Sociedad QuíMica y Minera de Chile: Why Investors Should Get Back In The Ring (NYSE:SQM)

Summary

In my view it’s time for investors to get back into the ring, the risk-reward symmetry has changed to the upside for Sociedad Química y Minera de Chile S.A. (NYSE:SQM). The balance between supply and demand flipped in less than a year. In 2022 EV, battery, and lithium demand grew over 60% (9% penetration) catching the supply chain off guard and resulting in a massive spike in prices. I assumed the LCE (Lithium carbonate equivalent) prices would decline from US$80kg to US$20kg in 2024 under a more balanced supply-demand equation. I did not foresee an even sharper decline due to slowing EV demand and increased supply coming from everywhere, incentivized by high prices and long-term growth of EVs as well as integration from battery OEMs. The current LCE prices in China are slightly above the industry cost curve suggesting new mines and expansion plans may begin to be delayed and if EV demand continues or picks up speed, LCE prices could recuperate to the US$20kg range. However, to be more conservative, I have cut the price to US$11kg forever and arrived at a US$48 price target for 2024.

The Codelco Deal

In the current Chilean government’s infinite wisdom and SQMs nervousness, the two struck a deal for Codelco (State-owned Copper company) to ¨share¨ and extend the Salar de Atacama concession, along with chemical processing plants from 2030 to 2060. This JV, where Codelco has 51% control, should implement the Direct Lithium Extraction (DLE) process and produce about 300k tons of LCE. For SQM this means that it will be a minority shareholder, will not consolidate the operations, and will likely receive dividend flow. In my view, this deal means that SQM has abdicated its Lithium operations in Chile and will move investment, and expansion to Australia where it already has a JV at Mount Holland (25k ton LCE) and is acquiring 50% of Azure a pre-operational company in association with Gina Rinehart of iron ore miner Fortescue.

The impact on SQM valuation post this deal is neither positive nor negative. Using a DCF (discounted cash flow) method I arrive at a US$49 fair value. This means that in 2030 SQM should see a 30% decline in free cash flow assuming no further expansion in Australia or anywhere else.

4Q23 Preview

I estimate that SQM will see a reduction in EPS of 68% driven by lower LCE price (US$20kg vs US$58Kg) that impacts revenue and margins. The other business segments, iodine and fertilizers, should not disappoint. The market will likely be fully focused on what SQM’s strategic plans will be post the Codelco deal.

Forecast Update

Given the deeper correction to LCE prices than envisioned in my last update, post 3Q24 results, I am further reducing estimates from US$18kg to US$11kg for 2024 to 2030. As can be seen in the table below gross margins also come under pressure due to SQM’s rapid capacity expansion (100%) as well as cost inflation. There may be an upside to margins as capacity utilization increases and a focus on productivity post the 2022 price spike. I do not expect the company to add capacity in Chile above 240kmt post the Codelco deal, in 2025 Australian operations add 25kmt to top off total capacity at 265kmt. The other segments have a 3% growth rate and 3% price increase, except Iodine which I assume will be flat. The company should generate over US$2bn in EBITDA and starting in 2026 close to US$1bn in free cash flow that could be used for further Lithium expansion in Australia, Brazil, or even Argentina.

Valuation and Financial Summary

I continue to value SQM at 8x EV/EBITDA, below its historical average of 10x to add another layer of safety to the investment thesis. The new price target of US$48 incorporates a low LCE price, lower margins, and the de-risked concession agreement (Codelco). I assume a dividend payout of 50% should support a healthy dividend yield of 5% long term. Debt is not an issue, factoring in the US$350m for the Azure acquisition in 2024, net debt/ EBITDA is comfortable at .6x, and there is room for substantially more debt to fund projects.

Consensus Estimates

My new estimates are in line with the low end of the consensus. Most sell ratings are now in buy territory after the continued LCE price decline and many analysts have assumed US$11kg to US$13kg prices long term. Consensus still has some room to decline, and I would expect a final round of downgrades to estimates and price targets but still in buy territory.

Conclusion

SQM has been de-risked with the stock’s price decline and the current valuation suggesting the market has thrown in the towel. In my view, this suggests the market is ignoring the Codelco agreement that has ended concession risk, for better or worse. More importantly, the LCE price is back to 2021 levels and hovering at the marginal cost curve with new supply beginning to recede or delayed. A modest shift in EV demand or a restocking drive could provoke higher prices and the sector and SQM would suddenly come to life again. The risk-reward equation has shifted to buy for SQM.