Small Caps | Jul 25 2019
High lithium inventory, trade and political tensions have impacted Orocobre in the June quarter. Nevertheless, brokers believe the business is well-positioned for when the market turns around.
-Cash flow is benefiting from full sales of production, unlike hard-rock peers
-Focus on improving product quality and range
-No change in current prices considered imminent
By Eva Brocklehurst
A depressed lithium price may be compressing margins for Orocobre ((ORE)) but brokers find plenty of positive aspects to the company's outlook. There is a strong balance sheet to fund growth plans and the business is positioned for when the lithium market is more buoyant.
The company acknowledges the market is soft, affected by both industry and macro dynamics. Inventory is high at the customer end and trade and political tensions globally are affecting investor decisions.
Cash costs of US$4493/t were higher than expected in the June quarter, primarily because of local cost inflation and batch production of higher-cost purified product. Sales volumes are projected to match production, nevertheless, supported by 70% being under contract. Sales of 3400t were at US$8220/t, a -13% drop in pricing quarter on quarter. Cash costs were higher, reflecting increased purified production.
Despite a drop in prices and higher costs the company still managed to produce a gross cash margin of 45%. This is a favourable outcome versus peers, Credit Suisse points out, as around 98% of production was sold, in contrast to spodumene producers that are struggling to clear around 50%.
Cash flow is benefiting from the full sale of production, unlike hard-rock peers. Furthermore, it is a reminder, Canaccord Genuity asserts, of the low position on the cost curve of Olaroz and the options for any recovery in lithium pricing.
Production
The company intends to provide FY20 guidance for production in conjunction with its August results. Orocobre has not provided guidance since the first quarter of FY18. Canaccord Genuity, not one of the seven brokers monitored daily on the FNArena database, considers this a reflection of increased confidence in the additional ponds ahead of stage 2 expansion and retains a Buy rating and $6.50 target.
Yet there are still risks to the sustainability of Olaroz stage 1 nameplate production amid construction/commissioning risk for stage 2, Morgan Stanley asserts. On the other hand, Baillieu expects improvements in the stability of operations as expenditure on stage 2 ponds will add to the resilience of stage 1 operations.
The company plans to improve plant availability and reduce unplanned maintenance amid a potential reduction in soda ash consumption, hopefully leading to lower costs in the September quarter. Still, Baillieu, not one of the seven, considers the share price is more likely to reflect the lithium carbonate price rather than improvements in operating performance. The broker has a Hold rating and $3.01 target.
Morgans points out production from Olaroz is seasonal, affected by rainfall, snow and evaporation rates. Higher lithium grades and harvest ponds are conducive to increased battery grade product. Hence, Orocobre is focused on improving product quality and range and also bettering margins.
The company has advanced stage 2 works at Olaroz, having spent US$40m of its US$295m budget. While a formal review is ongoing, Orocobre has indicated there are no surprises, which suggests to Credit Suisse there is limited risk of any design change or expenditure blow-out. The commissioning timetable for Naraha is unchanged, slated for the first half of 2021.
Pricing
The main issue for brokers is about how the company's realised lithium carbonate pricing is playing out amid weakness in the Chinese price, and the potential impact from the intended increase in purified product.
While management believes all production can be sold, Baillieu notes negotiations with customers over schedules continue. The company does not find any change in price from current levels is imminent. Credit Suisse, on the other hand, envisages downside risk, as the market is likely to be in oversupply before the balance improves.
Considering subdued electric vehicle sales in China and the transition to the new subsidy environment the broker reduces forecasts for lithium carbonate and projects a 2020 battery grade price of US$9750/t, versus US$12,000/t, bringing forward the timing of price declines.
Citi also observes no imminent turnaround in lithium pricing. Inventory remains high at the customer end, reflecting weak demand for lithium product at an industry level. The broker notes a transition period for Chinese new electric vehicles subsidies concluded at the end of June and this is likely to keep the lithium market subdued at least for the second half of 2019.
Citi believes Orocobre offers leverage to volume growth and a better product mix, and the benefits from its two projects should be visible from 2021 onwards, supporting earnings despite the weak macro backdrop.
Credit Suisse, too, continues to like the stock for its quality, scalability and cost advantages and the benefits a successful execution on stage 2 should deliver. There are also other growth options including hydroxide, Cauchari and stage 3 at Olaroz.
FNArena's database has five Buy ratings and two Hold. The consensus target is $4.13, signalling 44.4% upside to the last share price targets range from $3.25 (Morgan Stanley) to $5.05 (Morgans).
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