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Is This High-Yield Lithium Stock a Buy?

- By Ben Reynolds

Sociedad Quimica y Minera de Chile (SQM) has dramatically underperformed the market since it peaked early last year. The stock has plunged 47% over this period, whereas the S&P 500 has gained 8%. Consequently, while the index is hovering around all-time highs, the stock is trading near two-year lows.

Such a great divergence is likely to lead many investors to wonder whether the stock has become a bargain, particularly given the exciting growth prospects of lithium. As a result, the Chilean company could be one of the top lithium stocks to buy right now.


Business overview

Lithium stocks have attracted the interest of many investors thanks to booming demand. Global demand has increased at a fast pace in recent years as a result of the steep increase in the number of mobile phones and electric vehicles used by consumers. An electric vehicle requires 5,000 to 10,000 times as much lithium as a mobile phone. Moreover, electric vehicles are only in the early phases of their growth trajectory.

According to the estimates of two major producers, global annual demand for lithium will grow from its current level of 210,000 tons to about 1,000,000 tons in just seven years, a 25% annual compounded growth rate. As such, it is obvious lithium producers have ample room for future growth. It is also remarkable that the three major lithium producers, namely Sociedad Quimica y Minera , Albemarle (ALB) and FMC (FMC), have an aggregate market share of 85%.

Sociedad Quimica y Minera is involved in the production and sale of five categories of products: lithium and derivatives, specialty plant nutrition, iodine and derivatives, potassium and industrial chemicals. The company has 56% market share in specialty plant nutrition and 36% market share in iodine, while it has market share of only 17% in lithium. The latter is by far the most important segment of the company, however, as it generates 53% of its gross profit.

In 2018, global demand for lithium continued to grow at an impressive pace. Thanks to increased production of electric vehicles, demand for lithium grew more than 25% over the prior year. The penetration of electric vehicles rose to 2% last year and is likely to double over the next five years. The strong demand for lithium greatly benefited Sociedad Quimica y Minera , which realized 25% higher average selling prices compared to the prior year. Notably, the company was able to capture a meaningful price premium compared to many of its competitors last year.

New supply, however, has entered the market this year. As a result, the company's management has become cautious in its outlook, stating it may not be able to capture a premium over its competitors this year. In retaliation, the market punished the stock for the lower outlook for its lithium business.

Growth prospects

Last year, Sociedad Quimica y Minera announced a three-stage expansion of its lithium carbonate operations in Chile. The company will focus on expanding its capacity to 180,000 tons per year.

Moreover, in Australia, the company continues to move forward with the Mount Holland lithium project, one of the largest hard rock lithium deposits in the world. The project is expected to come online in 2010 or 2021 and will have an annual capacity of 45,000 tons.

Sociedad Quimica y Minera also expects to enjoy significant growth in its second-largest business, namely the potassium nitrate market, which generates 22% of total gross profit. This segment grew its sales volumes by 12% last year on an annual basis thanks to 6% underlying market growth and limited supply from competitors. Management expects global demand to grow 6% this year, though it also expects new incoming supply from competitors.

While competition is intense, Sociedad Quimica y Minera is a low-cost producer of muriate of potash, which is the most common potassium-based fertilizer. In addition, the company is a low-cost producer of industrial chemicals and the lowest-cost producer of iodine and derivatives, which generate 14% of its total gross profit.

Behavior in recessions

Materials stocks are very sensitive to commodity prices and, hence, they are highly vulnerable to recessions. Sociedad Quimica y Minera is not an exception. Whenever the next recession shows up, the company will be hurt by declining sales volumes and decreases in its selling prices. In addition, its stock will probably be wounded by a contraction of its price-earnings ratio. As a result, the stock will incur a double hit; much lower earnings and a lower price-earnings ratio. That's why materials stocks tend to underperform the broad market during rough economic periods and bear markets.

As a recession has not shown up for a whole decade, the vulnerability of Sociedad Quimica y Minera to economic downturns is a significant risk factor to keep in mind. Nevertheless, it is worth noting the company has a healthy balance sheet, with net debt of $0.8 billion, which is worth less than two years' earnings. As a result, the company is not likely to face any financial problems whenever the next downturn occurs, though its stock price will certainly come under great pressure.

Valuation

After a 47% plunge in just 16 months, one would expect Sociedad Quimica y Minera to have become cheaply valued. However, the stock is still trading at a forward price-earnings ratio of 20.1. While the growth prospects of the lithium market are certainly exciting, they hardly justify such a rich valuation, particularly given the high cyclicality of the stock.

The rich valuation can be partly attributed to the reduced earnings per share estimates, which resulted from the cautious outlook provided by the company. Nevertheless, due to the high sensitivity of Sociedad Quimica y Minera to downturns, investors should pay special attention to the valuation of the stock and should not purchase it at its current premium valuation.

Final thoughts

While the growth prospects of the lithium market are undoubtedly attractive, investors should not ignore the valuation of lithium stocks. Due to their high sensitivity to commodity prices, these stocks may cause disastrous losses to investors if they are purchased at rich valuation levels and new supply from competitors exerts pressure on product prices. Sociedad Quimica y Minera is a high-risk stock due to the volatile nature of the lithium industry, but it has an attractive dividend yield and future growth potential.

Disclosure: I am not long any stocks mentioned in this article.

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This article first appeared on GuruFocus.