Canada Lithium Should Benefit From Strong Secular Demand Growth For Lithium

| About: Canada Lithium (CLQMF)
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Canada Lithium (OTCQX:CLQMF) should benefit from the increasing demand for lithium used in mobile devices, electric/hybrid vehicles and smart grid storage. The typical exploration stage risk is significantly reduced given expected near-term production and off-take agreements.

Company overview

CLQMF.PK is engaged in the exploration and development of mineral properties with lithium deposits in Canada. In 2008, CLQMF.PK acquired 100% of the Québec Lithium Project (previously operated by Quebec Lithium from 1955-1965 until production was suspended due to falling prices). The property is located in one of the lowest risk countries for mining and near significant existing infrastructure with access to low cost and environmentally friendly hydropower. The hard-rock lithium deposit has a competitive advantage over brine in terms of production speed (e.g. lithium carbonate can be mined and ready to ship in five days compared to 18-24 months for brine evaporation).

CLQMF.PK expects annual output of ~20,000 tonnes of battery-grade, 99.5% lithium carbonate with the potential to produce an additional 2,000 tonnes of lithium hydroxide and up to 30,000 tonnes of sodium sulphate. In July 2013, sample shipments of lithium carbonate were produced and shipped to Tewoo Group in China. The ramp-up to annual design capacity is expected to be completed in 1Q14. CLQMF.PK should become the fourth largest lithium producer with ~12% of the world's lithium carbonate supply.

Lithium is used primarily in batteries due to its many advantages including a high energy density, longer life and faster recharge. Lithium is also used in lubricants as well as ceramics and glass.

Investment thesis

CLQMF.PK is an overlooked "second derivative" alternative to Tesla (NASDAQ:TSLA) as it produces the raw material used in the batteries that power electric cars. Moreover, the 33% decline YTD due to minor production delays provides an opportunity to enter at a significantly lower valuation.

Investors tend to focus on more "visible" companies that use lithium in the manufacturing process (e.g. TSLA, Apple (NASDAQ:AAPL)) and ignore the lithium miners (especially microcaps).

CLQMF.PK is uniquely positioned to benefit from multiple secular growth trends as one of the few pure-play lithium miners near production. As the charts below show, rising consumption is driving higher prices.

Source: Company presentation

Source: Company presentation

The process of pricing in a positive fundamental change is longer than most investors realize and provides a low risk/high reward opportunity for those willing to do their own homework (as opposed to waiting for an analyst to recommend the stock after it has risen significantly). For example, after introducing the original iPhone on 1/9/07, Apple initially jumped higher then pulled back to the breakout area. AAPL traded in a tight range (~83-91) for the next two months before breaking out again and more than doubling by the end of the year. The market is better at pricing in a trend continuation than a trend change.

The market is even less efficient in pricing the "turning points" for miners (e.g. transition from exploration to production) and especially for microcaps (such as Lucara Diamond (OTCPK:LUCRF)) for two reasons.

First, institutional inertia created from years of losses (and usually missed production goals, cost overruns, etc.) causes any valuation change to be unusually slow. CLQMF.PK suffers from this due to the sharp fall in the spring of 2011 after a material reduction in the measured, indicated and inferred mineral resources estimate. However, forward looking investors should be encouraged by two factors. First, in addition to construction being on time and on budget, the updated feasibility study projected significantly higher EBITDA and NPV (due in part to lithium co-products). Second, the threat of dilution (an inherent risk in exploration stage miners) is significantly reduced given that all of the money required to bring the project online has been raised as well as the fact that the recent convertible debt has a conversion price well above the current price (0.72).

Source: Company

Second, the inherent uncertainty involved in projected future production results in the market erring on the side of caution and assuming the worst, rather than base or best case scenario. These two factors provide the potential for significant price appreciation in a short time frame if production is merely on target.

Furthermore, risk is significantly reduced given the off-take agreements for 75% of production with Tewoo and Marubeni, two of the largest commodities traders in China and Japan, respectively. CLQMF.PK is looking to secure additional off-take agreements with other lithium end users.

Secular end user demand growth should drive strong pricing power

CLQMF.PK is at the intersection of three significant secular growth trends: consumer electronics, electric/hybrid vehicles and smart grid-storage.

Consumer electronics. The increasing popularity of tablets and smartphones should drive increased lithium consumption. CLQMF.PK should benefit as investors eventually look "inside" the device for derivative plays. Furthermore, the use of lithium in less high tech products (e.g. power tools) represents an additional source of demand as it is currently only used in 30% of batteries.

Electric/hybrid vehicles. The rising tide of electric/hybrid vehicle demand is only lifting one automaker rather than the companies supplying the critical components. CLQMF.PK is a more attractive way to play this trend, especially given that the CEO doesn't think the stock is overvalued, unlike the CEO of TSLA*. Moreover, given the increasing electric/hybrid competition (Toyota discounts leases, GM and Nissan reduced prices, luxury automaker BMW introduces its own electric rather than lose the high end to TSLA), the risk is arguably lower for CLQMF.PK than TSLA as the former benefits from more competition while the latter suffers from it.

Smart grid storage. Lithium batteries can power storage units and generators and feed electricity back to the grid. CLQMF.PK should benefit from the fast growing trend of distributed power generation and storage. Again, the focus is mainly on how utilities will be negatively affected rather than how lithium miners will benefit.

AES Systems recently installed a 32 MW storage unit in West Virginia to serve a wind farm. This is a significant development for two reasons. First, storage units require much more lithium compared to smartphones and tablets (e.g. a smartphone uses five grams of lithium carbonate while a 1 MW storage unit uses 600 kg), which allows for even small unit demand growth to drive high lithium demand. Second, the use of storage units removes a major obstacle to the adoption of alternative energy (e.g. the energy generated from high wind conditions is "lost" when the wind stops blowing). In this aspect, CLQMF.PK is a lower risk way to play the alternative energy trend given that it has less headline risk (e.g. threat of elimination of politically unpopular subsidies).

*Elon Musk said "the valuation is more than we have any right to deserve". I can probably count on one hard (with fingers to spare) the number of times a CEO said their stock price is too high. When the CEO says (for all intents and purposes) that the valuation should be lower, don't be surprised if the market eventually listens.

Strategic interest in limited number of lithium mines provides valuation floor

In August 2013, chemical and material manufacturer Rockwood Holdings (NYSE:ROC) offered to acquire Talison for $728 Million in order to gain its lithium assets. However a Chinese conglomerate Chengdu Tianqi Industry Group offered more and ROC walked away rather than start a bidding war. In March 2012, Galaxy Resources agreed to acquire Lithium One for $109 million.

There are two key takeaways. First, ROC presumably still has a desire to diversify its lithium asset base and might attempt another takeover. Second, Tianqi specifically cited hard rock lithium as a reason for the acquisition. This is the same type of lithium found in the CLQMF.PK project.

Risks

Investor lawsuit. In April 2011, CLQMF.PK announced it was the target of a proposed class action lawsuit relating to the release of a change in the mineral resource estimate on 10/28/10. In March 2011, CLQMF.PK announced that Roscoe, Postle & Associates confirmed that "there were significant issues with the geological modeling that had produced the mineral resource estimate". CLQMF.PK appointed AMC Mining Consultants to independently conduct a resource estimate and prepare a new NI 43-101 compliant report. In August 2013, a court issued order certified the class action status and narrowed the scope of the claims.

Competition. CLQMF.PK faces competition from other miners, many with much larger scale and resources.

Potential increased taxes. In March 2013, the government of Québec proposed increasing taxes on the mining industry (base royalty of 5% on gross mining output and an additional tax on mining profits instead of the existing system based solely on taxing mining profits). However the changes are less than initially feared.

Dilution. The exercise of options and warrants, as well as the conversion of convertible debt into shares, will cause existing shares to be diluted. Going forward, any additional capital raised may further dilute shareholders.

Relative lack of pricing transparency. Compared to other commodities such as oil, the market for lithium is less transparent. There is a modest spot market and no internationally recognized lithium spot price. The majority of lithium is traded on a negotiated contract basis for fixed periods ranging from three months to three years. As a result, supplier/customer relationships determine the price for lithium (as opposed to investors).

Lack of current revenue. As an exploration stage miner, CLQMF.PK currently does not generate revenue from its development projects and therefore must rely on debt and equity issuance as well as credit facilities to fund operations.

Inherent mining risks. CLQMF.PK is subject to the same risks facing every miner (not just lithium) including lack of economically feasible reserves, reserve estimation uncertainty, delays, cost overruns, reduced demand, lower prices, ability to obtain required permits and changing government regulation.

Property concentration. CLQMF.PK currently only owns one property and is solely dependent on it for future development.

Conclusion

The target price is based on a 5x EBITDA multiple using the following assumptions:

Conservative investors could enter on strength above the 50 DMA while more aggressive investors could enter now with an extremely tight stop (no more than 5%) given the recent downtrend. The time frame is 12-18 months given the time required for production to start early next year and for the market to fully price in the growth story.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.