Rockwood's Low-Cost Lithium Assets Set to Shine After Divestitures
We've upgraded Rockwood's moat rating to narrow.
We've upgraded Rockwood Holdings' economic moat rating to narrow from none. Our narrow moat rating is based on the firm's low-cost position in lithium production, which will manifest more strongly following the sale of several less advantaged business lines. We believe that Rockwood and fellow narrow-moat Chilean producer Sociedad Quimica Y Minera De Chile (SQM) are the world's lowest-cost producers of lithium carbonate. Additionally, Rockwood's surface treatment business contributes to its narrow moat rating.
During the last year, Rockwood's management has set a course to dramatically change the company's portfolio of chemical and material assets. In our opinion, Rockwood has secured solid prices for most of its divestitures, with titanium dioxide as the notable exception. By mid-2104, Rockwood will operate only two primary business lines, lithium and surface treatment. The firm has sold or plans to divest businesses that generated roughly 60% of 2012 net sales.
In June 2013, Rockwood announced the sale of its advanced ceramics business to a European private equity firm for roughly $2 billion. In 2012, the business generated EBITDA of $175 million, implying a purchase multiple of roughly 11 times. We think this is an attractive multiple, and as a result we raised our fair value estimate to $58 per share from $54 following the deal's announcement. We viewed the ceramics business as potentially holding sustainable competitive advantages, so it was encouraging to see Rockwood secure a solid price for the business. We liked the prospects for the advanced ceramics line, which sported an impressive EBITDA margin of about 30%. Rockwood completed the ceramics sale on Sept. 4, 2013.
Next up, Rockwood announced the sale of its clay-based additives business near the end of July 2013; the sale was completed in October 2013. The business was sold to ALTANA Group, a German specialty chemical company, for $635 million. In 2012, the clay additives business generated sales of $191.4 million, 5.5% of total company sales. Following the announcement to sell clay additives, we raised our fair value estimate to $60 per share from $58. Rockwood disclosed that normalized EBITDA margin for the clay-based additives business was 25%-26%, which implied an EV/EBITDA multiple of roughly 12.5 times. We view this as an attractive multiple.
Finally, in mid-September, the company announced the sale of its titanium dioxide business, along with various other noncore chemical units, to Huntsman for $1.1 billion in cash plus $225 million in assumed pension obligations. Huntsman expects the businesses it's buying to generate $200 million in EBITDA in 2014. In our opinion, this midsingle-digit multiple is disappointing from Rockwood's perspective. The titanium dioxide business has struggled to generate profits over the last few quarters. In the second quarter, TiO2 posted an adjusted EBITDA loss of $10 million compared with a $55 million EBITDA profit in the second quarter of 2012. We think this business is somewhere near a cyclical trough.
After the titanium dioxide sale closes, likely in the first half of 2014, Rockwood's portfolio will include only lithium and surface treatment. By our estimates, lithium will account for roughly 60% of company EBITDA with the balance coming from surface treatment.
Chilean Assets Support Rockwood's Lithium Business
With an attractive asset base in Chile, Rockwood is a low-cost producer of lithium and its derivative products. The firm's cost advantage stems from Chilean assets in the Salar de Atacama. Salt brine is pumped from just below the surface and then dried by the sun's rays in massive evaporation ponds. Marginal cost producers of lithium either extract the element from salt brines with lower concentrations or mine spodumene and process the mineral to make lithium carbonate. Both methods produce lithium at significantly higher costs compared with the Chilean brines used by Rockwood and close competitor SQM. Processing spodumene into lithium carbonate involves grinding, heating, and dissolution, which incur higher costs than brine production. A dated, but we think still relevant, 1990 study by P. Pavlovic estimated that spodumene-based lithium production in North Carolina was more than twice as costly as Atacama-based lithium production. We think Rockwood is at the low end of the industry cost curve and can produce lithium for less than half the cost of marginal producers, many of which produce lithium carbonate in China from Australian-mined spodumene.
Research by Paul W. Gruber et al. published in the Journal of Industrial Ecology suggests that the Salar de Atacama not only is the largest developed lithium brine deposit in the world, but also holds the highest concentration of lithium. The Salar de Atacama's average lithium concentration (0.14%) is much higher than that of large developed brine deposits in China (Qaidam, 0.03%; and Zabuye, 0.068%) and Argentina (Hombre Muerto, 0.052%). The higher lithium concentration helps put the Salar de Atacama at the low end of the industry cost curve.
While the majority of Rockwood's lithium production comes from Atacama in Chile, the company also produces a portion of its lithium in the United States at the Silver Peak brine deposit in Nevada. Silver Peak's lithium concentration (0.02%) is much lower than Atacama's. We believe Silver Peak production pulls Rockwood a little way up the cost curve, potentially above SQM, which produces lithium exclusively out of Atacama. That said, Rockwood's management has stressed that the company is "absolutely the lowest cost producer of lithium and lithium compounds in the world."
We hesitate to give Rockwood a wide economic moat because of the possibility that new players will enter the low end of the lithium cost curve in the years ahead. In fact, the Chilean government has already made efforts to open lithium production at Atacama to new entrants. Additionally, lithium reserves in Bolivia would also likely sit toward the low half of the cost curve after development, but we note that lithium concentrations at Bolivia's Salar de Uyuni are only about 0.05%. If these reserves are developed, Bolivian producers will also have to deal with processing a large amount of magnesium in the brine. This would also likely raise production costs compared with Rockwood's and SQM's operations in the Salar de Atacama. While we do not have enough confidence that Rockwood will generate economic profits for the next 20 years, large and lower-cost new entrants into the lithium market are not imminent, and developing new deposits takes considerable time and investment.
Importance of Lithium in Rechargeable Batteries
The primary driver of lithium demand over the last decade and the reason why investors generally get excited about lithium is the element's use in rechargeable batteries, specifically the potential for use in electric vehicles. We're expecting a lithium demand CAGR of about 8% through 2020. Lithium is widely used in lithium-ion, or Li-ion, batteries for personal electronics, but it's important to note that battery demand currently accounts for only 22% of global end-use demand. We expect this percentage to increase, as the growth rate for lithium personal-electronics battery applications will likely be much higher (10%-15% pa) than growth rates for other uses (2%-5% pa), such as ceramics and glass. With incomes rising in China, India, and other developing economies, personal electronics (such as laptop computers and mobile phones) demand is set to grow. However, the big potential growth driver for lithium is the element's use in rechargeable batteries for all-electric and hybrid vehicles. Electric cars are generally divided into three buckets: all electric, or EV; hybrid electric, or HEV; and plug-in hybrid electric, or PHEV. The amount of lithium used in each type of vehicle varies significantly.
While electric cars have been on the market for some time, with the first major commercial success being the Toyota Prius, lithium-ion technology has not grabbed a large share of market as of yet. The dominant technology in HEVs has been nickel-metal-hydride, or NiMH, batteries, including use in the aforementioned Prius. Despite NiMH's lead position, Li batteries stack up favorably in a number of important categories, including charge/weight ratio and a lack of "memory effect"--NiMH batteries need to be fully drained before recharging.
Despite these advantages, the dominance of Li-ion batteries in electric vehicles is not a foregone conclusion, as safety issues have always been a concern. A handful of recent incidents have highlighted this concern, including reports of a Tesla Model S catching fire and Boeing's Li-ion battery fires on the 787 Dreamliner. While safety concerns and competing battery technologies could pose a threat to lithium's demand outlook, we note that lithium has the highest charge/weight ratio of the main battery metals, including cobalt, manganese, nickel, and phosphorus.
While electronics and other uses will continue to be important demand drivers for lithium, long-term projections for lithium demand hinge on the global penetration of electric vehicles, lithium's use in rechargeable vehicle batteries, and the mix of EVs, HEVs, and PHEVs in the electric car market. In our view, the primary factor that will influence electric vehicle adoption is cost--both the cost of the cars themselves and the cost of electricity--compared with traditional gas-powered vehicles. Further, electricity grid capacity would also likely need to increase to support a widespread adoption of electric vehicles in the United States.
Strong Future Demand Encourages New Lithium Development
In anticipation of strong demand, lithium capacity has grown substantially. With further capacity additions planned, we think the market will likely be facing an oversupply situation toward the end of the decade. Lithium supply is fairly concentrated, with South America, China, and the United States as the main producing regions. As we noted earlier, lithium is produced from two primary deposit types: brine (roughly 90% of global reserves) and mineral rock (10% of reserves), with spodumene being the most prevalent mineral source. Major lithium brine producers in South America include Rockwood (Chile), SQM (Chile), and FMC (Argentina). The majority of spodumene-based lithium production starts in Australia (Talison Lithium), with final lithium carbonate production usually happening in China. China also produces lithium from brines, with salt lakes distributed across Qinghai, Tibet, Xinjaing, and Inner Mongolia. However, based on lower concentration and lack of scale, we think Chinese brine producers sit well above South American brine producers on the global cost curve.
There are numerous and sizable undeveloped lithium assets across the globe. The most notable is Uyuni in Bolivia, the largest known deposit in the world. This deposit is under consideration for large-scale development, but has a lithium concentration of only 0.05%, compared with 0.14% at Atacama. A trial plant in Bolivia will produce only 40 metric tons of lithium this year. The Bolivian government, which has kept a tight hold on the lithium resource, hopes to eventually produce 30,000 tpa, which would be roughly 20% of 2012 demand. However, hurdles remain for the development of Bolivia's deposits, including the high amount of magnesium in the deposit (which drives up costs), a lack of freshwater and infrastructure, and the reticence of the Bolivian government to use the help of an outside development partner.
While development of new deposits may face hurdles, current producers, especially brine produces, can expand production capacity relatively cheaply and quickly. Rockwood is wrapping up construction of a new 20,000 tpa facility in Chile that will bring LCE capacity to 50,000 tpa. And over the long run, we expect SQM to increase its production volume to 60,000 tpa compared with about 45,000 tpa in 2012. Another major South American brine producer, FMC, has capacity of about 23,000 tpa, having increased capacity by 30% over the last few years.
On the rock production side, a notable recent expansion project comes from Talison Lithium, which was acquired by Chinese company Tianqui after a failed takeover bid from Rockwood. Talison is a spodumene-based producer operating out of the Greenbushes deposit in Western Australia. Talison produces lithium concentrate, a precursor to lithium carbonate, and exports most of its product for finishing in China. Talison recently finished a major expansion project, doubling capacity to enough lithium concentrate to make 100,000 tpa LCE. It will be interesting to see how China makes use of this new capacity, as Tianqui now has the ability to swamp the global lithium market. SQM management mentioned in its second-quarter press release that 2013 lithium volumes were lower than expected as a result of a higher-than-predicted increase in supply, mainly from competitors in China. It's important to note that the Greenbushes mine likely has only about two decades of production left. This time frame could decrease considerably at higher production levels expected after expansion.
Other recent projects have been supported by off-take and supply agreements with battery makers. For example, Canada Lithium Corp. is in the process of ramping up production at a new mine with a capacity of 20,000 tpa. We expect that other projects on the drawing board and in development will come to fruition. Considering this along with expansions from current producers, we expect oversupply in the lithium market in the years to come, despite our forecast for strong lithium demand, which will be discussed next. The exact level of oversupply is difficult to peg, in our opinion, given the relative ease with which capacity can be expanded at Atacama and other already-developed brine deposits. That said, we feel comfortable forecasting 2017 LCE supply of greater than 300,000 tpa versus demand of about 270,000 tpa.
Lithium and Surface Treatment Support Rockwood's Narrow Moat
We're using a $4,750 per metric ton long-term price forecast for lithium carbonate in our assumptions that lead to narrow moat ratings for Rockwood Holdings and SQM. This forecast is in nominal 2017 dollars and implies a 2013 real price of about $4,300 in 2013 dollars. Our forecast is based on estimates of marginal costs of production and our view that recently added and upcoming additions to industry supply will likely suppress industry operating rates and prices. Our long-term forecast implies pressure on prices from the current level of about $5,500/mt, based on results from SQM's first half of 2013. We admit that lithium supply and demand are both difficult to forecast. On the demand side, the penetration of electric vehicles, the mix of electric vehicles by type (EV, PHEV, and HEV), and the penetration of lithium use in the car battery market are the primary drivers of variability. On the supply side, because of the scalability of lithium brine deposits in Chile, Rockwood and SQM can easily increase supply. And while this leads to a positive moat trend for the two companies, it also makes it more difficult to predict supply five or 10 years down the road. With other lithium projects on the docket, Rockwood and SQM will need to decide how they want to shape the market. Even with strong demand growth, we think lithium suppliers should have sufficient capacity to meet demand, with the huge expansion by Talison the primary driver of a potentially loose lithium market to 2020.
Metal surface treatment is also a solid business for Rockwood, and we believe the company has created some switching costs by becoming ingrained in its customers' development processes. After asset sales are complete, Rockwood's only other business line will be surface treatment. The company has built a strong position in metal surface treatment with a solid portfolio of products, many of which are based on proprietary formulations. We believe a portion of this segment deserves a narrow economic moat rating. Thus, the surface treatment business marginally strengthens our narrow moat rating for Rockwood. In our view, customers value Rockwood's technical know-how and ability to develop new products, and as such, the majority of revenues in this business come not from the sale of surface treatment chemicals, but rather from the service provided with those chemical sales. In the surface treatment business, Rockwood is a competitor of PPG Industries (PPG), which also holds a narrow moat rating.
We're maintaining our positive moat trend rating for Rockwood. We think the lithium market is set to expand further as personal-electronics penetration increases in emerging markets and hybrid-electric vehicle production ramps up. In our opinion, Rockwood's competitive advantages will widen as the company invests in higher lithium production capacity, exploiting its low-cost position. By 2014, the company plans to expand its lithium carbonate and lithium hydroxide capacity from 38,000 tpa to 60,000 tpa. Both Rockwood and SQM have the capability to expand capacities with relatively low capital investments, compared with a player that would build a new lithium operation in Chile. That said, Rockwood's positive momentum could be dented by the Chilean government's efforts to open lithium production to new entrants. We think meaningful lithium competition from a new Chilean player is still uncertain and likely many years down the line.
Asset sales have significantly reduced Rockwood's financial leverage, eliminating a potential drag on equity performance. Rockwood wrapped up 2012 with a debt/capital ratio of 0.62. However, this ratio is set to improve meaningfully with the sale of several business lines and the retirement of debt. We expect the company to be in a negative net debt position at the end of 2014 after all divestitures have closed. We think Rockwood will use cash to make acquisitions. If attractive acquisitions are unavailable, we think the company is likely to return more cash to shareholders. We no longer see Rockwood's debt covenants as a potential stumbling block.
Rockwood has operated with high financial leverage since private equity firm Kohlberg Kravis & Roberts formed the company in 2000 by combining various chemical assets. Since then, Rockwood has decreased its financial leverage, ending 2012 with $2.2 billion in long-term debt and $1.3 billion in cash. Per the company's credit agreement, Rockwood's leverage ratio, as measured by net senior secured debt divided by adjusted EBITDA, cannot exceed 2.75 times through 2014. At the end of 2012, this ratio stood at 1.52 times for the trailing 12-month period. We don't think the company is in danger of violating this covenant during the next five years, especially given recent asset sales. Rockwood has no major debt commitments maturing over the next five years.
Solid Stewardship Safeguards Rockwood's Future
We've upgraded Rockwood's stewardship rating to Exemplary from Standard. In our view, the company has done well to focus on businesses with sustainable competitive advantages. Recent and planned divestitures will make the firm's low-cost lithium business a much larger portion of the company's total overall profits. And importantly, we think Rockwood generally has received fair market values for the assets it has sold as part of the company's transformation. The titanium dioxide assets are a notable exception in this regard, but the lower price for TiO2 is not enough to negatively shade our opinion of the transactions as a whole. Along with lithium, the company will focus on surface treatment, which has been a strong cash flow generator for Rockwood over the past several years. While it is perhaps not as attractive as the firm's lithium assets, we think Rockwood holds some competitive advantages in surface treatment as well. Further, management has done an admirable job of increasing profitability in the surface treatment business since it was purchased in 2004. In 2005, surface treatment EBITDA margin clocked in at less than 15%, compared with more than 21% for 2012.
Seifi Ghasemi has been CEO and chairman of Rockwood since 2001. Before Rockwood, Ghasemi spent more than 20 years at industrial companies GKN and BOC Group. In our opinion, Ghasemi has done a solid job of navigating for the company during the last decade, considering the ominous debt burden Rockwood has dealt with since Kohlberg Kravis & Roberts formed the company in 2000. Rockwood has sold off segments where it does not hold industry-leading positions, choosing to focus on higher-margin niche markets--a sound strategy, in our opinion. KKR still owns about 30% of the firm's equity and holds two seats on the board. The recent reluctance to get into a bidding war for Talison Lithium shows discipline, in our opinion. However, Talison's capacity expansions have the ability to swamp the global market, and a purchase by Rockwood would have removed this worry. Talison was eventually purchased by a Chinese company, so there is the concern that the decision of how much lithium Talison will supply may not be based solely on an economic decision-making process. That said, it's not certain that China will flood the market with lithium supply, and we don't view the decision not to purchase Talison as a clear misstep by management.
Jeffrey Stafford does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.