The Haiku of Finance for 10/11/13

Raytheon winner
Missile defense radar bid
Destroyer contract

API Technologies Corporation (ATNY) Not For Me

API Technologies Corporation (ATNY) offers a complex line of electronic components and systems to government customers in the NATO countries.  The business model is right up my alley but defense contractors everywhere are up against major economic headwinds.  Many European NATO countries will have to trim spending to stay within EU budget guidelines.

They've been losing money for the past three years, with only the most recent quarter showing positive earnings.  Their long term debt has absolutely exploded since 2012.  Their retained earnings are massively negative and FCF for much of their recent history has been negative.

I'm sorry, folks, but if the financials don't meet my standards then I don't waste time delving into the business model.

Full disclosure:  No position in ATNY at this time.  

The Haiku of Finance for 08/04/12

Peak defense bubble
Uncle Sam can't afford it
Budget cuts will come

You Can't See An Asset Bubble From The Inside

I can attribute some of my portfolio's success to the avoidance of asset bubbles.  If I had been invested in any of the crazes that hit the markets since the mid-'90s I'd be in a world of hurt.  Fortunately I don't follow crowds.  

I stayed in cash and fixed income while plenty of very smart people chased dot-com dreams in the late 1990s.  I remained in cash after that stuff peaked in March 2000 and wiped out plenty of people who thought they knew better than me.  I had a bad feeling about the Federal Reserve's stimulative monetary policy of the early 2000s and didn't want to pick the next bad thing by accident.  

In 2002 I attended a hiring conference in the San Francisco area (one of the Burlingame airport hotels to be precise) put on by one of the recruiting firms that love to place former military officers with large companies.  I sometimes wonder whether these recruiters collect the first-year bonus their candidates would otherwise get if they were hired on their own, but that's not germane to this article.  The clearest memories I have of that hiring conference were the pitches the recruiters gave for homebuilders, specifically Pulte and Centex.  The home mortgage bubble was in full swing and developers were busy paving over pristine farmland in Stockton, Pleasanton, and elsewhere to accommodate the Greenspan Fed's loose money policy.  The housing bubble sure looked great to the people inside homebuilders who thought they had it made.  I decided to pass on the homebuilding jobs available; they just weren't suited for my white-collar ambitions.

In 2005 and 2006 I was a trainee broker at UBS Wealth Management in The City, an outsider among the anointed children of our hereditary ruling class.  Some of top-producing brokers swore by real estate mutual funds tracking the Cohen & Steers Realty Majors Portfolio Index, thinking they were geniuses.  I went the other direction and bought a structured note (in my own portfolio) that bet on a decline in the homebuilding sector.  I was later fired from that brokerage job for having produced zero revenue, but I liquidated that structured note at a hefty gain when I was forced to transfer my account to another firm.  

My most loyal readers, all three of them, may be aware that I believe defense spending to be an unsustainable bubble.  I have tried in vain to convince my military friends not to pin their hopes on a second career with defense contractors.  The Pentagon itself is probably in denial about the bubble it helped inflate, with very little visible contingency planning underway for a radically austere future.  

Some things never change.  A lot of defense sector bulls are going to be let down.  That suits me just fine.  I'll be ready to buy the defense stocks they'll be forced to abandon.  

Full disclosure:  No positions in any companies mentioned.

Financial Sarcasm Roundup for 07/16/12

It's Monday.  That means it's time to bust out of your workday boredom and pay attention to my bitterness.

Federal prosecutors are supposedly making a criminal case against bankers over Libor.  I don't believe for a minute that DOJ is serious about prosecuting bankers who fudged Libor.  This is the same DOJ that could find no criminal wrongdoing in the financial crisis of 2008 or bankers' extortion of municipalities though interest rate swaps.  They haven't even indicted John Corzine for his theft of billions from MF Global clients.  Puh-lease.  Let's get real.  Government prosecutors won't prosecute the heads of banks who will employ them in the future for corporate legal work.  Expect a few eight-figure settlements later this year and nothing at all afterwards.  Only smaller players get caught and punished, like the CEO of now-busted Peregrine Financial Group.

I was embarrassed when the U.S. government elected to keep GM and Chrysler alive with pre-packaged bankruptcies and bailouts.  The government still hasn't been made whole on those deals.  Now France is heading down pretty much the same road if it decides to save Peugeot.  Automaking gravitates to lower-cost locales, which now even includes the non-unionized southern states of the U.S.  Keeping high-cost producers alive keeps their products priced artificially high, ensuring an endless cycle of government bailouts and business failure.  Unionized automakers will continue in this zombie pattern until the taxpayer has had enough and allows them to fail.

It's funny that we Americans think we have the right to criticize other countries' restrictions on foreign investment.  The U.S. has placed so many reporting requirements on foreign-domiciled banks that they are refusing to open accounts for American citizens who want to do business overseas.  The U.S. has also declined to adopt international accounting standards that would enable investors to compare financial results across national borders.  I remember the debate about U.S. GAAP versus international standards from my MBA studies a decade ago, and back then the switch to international standards seemed imminent.  I can only shake my head at the wrong turns the U.S. has taken since then, with SarBox and other stuff.  Doing the right thing used to be so easy.

The defense bubble I've been warning about for years is about to pop.  Wall Street is finally pricing in the likelihood that forced budget cuts will hurt the earnings of major federal contractors.  This is good news for cheap analysts like yours truly, because there are some decent defense stocks I'd like to pick up at a discount.  It's bad news for all of the Pentagon watchers and players who are still in denial about the inevitable end of major contingency operations.  I've known plenty of people on active duty who were counting on jobs with contractors as second careers.  They really need to switch gears now and make other plans.

I've had enough for one Monday.  

Carlyle Group (CG) IPO Disappoints Market

The Carlyle Group (CG) has returned a stunning performance for its founders and private investors since the 1990s.  Its performance today in its IPO was not so stunning, trading below the first estimates of its filing price range.

Carlyle's investment performance has a lot do with the health of its favorite sectors:  defense, aerospace, and health care.  Growth in those sectors has been driven by big factors (like government spending) out of Carlyle's control for much of the firm's existence.  Those fire hoses are going to run dry in a couple of years.  U.S. defense spending will decline as our land wars in the Middle East and Central Asia wind down.  Aerospace is on the ropes again thanks to high oil prices and perennial bankruptcies (here goes AMR through Chapter 11).  Health care spending will be whittled down by some combination of government-imposed cost controls and a probable hyperinflation attempt by the Fed.

More importantly from my perspective is that Carlyle is one of the private equity firms that wouldn't hire me years ago went I sent them my resume.  I thought at the time that my knowledge of finance and military affairs would have made me a shoe-in for one of their analyst jobs.  It turns out that my expertise was less relevant than my lack of a pedigree.  The one Carlyle employee I've ever met was a junior analyst with a bachelor's degree from Notre Dame, my alma mater.  His response to my inquiry for an informational interview was to brush me off.  The dude was two years younger than me and had no MBA (I had just finished mine) and considered me to be a loser.  That told me more about what Carlyle values in their employees than any formal interview would have revealed.

My pedigree and connections didn't meet Carlyle's expectations.  My industry knowledge and academic credentials were irrelevant.  Carlyle built a successful business model on inside connections to big shots who understood where government spending goes.  Now that government spending has peaked in the face of an inevitable decline, Carlyle's performance is starting to disappoint Mr. Market.  This lackluster IPO is the first sign.

Full disclosure:  No position in CG or any of its portfolio companies at this time.  No position in AMR either.  

Machinist Union Strike Bodes Poorly For Lockheed

The machinist union at Lockheed Martin has voted to strike.  The company's offer to line out the defined benefit pension for new hires was a red line the union couldn't cross.  That's too bad, because the future of defense companies like Lockheed depends very much on keeping pension liabilities down in the face of declining defense budgets.

This particular strike will very likely cause a work stoppage at the primary assembly facility for the F-35 fighter, Lockheed's bet-the-company cash cow for the next three decades.  This troubled program somehow survived a Nunn-McCurdy breach that should have caused dramatic changes to the platform.  The plane has already cost at least 50% more than originally planned and now work will be delayed for weeks by this strike.

Multirole fighters were affordable when their structural engineering and avionics were simpler.  Reconfiguring multiple systems several times for the same airframe, including for a VSTOL version, has not proven to be the cost-saving procurement method originally promised.  No one at DOD seems to care.  That's too bad, because the federal government's eventual budget cliff-dive will render it unable to pay for its most coveted legacy weapon systems or backstop the losses of its prime contractors.  The striking machinists need a plan B.

Full disclosure:  No position in LMT at this time.  

The Haiku of Finance for 04/10/12

New rare earth report
Disregards global supply
Unknown risk is high

Defense Contractors At Risk From Pension Obligations

Moody's is saying that America's leading defense contractors are at risk from underfunded pension plans.  There is little comfort in arguing that contractors' ability to bill the government for their pension gaps will reduce the risk to their balance sheets or credit ratings.  The government's ability to pay any unanticipated pension shortfalls is limited by the total appropriations for a given fiscal year.  DOD's typical practice is to reduce Operations and Maintenance spending when it finds contingency-driven costs exceeding budgeted estimates.  Paying such a sudden request for pension shortfalls will force DOD to rob money from O&M accounts even earlier in a fiscal year than it already does.  This will place any contingency operations at serious risk and force DOD to seek even more frequent supplemental appropriations throughout the year.

This unheralded DOD accounting change will add a measurable burden to the federal government's already large unfunded liabilities.  The defense industry lobbyists who pushed for this change shouldn't gloat.  Any acceleration in the U.S. government's default/hyperinflation inflection point accelerates the day when defense contracts will be paid in hyperinflated dollars or go unfunded altogether.  The defense sector has gained hypothetical relief for its balance sheet and credit rating pressures in the face of an oncoming fiscal train wreck.  

Intellicheck Mobilisa (IDN) Shows Its Identification

I've been following Intellicheck Mobilisa (IDN) for about two years.  They have some intriguing technology and  I'd like to see them achieve some real business success.  Their management team is certainly capable enough and has been around long enough to turn this maker of ID scanners into a consistently profitable company.

Part of the problem is the structure of their market.  They sell handheld ID scanners to government agencies.  Breaking into the market is difficult for a small firm because they have to compete against existing products from large defense firms.  If scanners are built to last and the physical configuration of the cards they read hardly changes, the market can fill up pretty quickly and stay full for years.  Intellicheck is doing some strategic things right by being located in a HUB Zone and being listed in the GSA Register.  Local military installation commanders do have a wide degree of latitude over procurement for local security solutions.  Intellicheck could help itself with more visibility at military-related trade shows and more effort in areas where military and federal installations are highly concentrated.

I often root for the little guy and the security market badly needs a diverse supply base.  Intellicheck's challenge is to turn the momentum they get from their publicly announced milestones into consistent earnings.  Competing for homeland security news recognition and getting recognition as a fast-growing tech company only go so far.  IDN's share price was north of $7 in the spring of 2007 until it collapsed in 2008 along with the rest of the market.  Since then it has gone pretty much nowhere for years with the exception of a brief run-up to about four bucks in early 2010.  The stock even managed to slide during much of the last decade while the U.S. has spent enormous sums on defense.  Intellicheck's strategy must evolve beyond the basics if it is to thrive during the coming years of severe cuts in defense spending.

Full disclosure:  No position in IDN at this time.  

Alfidi Capital Lessons From TREM12

My more inquisitive readers may know that I was invited to be an expert panelist at the IAGS Technology and Rare Earth Metals Center "TREM12" conference this month in Washington, D.C.  I never miss a chance to show off my knowledge and feed my ego.

I can't recap the entire two-day knowledge fest but I'll offer some highlights.  Sen. Lisa Murkowski (R-AK) gave an impressive talk on Congress' efforts to streamline permitting regulations for mining and the need for more aerial hyperspectral imaging surveys of unexplored properties in the U.S.  David Sandalow, an Assistant Secretary at the U.S. DOE, acknowledged that the White House Office of Science and Technology Policy was the natural choice to lead the "whole of government" interagency effort on critical metal supply security.  DOE's Innovation Hubs are fully funded, but IMHO they should focus on business incubation and license out the tech they're developing.  One panelist said something ignorant about wind energy, that its cost is essentially free once you amortize away the initial capital costs (IMHO this is stupid because it ignores the cost of regular maintenance, inspections, blade failure, etc.).  

The panel on automotive tech and grid storage made it clear that there will be no shortage of lithium to meet the world's needs, which is one reason why the Li-Ion battery market is expected to consolidate into a smaller number of manufacturers.  The automotive panel also emphasized that the U.S. will need to update its transmission grid to accommodate a growing hybrid/electric vehicle market, and the demands of energy storage at grid level will help drive smart grid build-outs that will optimize charging times for vehicles.  The graphite panel noted the many applications for this material but some have no synthetic alternative.  Ambassador Ichiro Fujisaki of Japan discussed how Japan, the EU, and the U.S. have coordinated their WTO complaint about China's REE policy; they've learned lessons from past oil supply shocks and know that Japan's increasing reliance on renewable energy (especially after the Fukushima meltdown) will make REEs critical.

The final speaker, Dr. Si Jinsong from the Chinese Embassy, restated the PRC's official view on why they are curtailing rare earth exports.  Environmental damage is IMHO a red herring.  China can always dial back its domestic industrial use of REEs or get more aggressive about enforcing environmental regulations to mitigate damage from REE production.  His claims that China has exported too much already and is facing resource exhaustion mean little to me.  REEs are typically found in conjunction with base metals and China still has plenty of those.  The real money quote came late in his presentation when he said the U.S. and China should work together to expand high-value manufacturing.  That is as transparent a statement of intent as the West will ever see from China.  The PRC's longstanding policy is to attract the onshoring of high-tech manufacturing supported by foreign direct investment so Chinese engineers can capture technical knowledge and Chinese industry can build a high-tech export base.  U.S. policymakers need a thorough education in China's grand strategy, and they should start by reading Unrestricted Warfare to see recommendations straight from the People's Liberation Army.  

The fun part for me was my participation on the panel "Supply and Demand: In Balance or Imbalance?" moderated by Clint Cox of The Anchor House.  We had some pretty lively discussions of the structure of the REE market, with Dr. Michael Berry contributing his macroeconomic perspective and Michael Silver from American Elements speaking as an operator within the sector. I'll restate some of my own points from the panel below.

I led off with my assessment of the massive imbalance in the critical metal market and forecast for a future balanced market. Any market where 97% of supply and 100% of alloy processing must originate in China is the definition of a market far out of balance. I argue that a balanced market in strategic metals will eventually look like today's energy market. A power plant doesn't care if the feedstock is natural gas or coal because you don't have to change a turbine's physical structure to use either one. A transmission grid doesn't care whether electrons come from hydropower, geothermal, solar, nuclear, or fossil fuels so long as those electrons can get to your home appliances. Eventually the metals markets will balance when diverse supply sources, efficient technologies, and synthetic substitutes can arbitrage away single sources of supply. U.S. GDP has grown for the past several decades even though per capita energy use has declined. We can use the same energy metrics for the metals market.

I noted that Molycorp's acquisition of Neo Materials changed the game for REE producers by creating a true vertical business model. The deal was cash-heavy rather than stock-heavy, which I thought odd given the strength of MCP shares trading at 23 times earnings. I wondered out loud whether Molycorp thought that the balance sheet risk of assuming a half billion dollars in debt outweighed the avoidance of shareholder dilution. Molycorp is the only REE producer than has the financial and operational strength to initiate M&A; all other REE producers are still young and are thus more likely to be bought themselves (like by an oil supermajor seeking lanthanum or cerium for fluid cracking) than to be buyers of alloy processors.

I threw several policy prescriptions at the audience, starting with a big one for federal government policy. Several other panelists had noted that DOD seemed to be the weak link in the interagency effort to secure critical metal supplies. I think I know why. DOD's weapon system procurement program managers are selected from career warfighting officers, which makes sense if you want people who can dream up future capabilities for armored vehicles and fighter aircraft. The weakness of this approach is that warfighters don't think like logisticians. They don't know how to reach down three or four levels worth of subcontractors to find supply chain vulnerabilities. I would like to see DOD's Defense Acquisition University incorporate supply chain security into its curriculum so program managers get the insight they need. I would also like those professional logisticians who do join the acquisition workforce to think more like intelligence officers when they screen contract sources for components and raw materials. The intelligence community has plenty of data on natural resource repositories in many countries; developing indicators and warnings of supply curtailments that procurement managers and logisticians can use should be a priority for the intelligence community.

I also had three other policy recommendations up my sleeve; these were more attuned to things that will help the markets for critical metals become more transparent and liquid. First, I argued that some exchange (preferably the Chicago Mercantile Exchange) should create a futures market for rare earth metals. Producers and end users of both base metals and precious metals can hedge their needs with future contracts in gold, copper, and steel. Agribusiness can do the same with contracts in rice and soybeans. Creating contracts for rare earth metals seems like a decent thing to do for manufacturers who can't mitigate single-source supply risk with contracts for guaranteed delivery from miners. Second, I believe the U.S. Securities and Exchange Commission should adopt some version of Canada's National Instrument 43-101 resource reporting convention that accommodates nuances in ore deposit volumes and grade quality. This will accelerate mining investment in the U.S. by allowing miners to identify more exploration projects that show some early promise. Finally, I suggested that the U.S. government fund an estimate of the production cost curves for REE mining projects worldwide. Investment banks publish costs curves for base metals, precious metals, and oil/gas wells because the thousands of those sources worldwide are well-known. The small number of rare earth mines operating worldwide are so early in production that their costs are only estimates, or they are in semi-transparent economies like China where state subsidies can mask true cash costs. The U.S. intelligence community has enough analytic horsepower and data to publish initial estimates of the world's REE mining costs. Uncle Sam should do this in the spirit of the CIA's World Factbook as an open-source, unclassified academic reference for the entire world, and the best place to publish it is on the U.S. Geological Survey website.  

That just about completes the wonderful time I had at TREM12. I made plenty of contacts from the Defense Logistics Agency, the Institute for Defense Analyses, and other government agencies that will have to carry the ball on policy execution for critical metal security. I even got some free entertainment when I saw a junior executive from a mining company try to flirt with a hot babe from an executive branch office. I'll conclude by saying that I'll definitely return in the future, because I can never get enough lunch buffets, fruit smoothies, and house recipe cannolis from the Ritz-Carlton Pentagon City.  It's nice that TREM holds its annual conference someplace swanky.

Valdor Technology (VTIFF) Shoots For Fiber Optic Niche

Fiber optic aficionados like the folks at Valdor Technology (VTIFF) are fond of well-crafted engineering solutions.  I don't doubt the quality of their product.  I admit skepticism about this company's ability to sell premium products in a heavily commoditized niche industry like fiber optic connectors.  I am concerned that the most recently available financial report on Valdor's website dates to Q1 2009 and it is unaudited.  The income statement shows progressively larger losses from 2008 to 2009 and there is a similarly widening "shareholder deficiency" on the balance sheet. 

Typical fiber optic connectivity involves cheap solutions like epoxies and gels.  The fiber optic market is dominated by big companies like Corning and 3M.  That seems to be good enough for the $2B annual market for cable and connections.  Valdor's premium product is aimed at a niche in high-performing systems operating in extreme environments.  There's nothing wrong with carving out a niche, provided it's sufficiently lucrative. 

Let's do a quick back-of-the-envelope example.  Lockheed Martin's F-35 Lightning II may be a prime candidate to have its fiber optic cables linked by the kind of clamped connectors offered by Valdor.  It needs cable for its control systems and must operate at high speeds in extreme conditions.  The problem lies in the size of the market.  The total planned production for the F-35 is probably no more than 3000 right now, including planned buys from non-U.S. partners.  I have no idea how many of these connectors would be needed on each aircraft, so I'll just assume ten per airframe.  The upper end of the market price range for one of Valdor's connectors is $35, so that's revenue of $350 per aircraft.  Multiply that by 3000 for a total market size of $1,050,000.  Note that the figure is not annualized, but represents the total lifetime product cycle revenue possible for that particular niche.  These are my uneducated guesses, of course, but that total is still a fairly small number compared to the total market for connection.  Perhaps each aircraft requires more connections for cable.  Perhaps Valdor can raise its price per installation.  Perhaps oil and gas wellheads, another potential target market, require much more numerous connections. 

It won't be difficult for the leading gel/epoxy manufacturers to tweak their formulas periodically to get just a little more adhesive capability.  A slightly improved mass solution at a lowball price is probably suitable for most applications anyway.  Products like Valdor's would be better candidates for on-site manufacture by high-tech customers themselves if Valdor is willing to license the technology for small batch use.  That's why I like engineers - they're adaptable.  I like Valdor's product, but I believe small-batch tech producers should change their business models from making products to making designs amenable to additive manufacturing. 

Full disclosure:  No positions in any companies mentioned. 

Huntington Ingalls Scores Nuke Revenue

Here's a story about a government contractor that caught my eye.  Huntington Ingalls Industries (HII), which spun off from Northrop Grumman (NOC) this past March, just landed a decent-sized contract to maintain prototype nuclear reactors for a U.S. Navy research program.  The minimum they'll earn is about $40mm per year with the base contract and another $80mm per year with the option.  Based on gross revenue of about $3B per year (an estimate based on six months' of data from their 10-Qs), that will amount to a topline increase of 1.33% to 4% depending on whether they fully earn that option.  That's not bad, but any contribution to earnings will depend on the cost of servicing this contract.  HII's ROE is clocking in at a respectable 12.73% but ROA lags at 2.75%, indicating that HII is not efficient at using its existing assets to generate earnings. 

Here's another tiny feather in HII's cap.  Its Continental Maritime of San Diego subsidiary was awarded OSHA's star status.  Nice work, folks.  Now translate that into lower costs for the contracts you service and you'll really impress me. 

Full disclosure:  No position in HII or NOC at this time. 

The Limerick of Finance for 08/14/11

With big defense cuts on the way
Politicians will have lots to say
Some cheaper program
Launched by old Uncle Sam
Is enough to keep rogue states at bay

The Haiku of Finance for 06/27/11

Defense cuts looming
Still want to buy defense stocks?
Think dual-use tech

Tomahawk Strike On Libya Great News For Raytheon

Whoever said war is bad for business never worked for a defense contractor.  The international community has begun launching strikes on Muammar Gaddhafi's regime to prevent further atrocities.  That in itself is great news.  The U.S. won't take the lead but its edge in specialty weapons comes into play early.  The allies have fired over 100 Tomahawk cruise missiles to knock out Libyan air defense systems.  This will require spent inventories to be replenished.  That's great news for Raytheon, the Tomahawk's contractor. 

The Tomahawk reportedly costs $756k a copy.  RTN can thus expect new orders for at least $76mm later this year as soon as the relevant procurement commands generate their requirement statements.  The company will have to wait until the battle damage assessment photos are declassified before it can use the results in its advertisements.  War is hell, but you can't make money in hell like you can in war.

Full disclosure:  No position in RTN at this time. 

The Haiku of Finance for 03/11/11

Pentagon accounts
Impervious to audits
Spending in stealth mode

China Prepares Tough Hurdles For Mergers

China wants to have its cake and eat it too.  In a throwback to imperial China's historical insistence that foreigners kowtow and pay tribute, the Middle Kingdom is preparing to exact a new form of tribute from foreign investors:

Foreign investments in military, agriculture, energy and resources, key infrastructure, transport systems, key technology sectors and "important equipment manufacturers" may be subject to reviews, according to a statement published on the central government Internet portal, http://www.gov.cn/.

This isn't merely a response to other countries' barriers to China's strategy of resource acquisitions.  Replace the words "national security" with "rare earth metals" and you'll see the hidden agenda.  China wants to ensure that foreign investment adds to its high-end manufacturing capability without surrendering control of its rare earth metals.  Note the article's comparison to Australia's own review board.  The common theme is that resource-rich countries seek to husband their deposits for the strategic advantage they confer.  Those investments that are permitted will be exclusively to China's advantage. Western corporations will pay a huge premium if they wish to secure their supply chains from China. 

The main driver of strategic conflict in the rest of the 21st Century will be a contest for resources in high-value manufacturing.  The main contestants will be China, India, and the Anglo-West's transnational corporations.  You heard it here first. 

Normalizing Container Shippers

Last year brought plenty of newbuild orders for big hulls from big shippers.  Those newbuilds are now tapering off, with orders expected to return to normal levels.  This is a sign of sanity for the shipping industry given that many of its players are loaded to the gills with debt.  Newbuilds orders need to stay at levels that can replace obsolete ships. 

One shipbuilding sector that will probably not be able to maintain even a status quo level of production is the defense sector.  Northrop Grumman's shipbuilding spinoff is encountering rough waters before it even leaves its corporate drydock.  Credit rating agencies are giving NG Shipbuilding a massive thumbs down.  This is an appropriate signal anticipating a peak in defense spending for capital ships. 

Full disclosure:  No position in NOC.

Pentagon's Plan For Rare Earth Shortages

The U.S. Department of Defense is preparing to release a study of rare earth metals and their importance to national security. This study comes in the wake of findings from the GAO and other sources highlighting the critical role that rare earths and other “technology metals” play in U.S. national security. Media reports indicate that the DOD report will downplay the impact of rare earth shortages on US military applications. 

On Oct. 8, 2010, the DLA Strategic Materials section released its implementation plan for the transformation of the National Defense Stockpile (NDS) into the Strategic Material Security Program (SMSP).  It discusses process, milestones, and program criteria but does not mention rare earth metals as an acquisition objective. The DLA Strategic and Critical Materials Report for FY 2009 lists the materials stockpiled in DLA’s inventory on page 57. The inventory does not contain any rare earth metals. 

The coming DOD study apparently contradicts the GAO study from April 2010, which clearly indicated that major defense contractors were canvassing their supply chains for assurances of rare earth metal supplies, and that the Hellfire missile in particular is dependent on a special chemical available only from China at present. The National Defense Stockpile has been shrinking since the mid-1990s as policymakers have authorized the sale of resources no longer deemed critical to national security. Washington allowed this to happen without considering how strategic competitors could affect the availability of resources. America's potential peer competitors are not so short-sighted.  China is considering the creation of its own strategic metals reserve. 

The private sector is not waiting to seize the opportunity posed by latent demand for rare earth metals. Goldman Sachs helped finance the reactivation of the Mountain Pass mine in California, formerly a leading producer of rare earth metals. It now forms part of Molycorp (MCP). Another company, Rare Earth Elements (REE) has seen a massive increase in its share price this year due to investor excitement (panic?). Most other rare earth miners and refiners, like Great Western Minerals Group (GWG.V), tend to be small and unpublicized. That may change very quickly if the U.S. government is serious about addressing its potential rare earth supply problems.

Full disclosure:  No positions in any stocks mentioned.