Orocobre Output Sputters, Likely Short Term

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Lithium producer Orocobre has encountered problems with its inventory and production guidance has been lowered. Brokers are reasonably confident the issues can be addressed.

-Production rates downgraded, reducing overall earnings estimates for several years
-Short-term issues in a long-term project are considered surmountable
-Yet, lack of clarity regarding the length of time to address the problems
 

By Eva Brocklehurst

Lithium producer Orocobre ((ORE)) has indicated that costs will take longer to fall and production will take longer to hit the target, as it has encountered problems with its inventory. Production guidance has been reduced at the company's Olaroz project in Argentina.

There was a shortfall in sales in the first half because of a port strike at Antofagasta, with those shipments deferred to the current quarter. The weaker average price the company received reflected the delivery of legacy contracts, which are now largely fulfilled. Otherwise, the company reports that market conditions are strong.

Morgans believes the market's reaction to the reduced production rate is overdone and maintains an Add rating. Orocobre remains a preferred investment in the lithium sector and the weakness presents a good opportunity to buy the stock, in the broker's view.

Macquarie pushes back expectations of nameplate production until FY19 and this reduces overall earnings estimates for the next several years. With the domino effect, the broker wonders whether the company should still assume it can fund its Olaroz expansion from operating cash flows. As a result, the broker delays its forecast for phase 2 by around 12 months, to avoid the joint venture going negative on cash flow.

No Call On Equity For Olaroz (as yet)

The broker finds the outlook extremely challenging although, outside of the potential delay for phase 2 at Olaroz, considers the proposal for a Japanese lithium hydroxide plant provides potential upside. No value is attributed to this plant in the broker's analysis, but Macquarie acknowledges this could ease some of the reductions in earnings that are now expected. Additionally, Macquarie assumes further shareholder loans may be necessary from Orocobre.

Citi has upgraded to Buy/High Risk. Although the downgrade to production from evaporation pond flow issues is increasing the risk profile, and raises questions over the management of operations, the broker believes these are short-term issues in a long-term project, and surmountable. The broker always believed original production guidance was unrealistic but was surprised by the magnitude of the downgrade.

Citi assumes a six month delay to the timeline and includes the expansion at an unchanged 50% probability until approved. What has changed, the broker notes, is the increased proportion of industrial grade production, as the expansion of the purification circuit has been dropped from plans.

The development signals to Citi that investors have been burned by the latest production downgrade and will not get clarity on whether management is capable of turning around the operation until the December quarter. Despite lower production, the broker does not envisage a need for the company to raise equity to fund the Olaroz expansion.

Deutsche Bank is disappointed in the update, given the company promised in the current half year to increase production and cash flow. The broker believes the phase 2 expansion should be self-funded out of phase 1 cash flow to avoid undue pressure on the balance sheet and further raising concerns among investors.

Canaccord Genuity, assuming the pond inventory problems and production curtailment can be resolved, still believes the company and its joint venture on Olaroz can fund the expansion as well as the lithium hydroxide project without the need for additional equity.

The JV has announced a proposed development of a US$30m plant for production of 10,000 tonnes per annum of battery grade lithium hydroxide to be built close to the Japanese market. The Japanese government is fronting up with 50% of the capital cost.

Orocobre had estimated it may contribute US$4m in equity for the plant. Several brokers note the company has now confirmed, after the downgrade in projected June half production, that it will not make call on equity for either the expansion or the new plant.

Canaccord Genuity recognises the strategic at value of the asset base and considers the shares oversold. The broker assumes a 9-12 months period to rectify the inventory imbalance and adjusts its FY18 production estimates to 14,900 tonnes from 16,300t. The broker, not one of the eight stockbrokers monitored daily on the FNArena database, has a Buy rating and $5.95 target.

Inventory Issue

Unlike earlier commissioning issues that were located in the plant, this time the problem is balance. The brine inventory imbalance through the evaporation pond system has resulted in a need to reduce plant brine feed rates for at least six months. This feed equates to lithium production. Production guidance, therefore, for FY17 has been reduced to 12-12,500t (Morgans previously projected 15,050t), implying second-half production of 5,500-6,000t.

The lithium inventory in the brine ponds is at the required rate, close to 40,000t, but the level in the harvest ponds, which feed the plant, is too low for efficient operation of the plant and high recovery. Brokers are relatively comfortable with these issues and believe they can be rectified. There is less certainty as to the time required to re-balance the inventory in the ponds.

Deutsche Bank notes there is a 25% fall in lithium grades reporting to the plant and a six-month period to re-allocate brine through the ponds while allowance for evaporation times is also increased. The broker observes, while the explanation for the problem is baffling in its simplicity, there are no long-term impacts.

Nevertheless, it has an impact on FY18 production volumes and highlights, in the broker's opinion, the need for efficacious monitoring and sampling procedures. The company has reduced its capital expenditure estimate for the phase 2 expansion by 15% by removing the purification circuit.

There are three Buy ratings on FNArena's database and one Hold (Macquarie). The consensus target is $4.14, suggesting 34.5% upside to the last share price. This compares with $4.77 ahead of the results. Targets range from $3.17 (Macquarie) to $5.39 (Morgans).
 

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