SQM - SQM: Brace For Impact

2023-04-22 04:39:07 ET

Summary

• Investors were jolted as SQM took a plunge of almost 20% to close yesterday's trading session, triggered by the Chilean government's bombshell announcement of nationalizing its lithium mining sector.
• Investors are now bracing for turbulence as SQM's fortunes, pinned on the low-cost Salar de Atacama, hang in the balance with significant uncertainty.
• Investors are facing a nail-biting situation as SQM's lease, set to expire in 2030, leaves the government poised to undertake a controlling 51% stake.
• While we noted that SQM is facing significant political uncertainty, yesterday's selloff has improved its valuation significantly, presenting a highly attractive opportunity.

Leading Chilean lithium miner Sociedad Quimica y Minera de Chile S.A. (SQM) was hit by a massive wave of panic selling as holders bailed out of the stock following the announcement by the Chilean government to nationalize its lithium industry.

Accordingly, President Gabriel Boric's administration unveiled a " new public-private model for the lithium mining industry." As such, the government will take majority stakes in companies engaged in lithium mining operations in Chile, including SQM and Albemarle (ALB).

However, SQM felt a harsher blow than ALB yesterday, as it declined nearly 20% at the close of yesterday's session, relative to ALB's 10% fall.

Investors new to SQM are encouraged to refer to our previous article for a primer.

The critical question that investors need to ask is whether yesterday's selloff is justified?

Morningstar updated that there is a " 50% probability that the proposal will move forward, as it needs congressional approval." As such, the political risks of investing in lithium miners heavily exposed to Chile are coming home to roost, benefiting lithium mining investors who diversified their geographical exposure.

Notwithstanding, the allure of investing in SQM, leveraging its low-cost advantage in the Salar de Atacama, likely appealed to investors. However, with the formalization of the Chilean government's public-private partnership, investors must brace for the possible outcome of the government's involvement in SQM.

What's at stake for SQM is pressing, as its current lease with the Chilean government expires in 2030. According to the new model, SQM "would move to the state-controlled model once contracts expire in 2030," or earlier if it opts in.

Assuming that SQM chooses not to opt in, it's estimated that SQM would need to sell a 51% stake to the Chilean government "around asset value when its lease expires in 2030," necessitating a reduction in its fair value estimates.

With yesterday's selloff, SQM's blended fair value estimate has dropped to highly attractive zones, likely reflecting the significant political and execution uncertainty surrounding the new public-private model.

Morningstar also increased its fair value uncertainty rating from high to very high, suggesting investors will need to consider a significant level of discount against its fair valuation.

Seeking Alpha Quant factor ratings suggest the best possible A+ grade for its valuation, among other notable A+ grades for growth and profitability.

We also noted that SQM's NTM EBITDA has dropped to 3.6x, well below its 10Y average of 10.8x. It's also well below ALB's 5.1x and its peers' median of 4.6x (according to S&P Cap IQ data).

As such, we assessed that SQM's fair value uncertainty has likely been captured by yesterday's downward de-rating, opening up an attractive opportunity for investors waiting to add exposure.

SQM's price action suggests that recent dip buyers in March have been taken out decisively, opening up toward the gap to its critical support level of $45.

We believe the $45 level should hold, as it's also in line with Morningstar's bear case of $40. The bear case incorporates significant weakness in medium-term lithium pricing and more efficient extraction techniques that could reduce lithium prices further through the cycle.

For instance, direct lithium extraction, or DLE, is one of the considerable risks that investors must pay attention to. However, the technology is still in the nascent stages of development but has the potential to "disrupt the traditional lithium supply chain."

Moreover, Chile intends to require DLE for lithium mining operations in "a bid to reduce water losses," further complicating Chilean lithium miners' efforts to improve their scale and operating efficiencies.

Therefore, while we think the $45 level (December 2021 lows) should attract long-term buyers back into the fold aggressively, SQM might still be bedeviled by near- to medium-term volatility at the current levels if it loses its $70 support level.

However, we assessed that its valuation had reached highly attractive zones, even when considering a considerable margin of safety to reflect such execution and political risks.

Investors are encouraged to keep additional ammo to average down as SQM falls through the gap.

Rating: Strong Buy (Revised from Buy).

Important note: Investors are reminded to do their own due diligence and not rely on the information provided as financial advice. The rating is also not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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