2023-09-22 10:15:08 ET
Summary
- Elkem, a basic materials company based in Norway, has seen a significant drop in its stock price but still has potential upside.
- The company's positive thesis is based on a reversal of underlying markets and its strong portfolio and sales.
- Elkem is facing challenges in the silicone market, but its carbon solutions and silicon products are performing well.
Dear readers/followers,
Elkem (ELKEF) is a basic materials company out of Norway - and it's not a bad company, despite the significant drop we've seen since my first article on the business. This is an update on my thesis that I last covered in this article .
Since that article, Elkem has actually dropped further, and now is starting to approach levels we've not seen since the COVID-19 decline. Elkem's positive thesis is based on an eventual reversal of the underlying markets. The company's risk profile is well-known and covered by me over the past two articles, involving above all a significant Chinese ownership stake in an otherwise predominantly European company. Elkem is majority-owned by the China National Bluestar-controlled Bluestar Elkem Co. LTD, with 52.91% of the voting power. This is very rare for a Norwegian company, which typically likes national control - but in Elkem the government only has around 5%.
In this article, I'll update coverage as of the latest quarterly report, the 2Q23 which we received about a month back. (Source: 2Q23 Elkem Report )
Elkem - An upside exists here
Silicone-based material providers have not had an easy time of things in the last few months - even one with dozens of billions in sales. Elkem is one such company. With over 45B NOK in annual sales, it's a market-leading basic materials company with an upside that deserves consideration. Even if the majority of Chinese ownership might leave some investors with a bad taste in their mouth in terms of risk profile, the company's portfolio and sales are convincing.
As with every single chemical company I currently review, Elkem is suffering from very volatile market trends. The company is seeing the same weak market trends in 2Q23 as well, and this is despite delivering over a billion NOK in quarterly EBITDA. The effects were visibly impacted by some one-offs - around a quarter billion on a quarterly basis. (Source: 2Q23 Elkem Report )
On a segment-specific basis, we saw carbon solutions and silicon products delivering very strong results based on superior costs and market positioning for the company. So products and solutions, working fine.
Silicones remain the problem here. Company inventories are filled - but no longer worth their noted value. The company has had to write down the value of this inventory. Combine this with a stop for maintenance in China, and you see why the sector, aside from weak current cyclical development, is suffering.
The company's overall "arguments" remain the same - positioning for recovery. This might be a tired argument to hear, but it's nonetheless one that is very true. If we see a reversal for Elkem sales, especially in Silicones, I believe that's going to generate absolutely massive levels of potential returns that could mark a justification for a significant reversal in share price and RoR.
As with most chemical companies, the company's current strategy has a focus on moving to more and more attractive specialty markets. To this effect, the company has entered into an agreement with VUM, a Slovak manufacturer of carbon-based materials. Elkem is increasing its continental footprint with an additional 360M NOK in annual sales and 50,000 mt of carbon-based material capacity for industrial smelters, including things like anode paste, electrode paste, and recarburisers, further increasing this company's appeal.
At the same time, also reported in 2Q23, the company is accelerating its maintenance schedule to take advantage of weak overall markets to "get things done". Both of the maintenance in Thamshavn and Rana are now completed, and both plants have restarted their production, being well-positioned for the future. (Source: 2Q23 Elkem Report)
Elkem is, however, limiting project investments to 300M NOK. Elkem sounds and is Norwegian, but the scope is global - and specialization is what's being talked about here. You can see below just the scope of ongoing specialization projects for Elkem.
The problem for Elkem is for the moment increasingly weak silicone markets. How is the company countering or accounting for this? A few things - obvious hiring freezes and capacity reductions, lowering logistical services and warehousing/inventory. Curtailing both employee and other capacity and increasing recycling of waste, which comes with some potential savings of at least 300 MNOK for the company. CapEx optimization is also possible, and to be clear here we're talking about both cost measures and postponements.
The reason, mainly?
Slowing macro - that's what we're talking about. The challenging trends in LVP, though it's slowly turning around, as well as the construction sector is making sure that many companies in the sectors and trends such as these are currently seeing very negative trends and estimates for the coming 12-24 months - though some companies are definitely seeing the potential for turnarounds - such as Elkem.
But it's mostly weak overall demand - which by the way saw a peak demand level back in late 2021, and which now is back down to almost COVID-19 levels. It's unnaturally low, and pricing follows suit. Destocking is still very much in effect, and we've seen over the course of several years considerable overcapacity in this field, with current prices for silicones in China being at the lowest level in almost 10 years (Source: 2Q23 Elkem Report).
It's so different compared to the worldwide carbon market. Demand trends here are up significantly over time, with solid underlying stability based on steel, ferroalloys, and aluminum. Global production of steel and demand is stable, with an estimate for it to continue to grow going forward. The company's diversified portfolio is providing stability in an unstable world and despite the somewhat weak trends we're seeing in key parts of the company here, other parts are weighing up.
So - a summary - parts of the company, meaning products and solutions in silicon/carbon, were strong. Silicones, not so much. From a high-level mix perspective, this means some impacts for the company, and the financial ratios aren't superb here with some items on the expense side of things. Weak markets, maintenance, and write-downs are really the key culprits here and what's driving operating income lower.
The company's fundamentals though, despite all of this, remain as what I would call "solid". The company's equity is at over 26B NOK, with a 50%+ equity ratio, slightly down due to the dividend. Earnings have fallen to what is the equivalent of the basement, from a 1Q23 EPS of 1.5 NOK to a whopping 0.06 NOK for 2Q23 - but this is expected to recover in short order for 2023-2025.
So, Elkem, with its native symbol ELK, is essentially coming out of one of the best environments in its history, enabling the company to pay the equivalent of a current dividend yield of over 20%, is moving into a 79% EPS decline for 2023E. The question becomes - when does the market consider this "priced in". When should we consider it "priced in" and say "Now we can buy the company"?
This is fairly tricky. Current estimates for the company are incredibly difficult, but I'll still make an attempt to give you a good thesis and a good target for this company after this latest quarter.
Elkem - Plenty to like, but plenty of uncertainty in the future valuation
The valuation is going to be based on two assumptions. First off, the company is going to trough this year - hard. I'm expecting no less than a 75%+ EPS drop for the fiscal. But secondly, we're either flat for 2024 or maybe it will start growing, with recovery in the double digits and with much better fundamentals for 2025E and beyond. The proceeds from earnings we saw during 2021 and 2022 have been used by the company to improve fundamentals and invest in new capacity. The "new Elkem" is therefore delivering earnings at a higher overall level than before - and that's what we're waiting on. (Source: FactSet)
Current estimates are for an EPS of 2.5 NOK for 2023, which is less than 25% of the EPS for 2022. 2024 is going to 2.7 NOK, if we're to believe estimates, and 2025E is seeing it go beyond 3.5 NOK: The dividend payout is about 30-45% of that, which based on the current forecasted EPS, and dividend payouts would come to a yield of somewhere of 4.5% on the low side to 7% on the high side for 2023-2025E on the basis of a 22 NOK share price at this time. (Source: FactSet)
This of course does not include potential capital appreciation - which could cause returns much much higher than that.
In my last article, I gave you a conservative price target of 41 NOK/share. This is based on a 10x forward P/E for 2025E. I'm as of this article slightly adjusting this to 36 NOK/share to account for a longer basic materials pricing and input pressure. But this still gives us a longer-term target to around 9x P/E, which implies a 20% annualized upside for 2025E, or around 50% total RoR for this company.
Given this company's risk factors - Chinese ownership and cyclicality - this might not be enough for you to invest in. My position in the company is, at this point, extremely small. I too am waiting to see just how long things will go before we see the beginnings of a turnaround.
But with the company actually beating estimates more than 50% of the time on a 2-year basis with a 20% margin of error, it's in the cards that the company could perform a lot better than we expect from it - and this gives me conviction for the future of 2024-2026E. (Source: FactSet)
I continue to believe that Elkem remains undervalued here - and while I'm lowering my PT, I'm adding to my position in the company here. It's time to buy more shares and hold them until we see that turnaround.
As a side note, in terms of the company ownership, I'll likely never be 100% comfortable investing in something with a Chinese majority, but in the end, it's acceptable to me because it's a company with Norwegian history and over 50% of its assets and exposures in Europe.
After that, it's mostly mathematics, estimates, and other value-based fundamentals, we do live in a globalized world and money shouldn't have a nationality. It shouldn't matter where the influence comes from. I also expect, despite Chinese ownership, the Norwegian government to exercise influence based simply on the production assets found in Norway.
It also goes to the fact that it has over 100 years of native Norwegian history under its belt. So the ownership portion of the thesis isn't as simple as one could present it.
I give you the following thesis for Elkem.
Thesis
- I consider Elkem to be a very interesting chemical play, perhaps somewhat impaired by its majority of owners from China. The upside is a very diversified production base, with favorable exposure to low-cost environments, and also being a market leader.
- The downside is the company's size, cyclicality, and limited lifespan with its current operations, making forecasting or giving the company a fair value tricky.
- Still, at this time, I give the company the equivalent of a long-term 10x P/E as a PT, which comes to 41 NOK/share. That means that there's an upside and a "BUY". I can now, as of September 2023, also call this company "cheap".
Remember, I'm all about :
1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are my criteria and how the company fulfills them ( italicized ).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside based on earnings growth or multiple expansion/reversion.
I now call Elkem cheap and consider the company a significant "BUY" with a good upside here.
For further details see:
Elkem: When Is The Time To Invest In This Company?