My bullish thesis on Sociedad Quimica y Minera de Chile S.A. (NYSE:SQM) hasn’t worked out over the past six to seven months as the oversupply dynamics in the lithium market were more pronounced than I had anticipated.
The lessons learned include placing too much emphasis on SQM’s best-in-class “A+” valuation grade relative to its sector peers. Despite its reputation as one of the world’s lowest-cost lithium miners with significant cost advantages in the Salar de Atacama region, SQM suffered a 1Y total return of -38%.
However, SQM’s decline should be considered within a broad valuation de-rating across its lithium mining peers. As seen above, SQM has suffered a relatively “less intense” battering than Albemarle (ALB) stock. Albemarle is arguably its most significant competitor, with cost-advantaged assets in Chile, bolstered by a more globally well-diversified mining and production base.
Therefore, some SQM bulls could argue that its relatively attractive valuation could have priced in significant execution and geopolitical risks, helping it to defend against a worse selloff.
Despite that, SQM’s recent third-quarter or FQ3 earnings release highlighted the immense challenges and substantial impact on the company’s operating performance due to the lithium market cyclicality.
Observant investors should recall that SQM reported higher lithium and derivative sales volume in the third quarter compared to the same period in 2022. Accordingly, the company achieved a sales volume of 43.3K metric tons, “representing a 4% increase from 41.6 thousand metric tons in 3Q2022.”
Despite that, SQM suffered a 45% revenue decline in the segment, attributed to lower realized prices amid an unanticipated supply glut. As such, it significantly impacted the company’s overall performance, given the exposure of the lithium segment. Investors should note that the segment contributes about 74% of its gross operating profit for the first nine months of the current fiscal year.
As a result, SQM posted an overall revenue decline of 38% for FQ3. Its adjusted EBITDA of $788M saw a worse decline, falling by nearly 53% YoY. Management highlighted that Q4 could see the headwinds persist, with “its lithium volumes in Q4 will either remain similar to or be lower than those in Q3.”
However, SQM isn’t unduly concerned with the near-term supply overhang, as it works to secure its market share and possibly expand it when the challenges normalize. Management stressed that it’s “focusing on producing at maximum capacity in Chile, China, and Australia.” As a result, the company wants to ensure that it is well-primed to capitalize on an expected cyclical upswing “when inventories return to normal levels and customer purchasing activity reactivates.”
Notwithstanding management’s optimism, market participants remained cautiously positioned as they assessed the extent and duration of the oversupply. Revised analysts’ estimates suggest that SQM is still expected to deliver free cash flow or FCF profitability in FY23. However, its FCF margin is expected to decline to 25.9% in 2024, down markedly from 29.6% in FY22 and an estimated 31.3% for FY23. Therefore, I believe it’s clear that investors are looking past FY23, as they priced in the impact of lower profitability estimates for FY24, even as SQM expands its production.
Despite that, investors should also give due credit to SQM’s solid FCF profitability metrics, notwithstanding the battering in the lithium market. It corroborates its best-in-class “A+” profitability grade, underpinning its ability to weather the near-term volatility and emerge stronger ahead of its less profitable peers. Hence, I assessed that management’s outlook and execution strategies for capturing market share against peers who pull back in the near term are sound. The critical question for dip buyers should be whether the battering is near peak pessimism.
I assessed that SQM’s long-term price action suggests it’s potentially at a pivotal inflection point. It has regained most of the losses (so far) that it incurred in November, although I must admit it’s still too early to declare victory, as it’s a long-term chart (monthly price action).
Hence, more conservative investors should consider waiting until the end of the month to assess how SQM’s price action pans out before committing more funds. However, with SQM re-testing its December 2021 lows at the $45 to $50 level, dip buyers are expected to return with higher conviction.
I assessed that SQM’s risk/reward profile remains highly favorable as it’s still in a long-term uptrend. Therefore, investors who have always wanted to consider buying into a solidly profitable company partaking in a secular growth industry are given a remarkable opportunity as the stock fell to a two-year low.
Rating: Maintain Strong Buy.
Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.
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