Lithium Boosts Albemarle's Outlook

Narrow-moat lithium producer

Albemarle ALB is one of the best ways to play higher electric and hybrid vehicle penetration. As the largest and one of the lowest-cost suppliers of lithium globally, Albemarle is well positioned to benefit from higher lithium demand and prices through its significant expansions in the coming years, with cash flows set to double by 2020. We believe the shares are undervalued, trading more than 20% below our $120 fair value estimate.

We think the market underestimates the potential for electric vehicles. Bears point to high costs and low range versus internal combustion engine vehicles as reasons adoption will not take off, noting that despite much fanfare and excitement, electric vehicles still made up less than 1% of global vehicle sales in 2015. Consensus forecasts electric vehicle adoption growing to 2%-3% by 2020 and 4%-5% by 2025--just enough to meet fuel efficiency requirements. While we also see regulation as the main driver through 2020, we expect far greater adoption in subsequent years as battery technology improvements allow electric vehicles to reach cost parity with internal combustion engines by 2025. We forecast electric vehicle penetration of 10% by 2025, comparable to the ramp rates of similar innovations that have reached cost parity. In absolute terms, electric vehicle sales should grow more than 30-fold from roughly 0.33 million units in 2015 to 11 million units by 2025, slightly more than the 10 million or so total vehicle sales for a top three global automaker.

We forecast 16% annual lithium demand growth over the next decade, faster than we've witnessed for almost any major commodity over the past century. We project 2025 lithium demand at 775,000 tonnes, well above the consensus outlook for 400,000-600,000 tonnes. To encourage sufficient supply, lithium carbonate prices would need to rise more than 40% to $10,000 per tonne from current levels of roughly $7,000 per tonne.

We expect Albemarle will be able to increase its exposure to lithium from 28% of profits in 2015 to over 60% by 2020 and nearly 70% by 2025. We expect production to increase from 49,000 tonnes in 2015 to 117,000 tonnes by 2020 and 170,000 tonnes by 2025. While cash flows from Albemarle's bromine segment should decrease with lower bromine demand and pricing, we expect this will be more than offset by a recovery in the refining catalyst business. These other business units should continue to be strong cash flow generators to help support investments in the higher-growth lithium segment.

We assign Albemarle a narrow economic moat rating because of its cost advantages in lithium and bromine as well as switching costs in refining catalysts. While the remaining businesses do not possess sustainable competitive advantages, they will make up only a small portion of companywide cash flows in the years to come. For lithium, Albemarle's assets in Salar de Atacama are some of the lowest cost globally because of the high lithium concentration and favorable environmental conditions for the production of lithium from brine. The company's bromine assets in Jordan are some of the lowest cost in the world due to high concentrations. The refining catalyst business benefits from switching costs. Market shares have remained fairly stable in this business, as customer switching is fairly rare. Catalysts create significant value for customers at little incremental cost, and existing suppliers can more easily improve the effectiveness of their catalysts for each customer's tailored needs than competitors can.

Cost-Advantaged Lithium Assets Result in Moat
Albemarle's long-lived, low-cost lithium assets form the basis of our narrow economic moat rating for the company. The lithium operation in Salar de Atacama in Chile is the company's crown jewel. This asset has some of the lowest operating costs globally because of its high lithium concentration, low precipitation rate, high evaporation rate, and low prevalence of contaminant byproducts.

As a partial offset to these benefits, lithium from Salar de Atacama has a slightly above-average concentration of magnesium, which needs to be removed from the final product. Furthermore, Salar de Atacama has a lower concentration of potash byproduct (which can be sold) than other large deposits, such as the Argentine salt flats. Despite these drawbacks, the Salar de Atacama operation surpasses the Argentine operations in numerous other operating characteristics, including climate (drier with higher precipitation), country risk (Chile's policies are more mining-friendly), and infrastructure (much of it has been built already).

Albemarle also has a 49% stake in the Australian hard-rock asset Talison. While hard-rock operations tend to be higher cost than brine operations, Talison is one of the highest-grade hard-rock assets globally, helping to keep its operating costs competitive.

Breadth of Lithium Production Capabilities Unmatched
Lithium will be Albemarle's fastest-growing segment by far. We expect lithium EBITDA to increase from $213 million in 2015 to $930 million by 2020 and $1.35 billion by 2025. Higher production volume and higher pricing, partially offset by higher costs, will drive the improvement.

We expect Albemarle to increase production from roughly 49,000 tonnes in 2015 to 117,000 tonnes by 2020 and over 170,000 tonnes by 2025. In the medium term, we expect production growth to come from the ramp-up of the 20,000-tonne La Negra expansion in Chile and the ramp-up of Talison's 80,000-tonne capacity (which operated at roughly 50% utilization in 2015). Beyond this, Albemarle should be able to expand production through the second 20,000- to 24,000-tonne La Negra expansion, as well as the doubling of capacity at Talison to 160,000 tonnes. We also expect Albemarle will develop its recently acquired lithium resource in Antofalla, which could add roughly 30,000 tonnes of production, as the company believes it will be the largest resource in Argentina. Without acquisitions, we think it will be difficult for Albemarle to capture half of incremental lithium demand, as management hopes. Management estimates global lithium demand will increase by roughly 20,000 tonnes per year over the next five years versus our expectation of roughly 35,000 tonnes per year. Regardless, the company's slated capacity expansions are the largest in the industry.

Albemarle provides lithium products that can be used across the industry, from specialty uses to the carbonate and hydroxide that will be used by battery makers for electric vehicles and hybrids. SQM SQM , FMC FMC , Tianqi, and Ganfeng tend to focus on just a few product types. Albemarle is better positioned for growth across the entire lithium market.

Headwinds for Cost-Advantaged Bromine Segment
Albemarle is a major player in the bromine market, as bromine accounted for 26% of its revenue in 2015 (excluding the Chemetall divestiture). Bromine is extracted from brine, or saltwater pools. A higher concentration of bromine results in a lower cost of production, as less subsequent processing is needed. Albemarle and Israel Chemicals are the only two companies that have bromine operations in the Dead Sea, where the heaviest concentrations of bromine can be found. Albemarle's cost-advantaged bromine assets contribute to our narrow moat rating for the company.

Bromine has multiple end uses, including brominated flame retardants, industrial materials, clear brine oil drilling fluid, and water treatment. Brominated flame retardants are chemicals added to consumer electronics and other products (furniture, automobiles, and textiles) to make them less flammable; they accounted for 41% of bromine demand in 2015. Industrial materials, which accounted for 29% of bromine demand in 2015, include rubber production and intermediate materials for pharmaceutical and pesticide production. Clear brine oil drilling fluids, which accounted for 19% of bromine demand in 2015, are used in deep-water oil drilling. Bromine is also used for water treatment as a substitute for chlorine in swimming pools and hot tubs, which accounted for 5% of bromine demand in 2015.

We expect Albemarle's bromine segment to face secular headwinds, with production decreasing from 154,000 tonnes in 2015 to 142,000 tonnes in 2025 as the market contracts. Continued oversupply should drive falling prices, albeit at a slower rate than the 4% price decline Albemarle experienced over the past two years. We expect operating margins to decline from 29% in 2015 to our long-term forecast of 26% in 2025.

Albemarle's bromine segment has a high degree of operating leverage, with margins heavily influenced by production volume. In 2011, we estimate the company was running around 80% capacity utilization and margins were 39%. Albemarle expanded capacity in 2012, shortly before bromine demand began to fall in 2013. In 2015, we estimate operations were running around 70% of capacity utilization, and margins fell to 29%. This suggests that a 1% decrease in utilization leads to roughly a 1% decrease in operating margins in a stagnant demand environment.

Bromine Profits Will Decline as Demand Does
We project total bromine demand to decrease from 495,000 tonnes in 2015 to 475,000 tonnes by 2025. Over this period, we expect bromine demand from brominated flame retardants and clear brine drilling fluid (together 60% of total demand) to decline by 30,000 tonnes. While we forecast low-single-digit growth in industrial uses as well as water treatment and other, the combined increase of roughly 10,000 tonnes would not be enough to offset the declines in brominated flame retardants and clear brine fluid.

Consumer electronics demand for brominated flame retardants is declining, owing to a mix shift to less BFR-intensive devices and lower use across all devices as a result of regulations and substitution. This will be partially offset by growth in automobiles that come equipped with more electronics and demand for servers. We expect brominated flame retardant demand to decrease a cumulative 10% from 2015 to 2025, with the mix shift accounting for a 1% decrease, lower use across all devices accounting for 21%, and an 11% increase from growth in automobiles electronics and servers.

We expect bromine demand from the clear brine end market to decline 1.2% annually from 2015 to 2025. The bulk of this decline is due to an average 3% annual decline from 2015 to 2020; this is broadly in line with Morningstar's outlook for Gulf of Mexico offshore rigs, which forecasts a decline from 35 in 2015 to 30 in 2020. Bromine is used to make a clear brine water solution that is used as a drilling fluid in deep-water oil drilling. It is more expensive than traditional water-based drilling fluids, but it reduces overall costs because traditional fluids allow mud and solid particles to enter oil wells, which reduces the volume that can be pumped and damages the drilling equipment.

The bromine market has been oversupplied the past couple of years, as demand has fallen and production has not been curtailed fast enough to keep the market balanced. This oversupply has led to lower prices. While pricing is hard to track (there isn't a public index and there are many derivatives of bromine with different pricing levels), we do have broad indications based on management comments. Albemarle states that it has seen bromine price declines of around 4% in total from 2013 to 2015. To balance the market, Albemarle and Israel Chemicals are likely to cut production. We expect Albemarle to decrease production in line with the market decline, from roughly 154,000 tonnes in 2015 to 142,000 tonnes in 2025. Israel Chemicals should decrease production from its 2014 levels of 212,000 tonnes to 173,000 tonnes in 2025.

Catalyst Revenue Should Track Industry
Refining catalysts are used in oil refining to turn crude oil into fuels such as gasoline and diesel. There are two types of refining catalysts. Hydroprocessing catalysts, or HPCs, are used to remove sulfur, nitrogen, and other impurities from the crude oil feedstock in order to meet regulatory standards. Refiners book their purchase as a capital expenditure, as HPCs generally last two to four years before they can no longer produce fuel that meets specifications. As such, refiners have some leeway on how often they replace HPCs.

Fluid catalytic cracking, or FCC, catalysts are used by oil refiners to increase the fuel yields per barrel of crude oil that is refined. An increase in a refiner's yield translates to higher operating margins, so refiners rely on FCC catalysts to support profitability. Additionally, FCC catalysts are used in the production of higher-octane gasoline. FCC catalysts last as short a time as one week. Refiners continuously purchase FCC catalysts for the value-added higher yields.

We expect Albemarle's refining catalyst revenue will grow in line with our projections for the overall refining catalyst market, given the stability of the company's market shares over time. We expect FCC catalyst revenue to grow roughly 4% per year from 2015 to 2025 and HPC revenue to grow about 2% per year over the same time frame. Based on the benefits of operating leverage from higher production volume, as well as price increases, we expect EBITDA margins to expand from 27% in 2015 to 35% by 2025, in line with the average W.R. Grace GRA EBITDA margin from 2012 to 2015.

Demand Drivers Differ by Catalyst Type
Because FCC catalysts are used to enhance fuel yields, global demand for FCC catalysts is largely driven by refiner throughput and crude oil demand. Refiners make FCC catalyst purchase decisions based on crude oil purchases.

Another component of FCC catalyst demand is refiner octane requirements. FCC catalysts are used in the process of enhancing the octane of gasoline. Premium gasoline typically has higher octane than regular gasoline. As the spread between regular and premium gasoline has increased, the production share of premium gasoline has risen. Higher premium production increases FCC demand as refiners need more FCC catalysts.

We forecast that FCC catalyst volume will grow 2% annually from 2016 to 2025, driven by 1% annual growth in global crude oil demand and 1% annual growth from increased demand for premium gasoline. We also expect 2% average pricing growth for FCC catalysts over the next decade, roughly in line with inflation. Albemarle has announced price increases on a regular basis every three years (2007, 2010, 2013, and 2016), which is the typical FCC catalyst contract length.

HPCs are primarily used to meet regulatory standards for content such as sulfur and lead, unlike FCC catalysts, which boost profits via higher feedstock yields. As such, refiners try to minimize HPC spending while still meeting specifications.

That said, specifications are tightening over time. For example, newer HPCs produce fuel with lower sulfur content. Low-sulfur content is required by stricter regulatory standards set by governing bodies around the world, and refiners will need to purchase higher-value catalysts to meet these standards. Our analysis suggests that HPC expenses have increased from approximately $0.33 per barrel in 2010 to roughly $0.49 per barrel in 2015. With greater implementation of tightening specifications around the world, we expect HPC value will increase to about $0.55 per barrel by 2020.

The Morningstar energy team forecasts that the global production share of U.S. tight oil will grow from 4.4 million barrels per day, or 4.6% of global supply, in 2015 to 6.7 mmb/d, or 6.7% of global supply, by 2020. While tight oil tends to contain less sulfur, it also contains uncommon contaminant metals, such as iron, calcium, sodium, and lead, which require the use of additional HPCs. These contaminants in tight oil also require special FCC catalysts, for which Albemarle is well positioned when production grows.

HPC demand is also driven by replacement frequency. Integrated oil companies looking to cut capital expenditures in response to low oil prices in 2014 and 2015 deferred some of their HPC spending. Unlike FCC catalysts, which are purchased continuously throughout the year, HPCs can last roughly two to four years. Many refiners that previously used HPCs to roughly 85%-90% of useful life have begun to use the catalysts to 95% of useful life, hoping not to breach maximum sulfur specifications. While the average age of catalysts has increased due to the deferral of replacement purchases, we expect it to return to more normalized levels as refining companies play catch-up via new HPC purchases.

Market Share Stability Points to Narrow Moat for Catalyst Segment
Similar to the bromine market, the refining catalyst market is highly concentrated, with the three biggest players controlling over 75% of the market. W.R. Grace is the leader, followed by Albemarle and BASF BASFY .

We believe Albemarle's refining catalyst segment has a narrow economic moat. Even though W.R. Grace is the market leader, its and Albemarle's refining revenues have moved in sync from 2011 to 2015, growing and declining in tandem each year. While BASF does not disclose refinery catalyst revenue versus its overall catalyst segment, annual report commentary indicates that its refinery catalyst revenue has also moved roughly in line with that of W.R. Grace and Albemarle.

It would be difficult for any of these players to gain or lose significant market share in any given year, owing to the switching costs associated with changing catalyst suppliers. Refining catalysts are tailored to specific refineries to maximize customer profits. Variations in regional crude oil quality and refinery specifications require Albemarle to work closely with customers to formulate customized catalysts for each refinery. Catalysts provide value to refiners far in excess of their cost; they 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. Existing catalyst manufacturers hold the advantage of being able to improve catalyst effectiveness over time, which further improves refiner economics. Because of the highly customized nature of these products, customers are generally unwilling to switch suppliers on the basis of price alone. This is particularly true given that alternative suppliers must undergo trial periods to demonstrate superior efficacy. These switching costs in catalysts and the cost advantages in lithium and bromine underpin our narrow economic moat rating for Albemarle.