SQM - SQM: Capitalize On The Bureaucratic Chilean Government

2023-06-20 06:03:45 ET

Summary

• Chilean President Gabriel Boric has empowered state-owned Codelco to drive the revival of the country's sluggish lithium industry.
• Codelco lacks experience in lithium mining and marketing and is known for bureaucracy and being slow to act.
• Due to the sluggishness and bureaucracy of the Chilean government, I believe nothing will happen during Boric's presidency.
• In the case that Codelco takes gradual control of SQM, I expect SQM to return 80% of its current share price in the form of dividends.

Since my previous article , the shares of Sociedad Química y Minera de Chile S.A. ( SQM ) have experienced a 19% decrease. Despite this, I have been increasing my holdings in SQM because I believe that concerns about the company are exaggerated. I believe there is a 39% upside in the share price compared to a possible downside of 19%.

Chilean President Empowers Codelco to Drive Revival of Sluggish Lithium Industry

Chilean President Gabriel Boric aims to strengthen the country's sluggish lithium industry and has entrusted state-owned Codelco, the world's largest copper mining company, with leading the development of lithium for electric vehicle batteries.

Currently, Chile ranks as the second-largest global lithium producer, trailing only Australia. However, with the surge in EV manufacturing, there is a growing worldwide demand for lithium. Chile possesses abundant lithium deposits, prompting President Boric to assign Codelco the responsibility of negotiating agreements with both new companies and existing lithium miners such as Albemarle ( ALB ) and Sociedad Química y Minera de Chile S.A..

Having resided in Chile for over a decade and covered the mining sector in the region, I have concerns about Codelco assuming control over the country's lithium industry. Codelco is a slow and inflexible state-run company known for overpaying executives and being hindered by bureaucracy. Moreover, Codelco lacks experience in exploiting and marketing lithium. The extraction methods for lithium and copper differ significantly, as lithium is typically derived from brine or hard rock deposits, while copper is extracted from sulphide or oxide ores. These minerals also have distinct applications and demand drivers. Lithium finds extensive use in EV batteries, energy storage systems, and consumer electronics, whereas copper is employed in various applications such as electrical wiring, plumbing, and industrial machinery.

The government’s objective is to establish state-controlled partnerships with SQM and ALB before their current contracts expire, while concurrently seeking to increase copper production, which currently stands at its lowest point in 25 years. However, I am uncertain whether Codelco, lacking experience in lithium mining and marketing, can effectively tackle both challenges simultaneously.

One approach for Codelco to address this challenge is to concentrate on its own copper resources while negotiating contracts for lithium operations and entrusting other mining companies to handle the practical aspects.

I believe there are three possible outcomes:

• Scenario #1: The government efforts are delayed and diluted not impacting SQM in any meaningful way.
• Scenario #2: The government will gradually take ownership of the lithium projects.
• Scenario #3: The government will swiftly take control of all lithium projects in Chile.

Now let’s elaborate on each potential outcome and the potential value of SQM shares.

#1 Nothing material happens

As a cautious optimist, I find it likely that this outcome will unfold (my crystal ball suggests a 65% chance). Chile is a country characterized by bureaucracies, contradictions, and polarization. A prime example is the recent constitutional proposal: while Chileans voted for a socialist president, they rejected the progressive constitution that was put forward. This rejection took place in September 2022, and nearly nine months have passed since then without any significant progress. Currently, the conservatives hold a prominent role in crafting a new proposal.

Considering the timeframe until the end of Gabriel Boric's presidency in March 2026, during which he needs to finalize both the new constitution and the lithium structure, I am willing to bet that nothing substantial will occur by then. In line with my previous article , I believe that SQM shares will hold a value of $100 per share under this scenario.

#2 Gradual ownership transition

I estimate a 34% likelihood of this scenario occurring. A relevant example of a similar situation is the nationalization of the British coal industry in 1947. Over time, the British government gradually acquired shares in private coal companies until it held a controlling stake. By 1947, the government had obtained enough shares to assume full control of the industry. Another case is Norway's Statoil, one of the world's largest oil and gas companies, in which the government holds a majority stake. Starting in the 1970s, the government began acquiring shares in Statoil and now owns over 67% of the company. In this scenario, I would anticipate Codelco taking control of SQM within a minimum of 5 years from today.

In that scenario, I expect SQM’s management to return as much value back to current shareholders via dividends. This is what another Chilean company has done. Entel, the largest Chilean telco, has sold its precious gems recently and paid large dividends. In the last couple of years, it has sold its towers , data centers and fiber optic assets. Half of those proceeds ($865 million out of $1.78 billion) were distributed as dividends.

Why did Entel’s management decide to return so much cash to shareholders rather than invest in the business? This decision was likely influenced by factors such as the social unrest of 2019, the entry of a fourth player in 2016, and Chile's declining attractiveness as a business environment.

Returning to SQM, given the uncertain future, I envision the company striving to return shareholders as much cash as possible. How much cash? I anticipate SQM being capable of distributing $58 per share in dividends over the next five years. This projection is based on my expectation that SQM will generate $14 billion in cash flow after capex and interest payments during that period. Additionally, SQM currently holds $2.8 billion in cash on its balance sheet, and assuming 80% of that amount is paid out as dividends before losing control, the total cash returned to shareholders would reach $16 billion or $58 per share. This value represents approximately 81% of the current stock price. It is worth noting that SQM could adopt an even more aggressive approach, such as taking on additional debt and optimizing working capital.

Note that this scenario does not consider the proceeds from the government's payment for its ownership of SQM. This implies that even in this scenario if the government pays only 1/5 of the current market value of SQM, shareholders would break even.

#3 Codelco takes over tomorrow

I assign a mere 1% probability to this particular scenario. Normally, I would assign it a zero probability, but considering that unexpected events are becoming more frequent, black swans cannot be entirely ruled out. However, even in this rare scenario, SQM would still retain 21% of its EBITDA, and as a result, the stock price could potentially decline to the range of $15 to $25.

Conclusion

Despite the recent decrease in SQM shares, I remain optimistic about the company's prospects. With a potential 39% upside compared to a 19% downside, I believe concerns are exaggerated. My target price of $100 per share stands firm and I recommend buying the shares.

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