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.Morningstar Investment Research Center
Maintaining $350 FVE After Albemarle's Strategic Update Affirms Our View; Shares Undervalued
Analyst Note | by Seth Goldstein Updated Jan 24, 2023
We maintain our $350 per share fair value estimate for Albemarle after updating our model to reflect the company's strategic update. Our narrow moat rating is also unchanged. Our largest key takeaway from the event was Albemarle's plan to transition its lithium sold from long-term price contracts to an index-referenced pricing scheme is compete. Additionally, the event reaffirmed our view that Albemarle's plan to grow its annual lithium volumes is on track. While we updated our outlook for higher volumes and lithium prices in the energy storage segment, we also updated our assumptions for higher unit production costs and capital expenditures, which roughly offset.
At current prices, we view Albemarle shares as undervalued with the stock trading firmly in 4-star territory. In our view, the market is skeptical that lithium prices will remain at or above $70,000 per metric ton in 2023. Admittedly, current spot prices have fallen from $78,000 per metric ton for lithium carbonate in late-November to current levels of $72,000 per metric ton. However, we anticipated a slight decline in lithium prices in 2023 as new supply enters the market and demand growth slows on a percentage basis versus 2021 and 2022. We maintain our 2023 lithium carbonate price forecast of $70,000 per metric ton as we expect the market to be undersupplied.
At these levels, Albemarle should see higher realized lithium prices in 2023 due to the conversion of customers from one-year contracts signed in early 2022 to index-referenced prices this year. This should result in Albemarle's energy storage segment realizing average lithium price increase of roughly 25% in 2023. We are in favor of Albemarle's new pricing scheme where 20%-25% of lithium is sold at spot prices, with the remaining volumes sold at index-referenced prices that feature a cap and floor. Over time, this should allow the company to realize higher lithium prices versus the company's old long-term contract method.
Business Strategy and Outlook | by Seth Goldstein Updated Jan 24, 2023
Albemarle is one of the world's largest lithium producers, which generates the majority of total profits. It produces lithium through its own salt brine assets in Chile and the United States and two joint venture interests in Australian mines, Talison and Wodgina. The Chilean operation is among the world's lowest-cost sources of lithium. Talison is one of the best spodumene resources in the world, which allows Albemarle to be one of the lowest-cost lithium hydroxide producers as spodumene can be converted directly into hydroxide.
As electric vehicle adoption increases, we expect high-double-digit annual growth in global lithium demand. In response, Albemarle plans to expand its annual lithium production capacity from 200,000 metric tons in 2022 to 500,000-600,000 metric tons by 2030. This includes the company's 60% interest in the Wodgina spodumene operation from Mineral Resources. Mineral Resources retains the other 40% interest and the two operate a joint venture, though this will likely become a 50-50 JV as the two are in discussions to expand the partnership. The joint venture will begin producing spodumene (lithium hard rock concentrate) and a 50,000-metric-ton lithium hydroxide plant in Australia. We expect Albemarle will continue to increase its lithium capacity largely through brownfield expansions at existing operations, including the expansion of recently acquired spodumene conversion assets in China and a greenfield mine in the U.S.
Albemarle is the world's second-largest producer of bromine, a chemical used primarily in flame retardants for electronics. Bromine prices have begun to rise as increased demand for use in servers and automobile electronics is offset by a decline in demand from TVs, desktops, and laptops as well as lower demand for bromine used in oilfield completion fluids. Over the long term, we expect Albemarle to generate healthy bromine profits due to its low-cost position in the Dead Sea.
Albemarle is also a top producer of catalysts used in oil refining and petrochemical production. These chemicals are highly tailored to specific refineries. However, the company is conducting a strategic review and may ultimately divest the business.
Economic Moat | by Seth Goldstein Updated Jan 24, 2023
Cost advantage and switching costs form the basis of Albemarle's narrow economic moat. Albemarle possesses the lowest-cost sources of lithium and bromine production. The company also benefits from switching costs in its catalyst business, where refiners and petrochemical producers tend to stick with existing catalysts tailored to their facilities in order to maximize product yields.
Globally, lithium carbonate is produced from either lower-cost evaporation of brine or higher-cost mining of spodumene minerals. Albemarle has a cost advantage in lithium carbonate production due to its lucrative brine assets in the Salar de Atacama in Chile.
Two factors make the Salar de Atacama the lowest-cost source of lithium in the world: dry conditions and high lithium concentration. The Salar de Atacama is one of the driest places in the world and the largest salt flat in Chile. It has an extremely high evaporation rate and low rainfall. Snow from the Andes Mountains melts and flows underground into pools of brine, which have the highest concentration of lithium globally. This high concentration makes the company one of the lowest-cost lithium producers even among brine-based producers. The company pumps the brine above ground into a network of large evaporation ponds. Water evaporates from the ponds over the course of approximately 18 months, leaving behind concentrated lithium brine, which is then processed into lithium derivatives, including lithium carbonate and lithium hydroxide for batteries. Albemarle has a long-term contract through 2043 with the Chilean government to extract around 80,000 metric tons of lithium per year.
Albemarle also has lithium brine assets in Silver Peak, Nevada. While not as advantaged as the prime Chilean asset due to lower lithium concentration, this Nevada asset still sits on the lower half of the lithium carbonate cost curve.
Albemarle owns a 49% joint venture interest in Talison's operations in Greenbushes, Western Australia. The Talison mine produces spodumene, a hard rock mineral extracted through traditional mining methods, that is the feedstock converted into a downstream lithium product. Traditionally, spodumene-based production has set the marginal cost for lithium carbonate, and we do not view Talison as moatworthy in lithium carbonate production.
However, lithium hydroxide can be produced directly from spodumene, whereas brine-based operations must first produce carbonate and then convert to hydroxide. Although lithium hydroxide has traditionally made up a small portion of total lithium demand, electric vehicle batteries will increasingly use lithium hydroxide as hydroxide-based battery chemistries generally allow electric vehicles to have a greater range than lithium carbonate. As a result, we expect lithium hydroxide demand growth will outpace lithium carbonate as electric vehicle adoption increases.
The ability to directly produce hydroxide from spodumene makes low-cost spodumene producers the lowest-cost lithium hydroxide producers globally. The Talison operation is one of the highest-quality spodumene deposits and sits on the low end of the lithium hydroxide cost curve, owing to its geological advantage. Talison's spodumene has roughly double the lithium concentration of most other spodumene production, and we view the operation as moatworthy based on Albemarle's cost-advantaged lithium hydroxide production.
Further, Albemarle's joint venture with Mineral Resources at the Wodgina operation in Western Australia will produce low-cost lithium hydroxide. While hydroxide made from Wodgina spodumene will not be as low-cost as hydroxide made from Talison spodumene, the Wodgina operation will still sit on the low end of the lithium hydroxide cost curve.
Albemarle's advantaged position in bromine comes from its low-cost and long-lived asset in the Dead Sea and Arkansas. Production costs are largely determined by concentration, as higher concentration mean that less water needs to be evaporated to produce bromine from brine. The Dead Sea is the lowest-cost bromine source, with concentrations of 10,000 parts per million, while Arkansas has concentrations of 5,000 parts per million. These assets have 2.5-5.0 times the concentration of the next-best reserves in India and 25-50 times the concentration of producers in China. Albemarle's Arkansas asset has more than 70 years of reserves remaining. The Dead Sea, for all intents and purposes, is an inexhaustible asset, given its enormous reserves compared with production volume. Albemarle's Dead Sea production comes from its 50% interest in Jordan Bromine, which it operates with Arab Potash.
The company benefits from switching costs in refining catalysts, which are tailored to specific refineries to maximize customer profits. Refiners are essentially a commodity spread business, earning profits by converting crude oil into refined end products, including gasoline and diesel. Catalysts used in fluidized catalytic cracking help refiners reduce costs by processing heavier crudes or realizing higher prices through more-refined products. Variations in regional crude oil quality and refinery specifications require Albemarle to work closely with customers to formulate customized catalysts for each refinery. These catalysts make up a small portion of a refiner's costs and are priced based on the value they contribute to customers through improving yields, quality, and output. Catalysts provide value to refiners far in excess of their cost. Albemarle, W.R. Grace, and BASF make up the majority of the FCC catalyst market. Existing catalyst providers hold the advantage of being able to tweak their catalyst over time and maintain customer relationships, as catalyst suppliers continually improve refiner economics. Because of the highly customized nature of the product, it is difficult for competitors to provide products that offer greater value than existing catalysts, particularly as they must undergo trial periods to demonstrate superior efficacy.
Fair Value and Profit Drivers | by Seth Goldstein Updated Jan 24, 2023
Our fair value estimate is $350 per share. We assume roughly a 10% weighted average cost of capital. We use a multiple of 12.5 times midcycle EBITDA to value free cash flows generated beyond our 10-year explicit forecast horizon.
The bulk of growth will come from lithium. We expect contract lithium prices will continue to rise in 2022. Lithium carbonate spot prices, which tend to be a leading indicator of contract prices, are currently around $72,000 per metric ton (based on published indexes). As demand growth outpaces supply, we expect lithium prices will remain well above our long-term forecast for lithium carbonate at $12,000 per metric ton through the rest of the decade. Based on our price elasticity analysis, we forecast spot prices will average $70,000 in 2023. We expect high-quality lithium hydroxide used in long-range batteries will continue to sell at a premium to carbonate, reflecting higher conversion costs.
Our price forecast is based on our forecast for the marginal cost of lithium production on an all-in-sustaining cost basis. We expect lithium demand to grow at nearly a 20% annual rate from around 473,000 metric tons in 2021 to over 2.3 million metric tons by 2030. By 2030, over 90% of lithium demand will come from batteries that require high-quality lithium with few impurities. To meet demand, higher-cost supply will need to come on line from lower-quality resources that will require higher processing costs.
We forecast Albemarle's lithium capacity will grow to roughly 550,000 metric tons during the next decade and will benefit from strong demand growth. Albemarle's low costs should allow it to benefit tremendously from additional volume sold. Higher prices and volumes will help Albemarle's energy storage (lithium) segment EBITDA grow nearly 8 times 2021 levels by 2030.
We forecast specialties (bromine and non-battery lithium) will in the low-to-mid single digits. Brominated flame retardant demand should see growth from an increase in 5G devices, Internet of Things technology, servers, and increased content per vehicle in automobile electronics. Combined with Albemarle's cost reductions, we expect specialties EBITDA margins will expand from the low-30% range to the mid-30% range over the next several years.
After a COVID-19-related decline saw Ketjen (catalysts) profits fall 60% from 2019 to 2021, we expect a gradual recovery as FCC sales grow broadly in line with transportation fuel demand and HPC sales recover from trough levels. Our valuation does not include a potential divestiture of the business.
Given the wide range of potential lithium prices, we see a range of outcomes for Albemarle. In an upside scenario, continued strong lithium demand growth would create the need for poor-quality resources to enter production. The marginal cost of lithium production would rise to $20,000 per metric ton and Albemarle would realize higher midcycle prices. In this upside scenario, our fair value estimate would be $550 per share.
Conversely, in a downside scenario, new supply extraction technologies allow more lithium resources to enter production and drive down operations costs. The marginal cost of lithium production would fall to $7,000 per metric ton and Albemarle would realize lower midcycle prices. The company would also likely put new projects on hold, falling short of management's long-term volume goals. In this downside scenario, our fair value estimate would be $100 per share.
Risk and Uncertainty | by Seth Goldstein Updated Jan 24, 2023
We assign Albemarle a High Morningstar Uncertainty Rating.
The biggest risk for Albemarle is lithium prices. Lithium prices could decline if electric vehicle demand grows more slowly than expected or new supply comes on line too quickly. EV demand could undershoot expectations if fuel cell or other technologies overtake lithium as the preferred powertrain for zero-emission vehicles.
Lithium production could ramp up more quickly than demand warrants if producers bring too much supply to the market. Further, new lithium production technologies could alter the cost curve in carbonate and hydroxide. Albemarle also faces execution risk in ramping up its lithium production, which include production delays and cost overruns. Albemarle is also subject to political risk in Chile as a new constitution or left-wing president Gabriel Boric's government could result in the creation of laws that affect the company's operations.
The largest ESG risks come from potential new regulations. Regulations that limit emissions in the bromine business could hurt profit margins as Albemarle's profits come from its cost advantage, rather than pricing power, and it may not be able to pass along the cost increases. We see this as having a moderate probability and materiality.
Another risk is that Albemarle may have its products banned due to the environmental impact, which has occurred before in the bromine business. We see a moderate probability but a low materiality as Albemarle doesn't rely on a single product and could likely modify its products to meet new regulations, similar to what occurred when products have been banned.
Lithium customers may require Albemarle to reduce its emissions. While we see this as having a moderate probability to occur, we see a low materiality as all lithium producers would be subject to the same requirements so the company could likely pass along these costs. Albemarle could also serve these customers from its already reduced-emission lithium from Chile.
Capital Allocation | by Seth Goldstein Updated Jan 24, 2023
We assign a Standard capital allocation rating to Albemarle based on our framework that assesses the balance sheet, investment decisions, and shareholder distributions.
We view Albemarle's balance sheet as sound. The company's debt is manageable, and we think the balance sheet should remain in good health over the next few years.
We see management's investments as fair. We are in favor of management's investment strategy to expand its low-cost lithium capacity, which we think will allow the company to take advantage of growing lithium demand from increased electric vehicle adoption. We are also in favor of management's focus on growing its low-cost lithium hydroxide production through the expansion of relatively lower-capital-intensity operations such as in China or through brownfield capacity expansions. We think these investments will create significant shareholder value over the long run.
Alternatively, management's former lithium pricing strategy hurt shareholder value in the past. The previous pricing strategy limited the company's upside and did not prevent downside when prices fell. However, we credit management with the willingness to change its approach. In 2022, Albemarle announced a new three-tier pricing system. Starting in 2023, 20%-25% of battery quality lithium is sold at short-term prices based on the market, with the remaining 75%-80% sold at index-referenced prices, some of which have a set cap and floor but fluctuate based on market prices.
We are in favor of this move to shorter-term pricing that closer reflects market dynamics. As a low-cost producer, the company should remain profitable even when prices hit a cyclical low, which in our view, diminishes the need to lock in prices. Notably, the initial results of the new pricing system have led to Albemarle seeing its prices rise to more closely reflect spot prices throughout 2022. However, we will wait to see how the company's realized prices evolve before revisiting our rating.
Finally, we think distributions are appropriate. The current policy to increase dividends seems appropriate as we forecast dividends to average around 30% of net income over the next five years.
J. Kent Masters became CEO and board chair in April 2020. Masters brings nearly 15 years of experience with Albemarle's lithium business in a board role. He sat on the board of Rockwood, the lithium company Albemarle acquired, from 2007 until the acquisition closed in 2015. He then became a member of Albemarle's board and served as lead independent director from 2018 to 2020. Masters brings engineering and specialty chemical leadership experience to Albemarle. Previously, he was CEO of Foster Wheeler, a global engineering and construction contractor, and a member of the executive board of Linde, a global industrial gas provider.
Managementís long-term compensation is based on total shareholder return over a rolling three-year period. Short-term compensation is based on annual adjusted EBITDA and adjusted free cash flow. While the shareholder return metric aligns management with shareholders over the short term, we would prefer compensation metrics to include return on invested capital to encourage management to position the business for long-term success.
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