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Raising Albemarle FVE to $130 on Higher Long-Term Lithium Volume, but We View Shares as OvervaluedRaising Albemarle FVE to $130 on Higher Long-Term Lithium Volume, but We View Shares as Overvalued Seth Goldstein Senior Equity Analyst Analyst Note | by Seth Goldstein Updated Jan 08, 2021 On Jan. 7, Albemarle announced plans to double its brine-based lithium capacity at its existing Silver Peak operation in Nevada. The operation is Albemarle's smallest lithium resource and currently produces roughly 5,000 metric tons per year, growing to 10,000 metric tons by 2025. The company also announced it was studying potential lithium production from clay-based resources in Nevada. We have increased our lithium volume forecast to account for the Silver Peak capacity expansion. The potential clay project is still in the exploration phase, so we do not include it in our valuation model. Our fair value estimate rises to $130 per share from $125 due to the additional Silver Peak volume and the time value of money since our last update. Our narrow moat rating is intact. At current prices, we view Albemarle as overvalued on a risk-adjusted basis, with the shares trading in 2-star territory. The shares have appreciated 3.7 times since hitting a 52-week low last March, but we think market sentiment is overly bullish, with shares trading nearly 10% above our $171 bull-case fair value estimate. As such, current market prices implicitly assume long-term lithium prices well above the marginal cost of production. We continue to view lithium as an industry with one of the best growth profiles across the basic materials sector. We forecast lithium demand will grow 6 times over the next decade due to rising electric vehicle adoption and greater energy storage to support renewable electricity. As higher-cost supply is needed to meet demand, we continue to forecast lithium prices will appreciate nearly 80% from current levels to our long-term price forecast of $12,000 per metric ton for lithium carbonate in 2020 real terms. Our long-term price assumption is based on the marginal cost of production on an all-in sustaining cost basis. Business Strategy and Outlook | by Seth Goldstein Updated Jan 08, 2021 Albemarle is the world's largest producer of lithium, which generates roughly half of total profits. It produces lithium through its own salt brine assets in Chile and the U.S. 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 lithium production capacity from roughly 85,000 metric tons in 2019 to 155,000 metric tons by the end of 2021. This includes the recent purchase of a 60% interest in the Wodgina spodumene operation from Mineral Resources. Mineral Resources retains the other 40% interest and the two operate a joint venture. The joint venture will begin producing spodumene (lithium hard rock concentrate) and one 50,000-metric-ton lithium hydroxide plant in Australia that will use Wodgina spodumene as its feedstock. We expect the company to continue investing in increasing its lithium capacity after 2021. In our view, this will likely occur through either the acquisition of spodumene conversion assets, such as the Xinyu acquisition in 2017 or through brownfield capacity expansions in China and Australia. 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 and most need to be constantly replaced, giving the company a steady cash flow stream. Economic Moat | by Seth Goldstein Updated Jan 08, 2021 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, which make up approximately 80% of its lithium profits. 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 also 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 08, 2021 Our fair value estimate is $130 per share. We assume a 9.7% 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 lithium carbonate prices (based on published LME prices) will average $7,750 per metric ton in 2020, down from a peak of over $20,000 per metric ton in 2018. Spodumene oversupply from new mines in Western Australia has caused spodumene prices to fall, and lowered lithium producer costs for marginal-cost spodumene converters. However, this oversupply will be short-lived. We see prices beginning to rise again in 2021 as demand has continued to grow, new supply has been delayed, and some spodumene production has been curtailed. Our long-term lithium carbonate price is $12,000 per metric ton. We expect lithium hydroxide prices 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. After a COVID-19-related demand decline in 2020, we expect demand to grow from around 288,000 metric tons in 2020 to 1.9 million metric tons by 2030. By 2030, 80% 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. Albemarle's Chilean expansions and its Talison joint venture will ramp up production to help meet strong market demand growth. Albemarle's low costs should allow it to benefit tremendously from additional volume sold. We expect higher lithium prices and volume will help Albemarle more than triple its lithium EBITDA over the next decade. After a COVID-19-related decline in 2020, we forecast bromine demand to grow by the low single digits. Brominated flame retardant demand should see growth from servers and increased content per vehicle in automobile electronics. After a COVID-19-related mid-double-digit decline in 2020, catalyst sales will recover, then grow at low- to mid-single-digit rates as FCC sales grow broadly in line with transportation fuel demand and HPC sales recover from trough levels following the collapse of oil prices. We expect HPC intensity to increase over time as clean fuel standards continue to tighten around the world for particles such as sulfur and lead. Risk and Uncertainty | by Seth Goldstein Updated Jan 08, 2021 The biggest risk for Albemarle is a material decline in the price of lithium. Other major risks include a decline in bromine prices, lower catalyst demand, and project execution risk. Lithium prices could decline if electric vehicle demand grows more slowly than expected or new supply comes online too quickly. Electric vehicle 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 supply curve in both carbonate and hydroxide. Albemarle also faces execution risk in ramping up its lithium production as the company has faced challenges in ramping up production of its new capacity, such as the La Negra III and IV facilities in Chile and the Kemerton facilities in Australia. As such, the company risks production delays and cost overruns. Bromine prices could fall if we see continued weakness in bromine flame-retardant, or BFR, demand. Shifts in consumer electronics purchases to less bromine-intensive smartphones and tablets over desktops and laptops would lead to lower bromine demand. In addition, bromine could be substituted with other flame-retardant material or the widespread use of flexible chips in smartphones and tablets that do not use BFRs could accelerate a decline in bromine demand. Lower margins of oil refiners could lead these companies to delay purchases of hydroprocessing catalysts used to remove pollutants from fuel oils. Unlike fluidized catalytic cracking catalysts, which are constantly replaced because they improve refiner yields, HPCs only need to be replaced every one to three years. As margins fall, refiners tend to delay purchases of new catalysts. Moreover, Albemarle must continuously develop new FCCs that enhance refiner yields in order to maintain pricing power. Stewardship | by Seth Goldstein Updated Jan 08, 2021 J. Kent Masters became CEO and board chairman 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. Masters replaced Luke Kissam. Under Kissam’s leadership, Albemarle transformed its portfolio to focus on businesses where it has a sustainable competitive advantage while divesting multiple middling chemical businesses. In 2014, the company made a strategic purchase to capitalize on lithium demand growth with the acquisition of Rockwood, and we think it paid a fair price for this asset. Given strong growth in lithium profits from Rockwood's Chilean assets and Talison joint venture, somewhat offset by moderate Chemetall Surface Treatment profit growth, we think the 11 times enterprise value/EBITDA multiple (14 times without synergies) that Albemarle paid was reasonable. The subsequent sale of Chemetall Surface Treatment to BASF in June 2016 was also a good move by management to divest a business that was not high priority relative to its lithium and catalyst segments. The company received an excellent price for the asset, as the $3.2 billion transaction represented an enterprise value/EBITDA multiple of 14-15 times. We would value the business at just 10-11 times, given precedent transactions and trading comparables. Albemarle’s management is investing heavily in lithium capacity expansion, which we think will allow the company to take advantage of growing lithium demand from increased electric vehicle adoption. At the same time, Albemarle is not investing significant capital expenditures (above maintenance) in its bromine or catalyst businesses. Instead, the bromine and catalyst businesses are being run to generate free cash flow that is used to partially fund the lithium capacity expansions, which we view as a prudent financial decision. We are also in favor of management's focus on growing its low-cost lithium hydroxide production through the expansion of low-cost Talison spodumene. Although we view the acquisition of a 60% interest in the Wodgina spodumene operation as value-neutral given the hefty $1.3 billion price tag (which includes the build-out of a hydroxide conversion asset), we think the move makes strategic sense as it provides Albemarle with another source of low-cost feedstock to produce lithium hydroxide, which will be needed as Albemarle expands capacity over the long term. However, we think management's lithium pricing strategy has hurt shareholder value. While most lithium producers sell at spot prices, Albemarle has locked in longer-term contracts, generally three to five years. We think these contracts have probably reduced Albemarle's ability to raise prices when lithium prices rallied in 2016 and 2017. For this pricing strategy to succeed over a cycle, we would need to see downside protection when lithium prices fall. Yet, this is not the case. Although Albemarle reported stable lithium prices during the first three quarters of 2019, the company ultimately cut 2019 guidance, partially due to lower lithium prices and guided to midteens lithium pricing declines for 2020. We think this means that some contracts probably contain provisions that reset prices based on market conditions. Overall, we think Albemarle's contract strategy has limited the company's upside and not prevented downside when prices fall, ultimately hurting shareholder value. Management’s 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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