A $2B U.S. Rare Earth Giant That Yields 8%

If its name is Molycorp (MCP), no.

If its name is Molycorp Convertible Preferred, yes. In fact, as of Friday’s close, it yields 8.7%!

Here’s what you get, good and bad, if you decide this dividend-payer is right for you:

First of all, remember that Molycorp is a speculative company, albeit one with a hefty market cap, lots of fans, and the likelihood that it will be the second-to-market outside of China of concentrated and processed rare earth elements (REEs) -- after our equally speculative favorite, Australia’s Lynas Corp (LYSDY). China currently produces some 95% of all “finished” ready for sale and application REEs.

I’m willing to accept the speculation. Because China has indicated that it will be keeping 100% of its domestic production in future years, the world desperately needs producers outside China. Since rare earths have many defense as well as environmental and consumer applications, I see the US government stepping in with taxpayer money if need be to support the only really large US miner and sort-of producer of REEs. ( I say “sort of” because they are really only producing tailings and stockpiled ore from their old location at Mountain Pass, California But the proceeds from this preferred and a common stock offering are being used to crank up big-time.)

That still doesn’t mean I want to own the common shares, however. They could fall further – as could the preferred. But I believe there is an investment "floor," which I think we are near, at which point MCP+A will trade on its value as if it were a fixed-income security. I don’t know if that floor is 8.7%, of course, but I have to think that at 8.7% and a mandatory conversion in March 2014 into shares of common stock, that there just may be another very nice run in the common between now and then. Being paid 8.7% with a growth kicker if the common moves back up beats a straight buy of the common stock any day.

(For those interested in the particulars, they are: a conversion settlement rate of 1 and 2/3rds common shares for each preferred share if the then-current market price is equal to or greater than $60.00 and 2 common shares for each preferred share if the market price is equal to or less than $50.00. For market prices between those values the settlement rate will be $100 divided by the market value. Dividends paid by the preferred are eligible prior to 1/1/2013 for the 15% tax rate on dividends under normal holding restrictions.)

That’s the short version of my logic for purchasing the convertible preferred shares of the company. As to the industry, which MCP is a key player in, all participants will be affected negatively if the supply were to overwhelm demand. Prices would plunge, just as they do with any commodity. But unlike some of the Cassandras out there who have read one sentence that rare earths aren’t really rare and parroted it back, I don’t see supply overwhelming demand for years. And if Lynas and Molycorp are the 1-2 punch of being first movers, they will sew up all the best supply contracts before other competitors can mount a price war.

It’s true that these elements are distributed widely throughout the earth's crust, but they exist in such small concentrations in most places that they simply can’t be mined economically. For most wannabe competitors and favorites of the penny stock pump-and-dump crowd, if they really tried to compete it would be like spending huge amounts of money to build a massive desalination plant at a salt water pond yielding only a smidgen of potable water.

So much for supply. How about demand?

Wow –- where to begin? I imagine the current applications are only the tip of the iceberg, but already they include enabling far more powerful magnets that are essential to producing the metal hydride batteries for electric cars; defense missile guidance systems; and lighter-weight, more powerful, fewer-moving-parts wind turbines. Even the Congressionally-mandated CFLs (compact fluorescent light bulbs) rely upon rare earth elements to work their magic. (Congress can’t produce a balanced budget or any other bipartisan legislation, but it can issue edicts about what light bulbs we are allowed to own and whether we should eat more pork during National Eat More Pork Month…)

Other products, which would be more expensive or unable to be manufactured without REEs include flat-screen monitors and TVs, fiber optics, smartphones, iPods, iPads, iWhatevers, and MRIs and other medical equipment we now take for granted. They also reduce the cost of gasoline by making the refining process smoother and more efficient. For a sense of the myriad applications and the known reserves, I am indebted to those credited in the map below, which comes from the new issue of Fortune Magazine.

(Click to enlarge)

There are still a number of question marks hanging over Moly. The good news is that, while it is not the only miner in America, it is the only producer of size with quantifiable known reserves in the USA. It will enjoy a certain favored status for that reason alone. But it likely won’t help it if it creates environmental hazards as part of its mining process.

And it is looking to lower production costs by tapping into a natural gas pipeline owned by Kern River Gas Transmission Company. This would only be a 9-mile pipeline coming directly off the current mainline. However, there are people who would use any excuse to disrupt any fossil fuel whether at the drilling site or in transmission. So MCP’s optimism that this solution will occur in the short term may be overly optimistic as disruptionists force it to slog through the courts to get approval (using their REE smartphones to get each other all a-twitter over some real or perceived threat, of course.)

The bottom line for me is that the product, REEs, are essential for many existing technologies; they are in the sweet spot of supply/demand imbalances; Molycorp is one of two companies with a likely first mover advantage; the company has the ear of both investors and politicians in the USA; and the way we have chosen to invest in their success pays us 8.7% for the next two years, during which time I think we’ll have ample opportunity to choose between sale or conversion.

Disclosure: We, and/or those clients for whom it is appropriate, are long MCP convertible preferred shares. Lots of them.

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