July 25, 2017
Current Price (as of close on 7/24/17): $118.60
While there are many sound investments in the Lithium space, we believe Albemarle is a great way to invest in the lithium boom while exposing funds to less risk (Some of the Junior miners that we like and will be covering in subsequent posts will have higher return potential, but with added risk). ALB is the clear leader in the industry, is gushing cash, has very low leverage, and long-term demand locked up for 80% of it’s production. Thus, ALB allows the investor to limit their downside risk in the event of an oversupply in the lithium market, while participate in the tremendous upside risk presented by the lithium demand growth story. Whether you’re looking to purchase stock in ALB or not, the company is extremely relevant for all Lithium followers since they are a bellwether for the overall Lithium Market.
Our analysis will begin by taking a look at the business and competitive advantages, then outline a pessimistic case for the valuation before getting into the upside potential, and wrap up with a discussion of what realistic expectations are surrounding the stock. We structured the post this way for a couple of reasons. First, we believe there will be uncertainty surrounding lithium industry supply and demand for at least the next few years, so estimating a reasonable upside target would be tough for any company dependent on lithium demand growth. Second, we wanted to show that ALB is fairly valued/slightly undervalued solely on the basis of growth in the lithium business. Thus, any buyer of the stock today would be getting growth in the other businesses for free. We don’t know about you, but we love buying businesses for free!
In this analysis, you will find that ALB may not have the same juicy returns as some of the junior miners that we will be discussing in future posts. However, the added risk that comes with investing in pre-revenue mining operations is not for everyone. In our opinion, putting money in ALB will allow investors to sleep better at night knowing that they won’t be exposed to the large draw-downs that come with production delay announcements. Additionally, ALB will provide above market returns while allowing the investor to take part in the lithium boom.
Let’s start by briefly going over what the company does. After their 2015 merger with Rockwood Holdings and subsequent divestitures of certain business units, Albemarle operates in three main businesses: Bromine, Refining Solutions, and Lithium and Advanced Materials.
The Bromine segment extracts elemental bromine but also processes it into products used in fire safety solutions, oil and gas well drilling and completion fluids, water purification, chemical synthesis, and various other industrial applications. This business has been struggling over the past few years, but management believes it is beginning to stabilize and return to growth.
It should be noted that ALB produces bromine from some of the highest concentration and lowest cost positioned sources in the world– the Dead Sea and Magnolia, Arkansas. Thus, during the downturn over the past few years, they were better positioned than others. Going forward, we believe the Bromine business will primarily serve as a cash generator to fund investments in the lithium business, and other attractive opportunities.
The Refining Solutions business consists of two main product lines: 1) Clean Fuels Technologies, composed of hydroprocessing catalysts (HPC), and 2) Heavy Oil Upgrading, composed of fluidized catalytic cracking (FCC) catalysts. HPC products are widely used in the refining industry to upgrade oil fractions to clean fuels (as shown above). FCC catalysts assist in the high yield cracking of less desired refinery petroleum streams into derivative, higher-value products such as transportation fuels and petrochemical feedstocks like propylene (as shown above).
Lithium & Advanced Materials
The Lithium and Advanced Materials segment consists of Lithium and Performance Catalyst Solutions (PCS). The PCS business has four product lines: polymer catalysts, curatives, organometallics, and electronic materials. The lithium business, mines lithium, and also converts it into different forms along the value chain like lithium carbonate, and lithium hydroxide, or value-added specialties like butyllithium and lithium aluminum hydride.
Given that investors are interested in ALB as a way to play the lithium boom, the lithium business will be the primary focus for the rest of this post.
As part of the normal investment checklist, we have to briefly mention company management. Coming from a law background, it might be a bit odd to see CEO Luke Kissam at the helm of a chemicals/mining company. But so far, he’s done a great job bringing Albemarle into the lithium business and quickly setting them up to maintain a dominant position in the space. His total compensation over the last three years ranged from $5 to $10 million. During that period, ALB’s market cap increased by over $6bn, so we’d say the pay package wasn’t egregious. Similarly, nothing really sticks out regarding compensation for the rest of the management team.
One issue that we should mention is that management has not been very transparent in terms of lithium pricing. In an environment plagued with demand and supply uncertainty, the largest producer in the world doesn’t like to talk much about the prices they are getting in the marketplace for their products. However, as investors, this creates inefficiency and uncertainty in the market. As we harp on throughout the post, the market is relying on management’s expectations and guidance to shape estimates. And management has decided they are going to say very little, and try to keep expectations lower. So although we would normally hate a lack of transparency, it allows investors who believe management are under promising to profit on the upside.
One of the most important aspects when it comes to investing and something we feel is not talked about often enough in Lithium circles, is a company’s competitive advantages. Albemarle’s return on invested capital for 2016 was approximately 16% (compared to their cost of capital of closer to 9%). For a mining business, this is really impressive. To figure out how they achieved that level of performance, let’s take a look at their competitive advantages.
Two sources of competitive advantage that we believe are applicable are scale and customer captivity. For those not familiar with these terms, let’s quickly walk through an example: Apple Inc. Apple Inc has 1. Scale – they produce millions of phones a year at a low cost which allows them to boast 70+% gross margins on those products. 2. Customer Captivity – We all love our Iphone and are often unlikely to switch to another phone brand.
Shifting back to Albemarle, usually the only competitive advantage for industrial companies is scale- i.e. who can produce at a low cost? As the largest lithium producer in the world, with production sites around the world, Albemarle definitely has scale. Additionally, they have locked up long-term supply agreements with their customers so you could give them credit for some level of customer captivity. And since they produce many lithium derivative products, they do provide a value add which also enhances customer captivity. But this advantage will erode over time as today’s value-added products become tomorrow’s commodities, and customers on expiring contracts leave to buy from the lowest cost producers.
Thus, In the long-run the only thing that will remain is scale. ALB is investing heavily in capacity additions globally to remain the largest and one of the lowest cost producers in the lithium industry. It should be noted that in the long run, hefty cash outlays on capital expenditures (capex) just to stay relevant generally serves as one of the detractors for investors looking at commodity businesses. But given that lithium is in the very early innings, we have not yet reached that stage of maturity in the industry, and we view the capex as ALB securing their leadership position of tomorrow.
For the valuation section, we want to present a picture that’s slightly different than what readers might be used to. Given that investors primarily care about the lithium business, we will show what they can expect to earn on their position in the stock in the absence of any growth in the other business lines. So the following assumptions were used:
- Bromine, Refining Solutions, and Corporate Segments’ Revenue and EBITDA were held constant at 2016 levels (i.e. 0% growth going forward).
- The “Other” section was adjusted to account for some divestitures in the last year and then also held constant going forward.
- Furthermore, given the uncertainty in lithium supply and demand that we outlined in our previous posts, we decided to assume lithium revenue growth equal to ALB’s forecast for demand growth. This basically assumes that ALB maintains constant market share as the industry as a whole grows according to their forecasted rate of 35,000 MT per year.
- Going along with the previous assumption, we ignore any effects of lithium pricing growth on revenue and EBITDA margins.
- EBITDA margins were held constant at 40% for the Lithium business during the forecast period
- Free cash flow over the forecast period was estimated using the midpoint of 2017 EBITDA and free cash flow ($855m and $250m, respectively) guidance. Based on this guidance, EBITDA is converted to free cash flow at a rate of approximately 29%. This conversion rate was used to estimate FCF for 2018-2020 as shown in the tables below.
- Dividends were held constant from 2017-2020- Although the dividend will likely increase, any increases in the dividend will add to the returns from dividends while decrease the returns from stock appreciation- i.e. the total return would remain unchanged.
- Finally, we base the valuation over the forecast period on the EBITDA multiple compressing to more reasonable levels- The company is trading at 20x trailing EBITDA today and we model it compressing over the next two years before stabilizing in 2019 and 2020 at 16x (the company ended 2016 trading at 16x trailing EBITDA)
Given these assumptions, here’s what the forecast and corresponding valuation looks like:
Now I know we just threw a bunch of assumptions at you followed by a couple of tables. But what does it all mean? Assuming that all of the other businesses aside from Lithium don’t grow one iota and Lithium keeps chugging along (without improving margins) at ALB’s estimated industry growth rate, investor’s make money and there’s low risk of losing money. In fact, you’ll gain 10.4%, or about 2.6% on an annual basis not including dividends, which add approximately 1% a year.
Right about now, you’re probably reading this thinking “wow, I just lost 10 minutes of my life because some quacks think I should buy ALB for the nearly 4% annual returns.” But let us remind you, that we are simply trying to gauge our pessimistic scenario here. Now that we’ve taken care of that, we can go about trying to see how much room there is to the upside.
In the above figure from ALB’s March presentation, management outlines their financial targets for the next 5 years. In the figure below, we did the same forecast as the previous section, but using these management targets instead. Here’s the range of potential 2020 stock prices, and the corresponding IRR:
Note: we didn’t include EBITDA margins in the above sensitivity table because as the higher margin lithium business grows to represent a larger portion of Albemarle’s overall business, the overall company margins will naturally grow. So we decided it would be better to test the sensitivity of the valuation to EBITDA multiple and revenue growth CAGR, two things that are tougher to forecast.
Looking at the table, we see that if the company hits the low end of their revenue growth CAGR (7%), and the EBITDA multiple compresses back down to where it was at the end of 2016 (16x), the stock would appreciate to $156.49 by the end of 2020, representing an IRR of 9.1%. Including dividends would bring that return to around 10% per year. That means that at the low end of their targets- you’d get a double-digit IRR through 2020 for investing in ALB today. Conversely, If they hit the high end of targets, and the market rightfully decides to maintain a higher multiple of 18x, investors would get close to a 20% IRR through 2020, including dividends.
While the sensitivity shows the potential of ALB’s stock, we are by no means telling you to buy the stock and forget about it until the end of 2020. The stock will not move in a straight line, it will overshoot on the way up as well as on the way down. Consequently, a periodic review of the valuation would need to be done. How often to do this will vary among investors, with each choosing what’s right for them. After major upward moves, some may deem that it’s run ahead of itself and decide to trim their position, only to pick it back up on a dip.
But fret not, we will be following the stock closely and posting updates on valuation for you routinely!
While the above sensitivity tables show promising returns, what levels can we reasonably expect the stock to attain? After all, even the low end of 7% revenue growth is great in today’s economic environment.
Given the uncertainty around lithium supply and demand, this question is very tough to answer. Hence, our goal of gauging downside risk more than the upside risk. However, in an effort to answer that question, we would start by looking at how management has performed on their past targets. The below table from ALB’s investor presentation shows management’s track record after the Rockwood deal.
As you can see, management not only met their targets, but they exceeded every last one of their goals set forth in 2016. Additionally, if you recall from our demand post, we believe that management is striving to under promise on lithium demand growth while hoping to over deliver. This tactic worked very well for them over the last several quarters. So as long as the market continues to let them downplay the growth targets, there will be room for an upside surprise. But even if you don’t get upside surprises, we can reasonably expect management to hit these growth target ranges in the absence of an oversupply in the lithium market.
Regarding EBITDA margins- with lithium pricing expected to remain stable given the tight supply/demand picture, margins will be supported at current levels. Additionally, as ALB ramps up production, margins will grow due to fixed costs being spread out over a larger production base. In the event that lithium pricing increases due to excess demand in the market, that will only lead to even higher EBITDA margins for the company as each incremental dollar in revenue due to pricing will flow to the bottom line. Conversely, it should be noted that in the event of an oversupply and drop in pricing, after an initial shock to margins, ALB will be able to offset some of the effects by closing down plants and increasing capacity utilization at fewer sites.
Next, let’s take a look at the valuation multiple. Although even 16x would be a high EBITDA multiple for a traditional mining operation, the juicy margins combined with the lithium growth expectations support an elevated multiple. Just look at today’s valuation as an example- the growth ALB has delivered above market expectations over the last year has led to the market valuing them at a whopping 20x LTM EBITDA. Looking ahead, the appropriate multiple would depend on company performance and market expectations. If the company delivers on the low end of revenue growth, we would reasonably expect a lower multiple because the market would start to expect less of future prospects for the company. Conversely, If revenue growth remains in double digits, and overall lithium demand continues to outpace supply, a higher multiple would be justified (possibly even beyond what’s shown in the sensitivity tables).
Risk to thesis
The obvious risk to our thesis is an oversupply of lithium in the marketplace. An oversupply would cause lithium pricing to come down, ALB’s revenue growth to slow, and margins to shrink. And given that the stock is trading at an elevated multiple due to their growth profile, any shock to growth expectations will lead to a rapid repricing the stock due to a multiple compression. Looking specifically at ALB, that would be a tough thing to watch. However, compared to junior miners, ALB will be better positioned given all of the positive qualities we’ve mentioned throughout the post. The long-term supply agreements with built in price floors, and the management of market expectations will help cushion selloffs in the stock.
Disclaimer: All thoughts presented are our own. These views are not investment advice, and investors should do their own research before entering any position.
Disclosure: We currently hold a small position in ALB.