The Big Difference Between Molycorp and BHP Billiton

Molycorp's recent earnings show the dangers of investing in small companies without considering more stable alternatives.

May 14, 2014 at 6:09AM

It is easy to look at upside potential and fall in love with a small miner like Molycorp (NYSE:MCP). The problem is that focusing on a single company and ignoring industry factors can easily backfire. Industry structure has a large impact on a miner's margins, income, and stability. A huge miner like BHP Billiton (NYSE:BHP) may appear to have little profit potential, but taking into account industry structure BHP Billiton becomes significantly more attractive.

Molycorp's challenges
Molycorp's Q1 2014 results show that being stuck between a rock and a hard place is never a good idea. Its resource segment produced rare earth oxides at a $49.5 million operating loss. This is a big loss for a company with only $119 million in total Q1 2014 revenue.

Molycorp's problem is simple. It competes with the world's major producer of rare earth metals, China. These metals are critical for military applications, making it very unlikely that China would ever relinquish control of its domestic supplies to global market forces. A Pentagon report explains how a 2011 price shock pushed many non-Chinese firms to develop alternatives to rare earth metals, leading to falling prices and demand for the commodity. These shifts in demand mean that Molycorp is competing in a market where entire nations are trying to abandon some of its major products and Molycorp is forced to compete head-to-head with China.

The other side of the coin
BHP Billiton is in the opposite situation. China needs the world's iron ore and BHP Billiton is happy to sell boat loads of iron ore at a juicy price. This reversal of power gives BHP Billiton iron ore EBIT margins that far supersede its margins in more competitive markets. 

Iron ore prices are still subject to macroeconomic fluctuations, but BHP Billiton has other ways to maintain profits. In 2013 it introduced driverless trucks into its iron ore operations to help reduce labor costs. Its productivity push has produced real results, increasing iron ore volumes to help improve its iron ore EBIT by more than $300 million in the latter half of 2013 relative to its fiscal year 2012 results.

BHP Billiton is not the only company using its big balance sheet and dominant position to introduce labor-reducing technology and help its bottom line. Rio Tinto (NYSE:RIO) is scheduled to introduce driverless trains into its Western Australian iron ore operations. Back in 2013 Rio Tinto announced that its driverless trucks in the same region had already hauled 100 million tonnes of earth.

These technologies help BHP Billiton and Rio Tinto maintain their dominance while smaller miners like Molycorp are subject to the market's whims. It should come as no surprise that Molycorp's 2013 EBIT margin of -67.4% was significantly worse than Rio Tinto's EBIT margin of 7.8% in the same time period and BHP Billiton's underlying EBIT margin of 34.8% in FY 2013.

Labor-reducing technology will also help out coal operations
BHP Billiton has also announced that it is going to start putting driverless trucks into its coal operations in Queensland, Australia. This should help out the challenging coal markets where falling prices are compressing margins. 

The downside is that the U.S. coal miner Peabody (NYSE:BTU) may be forced to upgrade its operations as well. It has mines in Queensland and New South Wales. Peabody is an order of magnitude smaller than BHP Billiton, but it still has a market cap around $5 billion and a balance sheet it can draw on to purchase productivity enhancing capital goods. Infrastructure upgrades to its Australian operations will not be cheap, but Peabody may need to act soon as its Q1 2014 Australian gross margins fell to $0.22 per ton.

Industry matters
Molycorp is a small miner competing against Chinese dominated rare earth exports and a U.S. industrial sector that is trying to reduce its dependence on rare earths altogether. Molycorp can do little to ward off these well-financed forces.

BHP Billiton and Rio Tinto are in fundamentally better positions. Their power in the iron ore market gives them high margins. In the presence of margin pressure they are able to use their massive balance sheets to purchase productivity-enhancing capital goods. The end result is BHP Billiton and Rio Tinto have an easier time maintaining profits and margins while forcing smaller competitors like Peabody to shell out for new upgrades.

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Joshua Bondy 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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