SQM - SQM: Buy The Overblown Lithium Pricing Fears

2023-04-04 09:30:10 ET

Summary

• SQM is a leading low-cost lithium producer which benefited significantly from last year's lithium price surge.
• However, that thesis has come under significant pressure in 2023, as spot battery-grade lithium prices have continued to fall in March, down more than 40% over the past month.
• SQM is also expected to post a revenue CAGR of -7% from FY22-25, suggesting some headwinds have likely been reflected. However, it's still likely to remain highly profitable.
• Investors who have waited patiently for a lower-risk entry point can consider adding some exposure at the current levels.
• However, a medium-term downtrend has taken over SQM's directional bias. As such, keep additional ammo to average down if necessary.

Sociedad Quimica y Minera de Chile S.A. ( SQM ) is among the world's top three lithium producers . The company focuses its efforts on the Salar de Atacama, leveraging its cost advantage in its lithium deposit.

Notably, it has "the highest concentration of lithium globally and benefits from high evaporation rates in the Chilean desert."

SQM derives its gross profits from lithium, iodine, and nitrates. However, keen investors should know that the company generated about 79% of its consolidated gross profit from its lithium segment in FY22.

As such, we believe the company is well-positioned to ride the secular growth drivers in EVs and energy storage as the world electrifies and continues its transition toward renewable energy sources.

Despite that, SQM has suffered the effects of the recent lithium pricing downturn. Accordingly, battery-grade lithium carbonate prices have fallen from RMB370K per metric ton or MT at the start of March to RMB219K per MT as of April 4.

As such, it represented a significant decline of more than 40% over the past month, as the market has gotten increasingly concerned about the sustainability of EV demand in China.

China's EV demand is likely to continue coming under pressure. China is projected to deliver about 9M EVs in 2023. However, there are concerns about whether China's durable goods consumer spending on EVs could slow down further, even as a more robust H2 recovery in consumption is expected.

Accordingly, China's leading NEV maker BYD Company ( OTCPK:BYDDF ), urged China's policymakers to extend its NEV purchase subsidies to 2025 to help " stabilize expectations and encourage the development of NEVs."

Deutsche Bank ( DB ) also updated in a recent commentary that consumer sentiments over auto spending have been relatively weak. In addition, they are also "waiting for better deals" amid the price cuts. However, it also added that China's auto sales growth should "normalize in the second half," helping to drive growth subsequently.

As such, we believe investors will need to assess whether lithium prices could stem their slide in time for a second-half recovery? However, there are suggestions that the fall could carry on touching as low as RMB100K per MT, indicating a further 50% slide could be in store.

Such a scenario will most likely lead to a downgrade in analysts' estimates for SQM in 2023 and possibly even 2024, even though analysts have likely reflected some headwinds.

However, based on Morningstar's assumptions in its fair value estimate of $110, it projected "contract lithium prices to continue to rise in 2023." In addition, it also expects "spot prices to average $70,000 in 2023."

Based on the most recent spot price of $30.5K per MT in China, the assumptions are not looking good, suggesting why SQM also suffered a 30% selloff from its January highs.

SQM is projected to deliver revenue growth of -4.1% in FY23, a reasonable assumption after last year's surge. Analysts' estimates from FY22-25 indicate a revenue CAGR of -6.8%. As such, analysts have likely priced in a more downcast scenario, reflecting the headwinds in the underlying market.

However, SQM is still expected to remain highly profitable, with adjusted EBITDA margins of 51.7% for FY23. In addition, despite the revenue decline, SQM is still expected to leverage its cost advantages to deliver an adjusted EBITDA margin of 53.6% in FY25.

Hence, SQM's profitability should continue to help justify its "narrow economic moat" as investors assess the impact on its fair value estimates.

SQM's blended fair value estimate is pretty close to Morningstar's projection. It suggests an EV/EBITDA of 5.9x, below its 10Y average of 10.8x. Hence, we assessed that the valuation is not aggressive, even though SQM has been impacted by weak near-term sentiments in the underlying lithium market.

The question is whether buyers have returned to help stem a further decline?

SQM formed a low in mid-March, despite the continued price decline in the spot lithium market.

We also noted a bear trap or false downside breakdown undergirding the recent bottom.

The recent recovery has pulled back slightly, in line with the weak sentiments seen in broad EV or lithium stocks. As such, investors considering entering a position could leverage the pullback to add more exposure.

However, we need to caution investors that SQM has moved into a medium-term downtrend, suggesting that sellers have gained control over its directional bias.

Therefore, SQM must regain the $100 level decisively to resume its uptrend bias. Moreover, investors will need to expect a further slide toward the gap between the $45 and $70 price levels if its recent bear trap gets invalidated.

Morningstar's bear case suggests a $40 valuation, in line with the critical support levels seen in SQM's price chart. We encourage investors to keep some spare ammo to average down more aggressively if needed subsequently.

Rating: 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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