Description

Company Overview

Albemarle Corp (ALB) is a leading global specialty chemicals manufacturer.  It has three business segments: Lithium, Bromine and Catalysts. As of 1Q19, Lithium accounted for almost half of company defined LTM adjusted EBITDA, while Bromine and Catalysts accounted for 27% and 25% of EBITDA, respectively.

Investment Thesis

Long ALB is a play on lithium and electric vehicles.  The company, through strategic acquisitions and dispositions, now owns a collection of high quality assets.  Due to secular growth in electric vehicles and grid-scale storage, demand for lithium is expected to grow at a minimum of 15 – 20% CAGR for the next five years. 

ALB’s business quality is higher than commodity chemicals peers.  Driven by Lithium, revenue and earnings growth should be materially higher than global GDP growth.  Its low leverage and strong cash flow from the Bromine and Catalysts businesses provide ammunition and flexibility to expand lithium capacity and return capital to shareholders through dividends and share buybacks.  On a relative basis, it should trade at a premium to peers.

A conservative sum-of-the-parts valuation of $95.6 per share represents 37% upside and  limited downside.

Why does this opportunity exist?

Just as positive sentiment drove lithium stocks to record highs in 2017, the change in sentiment (spot price decline and oversupply concern) caused lithium stocks to sell-off.  As a result, ALB declined from $140 (21x EV/LTM EBITDA) to its current price of $70 (8.9x EV/LTM EBITDA).

Declining lithium spot price

At present, industry participants view the ex works (EXW) spot price in China, and the cost, insurance and freight (CIF) spot price in China, Japan and Korea as a barometer of lithium health.  As the charts below indicate, spot price has halved since peaking in Nov 2017.

Concerns about lithium supply

Some estimates forecast supply to grow to 1,000kt in 2025, almost a fourfold increase from 270kt in 2018 (roughly 20% CAGR).  Supply growth is from both incumbents (ALB, SQM, Tianqui and LTHM, the FMC spinoff) and new entrants (Orocobre, Galaxy Resources, etc.).

The Lithium Disconnect

The disconnect – Mr Market is mispricing ALB as a commodity-like business despite its high business quality – is rooted in three misconceptions.

First, the relationship between spot price and ALB’s revenue is misunderstood.  Second, market participants are overly pessimistic about oversupply. Third, the long-term, relationship-based nature of ALB’s lithium business provides earnings visibility and stability despite the negative headlines.

1) The EXW China and CIF Asia spot price provide only a partial picture of lithium fundamentals and have limited impact on ALB.  ALB’s lithium pricing , ex FX, was up 8.6% in 2018 while the spot price declined by half. 

In contrast to other base metals such as copper or gold, there is no benchmark price for lithium.   The EXW China and CIF Asia spot price only represent a small part of the market. They do not represent the market segments that ALB operates in.

“No one in the majors are buying on the spot market. So if I think about the top 15 battery manufacturers in the world, like a Samsung, an LG, a Panasonic, a CATL, Nichia these types of customers, they may buy a little bit just to test the market. But at the end of the day, the bulk of what they're buying are coming from the major producers.”

“And they want somebody that they can rely on, not for 100 tons.  They are looking for someone that can supply 20,000 tons or 40,000 tons, right.  So that’s just a whole  another level of competition. So there will always be a small market out there because there are plenty of companies that are looking to enter the battery market, and they need to get supply from someplace. And if you look at China right now, while there is several large manufacturers, there's hundreds of small guys that are out there. And they're in and out of the market. They're going bankrupt, new entrants, those types of things. And it's really that tail that -- that's being served by the spot market.” ALB CFO at DB conference.

2)Historically, realized supply is below promised delivery by a wide margin due to the high barrier to entry.  For the same reason, the actual new supply will be lower than the headline, planned capacity supply number.

The high barrier to entry is because of several reasons. 

• Untapped reserves are often in areas with volatile regulation where new entrants need to secure mining rights (e.g. Chile, Argentina, Bolivia, Zimbabwe). 

o   ALB and SQM had to delay expansion plans due to disputes with the Chilean regulator, Corfo which dragged on for 3 – 4 years.

o   Chile recently increased royalties for both ALB and SQM.  Argentina implemented an export tax of 25% in 2018.

• Lithium mining requires complex and specialized engineering.  For lithium brine production, which relies heavily on evaporation, factors beyond human control such as weather can lead to delays. For new mines, new infrastructure (roads, power, water) is needed to overcome geographical constraints. 

o   Even ALB, the experienced operator, faced delays in China, Chile and Australia.

o   The YLB project at Uyuni is an extreme example, but it highlights the importance of technical expertise.  After nine years and $450mm of investments, it is only producing 120 tonnes per year due to poor management and lack of expertise.

• It takes at least several years for production to reach full output.

o   Orocobre’s Salar de Olaro brine mine is still short of production targets after seven years.

o   ALB’s La Negra II has struggled to ramp up.

3)The contraction of the valuation multiple of ALB along with other lithium stocks indicates the market has failed to distinguish ALB’s unique business model.  ALB’s lithium products, both carbonate and hydroxide, are primarily sold through long-term contracts with fixed pricing and minimum volume commitments. 

These contracts significantly lower earnings volatility and differentiate ALB with from specialty chemicals peers. 

In 2018, despite the drop in spot price in Asia, lithium revenue growth ex FX was up 18.9%, driven by volume (+10.3%) and pricing (+8.6%).  The positive trends in pricing and volume are expected to continue in the near future.

“As you can see, our pricing was up 3% year-over-year when a number of other lithium companies were talking about price being down year-over-year. So again, this strategy is one that we thought through to kind of shave off the highs and the lows and to get a quality return on what we invested. So we feel good about that strategy.  And they are long enough now that we have these contracts. The bulk of our carbonate are spoken for under these long term contracts through the end of 2021.  And we have the  bulk of our carbonate spoken all the way through -- I'm sorry, and the bulk of hydroxide, I apologize, Bob, spoken through the end of 2025 at prices.” ALB CEO in 1Q19 earnings call.

Business Quality/Competitive Edge

1)ALB’s Salar de Atacama lithium asset in Chile provides ALB a cost advantage in lithium production.

There are two forms of lithium extractions – from brines (saltwater aquifers) in evaporated salt ponds or hard rock mining.  Brine is a lower cost process than hard rock. Evaporation rate is a key determinant of lithium brine.

The Atacama brine pools, with a high evaporation rate and low rainfall (less than 20 millimeters per year), and the highest concentration of lithium on earth, are estimated to be the lowest cost production provides ALB with a cost advantage.

2)The Catalysts business benefits from high barriers to entry and switching costs.

A catalyst in this context is a substance that accelerates a chemical reaction.  Due to high variations in crude oil and end-product specifications, catalysts are often customized to maximize efficiency. 

As catalysts represent only a small portion of total refining costs and an even smaller portion of total value-add, the customization and existing relationship act as a barrier to entry for new competition.  There is also switching cost as new entrants need to prove their products are superior to incumbents.

3)Bromine is effectively an oligopoly with three players.

The three players are ALB, ICL and LANXESS, which bought Chemtura in 2016 for nearly 10x EBITDA pre-synergies.  This is a low growth business but the concentrated market share provides ALB pricing power. Earnings should at least track inflation.

Other Investment Positives

Contractual terms are trending longer with increase pricing.

ALB is negotiating 7 to 10 year contract terms, moving from 3 to 5 year terms in 2016, further shielding ALB from cyclicality.  Customers are willing to engage as they want to lock in supply and plan their productions.

Natural mix shift towards high quality

An increasing percentage of revenue and earnings will come from the Lithium segment due to higher growth from its end markets.  Both Bromine and Catalysts are expected to grow at the same pace as GDP.

Valuation

ALB currently trades at $70, or 8x NTM EBITDA, compared to a range of 7 – 19x post-Rockwood acquisition.  

In my normal case, I only assume 5% EBITDA growth for Lithium (guidance at mid teens) and 2% for Bromine (guidance at mid to high-single-digit).  I assume zero EBITDA growth for my bear case.  

Management stated maintenance capex is 4 - 6% of sales which is reasonable.  I have cross-checked with Rockwood’s numbers. Rockwood did not spend any growth capex in 2009 - 10.  In both years capex/sales were < 6%.

Catalyst

Ramp up at Greenbushes JV and Xinyu II.

Higher EV Adoption

OEM battery investments

Investors giving credit to ALB's long-term contract cash flow