Quick Note On Recent Lithium Majors' Earnings

Summary

• Albemarle and SQM are down 27% and 24% respectively YTD, whilst the S&P 500 is practically flat.
• Fall comes on the back of CORFO deal and Morgan Stanley Report.
• Competitive advantages these companies have enjoyed, including customer trust and lowest cost to market, remain unchanged.
• Current share prices could prove attractive to latecomers.

Not an auspicious start of the year for the two largest producers of lithium in the world with sharp share price declines in spite of improved revenues and earnings factoring out one-offs.

Source: Capital IQ

Admittedly, including SQM's (NYSE:SQM) $20 million settlement with the Chilean government and Albemarle's (NYSE:ALB) $366.9 million TCJA-related provisional net tax expense, both companies had GAAP earnings per share below consensus estimates. Another concern was with the Capex of both ALB (ca. $500mn in 2018) and SQM ($170mn over the next couple of years), which will lower the latter's FCF in the near future and lead to negative cash returns for the former in 2018. I am personally a bit puzzled by this as I find the ability to deploy cash to invest in lower cost production to be a source of competitive advantage, especially if there aren't any funding concerns. I would expect the Street to also deem these investments to be value accretive in due course.

Casting the aforementioned aside, if we judge the underlying businesses of both companies excluding one-offs, we find that they have been improving consistently over the past year owing to a mixture of improved demand and pricing. This was highlighted by Albemarle in its earnings presentation (SQM deck not available).

Source: Albemarle Q4'17 earnings presentation

In light of this operational performance, one ought to wonder what has lead to such precipitous share-price falls. Two catalysts can be singled out. First, in mid-January, SQM reached an agreement with CORFO that grants it the right to expand its production by an additional 2.2 million MT of Lithium Carbonate Equivalent (LCE) through 2030 in Chile. That was then followed by a related announcement by Morgan Stanley (MS) in late February claiming that because of the impending excess supply, LCE prices would fall by 45% in the next 4 years. This resulted in two subsequent sharp falls of most non-Chinese lithium stocks as can be seen below.

Source: Capital IQ

Both companies were quick to assert that prices were actually increasing in 2018 and that the price decrease would not be as steep as expected by MS. Orocobre (OTCPK:OROCF) and Pilbara Minerals (OTCPK:PILBF) did the same. Specifically, SQM alerted analysts that it would only increase capacity "based on market conditions". Albemarle went one step further by asserting that its capacity expansions would not stem from forecasts but rather be linked to actual customer demand and confirmed orders.

A scenario wherein supply is added gradually is sound for two reasons. (a) The end customers are parts suppliers to automotive OEMs who go through rigorous approval processes. This implies that they would have a preference for established and reputable companies such ALB and SQM, as evidenced by a number of recent announcements hinting to several OEMs' interest in either some form of ownership or secured supply from miners. Majors would then ramp up supply based on actual demand, and the incentive for suppliers without such commitments to add capacity would be lower. (b) There would be little incentive for major miners to flood the market by hurting their own margins.

And even if, remote as that possibility may be, companies such as SQM decided to gain share through pricing, that would be offset by its lower cost basis, as outlined here. It would be indeed very difficult for any supplier besides Albemarle, SQM or FMC to sustainably undercut market prices because spodumene mined in Australia is more expensive and no group of companies has the capacity/output to be able to consistently provide LCE below the price of those three companies.

I am not sure who named Morgan Stanley the moral arbiter of lithium supply and demand (Goldman Sachs (GS), JPMorgan (JPM), and Citi (C) have left their target prices unchanged). Notwithstanding, their note accelerated a decline in both of these companies' market value, and SQM and ALB now have the lowest EV/EBITDA growth in their peer group.

Source: Capital IQ

This could prove an interesting entry point for latecomers to the lithium universe, as company fundamentals are still robust and the SD worries seem exacerbated. Moreover, I see a lot of upside risk with a new pro-business government in Chile, the sale of Potash Corp.'s SQM stake (POT), Albemarle now becoming technically oversold and question marks over competitors' ability to bring new capacity online.

Analyst’s Disclosure: I am/we are long SQM. 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.