Stock of the Month: SQM
When Elon Musk announced that Tesla Motors is finally building that lithium battery “giga factory” in Nevada to scale up production of his cars, I knew it was time lithium graduated from niche industrial material to the center of a new energy economy. And as Wall Street wakes up to this, lithium producers like Chemical & Mining Company of Chile (SQM) will reap the rewards.
Every Tesla battery incorporates about 47 pounds of lithium, which means that if the company wants to create the capacity to sell 500,000 cars a year by 2020, this factory is going to need to buy about 11,000 tons of the metal every 12 months. This boosts global demand for lithium by around 13% and existing suppliers, with SQM (Sociedad Quimica y Minera de Chile in Spanish) being the largest, have a chance to grow to meet that demand.
Chile is the top producer of lithium on the planet, feeding at least 40% of U.S. demand. SQM is for all practical purposes the only Chilean lithium producer on the market. And the company’s passive solar extraction process has allowed it to maintain a breathtaking margin advantage even over Chinese competitors. If there ever was a lithium cartel, SQM would be it.
As it is, lithium has become a strategic business. SQM still only books about 10% of its revenue from this side of its mining operation, but that share has been growing a percentage point or two a year simply because demand for computer and now car batteries is expected to accelerate at a rate of 20%–25% a year through the next decade.
Right now, SQM is seeing lithium demand up 10% over last year and has expanded its deliveries and dollar sales by 17% and 13%, respectively, in 2014 so far. Given recent production figures, this would place the company’s total output at around 45,000 tons of lithium a year, which again indicates just how much of a footprint in this market Elon Musk plans to displace.
Pricing has weakened a bit as new mines come online in China, Canada and elsewhere, but SQM still has a commanding 27% share of the overall market and much of the world’s surplus production capacity under its control. What is noteworthy here is not that lithium pricing has softened, but that the price is holding well even with so many start-up miners rushing to market.
Battery-grade lithium carbonate is still quoted above $6,500 per ton, which demonstrates that even though this business is evolving fast from niche to global commodity, producers are maintaining some discipline. Since SQM books most of its non-lithium sales on potassium fertilizer – a market that largely collapsed last year amid tension between Russia and its neighbors – this is a crucial part of the lithium story.
Two years ago, fertilizer was the king of commodities and investors couldn’t get enough of the stocks. SQM comfortably traded in roughly a $51–$56 range. Since then, demand for potash has remained robust but pricing is still 20% below what producers could demand last summer. This represents about 30% of SQM’s top line, so it is not surprising that operating earnings are down close to 40% in the trailing 12 months.
The opportunity is that down here at $27, SQM has priced in even more turmoil in the potash market and practically no support from lithium and its other specialty chemical businesses. Other fertilizer markets have held up well and management is getting serious about rebuilding their ability to crush iodine competitors, which makes me think a 50% haircut is too severe.
If anything, I think the potash crash looks a little overdone purely because the breakdown in cartel discipline has already happened. We are in the new normal now and any further disruption here would probably be a matter of supply interruption rather than additional surplus flooding the market. Pricing is more likely to have a floor than it is to keep declining.
Furthermore, SQM is in an attractive place when it comes to operational and technical inflection points as well as increased global chatter about lithium. The chart looks strong enough to finally push above long-term resistance around $28, and Wall Street thinks earnings are ready to turn back in the right direction starting in the fourth quarter.
The fourth quarter starts next week, so I want us to get in now to play SQM’s potential rebound, as positive earnings results could be a nice catalyst for the stock. Buy SQM under $29.50.