I am researching the chemicals sector as there are many stocks with low PE ratios that look valuable at first sight.
The below is part of my list, I am looking at one by one, writing up short overviews, and at the end of the process, I’ll see what are the best businesses to watch over time and perhaps even buy when cheap. I’ll write up deep reports on the most interesting businesses.
Albemarle (NYSE: ALB) is a very interesting business creating a strong buzz with its lithium segment. The stock is down but the business looks strong, it is time to make a deep dive into the lithium sector.
On a side note, the above chart perfectly describes the biggest benefit of value investing versus growth investing is. During 2017, with high lithium prices, investors where extrapolating staggering growth rates for ALB and expecting lithium prices to grow forever. In such an exuberant environment few even consider the risks, but at some point, the growth has to slow down and when that happens, the situation gets ugly. It gets ugly for those that have chased growth, of course.
Value investors on the other hand, avoid hot stocks due their high risk. As seen in the above chart, growth stocks can easily fall 50% and more. However, this doesn’t mean anything. Value investors actually look at companies when there is usually a lot of negative sentiment while the fundamentals still offer attractive business returns. By buying businesses, with an attractive business earnings yield in relation to the price paid, you buy with a margin of safety. Thus, you don’t lose money, which is the key when it comes to investing!
Disappointed growth investors often create the best buying opportunities. When it comes to hot stocks, the excitement usually vanishes quickly and when that happens, one has to look at the fundamentals, estimate earnings with and without exuberance to see what is the investing risk and reward. This report will focus on that.
Albemarle business overview
Albemarle is a diversified business and there are 3 sectors to discuss: Lithium, Bromine and Catalysts. All sectors have different sector environments that make this an interesting, diversified business.
The market capitalization is $7.7 billion and the net income is $695 million for a price to earnings ratio of 11. We have to see about the trends and earnings for each specific sector so that we can make a forward-looking earnings model.
The lithium segment is the growth one while bromine and catalysts will be good if maintained at current levels.
The company has been good at rewarding shareholders with a 26 year dividend increase record and strong buybacks of $500 million. Combining the buybacks and dividend gives a yield of 9%. The lithium environment also offers excellent growth opportunities.
However, that is completely normal, when the price of a commodity goes up, more investment projects are feasible, therefore there is more supply and the price has to decline. The key is that, at some point in time, it will be nature that will determine the price. In such a scenario it is always good to be the lowest cost producer.
It is good to note here that lithium is not really a commodity as lithium products are not really the same in a way copper is. Albemarle recently decided not to notify the London Metals Exchange on its contracts as it is not possible to compare what is produced and sold. Lithium customers know what they need and they want to get it through long-term contracts.
Lithium cost curve
We can take a look at the cost curve for lithium, but it should be taken with a grain of salt as it depends on what the customer needs and whether the specific mine can provide the necessary chemical formula.
Alongside SQM, ALB has the lower production costs out there. This means that whatever happens with lithium prices, the company should have profitable operations. If we look at the projects they are ramping up. Xinyu is a project in China that should be on the middle of the cost curve. La Negra is in Chile, thus low cost. The Kemerton plant in Australia will be somewhere in the middle. However, this all depends on what the customer wants. Even if Australia is on the high end of the cost curve, ALB’s mine Talison is one of the best spodumene mines in the world, which means one on the lowest cost hydroxide lithium producers. So, both in Chile and Australia, low cost.
If we approach it from a commodity perspective, the question is what will be the price depending on the supply and demand. The current price is around $10,000 and the fact is that production can be easily increased, both in Australia and in South America.
The thing is that lithium is not sold on the spot market. It is sold through long-term contracts at defined prices. Only if ALB gets enough customers, it will develop its projects. For now, everything up to 2021 is sold.
ALB’s plans imply a 150% increase in production. Let’s assume they have half the current margins; lithium EBITDA should be $700 million. If lithium prices go up, well you know the story. At current margins, EBITDA should be $1.25 billion.
So, this should be the easy part of analyzing ALB, now we go to the hard part that includes all kinds of regulations, current situations etc.
Current analysis of Albemarle + the growth story
More rain in Chile slowed down the evaporation process in Q1 and therefore production has been smaller with higher costs.
Current lithium prices have been a bit lower, but still ALB has margins of above 40%. If the EV trend continues, ALB should keep those margins.
If we see the EV trend develop as expected, by 2030, ALB should be extremely well positioned to service the huge demand for lithium. However, as the ramp up in EV takes times, isn’t linear, lithium prices might first go down. This would be detrimental for ALB.
All in all, ALB plans to increase its production from 65,000 metric tons in 2018 to 250,000 metric tons in 2025. The company has invested $700 million in 2018, will invest $900 million in 2019 and this shows how the commitment is there. The company isn’t about what is going on now, but about what will be going on in 2025.
Thus, a 4x production increase in lithium, could lead to EBITDA increases between 3x and 5x, depending on the price of lithium.
Albemarle – Bromine & Catalysts
ALB is the second largest producer of bromine. Bromine is used in flame retardants for electronics. The company has a cost advantage thanks to its Dead Sea operations and we can expect healthy and steady profits there.
Catalysts are needed in oil refining and petrochemical production. There is a steady need for them and therefor the cash flows streams are also expected to be steady.
Both the catalysts and bromine business are nothing spectacular but slow and steady cash flows that help the company grow on the lithium field.
Given that EVs are a new trend, we don’t know whether it will last or not. Perhaps a new technology will be better and therefore there might be less demand for lithium. This is the biggest risk when it comes to ALB.
There are also operational risks in developing the assets. There could be also regulatory risks as countries, like Chile, decide on how much lithium can be exported.
Conclusion – expected investment returns
If lithium demand grows as expected, at double digits over the next years, so will ALB. Thus, at a PE ratio of 10, we can expect the same growth in the stock price. The question is whether the growth will be 10% per year or 18% per year as it ALB’s lithium growth forecast. As lithium makes now 50% of the profits and the other two segments are not expected to grow, we can put a 10% growth rate on earnings.
10% growth on earnings, and that should also be the investment return, plus a 2 to 3% dividend yield.
All in all, we are at 10 to 15%. If there comes a new round of exuberance related to lithium prices given that things look bad now because lithium prices are expected to decline in 2019, we could see the stock price trade at a PE ratio of 20 and then the returns can be achieved faster.
Let me check the other 5 lithium producers and then we will have a better perspective on the sector.