Description

With the worldwide move towards electric vehicles (EV) accelerating before our eyes (EV sales are expected to grow five-fold in the next decade), Umicore (UMI) -Belgian chemical materials company - is one of the more effective ways to invest in this trend. (France was selected in the Country section of the VIC Idea submission page, because the drop-down list of countries does not seem to include Belgium)

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Though most of its current revenues come from the internal combustion engine (ICE) world, UMI’s aggressive preparation for the EV adaption and growing demand for electric battery components puts it far ahead of its competitors in the race for the market share.

In addition to UMI’s currently-small battery components business (housed in the Energy and Surface Tech division), its two other main divisions are Catalysis and Recycling, contributing roughly 43% and 36% of UMI’s EBIT.  Besides accounting for the bulk of UMIs current valuation, these two businesses are important in securing UMI’s unique competitive advantages vs other participants targeting the growing EV market.  For the purposes of this write-up we will only briefly address these other divisions, to the extent that they relate to the Battery business, which while small contributor now, will dominate UMI’s revenue and profits going forward.

CATALYSIS: Umicore provides automotive catalysts for gasoline and diesel light duty vehicles as well as for heavy duty diesel applications including trucks and off-road vehicles. Autocatalysts, a mix of precious metal compounds, reduce harmful emissions from vehicle engines and are legally required in most countries. With new regulations car makers are forced to buy more sophisticated and expensive catalysts.  For the purposes of our EV-adoption driven thesis, the Autocatalysts division is critical in securing UMI’s place in the Auto OEM value chain (more on this later). And to add further context, the EV Battery business within the Energy& Surface Tech division evolved as a hedge against future potential decline in demand for catalysts. In the pure EV world car emissions will go down to zero, eventually removing the need for the catalysts. While this process is likely to take decades, in the meantime, UMI will reap the benefits from its place in both the ICE and the EV worlds.

RECYCLING: Umicore treats complex waste streams containing precious and other specialty metals. The operations can recover some 20 of these metals from a wide range of input materials ranging from industrial residues to end-of-life materials. Precious metals such as platinum, palladium, gold and silver are harvested and can be used for autocatalysts and other applications. Revenue comes in a form of a fixed fee and from the sale of excess metal harvested above what was contracted by the customers (miners, smelter, and scrap collectors). UMI’s expertise is in complex materials which its competitors cannot process. In contrast to its peers in the base metal refining and recycling, UMI’s expertise covers extraction of materials from rechargeable auto batteries. The company has become the world leader in recycling which is of growing importance, with increased focus on mining conditions in cobalt production. Sixty percent of global cobalt production comes from The Democratic Republic of Congo (DRC). Thanks to the dangerous conditions, human rights abuses, and routine, documented use of child labor in that country, the DRC’s mined minerals are dubbed “conflict minerals” or “blood metals,” making recycling solution offered by UMI an attractive option. Beyond recycling, UMI is one of a handful companies that have access to cobalt sources outside of DRC with operations in Belgium, Canada, China, and the US.

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Going back to the Battery business, broadly speaking the battery value chain looks as follows: Basic materials (lithium, graphite, cobalt etc) are mined by Glencores and FCXs (FCX sold out its interest to a consortium led by China Moly) of the world, turned into active materials (cathode and anode) by companies like UMI, which are then combined by battery producers (e.g. Panasonic LG Chem, Samsung, etc) into cells and ultimately into battery packs for use by the OEMs.

About 25%-30% of the total manufacturing cost of a lithium battery is attributable to the cathode materials. It is the costliest of the components, with the others breaking down as follows: 9% for anodes, 6% for Electrolytes and 4% for Separators. In addition to being key to lowering the cost of the battery, the composition of the cathode active material (CAM) determines the performance profile of batteries, making CAM the key-enabler of energy density improvement required for widespread EV adoption. CAM is also key to improvements in reduction of charging time and heat management. This puts cathode manufacturers in the position to capture significant profits during the ongoing shift towards EV and going forward.

Currently, among the five lithium metal oxides used in cathodes, two are used for mobile phones, laptops, power tools and medical instruments.   The other three are prevalent in use for passenger EVs. These are NCA (nickel cobalt aluminum), NMC (Nickel manganese cobalt) and LFP (lithium iron phosphate). Each of the three has its strengths and weaknesses according to five performance criteria - cost, lifespan, safety, power density and energy density. NMC presents the most favorable balance of these from automakers’ and consumers’ perspective. In particular it scores the highest on safety and durability without giving up much on the other parameters, as compared to NCA (weaker safety profile) and LFP (relatively low energy density compared to range, and slow progress on performance improvements. It is likely to remain in the domain of busses and trucks vs passenger cars in the future). NMC also presents the greatest potential for future improvements in power/energy characteristics.

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Given that cathode materials market is in a rapid growth phase, it is fragmented and market shares are uncertain. In the light duty autos market that employ NMC and NCA based cathodes there are five active players. We have seen a wide range of estimates for market shares but conservatively, Umicore is likely to currently command at least 25% of the market and is growing aggressively.  The other names in the space are Nichia, LG Chem, Sumitomo and Shansha currently focusing on cathode materials, while BASF and Johnson Matthey (UMI’s peers in the auto-catalyst space) are also aggressively attempting to enter the market.

We think that it is these latter two that will end up splitting the automotive OEM market with UMI.

Due to a different value chain and quality demands, the requirements for being a supplier to the automotive OEM’s are different from those of suppliers into consumer applications. For instance, a mobile phone battery needs to work just 3-4 years given the short replacement cycle for phones. Automotive OEM requires a minimum 10 years of life and has completely different parameters. Safety dimension is obviously also dramatically different between the two markets.

Also, in the case of automakers, the path to market via a direct relationship with the auto OEM, is different as compared to supplying into consumer market. Here there are some strong parallels with the catalysts business, as the OEM also defines the technology and locks the specs of the battery system, and then cathode material producer will often work with the OEM and the battery manufacturer.

Its’ not impossible for the existing consumer-focused cathode manufactures to enter the auto market, but the catalyst manufacturers have a clear advantage in both unique applicable technological expertise and in an established route to the end customer.  Their direct involvement in the innovation cycles of the industry and awareness of the required quality controls should enable them to become key suppliers of cathodes to the automakers.

None of the three we mentioned (JMAT, BASF or UMI) break down profitability in the space, but we know that BASF and JMAT are yet to really break even in this business. Of the three, UMI has the broadest product offerings (besides the strong focus on NMC it does have presence in all the other technologies), and is the only one with an actual profitable homegrown 15 year old business. Both competitors are trying to break into the space via acquisitions since 2010. We also note that JMAT seems to be currently focused on LFP cathodes, known for its lower energy density, and slower technological progress as compared to other cathode materials.

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UMI is THE market leader in NMC in terms of market share and quality of its product, and is determined to maintain and expand further this leadership.  According to the company, 1 of every 5 lithium batteries ever made contains UMI materials, as they sell to every major lithium battery manufacturer.

Last year it announced and started to implement a 3-fold expansion of its capacity, investing $300m+ in their Korean and Chinese plants. Several days ago they announced doubling of this effort citing a faster than anticipated take-off of the EV market. This places UMI extremely far ahead of its peers in terms of investment in the battery business, projecting their future market share to as high as 50%. And while this expansion is clearly very capital-intensive, by the same token it further raises the barriers to entry. UMI’s current capital commitments imply that its cathode business will be 5x the size of JMAT’s.  First-mover status is critical in auto industry. As an example JMAT enjoyed it in the auto-catalysts space at the time of the clean-air legislation in 2000s. Today it possesses market share of 60% (vs UMI’s 10%). Clearly UMI is learning from the past and is trying to replicate that trajectory in the battery space.

UMI’s market share leadership is coupled with its technological and innovation leadership in CAM production, ensuring that EV makers will be willing to pay premium for UMI’s cathodes over its less sophisticated peers. In comparison to consumer electronics, quality of the ingredients is even more critical for the large format batteries in EVs. For example, increasing nickel content in cathode is one of the avenues of improving battery characteristics and decreasing its costs. However it is extremely difficult technologically with very high levels of safety risks in both production and utilization. UMI had an early start here and possesses critical patents and stellar reputation in this area. UMI’s peers simply cannot compete with them in making more complex materials. Being backward integrated into metals processing gives UMI additional edge in making high quality product.

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At 59 €, the 13x EV/EBITDA (vs 9x for JMAT) valuation clearly implies an optimistic scenario of steady EV adaption with UMI’s ability to reap the benefits of its massive capital investment by capturing a dominant market share. We share this view and think the market is playing catch-up with the rapid changes in the competitive and technological landscape. With the most recent announcement of doubling the original expansion plans UMI’s management acknowledged its own surprise with the pace of this transition.  And as the market participants look for ways to invest in this accelerating trend, UMI clearly comes to the forefront as one of the more efficient investment vehicle.

Current conservative projections for EV penetration average at about 13% by 2025 (w/ 85% of that being pure EV vehicles and 10% hybrid). Assuming annual sales growth rate of 1.5% from 76m passenger cars sold in 2015 we get about 13 million electric vehicles replacing ICE cars by 2025. We think this is actually very conservative For instance Electric Vehicles Initiative calls for an electric car fleet of 20 million by 2020 and the Paris Declaration on Electro-Mobility and Climate Change and Call to Action setting a global deployment target of 100 million electric cars by 2030. There’s plenty of evidence that more aggressive estimates are more realistic than previously thought (E.g. surprising capacity expansion by UMI in the face of accelerating demand, recent announcement by ALB that it “basically sold out of lithium for the next 5 years” all point to a faster than expected ramp up of EV adaption).  

In our valuation we keep 13 million cars number as constant and use the size of UMI’s market share as the main driver of the stock price in the bear and bull case. But obviously as our assumed EV penetration rate starts to look conservative, the upside can get dramatically higher.

As discussed earlier we expect NMC will be the dominant technology in passenger cars (75%), w/ the remainder attributable to NCA. Assuming UMI’s share in NCA will be at modest 10%, we expect UMI’s overall share of that 13 million number will range from 37% to 25%, depending on whether it captures 30% or 50% of the NMC market.

Keeping the current cost relationship between NCA and NMC materials constant (NMC=.90*NCA), TESLA’s projected NCA price of $100/kWt by 2020 implies the NMC price per kWt to be around $90, with both prices reaching $95/$85.5 by 2025. With the battery size for NMC and NCA batteries at 55kwh and 65kwh per car, and with about 30% of the cost attributable to the cathode material, UMI should collect about €2000 from NMC and €1600 from NCA, per pure EV vehicle. Going through similar exercise for hybrid vehicles yields UMI about €450 per hybrid vehicle.

Assuming UMI’s 30% NMC market share, the sales prices above, and the EBIT margin of 13.5%, we arrive at EBIT contribution of €63m per 1m of global EV penetration. Similarly a 50% market share will translate into €100m per 1m EV vehicles on the road. 

Importantly (and this is often overemphasized in the bearish research we’ve seen), with every new EV vehicle replacing an ICE, UMI’s EBIT attributable to the catalyst business suffers a loss. Going through an exercise similar to the above, UMI catalyst business will lose about €100m in sales per 1m of ICE->EV switch. At 13.5% EBIT margin, we get a €13.5M EBIT reduction to the €63m or €$100m EBIT contribution numbers in the above paragraph.

In contrast (though less materially) the global EV adoption will provide a slight boost to UMI’s Recycling business. As the rechargeable batteries become available for recycling after 5 to 10 years of use, given UMI’s unique capabilities in this area it’s fair to expect them to capture 50% of this market. We will ignore this positive impact for the purposes of this write-up, as it’s relatively small, with most of it starting to truly accrue beyond our 2025 timeline, but it’s something to keep in mind.

Putting it all together, assuming the EV market penetration of about 13m passenger cars (11m of which is pure EV) by 2025, and using the figures above, we get UMI’s Battery business (net of auto catalyst reduction) contributing to the Surface Materials division about €500m in the 30% mkt share scenario and almost € 1000m in the bullish 50%. Assuming 2017 EBIT estimate of €115M for the division, this translates into 23% and 32% CAGR for in the two scenarios.                                                                                                                                           

We value UMI using the sum of the parts method. The range of P/E multiples for the Battery business is based on the earnings’ CAGRs associated with the projected NMC market share scenarios. We translate these CAGRs into multiples by observing the CAGR and multiple for UMI’s auto catalyst business (12xP/E vs 6% CAGR) and scaling Battery multiple proportionally. This makes sense given the similar long-term returns for the two businesses. (JMAT, the auto catalyst market leader w/ 60% share, guided its battery business’ long-term EBIT margins approaching its catalyst business of 14%. At the same time UMI is targeting 15%+ ROIC for all of its divisions together)

The auto catalyst multiple of 12x comes from its direct competitor in the space JMAT. Like UMI, it’s not a pure play (Catalysts are 55% of JMAT’s EBIT), but it’s possible to derive the implied PE 12x by stripping out from the overall 15x PE its other business lines, which have better observable pure-play competitors.

Using this method gives us a P/E for the battery business of 60x in the bullish 50% mkt share scenario, and 40x in the 30% scenario.

Lastly, UMI’s Recycling segment can be valued at ~14.5x using the average of multiples for gold/platinum miners (17.5x) and base metal recyclers (11.5x), because comping UMI just to the base-metal recyclers would ignore their significant exposure to precious metals. The key earnings drivers in recycling remain metals prices and UMI’s ability to keep (and sell) all of the gold and platinum they harvest beyond what they contracted w/ their clients.

Based on the street’s estimates for each division’s earnings contributions for 2017 (Surface Materials including the Battery business: 80 €m, Catalyst: 90 €m, Recycling: 100 €m) we arrive to a price range of 55 € to 70€.

Again, if the global EV penetration rates outpace the numbers we use here, our bullish case becomes extremely conservative. The stock has rallied quite a bit since I started this write up a few days ago, but we still think the risk reward is compelling especially on the back of the recent capacity expansion announcements in the battery division.

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As with many technology centered investment ideas, one concern repeatedly voiced by the skeptics is the potential for rapid erosion of any competitive advantage in the face of UMI’s European and Asian peers. This concern should be largely alleviated by recognizing multiple barriers to entry coming with UMI’s current market share, technological expertise and first mover advantage:

High level of technological sophistication, patents involved in production and capital intensive nature of the necessary investment should prevent late entrants such as JMAT from catching up; High level of automation involved in production, and UMI’s current strong presence in China will limit any of the Chinese competitors’ potential labor-cost advantages. Importantly, UMI’s current position within ICE value chain is characterized by very strong existing relationships with OEMs, giving UMI a closer perspective of OEM’s preferences in the EV space. This is particularly critical given that, unlike the short cycle in the consumer batteries case, the choices OEMs make in regards to the EV batteries will be much stickier and translate into multiyear commitments. UMI’s recycling expertise gives it a further advantage in the rising metal (particularly cobalt) price environment. And finally as mentioned earlier with cobalt mines located largely in DRC with its abysmal human rights, child labor and environmental records, UMI’s strict vetting for ethical sources gives them another advantage vs their less scrupulous competitors given the trend towards increased awareness of these issues by the ultimate consumer.

One more note on cobalt. We already discussed the Cobalt prices have doubled in the last year. This is primarily being driven by the accelerating demand from the electric battery manufactures, but also by supply issues. In addition to the public scrutiny of the DRC mines mentioned in the paragraph above, China is aggressively extending its control over cobalt mines in Africa, steadily gaining near monopolist control over the metal. Most recently FCX sold its cobalt mines to a consortium led by China Moly.  Over 85% of raw cobalt goes into china and over 85% processed Cobalt leaves China, leading to the possibility that China will adopt monopoly pricing power in the future {compare to what happened in rare earths}.  This is why there is a reason to believe that NMC processing will remain at a premium, and why UMI is in an advantageous position given its operations outside of China.  Besides making its recycling business more valuable, these increases in cobalt prices present another potentially favorable near-term dynamics for UMI.  In the auto battery market the high cobalt prices are simply passed through to the OEM. However these high prices can prompt the consumer electronics world to shift from the current cobalt-rich commoditized LCO materials towards the Low-cobalt higher-margin NMC, boosting UMI’s bottom line further.

Another risk that has been brought up in bear cases in the name is that the battery costs can drop so quickly that the move to full electric goes too fast, and so UMI’s catalyst business gets crippled before their battery business can compensate for that. This is brought up particularly often in the context of the declining diesel market in EU. The declining trend in diesel is indeed real due to (1) more stringent emission controls and regulatory environment; (2) The falling cost of electrification; (3) weakening demand due to consumer worries about residual values.  However we think this concern is overblown for the purposes of the UMI story, and expect NMC cathodes sales to more than offset any decline in the auto catalyst space. We compare the forecasted 40% sales CAGR for EV materials to the projected negative 7% CAGR for autocatalysts, and note that the value per EV vehicle is 6x higher than for diesel engines (it is ~25x in gasoline cars). This is due to the large proportion of battery cost attributable to NMC cathodes vs the low proportion of autocatalyst cost in the diesel/gas vehicles. This translates into UMI’s battery sales matching the auto catalysts by 2022/23, drastically surpassing them by 2025.

Further, while we are expecting a steady acceleration in worldwide EV adoption, we think the chances of a sudden drop in ICE use are negligible. For instance, currently the payback on an unsubsidized Tesla compared vs. its non-electric peers is still unfavorable.  The car will be scrap multiple times over before the difference in acquisition cost off can be paid off.  A $35,000 battery (such as Tesla’s) would need to cost $10,000 before we could compare it fairly. Nobody, including Tesla is suggesting that happens in the immediate future.

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Further capacity increase announcements

Acceleration in EV adoption by auto OEM’s

Precious metal and cobalt price increases

More stringent auto pollution regulations