Guilt by Association Breeds Value

There’s certain industries, ideas, and geographical pairings that can make a business undesirable to the majority of the market. Of course the idea of investing in a Cypriot bank, a low-end big box retailer, or a for-profit education business is going to come with quite a bit of skepticism and concern, but not all companies that fall into these categories should be labeled as toxic. You’d have missed out on amazing discount retailers like Ross Stores (ROST) and TJX (parent of TJ Maxx and Marshall’s, among others) because you were so deathly afraid of JC Penney, for example. Both ROST and TJX, though on the outside appearing to be extremely similar to a JC Penney or Kohl’s, actually operate on a fundamentally different business model. The same can likely be said of some financial institutions in Cyprus or some for-profit education related business. Our idea of the moment falls along this same line of thinking, taking advantage of the market’s hesitation to invest in a company whose description is so ominous on the outside (or at least sounds that way) that it goes unappreciated for being remarkably unique from its peers.

Imagine coming home to tell your family that you’ve invested your savings in a Chilean mining company.

With most commodities prices in the gutter and a huge correction in the precious metals markets, mining companies have taken a bit of a beating (and rightfully so). The idea of investing in one right now isn’t all that exciting – and let’s be honest, mining is never exciting – and putting the word Chilean in front of it only creates more concern thanks to the somewhat recent disaster in that area. But the Chilean mining company I find myself enamored with is hardly the same kind of company as typical miners like BHP, RIO, or VALE… in fact, this “mining company” could better be considered a well-hedged play on population growth and global technology.

So please do your best in attempting to pronounce our newest position, Sociedad Quimica y Minera de Chile (SQM), or for the benefit of my readers, Chemical & Mining Company of Chile. SQM is an almost $13B company which primarily trades on the Chilean exchanges but also on the NYSE, where its share price has recently hit a 52 week low even in the midst of a huge run up in the global markets, mostly on the heels of a slightly worse than expected fourth quarter and what I’ll describe as a lack of general market awareness of the business.

Overview of Business Segments

SQM is the world’s largest producer of several essential specialty chemicals and nutrients with vital applications in agriculture, semiconductor/electronic, and medical/pharmaceutical products. Particularly, SQM sells as much as 46% of the world’s potassium nitrate, a vital specialty nutrient for promoting growth in premium fruits, vegetables, and other sensitive crops that don’t respond well to lower-grade commodity fertilizers. As the economic climate continues to improve, particularly in first-world countries where the “Whole Foods” movement has boosted demand of premium produce, demand for potassium nitrate and other specialty nutrients has increased significantly, to the benefit of SQM and their main competitor, Haifa, an Israeli producer who produces about 34% of global supply. Obviously this industry is extremely concentrated, and being a market leader in a virtual duopoly with a product in rising demand is certainly a good thing. Prices have been pressured upwards over the past few years as these two producers have been disciplined in matching supply and demand, and can easily prevent additional supply from pushing down prices… considering together they are responsible for about 80% of it. Several other blends and offshoots of potassium nitrate are also marketed by SQM and have led to continued growth in areas that Haifa and other competitors currently have no presence.

Their second business segment, Iodine and Iodine Derivatives, has a very similar (but even more defensible) demand profile to that of the above Specialty Nutrients segment. Chile holds a majority of the world’s known iodine reserves, and SQM alone is responsible for 34% of world iodine sales. The rest comes mainly from a cohort of smaller Chilean producers, mostly private companies, who make up about 26% in total, making Chilean supply 60% of the global market. Iodine has a variety of uses, but demand primarily comes from its applications in X-ray technology and as a therapeutic/pharmaceutical product, as well as in table salt to prevent iodine deficiency. In the past few years, prices have skyrocket of late, as disciplined supply and remarkable spikes in demand have led to a 40% increase in iodine prices in the past twelve months alone. This trend is expected to continue as production becomes more and more consolidated among a limited number of producers (led by SQM) and its uses in the medical space increase.

Now on to my favorite segment, Lithium and Lithium Derivatives. While still a small part of SQM’s total revenues (approximately 10% of sales in 2012, with shipments growing at 25%+ per year and prices climbing even faster) lithium has seen unprecedented surges in demand in the past few years, with sales exceeding SQM expectations for three straight years and a global shortage poised to continue. The demand is perpetuated by the ongoing growth of its largest consumers: ion-lithium batteries for smartphones and other electronics (not to mention electric vehicles!), pharmaceutical uses, and (oddly enough) as lubricating grease for industrial purposes. SQM produces the two main lithium-based products these industries need, lithium carbonate and lithium hydroxide, and is responsible for about 35% of global production. It also has an enormous competitive advantage in this space as the lowest cost producer, thanks to what I’m calling a “closed-loop production system” though I’m sure there’s an actual name for this and my calling it that has no educated basis whatsoever (just can’t help myself). The way SQM’s operations are set up, production from their largest segment, Potassium, is a highly concentrated solution containing Lithium, which is then taken to a production facility to be refined and turned into Lithium Carbonate or Lithium Hydroxide. Byproduct from this process is then pumped back into the Salar de Atacama, a large basin SQM exploits in northern Chile for production of numerous chemicals, and its most value and high-quality asset. This self-sustaining system with byproducts being the raw material of other products who have byproducts of their own, and so on, means that increasing capacity at the top of the circuit results in increased production all the way down the chain. SQM has recently committed to sinking $500M into its production facilities to increase potassium chloride production (more commonly known as potash, a commodity-type fertilizer), which in turn would also increase lithium capacity, which is badly needed to keep up with global demand.

As mentioned before, SQM also produces potash and other potassium-based products for both agricultural and industrial uses. While it has capacity of about 2M tonnes of potash (a relatively small amount compared to 2012 global demand of about 50M tonnes), a lot of its potassium-based product is converted into sulfate of potash (SOP), which is more expensive than standard potassium chloride (also known as muriate of potash, or MOP) and necessary for crops that cannot withstand the addition of chloride that comes from MOP. This puts it more into the category of a specialty nutrient, thus it has a higher price point and more consistent demand, while the commoditized potash market has seen very inconsistent demand and unreliable pricing in recent years, as many farmers see it as unnecessary to be applied each application season. This, however, is not the case with SOP, and gives SQM something of a hedge against a weak agricultural market for potassium and commodity crops like corn, soybeans, etc.

Lastly, SQM markets its nitrate-based products for Industrial uses, mainly in the form of sodium nitrate and potassium nitrate of varying qualities. Revenues from this segment have comprised about 10% of total revenue historically, but have started growing at an outrageous clip, with shipments up over 50% in 2012. Historically, the most prominent uses of sodium nitrate and potassium nitrate have been in glass, ceramics, explosives, and simply as components of other chemical processes. However, a recent surge in demand in this segment has come from the solar industry, as the most effective material for solar panels to store thermal energy has been found to be a 60/40 blend of sodium nitrate and potassium nitrate. As the prevalence of government and private sector solar projects, and solar panel production in general, increases, these substances have become more and more in demand, and SQM has been best positioned to benefit due to their 40% share in potassium nitrate and 60% worldwide market share in aggregate for both of these products. Their next closest competitor has a 25% share in potassium nitrate (and no meaningfully large competitor in sodium nitrate), again demonstrating the fantastically consolidated market for these specialty chemicals and the dominance SQM has in each respective market. In this market as well, SQM is the low-cost producer due to its closed system of production between its major chemical-producing segments.

Where’s the Value?

Our belief that SQM is not just a mining company manifests itself best in its financials. The company has grown sales on the top line by mid teens the past several years and has enjoyed a continually increasing gross margin, going from 34.2% in 2010 to 39.8% in 2011, and increasing again to 42.3% in 2012. Are there mining companies that could ever come even remotely close to these numbers? No. Fertilizer companies, particularly potash companies? Maybe, but certainly not with SQM’s level of top-line growth, and certainly not having the level of margin expansion SQM has had over the past three years. As these chemicals increase in demand and SQM continues to consolidate the industry and gain market share, expect these gross margin figures to continue to increase, though at a much slower rate. I would expect improved demand to bring more supply online in certain product categories where mining rights are readily available for outside competitors, and this may temper any future gains in chemicals pricing though volume increases should still be expected, particularly in lithium which has seen its number of uses multiply significantly over the past decade. Even the aerospace market has become enamored with lithium, as many manufacturers have opted to invest in aluminum lithium alloys as opposed to composites for aircraft fuselages and in order to increase aircraft aspect ratios as the industry slowly moves towards a higher mix of narrow-body jets to improve efficiency across the air travel industry.

Currently, SQM’s NYSE shares sit just above their 52 week low at approximately $48.00 per share. These Class B shares can be owned by any domestic investor through the NYSE, and comprise about 10-12% of the company’s outstanding shares. Most of SQM’s shares are owned by a small number of entities, with its Chairman owning approximately 34% of the company, Potash Corp of Saskatchewan owning another 32%, and several smaller investors owning a few extra percentage points of the float, making this a difficult business to own in size (meaning, if you wanted to own 10% of the company through its ADS shares, you would have to literally buy every Class B share available, so it is difficult for large institutions to gain significant positions without purchasing the Class A shares on the Chilean Exchange. This opens up a nice opportunity for smaller funds and retail investors alike to hitch a ride alongside these insiders who own very large stakes and do business amongst one another. Potash Corp routinely did business with SQM in the past few decades and, after seeing the value of the company, took a large stake through several Chilean holding companies it owned in order to have some influence in being a preferred customer of SQM for SOP and other products Potash Corp would be interested in procuring.

SQM sports an impressive profit margin north of 25% and has seen this number climb a few hundred basis points year over year for the past handful of years. It currently trades at around 19x trailing earnings and 15-16x forward earnings, making it one of the cheaper businesses one could own that are organically growing the bottom line more than 20% consistently. The company, in compliance with Chilean law, must pay out at least 30% of annual net income in the form of a dividend, and the company’s Board of Directors has approved a 50% payout ratio for the time being, approved annually by the shareholders. This makes it an impressive dividend stock with a 4% yield, though it also limits SQM’s ability to plow those earnings entirely back into the business for strategic acquisition or share buyback, which given the current share price, may be ultimately better for the company’s equity going forward. I have skepticism that the BOD and executive management team would consider share repurchases, as they have never had a repurchase program as far as I have seen so far. At these depressed levels, I would argue it is the best use of that cash, rather than paying out a large dividend as they do. However, SQM has always had very generous financing due to its financial stability and its long-term debt pays in the 5-6% range on average, so they are able to finance any capital projects (including a buyback if ever approved) through debt and cash from operations.

Outlook

I will follow up on this business later, but wanted to get something out there about our latest idea. While I have not spoken with anyone from the management team and have only had a brief conversation with their IR Director, we felt compelled to purchase based on the long-term upside of the company’s competitive position, asset quality, and the positive trajectory of the specialty chemicals which they provide, most particularly their lithium business. We have been fortunate enough to get in at a price we think is reasonable and would recommend the stock to anyone at current levels of about $48 per share, as it has traded up as high as $65 in the past year at times when there was more uncertainty in their markets than there is today. We expect that if all goes right with SQM’s plans to expand capacity and continue to maintain its market shares in each of its fastest-growing segments, we should see this business earn over $1.1B by 2015, and setting our multiple at 17x for that time (today’s trailing multiple is mid-19s), that would yield a valuation of $18.7B, or just short of a 60% increase (~17% annualized) in the company’s value when we take into account dividend yield as well. While I’d expect the market to recognize even more value as the business grows, this is an estimate we can feel comfortable with, at least in the near term since we don’t yet have any opinion on management or management of competitors.

In short, people just don’t want to consider an obscure business that gets as little media attention as someone like SQM does, but we believe there to be the most value in those businesses that nobody else cares to understand or even pay attention to. Searching for diamonds in the rough is a very sexy thing to do, but we’d much rather search for the rough among the diamonds and polish it off.

 
eliteculture:

does this look like a pump and dump scheme?

On a $13B market cap stock?

"For I am a sinner in the hands of an angry God. Bloody Mary full of vodka, blessed are you among cocktails. Pray for me now and at the hour of my death, which I hope is soon. Amen."
 
eliteculture:

does this look like a pump and dump scheme?

LOL. Clearly WSO has the power to move the price of a $10bn+ stock.

"For all the tribulations in our lives, for all the troubles that remain in the world, the decline of violence is an accomplishment we can savor, and an impetus to cherish the forces of civilization and enlightenment that made it possible."
 
job.resume:

Just 4 minutes after this was posted (about how long it would take to read the post) there was heavy trading volume in SQM, and the stock has continued to go up since. Probably some megafund BSD looking to WSO for advice.

I do hope this isn't serious.

"For all the tribulations in our lives, for all the troubles that remain in the world, the decline of violence is an accomplishment we can savor, and an impetus to cherish the forces of civilization and enlightenment that made it possible."
 
nonos:
NorthSider:

job.resume:
Just 4 minutes after this was posted (about how long it would take to read the post) there was heavy trading volume in SQM, and the stock has continued to go up since. Probably some megafund BSD looking to WSO for advice.

I do hope this isn't serious.

Well
http://postimg.org/image/brpy2bcu9/

I mean, I know the volume spike happened, but that's likely just due to coincidence. Large orders are placed throughout the day and you'll see random spikes. I don't think anyone would seriously suggest that someone placed orders for >$1mm in stock based on a two page memo on WSO.

"For all the tribulations in our lives, for all the troubles that remain in the world, the decline of violence is an accomplishment we can savor, and an impetus to cherish the forces of civilization and enlightenment that made it possible."
 
Best Response
NorthSider:
nonos:

NorthSider:

job.resume:
Just 4 minutes after this was posted (about how long it would take to read the post) there was heavy trading volume in SQM, and the stock has continued to go up since. Probably some megafund BSD looking to WSO for advice.
I do hope this isn't serious.

Well
http://postimg.org/image/brpy2bcu9/

I mean, I know the volume spike happened, but that's likely just due to coincidence. Large orders are placed throughout the day and you'll see random spikes. I don't think anyone would seriously suggest that someone placed orders for >$1mm in stock based on a two page memo on WSO.

sorry, that was me - got excited by WH's analysis as usual.

 
job.resume:

Just 4 minutes after this was posted (about how long it would take to read the post) there was heavy trading volume in SQM, and the stock has continued to go up since. Probably some megafund BSD looking to WSO for advice.

this is awesome
 
prospie:
job.resume:

Just 4 minutes after this was posted (about how long it would take to read the post) there was heavy trading volume in SQM, and the stock has continued to go up since. Probably some megafund BSD looking to WSO for advice.

this is awesome

probably.

I hate victims who respect their executioners
 

Why the title [of the post] ?

4% div. yield is in line: the avg. dividend yield in frontier markets is 3.7% while the avg. div. yield in the emerging markets is 2.7%. Lots of growth is in those markets looking at those fat margins.

The Chairman owns 34% ? That's too much for one punk.

I was wondering if you had any specialized knowledge on valuing mining companies, which bear some similarities to O&G. Do you apply a real options model ?

Winners bring a bigger bag than you do. I have a degree in meritocracy.
 

still don't buy it. There are plenty of other options in commodities in other emerging markets. Secondly how can you say their nyse adr is class b shares?

Is it just me or do others here in wso get agitated by this dude whitehat's writing style. Dry pitches full of anecdotes with nothing substantive to back it up....Same thing with his tsla topic...Not buying into tsla current market cap or scty for that matter. Heck If I were a betting man, my money would be on bac otm jan 2014 call.lol

Sorry folks. Just having a bad day here. Cheers all

 

well written, but as others alluded to the 15-16 forward multiple for a cash heavy business is a bit disconcerting. Just doing a quick back of napkin look at cash flow looks like cap ex is normalized around 400 mill, dividend 300 million a year, CFO $600 mil a year. So I do not see how they can sustain either A)growth or B) dividend unless they want to take the ABX route and create a beautiful over-leveraged balance sheet.

 
ladubs111:
looks like cap ex is normalized around 400 mill, dividend 300 million a year, CFO $600 mil a year.

You can't know normalized business conditions from a "back of the napkin" number crunch. This is why we don't hire bankers.

I hate victims who respect their executioners
 

WH, I've covered SQM and told my PM to sell out of the stock a few month ago, which he did. While many of your points are valid, let me play Devil's advocate and explain what I believed the risks to be. I haven't followed the company as closely recently so let me know if I'm off base on any of these points.

1-potash industry as a whole is becoming more and more undisciplined. Contract times have gone from a year to six months. URKA was shipping to china in the winter at spot prices to offset extra supply on hand prior to a contract being signed, completely counter to the oligopoly structure of the industry. Indian subsidies are uncertain, and volume globally for potash is uncertain due to it being the most optional of the NPK nutrient trifecta.

Oversupply + uncertain demand + oligopoly getting weaker = shrinking margins = shrinking multiples

SQM ships ~2% of MOP globally and is a price taker (price makers are Uralkali, Potash Corp, K+S, and ICL to a lesser extent), so it's at the mercy of the industry as a whole.

2-iodine is at peak margins. Peak margins deserve trough multiples if theyre not sustainable. The Japan earthquake took a decent chunk of supply offline. That is starting to recover. The 2nd largest miner (also Chilean) lost license to mine due to illegal water access. There's still uncertainty there and nobody knows when that will be resolved. Best case scenario is that SQM gets all these assets and has even more control of the global iodine industry.

Last I remember, Iodine was the biggest contributor to operating profits but I expect that to recede once supply/demand is more balanced.

3- ROC and others are aggressively trying to expand lithium mining both in the Lithium Triangle (Argentina Bolivia Chile) and Australia (Talisman was acquired last year I believe). That being said, if electric vehicles start taking off there will def be a supply demand imbalance and you could see lithium go to $80/kg in no time. But for now, the THREAT of new supply makes me cautious in the near-medium term.


From the investor behavior I've seen, the stock seems to move with potash prices but trades at a premium multiple to other potash companies. This of course is due to the higher margin SOP, MOP, lithium, and iodine segments. I am getting a bit more interested at these levels and don't see the stock going to 12-13x multiple (a TON of support at current levels from Chilean pension funds - this company is a national treasure), but struggle to find a catalyst in the next few months. I understand your time horizon may be different than ours, hence our differing viewpoints on the stock at this point in time.

Finally, regarding the "normalized capex" comment above, BH is right. The best you can do is try to understand upcoming expansion projects but even those are highly sensitive to the underlying commodity price. Sometimes projects are delayed, canceled etc. SQM is even more complicated because it has multiple mining operations (potash and iodine) and these commodities don't have a high correlation. A lot of NPVs to calculate.

 

This was brilliant. Not sure how you were able to see the angles so clearly here.

I'm interested in knowing how much of this information was picked up from conversations with industry folk, versus just reading financials.

I'm assuming changes in contract times were a major red flag picked up in the financials of all companies? Not sure how you know URKA was shipping at spot or that they had extra supply before contracts signed - was this in their financials?

Just trying to get a better understanding of how you look at companies. I've read posts by other people, wouldn't mind reading about your approach as well.

Thanks.

 

This one wasn't really company-specific, it was more like the slow unraveling of a global oligopolistic structure. All the public Potash players (roughly ten public companies globally) got crushed yesterday and a bit more today as a result of a decision by two companies. Keep in mind that the saga isn't over yet, Uralkali could just be playing politics to get Belaruskali to behave better. I can go through the timeline in a separate post (from happy days to the shit show that is the current potash industry) if you and others would find it helpful.

 
WallStreetOasis.com:

SQM down 15% today....nice call

The entire potash oligopoly fell apart today when BPC (biggest potash conglomerate in the world) disbanded. There's been a lot of "cheating" going on by some producers - basically some guys are saying fuck it we have all this inventory let's clear it out to China for cheap. Why would China sign a contract for $450/tonne if they can keep buying on the cheap for $300/tonne?

This pretty much means all discipline goes out the window and it's a free-for-all. All the potash producer charts look like cliffs today: POT, SQM, MOS, URKA LI, SDF GR, IPI, ICL IT. Ugly ugly day...

 

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People demand freedom of speech as a compensation for freedom of thought which they seldom use.
 

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