $33.69/kg. 

This trend is the second reason to avoid Molycorp and is likely to continue because Molycorp's primary mine, Mountain Pass, is richest in lanthanum and cerium. These are some of the least valuable rare earth minerals, with current prices of $5.8/kg and $5.5/kg, respectively. (Lanthanum has dropped 96% from its peak.)

Throw in the recent WTO ruling that is likely to flood the market and depress prices further, along with Canada's recent decision to try to achieve 20% rare earth market share by 2018 and the long-term price trend for rare earth metals is probably downward. 

Finally, Molycorp investors are almost certain to face enormous dilution in the form of a 186% potential increase in share count on top of the 186% increase that's occurred in the last two years. This is because Molycorp's cash is down to $236 million, less than three quarters worth of current cash burn. 

With margins collapsing and rare earth prices likely to plunge further, losses are likely to grow meaning the company might only have one or two quarters of cash left. In a May 13 proxy statement, Molycorp requested shareholders approve a 350 million share issuance plan. If approved this would mean a quadrupling of share count in just three years and the amount of cash likely to be raised would be small. This is because with Molycorp's stock being down 94% from its highs, it would need to be offered at a steep discount. How much of a discount? Plug Power, when its stock was trading at recent highs and it was the darling of Wall Street, had to offer a 50% discount to sell additional shares.

With a far larger offering and worse growth prospects, Molycorp's discount might have to be larger, meaning the share price might decline 50% or more from current levels. With 245 million shares outstanding, and assuming a 50% discount, the maximum Molycorp could possibly raise is $569 million, which at its accelerating cash burn rate might last only three to four quarters. 

Foolish bottom line 
Molycorp is facing a perfect storm of free-falling commodity prices and exponentially growing cash burn that will likely leave it bankrupt by the end of 2014. That is unless shareholders approve a dilutionary share issuance agreement that will likely keep the company afloat only another year or so, at the expense of a greater than 50% share price decline. With long-term rare earth prices likely to fall further due to increased Chinese and Canadian supply, investors should run fast and far from Molycorp.

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The article Why You Should Avoid This Miner Like the Plague originally appeared on Fool.com.

Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

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