Attached DCF and presentation should be considered in conjunction with the written report.
Albemarle Corporation (ALB) is a specialty chemical company incorporated in North Carolina with segments in bromine specialties, lithium/advanced materials and performance catalyst solutions (PCS). In 2017, bromine specialties made up 27.8% of revenue, lithium/advanced materials made up 42.5% and PCS made up the other ~25%.
The lithium and advanced materials segment made up the largest share of revenue in 2017 following a growing trend since it was acquired from Rockwood holdings in 2015. Lithium and advanced materials include the extraction of lithium through brine and extraction through spodumene pegmatite mining. The process of brine extraction includes pumping the brine out from deep beneath the earth’s surface into large evaporation ponds where over the course of a couple years the lithium is separated from the other contents. Brine extraction is the relatively inexpensive option, however, spodumene mining in Australia remains an important part of Albemarle’s business. The process of spodumene mining is less capital intensive but requires a higher marginal cost of production to maintain.
The bromine specialties business is a mature, legacy business for Albemarle where they maintain a dominant global position as well as the lowest global cost basis of production through their Dead Sea operations. Bromine has applications in several different end markets but the largest share is consumed by the fire retardant business. Due to the chemical composition of Bromine, it serves as the most effective means of preventing fire and controlling the burn of any possible fire occurrence. Bromine is currently used as a fire retardant in a broad range of consumer devices including, personal computers, smartphones, tablets, televisions, etc… We remain confident in Albemarle’s ability to maintain a competitive advantage in this mature and relatively slower growing segment.
The final portion of Albemarle’s business is the performance catalyst solutions segment, which serves as a label for Albemarle’s various highly specialized catalyst products. A large portion of these catalyst products are designed for end use in petroleum refining where they serve as a necessary component in the reduction of sulfur and other impurities in the finished petroleum products. Their product lines are highly customized for use by oil refineries around the globe and remain at a competitive advantage due to this high level of customization and the associated long-standing customer relationships. Analysts currently see the PCS segment growing sustainably in the long run despite variability through oil production cycles that cause this segment to produce cash flows in a somewhat cyclical nature. The key driver for long term growth in the segment is a transition towards a more sour and heavy crude oil.
Investment Thesis Overview
Lithium is a unique specialty chemical that is unlike other popular commodities such as copper and gold. Due to the extensive requirements for lithium to naturally occur in sufficient quantities for economical extraction, there are few profitable locations around the world. As a result, Albemarle gained a significant first-mover advantage through the 2015 Rockwood acquisition and the associated right to the 2nd lowest cost basis lithium mine in the world. Through the exclusive access to these unique assets, we expect Albemarle to remain at an advantage throughout lithium pricing environments and maintain a dominant market share.
Albemarle’s management team continues to show focus on the promising lithium segment which is evident in recent acquisitions and divestments. As a committee, we currently view Lithium production as Albemarle’s most advantaged and relatively profitable segment. Management clearly reciprocates that viewpoint and we are confident in their knowledge and ability to continue placing the necessary focus on the lithium segment. A few recent examples of management’s strategy include a joint venture with Mineral Resources limited, acquisition of Jiangxi mining and the acquisition of Rockwood.
Albemarle maintains a unique competitive advantage over its lithium mining competitors due to the internal financing capabilities created by the diverse segments. While we do see lithium mining as Albemarle’s key growth segment going into the future, we also value Albemarle’s other segments for providing sustainable FCF and their associated divestment opportunities. In 2017 Albemarle’s bromine specialties and performance catalyst solution (PCS) segments made up 53% of adjusted EBITDA with a combined total of $470 million in segment EBITDA. We see these segments aside from core lithium as a vital source of funding for the very expensive capital expenditure projects in the past couple of years and the expected projects in the upcoming several years. Additionally, these other segments provide a unique source of funding through divestment opportunities. Recent examples include a portion of the PCS segment sale to W.R. Grace ($416 million) and Chemetall surface treatment sale to BASF ($3.2 billion).
Supply-side lithium expectations appear to be somewhat overstated and are heavily reliant on mine openings occurring according to schedule. The overall consensus amongst lithium and mining analysts is that supply capabilities will outpace demand growth in the lithium market over the next several years. However, we have decided to take a contrarian opinion on this after reviewing each of the several new mine openings expected to occur over the next several years. We don’t believe these mines will initially be able to produce as much as expected due to uncertain political regulations, expensive capital development requirements and history of overstating output expectations in the industry. As a result, our global lithium pricing outlook is more bullish than market consensus and will allow Albemarle to produce marginally higher EBITDA as a result. Still, our core investment thesis isn’t reliant on this assumption and we don’t have a high degree of conviction in our projections due to high levels of uncertainty.
Lithium Industry Conditions
Each of Albemarle’s segments operate in their own industry with various secular trends and varying outlooks based on unique drivers. As a result, we find it important to accurately and confidently understand the outlook of each industry.
The lithium industry is relatively immature and is constantly developing as a result of a recent uptick in demand driven by batteries and their related applications. As reported by the USGS, lithium consumption sources vary significantly overtime with a trend towards batteries and a steady share of demand from ceramics & glass. In 2006, the four largest sources of lithium consumption included, ceramics & glass (21%), batteries (19%), lubricating grease (16%) and polymer production (9%). In 2017, the four largest sources make up very different portions of consumption, batteries (46%), ceramics and glass (27%), lubricating grease (7%) and polymer production (5%). Alongside the shift in consumption sources the overall global lithium output has also changed significantly in recent years. In 2014 worldwide producers outputted a total of 162 kt LCE and in 2018 there was an estimated 293 kt LCE produced worldwide.
Despite the recent rapid expansion of lithium production capabilities, our outlook for the future of supply remains significantly more accelerated. The key source of increased production capabilities in the future, according to SRK consulting, is a long list of new mines opening worldwide, which will instrumentally change the supply side equation over the next several years. These new openings include mines in Uyuni Salt Flat, Rincon, Cauchari-Olaroz, Pilgangoora and several others making up a less significant portion of new supply. Many mining and lithium analysts remain cautious in regards to predicting the reliability of the new production, however, overall market consensus points towards a definitively accelerated growth on the supply side. Still, there are many variables that must align for production to increase at the rate currently projected. Regulatory climates in Argentina, Chile and Bolivia (the “lithium triangle”) remain uncertain, especially in Argentina and Bolivia. These countries hold 75% of international lithium reserves and thus play a critical role in enabling production and meeting the levels required by forecasted demand. Capital expenditure requirements are also a significant variable with some analysts projecting required financing in the ballpark of ~$8 billion to make new mines over the next decade a reality. This remains a significant obstacle for many lithium mining firms who rely on the capital markets that still haven’t properly classified lithium’s financing structure. We see Albemarle at an advantage in regards to both of these roadblocks due the comparatively favorable regulatory environment in Chile. and Albemarle's alternate sources of financing through internal FCF and divestment.
The bromine market is more mature and predictable, therefore, we expect significantly less variability on both the demand side and supply side of the equation going forward. In regards to Bromine, as reported by the USGS, in 2006 estimated global production of bromine was 556,000 metric tons of bromine. In 2017, the USGS reported worldwide production (excluding U.S.) at 350,000 metric tons. Assuming the United States maintained a similar market share as in 2006, global production can be adjusted to approximately ~610,000 metric tons of bromine - implying a CAGR of approximately 1%. Evidently, bromine is a rather mature industry and analysts expect global production growth to remain in line with GDP over the next decade. Growth on the demand side is largely driven by the increased proliferation of electronic devices requiring bromine as a flame retardant. However, a headwind going into the future is the relatively smaller size of newer electronics, which, as a result, decreases the bromine requirement per device.
The PCS segment is highly customized and broken up into many different compounds with a variety of end markets. The key end market, as previously mentioned, is the refining industry, which is cyclical in nature. Recently oil prices dropped from a short term peak of $75/barrel to $46/barrel ((West Texas Intermediate Crude). Due to the highly volatile pricing environment refineries produce variable amounts throughout cycles and the catalysts Albemarle sells need to be replenished in varying time intervals. As a committee, we don’t feel comfortable attempting to predict short term production levels, however, in the long run, we expect the catalyst solutions market to benefit from heavier oil that will run through the catalyst more rapidly.
Albemarle’s claim to a portion of the Salar de Atacama gained through the acquisition of Rockwood holdings remains near the bottom of the lithium production cost curve and will remain there for the foreseeable future. As previously discussed, due to lithium’s unique composition as a specialty chemical it only occurs in sufficient concentration for economical extraction in a limited set of geographies around the world. Amongst these locations, those suitable for lithium extraction through large brine reservoirs are substantially cheaper in the marginal cost of lithium extraction.
Lithium concentrations in brine vary significantly and so does the concentration of various other chemicals, which affects the evaporation rate and thus the potential extraction. A few notable brine operations contain significantly higher concentrations than competitors including, Salar de Atacama (up to 2,700 ppm), Salar de Uyuni (up to 1,500 ppm), Salar de Olaroz (up to 680 ppm) and Hombre Muerto (up to 620 ppm). While these figures aren’t absolutely accurate due to a mix of reporting sources and a variety of varying samples, we are confident that the Salar de Atacama contains the highest concentration of lithium in the world. Another key factor in brine extraction efficiency is the rate of evaporation created by the mine’s climate. The Salar de Atacama’s very low humidity, lack of precipitation, relative proximity to the equator and consistently sunny weather allows for a very high rate of evaporation - around 3,500 millimeters/year. Other mines in parts of Argentina and Bolivia don’t have the same climate advantage and therefore cannot extract lithium from the extracted brine as efficiently leading to longer evaporation periods. For example, precipitation reported in 2017 at each of the biggest mining sites in Argentina, Chile and Bolivia varied significantly. The Salar de Uyuni in Bolivia reported 413 mms of precipitation, the Salar de Atacama in Chile reported 28 mms of precipitation and the Salar de Jujuy in Argentina reported the most at 471 mms of precipitation. Additionally, the Salar de Atacama also has the most sunny days in a year at 324 days out of the year. As a result of these several favorable conditions, Albemarle’s claim to the Salar de Atacama will remain a substantial competitive advantage going into the future. Alongside the substantial competitive advantage, Albemarle’s long term claim to its mining operations in the Salar de Atacama award them a wide economic moat.
Management’s Focused Lithium Acquisition Strategy
Albemarle’s management has made it clear that their priorities are to increase lithium production through inorganic growth, which we deem to be the most intelligent and effective way. Lithium operations, especially brine fields, are unique compared to other commodities (e.g. copper, gold) in that the extraction requires a lot of waiting time. Analysts and mining companies currently report that the average lithium brine operation takes between three and six years to reach a meaningful level of production. Albemarle, understanding the urgency of demand from the electric vehicle revolution, sought to artificially accelerate growth in their lithium production capabilities through their initial acquisition of Rockwood Holdings. The acquisition’s timing in 2015 proved very beneficial for Albemarle given that the South American lithium price at the time was around ~$4700 USD and is now at ~$13500 USD. Furthermore, shortly after the acquisition management divested the Chemetall Surface Treatment segment of Rockwood’s business for $3.2 billion. Through the divestment, management effectively created a pure play acquisition on lithium mining and reduced the initial purchase price from $5.7 billion to $2.5 billion.
Since the monumental Rockwood holdings acquisition, Albemarle has continued along with the same growth through acquisition strategy that is proving both necessary and effective in capturing market share. On December 31, 2016, Albemarle acquired all equity interests in the lithium hydroxide and lithium carbonate conversion business of Jiangxi Jiangli New Materials Science and Technology co. for $145 million cash. The acquisition allowed Albemarle to expand their global reach to China, the largest electric vehicle market in the world. Following the acquisition, Albemarle rapidly increased production capabilities from 15,000 MT/year to 25,000 Mt/year through capital expenditures and patented engineering processes. Effectively, Albemarle gained exposure to the increasingly important Chinese market and amplified the plant’s production capabilities by almost 100% all in the matter of a couple of years.
Aside from acquisitions, Albemarle has also been actively working to establish joint ventures with other lithium mining operations as is common in the mining industry. Through the Rockwood holdings acquisition, Albemarle gained a 49% stake in the holding company of Talison mining, which has substantial operations in the Greenbushes mine in Western Australia. The Greenbushes mine is especially valuable because it is the lowest cost basis spodumene mine in the world and has high concentrations of lithium hydroxide, which battery manufacturers are shifting towards. Later, on November 21st, 2018, Albemarle signed a joint venture with Mineral Resources Limited for 50% of their lithium mining operations at a price point of $1.15 billion funded by cash and a credit revolver. The production facility is expected to produce 50 ktpa of battery grade lithium hydroxide in its first stage and eventually reach production capabilities of 100 ktpa. The joint venture helped further shift Albemarle’s production mix towards lithium hydroxide and better established their presence in Western Australia.
Legacy Bromine and PCS Create Advantaged Position
What makes Albemarle somewhat unique amongst lithium mining companies is its other business segments operating in the bromine specialties and PCS businesses. Albemarle’s history in bromine extraction through brine in the Dead Sea has proven useful in transitioning towards a lithium business with a focus on brine extraction and evaporation. While the processes for evaporating lithium and bromine aren’t identical, the same basic technologies and techniques are used in the process. Therefore, when Albemarle acquired Rockwood holdings in 2015 it was able to apply its wealth of experience in bromine extraction/evaporation to similar processes producing lithium. Aside from enabling the effective transition of knowledge to lithium mining, the bromine and PCS segments also have their own unique competitive advantages. The bromine mining segment is positioned favorably on the production cost curve for bromine internationally. Alongside Dead Sea Bromine Company and ICL, Albemarle produces a large share of its bromine from the indefinite assets located in and around the Dead Sea. The Dead Sea is the world’s most abundant identified source of bromine granting Albemarle a long-lasting competitive advantage. The other factor that makes the Dead Sea assets unique is the range of bromine qualities it produces for end uses across all applications from agriculture to flame retardants.
The performance catalyst solutions segment has its own unique competitive advantages built out of the highly customized nature of the products it sells. For example, oil refineries need customized compounds created and adapted to their specific oil compositions. When a refinery signs an initial contract with Albemarle’s refining solutions team there is a somewhat expensive process of crafting the specific compound that is most effective for the customer’s needs. Therefore, it’s common for oil refineries to contract out to the same refining solutions company year over year. As a result, we feel comfortable with our outlook on Albemarle’s ability to continuously generate free cash flow from the PCS segment.
In order to confidently and effectively value Albemarle we used historical relative public comparables, historical relative to self comparables and a discounted cash flow analysis. Our final valuation is a range of outputs from these unique methods that averages to our consensus intrinsic valuation.
Discounted Cash Flow Assumptions
The discounted cash flow model (DCF) constructed for Albemarle is included in the pitch materials. The DCF consists of a 5 year projection period, 12.5% nominal discount rate and 5.0% nominal long-term growth rate. We increased the discount rate above the standard nominal discount rate of 12% to account for relatively higher political and global exposure than other companies. The long-term growth rate is above nominal GDP growth of 4.5% because we expect lithium and the other business segments to maintain above GDP growth.
Short-term Revenue Growth
The key growth story for Albemarle in the short-term is lithium output growth driven by new mine openings and increased output for existing properties. In the base case of the DCF we project that new mine openings will stay in line with management’s expectations with 225,000 metric tons of lithium produced by 2023 - up from 65,000 in 2018. These numbers are based on information from management and we do believe there is a degree of uncertainty in regards to the certainty of this lithium production hike. In order to better understand the range of output scenarios we also included a bullish and bearish output projection. The bullish projection includes the 40,000 metric tons of lithium expected from the postponed Salar de Atacama expansion. The bearish projection takes a slightly more cautious approach and discounts total output increases by roughly 16%. The valuations derived from these approaches are ultimately rather similar - we do not believe relatively small variability in output production forecasts will ultimately significantly impact Albemarle’s intrinsic value. However, strong output growth still remains a key driver of the model and our resulting intrinsic valuation.
Any opportunities for margin expansion in the short term would be a result of lithium continuing to maintain its advantaged EBITDA margin and growing to become a large portion of revenue. Therefore, we took lithium as a percentage of revenue and projected out margins as a relative multiple of that increasing share as output increases. However, only a portion of that revenue is tied to minimum pricing agreements so the ultimate sale price is difficult to project and therefore confidently projecting an ebitda margin is difficult. To remain conservative, we only ticked EBITDA slightly down through the projection period to the terminal year. Our investment thesis and intrinsic valuation isn’t reliant on any EBITDA improvement, however, any improvements would surely be accretive to shareholder value.
The nature of Albemarle’s business segments, especially lithium, create a unique set of investment uncertainties.
Exposure to foreign markets
Albemarle currently has interests in operations in approximately 100 countries around the world. The large international exposure creates both advantages and disadvantages for Albemarle as well as a large range of political uncertainties. Further, mining is an especially regulated industry due to climate, resource and land concerns. For example, the Chilean government charges a royalty fee on all lithium produced each year while Western Australia has a significantly different fee structure. There is significant uncertainty regarding specific countries regulation and trade agreements made over the course of our investment time horizon. However, it is an industry level exposure and Albemarle’s industry-leading size affords them more negotiating power with countries.
Bromine mining facility in Dead Sea
The Dead Sea is culturally and religiously very significant to the people who live around it in Israel and Jordan. Given the sea’s prominence, there is a history of climate and religious complaints regarding the mining operations extracting minerals from beneath the sea’s surface. Largely as a result, several hundred potholes have been recorded happening in and around the sea over the past few years. Additionally, the excessive use of water from brine operations has driven down water levels over the past several years contributing to the source of climate complaints. Despite these concerns, bromine extraction from the Dead is expected to continue into the foreseeable future given the “indefinite” supply and low-cost basis of extraction.
Agreements with foreign governments
In a large majority of the countries in which Albemarle operates, it’s necessary to receive some degree of contractual agreement with the residing government before mining. Therefore, Albemarle remains reliant on the cooperation and the future stability of political platforms regarding mining in each of these countries. However, key countries such as Chile, Western Australia and Argentina remain positive on lithium. Governments maintain that lithium production is a key catalyst for sustained economic growth.
Chilean government audit and investigation
In January 2019, the Chilean government agency CCHEN considered launching an investigation into potential fraud after the results of an audit it ran showed that the agency failed to properly record exports of lithium between 1984 and 2015. While this audit affects not only Albemarle but main competitor SQM, it does raise concern about the transparency of ongoing international lithium operations and the competency of foreign government bodies tasked with their regulation. Albemarle acquired Rockwood Holdings and has been operating in Chile only since 2015, so as investors we are not concerned that Albemarle had anything to do with the inaccurate reportings, but rather they inherited discrepancies with their acquisition.
Shifting battery technologies create varying material requirements
From the first battery composition in 1799, formulations of batteries and associated resource requirements have changed repeatedly and somewhat consistently. Initially discovered in the 1950s, Alkaline batteries remained for approximately forty years before being replaced by the current lithium-ion battery which was formulated in the 1990s. Current lithium-ion technology and resource ratios change regularly overtime as well, however, the lithium material persists serving a vital role in the battery’s functionality. Lithium-ion batteries isn’t expected to be phased out soon largely due to the comparative favorably production economics and room for further optimization. Experts predict that we still have well over a decade until lithium-ion batteries reach “advanced lithium” capabilities, implying room for growth of over 30% in battery capacity, and well over a decade of end market opportunities growth. Amongst possible investment risks, changing battery technology is relatively unconcerning for a 3-5 year time horizon.
Disclosure: I am/we are long ALB. 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.