ABX:CC - Albemarle: Top Of The Cycle Bottom Of The Trough

2023-09-14 10:38:41 ET

Summary

• Many continue to search for the next big lithium project when the largest operator is selling for a steep discount, right under our noses.
• Albemarle is a first mover and has many advantages in connecting the dots between production and refining.
• Even if Albemarle lost half of its net income to margin compression and lower lithium prices, it would still be trading at about 11 X GAAP.

The only lithium "Blue Chip"

After going through my monthly exercise of looking through updated Magic Formula large caps on Joel Greenblatt's screener, I stumbled across an old friend I hadn't seen in a while. Albemarle ( ALB ), was my largest single stock holding before the Covid era, and one of my luckier, non-fundamentally based returns. I say non-fundamentally based as the thesis was wrapped up in lithium becoming a staple commodity once I saw that Tesla Giga 1 was going up in Nevada and that the specialty chemicals company had just acquired Rockwood lithium.

Before that acquisition, the company was not as lithium-focused as they are today. You could see it coming down the pipeline, but it was a long, slow pipeline. Euphoria took hold and the stock trebled for a brief period. Fundamentally the P/E ratio getting well over 100 was not encouraging and I jettisoned the holding for a profit, something I rarely do. I just didn't think they could grow into their valuation. Oddly enough, they did! But once they did, no one wanted it anymore.

I can see the reasoning to an extent being that lithium prices have dropped significantly as of late. Margin compression coming soon. Many junior miners are set to come online with their projects and it's questionable if the thirst for EVs is insatiable even if a recession hits. I see Albemarle as the first mover and most knowledgeable operator in the entire ecosystem.

I give them a lot of credit for executing and getting where they are today. I still don't understand why there is still a craze to find the next big project when you already have the biggest operator in front of our noses selling at a steep discount to their historic valuations. I'm cautiously buying here, but wouldn't be surprised if there is more downside in store as the supply-demand equation becomes more out of balance in the near term. This is a dollar cost average on an expected downward price trend.

The chart

At 43% off the all-time high and trading at 5.6 X trailing and 7.3 X forward earnings, Albemarle is certainly cheap on the surface. Let's examine more about the business to assess the entry point.

What they do

Albemarle used to be a specialty chemicals company first and foremost. They are now transitioning to a lithium producer as their first order of business.

From the MRQ 10Q :

Effective January 1, 2023, the Company realigned its Lithium and Bromine global business units into a new corporate structure designed to better meet customer needs and foster talent required to deliver in a competitive global environment. In addition, the Company announced its decision to retain its Catalysts business under a separate, wholly-owned subsidiary renamed Ketjen. As a result, the Company’s three reportable segments include: (1) Energy Storage; (2) Specialties; and (3) Ketjen.

Interestingly enough, Bromine, along with potassium, potash, etc. used to be the main target for many of the now lithium giants. Lithium was a by-product sold mainly for pharmaceutical and glass production along with some other metal alloy incorporations. Needless to say, this script has now been completely flipped. Looking at the three months ending June 30, 2023, "energy storage" now comprises 74% of total revenue.

Projects:

The current lithium resources for Albemarle are:

• Salar de Atecama, Chile 30% of supply
• Greenbushes and Wodgina, Australia 64% of supply
• Silver Peak, Nevada 6% of supply

The below resource amounts are in metric tonnes in thousands

The supply chain

Shown above is an excellent infographic on the supply chain for the current in-production projects. The brine is refined in La Negra and Silver Peak Nevada while the hard rock hydroxide is sent mostly to China. Keep in mind, that these production-to-refinement problems will all have to be tackled by smaller miners just now getting close to operational phases. This is a complicated networking process and Albemarle is ahead of the game.

Expected sales growth

Expecting a 20-30% CAGR in sales growth per year into 2027 would be phenomenal. As it stands, Albemarle seems to believe they will be firmly in the black as long as lithium stays above $20 per KG which should also self-fund expansion. As of today, the price is down to $27 per KG . The price direction of lithium has not been all that encouraging over the past few months, but more demand and EV growth will eventually correct this.

Valuation

This is a commodities company which by nature is highly cyclical. The more cyclical a company is the more difficult it is to price on growth, i.e. PEG ratio, or discounted cash flow. In this case, a snapshot of the return on invested capital combined with earnings yield tells me whether it's an attractive entry point or not. With a P/E of only 7.32, that equates to an earnings yield of 13.6 %. If we combine this with a calculated 21.33% ROIC, this is an ultra-cheap stock with high returns on capital.

Do I expect it to recede? Yes. But even at half the current net income, we have a good deal in a high future-demand market that should stabilize at some point and steadily grow with inflation.

ROIC

All numbers courtesy Seeking Alpha in millions:

Nopat (net operating income after taxes)/total LT + ST borrowings + total equity

• Nopat=EBIT X (1- tax rate)= 3,272 X (1- 11.8%)= 2,885.9
• TTM total equity= 10,088
• TTM Long term debt + short term borrowings = 3,393.5+46.9= 3,440.4
• Total interest bearing debt + total equity = 13,528
• NOPAT/ Invested Capital= 2,885.9/13,528= 21.33% ROIC

While ROIC is not a universally congruent measurement across all platforms, 21.33% is what I'm coming up with based on the current TTM data. Below we'll find a bit higher numbers on YCharts. Regardless, the trend lines will be similar:

As We can see, Albemarle has never operated at this elevated level of return on invested capital. To be fair, Albemarle was a completely different company before the acquisition of Rockwood and its' pivot into becoming a lithium leader. The pivot happened at the right time and now they have a near unlimited lithium off-take market.

Can the returns on capital be sustained

As is the question with commodities companies in a high demand, low output "super cycle", the top of the mountain is often seen as the cliff than the summit. Let's take a logical look at margin trends:

Albemarle is showing some unusual trailing 10-year margin trends for gross and operating margins. With the recent shrinking of margins, we can assume that the decrease in spot lithium prices is to blame for the curtailing. The question we have to ask ourselves in the years to come is; "will the supply outstrip the demand, or vice versa"?

The sharp decline since Jan 2023 could spell lower profits and margins down the road. As most off-take agreements are for a specified futures price and a specified length of time, this could take some time to show up in the financial data. We also know that Elon Musk and Tesla ( TSLA ) are big clients. With all the new supply coming online, it might be naive to assume that some of these contracts don't get reworked.

Normal returns on capital for miners

Here we can see mining broken down into a few different categories. The precious metals giants in Barrick Gold Corp ( GOLD ) and Wheaton Precious Metals ( WPM ). Conversely, we have the industrial metals in Rio Tinto ( RIO ) and Southern Copper ( SCCO ). Albemarle certainly falls in line with the industrial metals group of Rio Tinto and Southern Copper as good historical comps for returns on capital. Drilling down on those two, their ROIC lines look relatively flat from a historical perspective compared to the parabolic jump that Albemarle experienced.

While a lithium mine is certainly different in operational cost structure than hard metal mines, I believe eventually the returns on capital for brine, hard rock hydroxide and possibly clay lithium mines will gravitate more towards the returns on capital for copper and nickel. These are all battery/electronic metals and will see their demand curves closely track each other.

Balance sheet trends

With nothing coming due until 2025, the effect of interest expense on net income should be stable for the next two years. Come 2025, Albemarle will have to refinance or pay off the 11% of the debt outstanding. Although Albemarle does not generate the free cash flow needed to extinguish that debt, they do currently have $1.6 Billion in cash on the balance sheet. Using cash reserves rather than rolling the debt over into larger interest payments would be the wisest choice but may limit some expansion opportunities.

EBIT to net interest coverage

The dividend and free cash flow

Looking at the dividend and free cash flow, I am considering:

1. The $1.59, or .86 % dividend is paltry.
2. This is a dividend aristocrat with 28 years of dividend growth.
3. There is ample room to increase the dividend.

With such a wide margin between free cash flow per share and the dividend payout per share, we should as investors expect a bump in dividends as Albemarle's earnings stabilize and CAPEX subsides. With the company running a TTM all-time high CAPEX of $1.678 Billion for the TTM ending September 12th, we shouldn't expect a bump until that trends downward.

However, even though the yield is small, ample coverage is important. Being that Albemarle is a dividend aristocrat, a reduction or elimination of the dividend would create risk. Now that Albemarle is in a more unpredictable business than before, having a wide margin of coverage is wise to protect share value. You don't see many, if any industrial metals companies on the aristocrats list, and for good reason. Similar to Rio Tinto, they usually operate on a ratio of earnings basis for dividend payments versus a standard per annum increase policy.

Catalysts

The CAPEX has been spent to make the complete pivot into a lithium-centric company and it's paying off. Looking at +60% growth quarter over quarter MRQ 2022 to 2023. If 2023 wraps up with the expected 40-55% net sales increase, this is a big win for the company. Less tense relations with China and a less opaque situation in Chile are other catalysts. A sharp rise in lithium prices would also serve to catapult the stock. This company has finally executed and now the market is sour on it.

Risks

The dividend

Looking back at the dividend to free cash flow comparison chart, we can see that Albemarle just recently got the free cash flow per share trend line above the dividend per share. In an unpredictable business that could require large spouts of CAPEX followed by long periods of cooling off, the dividend is not as safe from a recent historical perspective as it is now. Maybe we should hope that Albemarle leaves the dividend alone until they've shown a few years of being able to maintain free cash flow at least 2 X the dividend.

Chile and China

The Chilean lithium nationalization announcemen t is what has sent Albemarle down to the bottom of the trough starting in April. The Chilean government forming a national company that could one day take over all existing mines once leases are up is a risk. The announcement also set off alarm bells that the government is probably looking for higher royalties. As of September 12th, Albemarle has already had to renegotiate labor agreements with its' Chilean workers union.

China is another big factor. They are the best at refining rare earths and other metals that would normally be difficult to do stateside due to environmental regulations in many areas. As we can see from the prior presentation notes, Albemarle is using Chinese refineries for their hard rock lithium from Australia. While Australia is the company's most reliable and safe large resource, putting China in the supply chain mix changes the calculus a bit.

As Chile and Australia represent the bulk of Albemarle's lithium production, these are both big risks. However, even trying to get a lithium project off the ground in the US presents challenges by local governments and environmentalists. Lithium Americas ( LAC ), knows this all too well with the delay in their Thacker Pass Nevada clay project.

Conclusion

Albemarle is experiencing a top-of-the-cycle moment that few believe will last. This is evidenced by the nearly 50% haircut. Once more product comes online and if we experience a recession, lithium prices could drop even further and continue to compress margins. That being said, Albemarle has some advantages in that they have been connecting the operational, political, and consumer network dots for longer than most in this business.

The junior miners will grab some business, but there should be a near-unlimited market to chase long term. Even if Albemarle lost half of its net income to margin compression, it would still be trading at about 11 X GAAP if we assume a market cap of $21.8 Billion and a halving of current net income. Paying 11 X for the best operator in the lithium space is hard to pass up as lithium should stabilize into an inflation-plus type of steady growth business eventually. Buying cautiously at this price level and below.

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