Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
What a difference a day makes.
Spooked by a one-day, 1,175-point plunge on the Dow, Wall Street largely sat out the rally in stocks on Tuesday, issuing only a handful of upgrades in the morning -- and then watched the Dow Jones Industrial Average surge 2.3%. Today though, investment bankers are making up for lost time, issuing nearly four dozen separate upgrades (according to StreetInsider.com's latest tally) and urging investors to buy stocks before they get (any more) expensive.
Case in point: Today's upgrade of Sociedad Quimica y Minera (SQM 1.08%).
In its natural form as a salt, lithium doesn't look like much. Refined as a metal and stuffed inside a battery, though, it's as good as gold. Image source: Getty Images.
Upgrading SQM
Many stocks suffered from the recent market rout, but few got hit quite so hard as Chilean lithium miner Sociedad Quimica y Minera.
From Thursday's high to Tuesday's low, SQM shares lost nearly 12.5% of their value as investors fled a once-popular stock with very high profit margins -- but a high valuation to match. Over at JPMorgan Chase, however, they think that was a mistake. Arguing that investors' "de-rating" of SQM "went [too] far," JP announced this morning it is upgrading SQM stock to overweight. The analyst is assigning SQM stock a new price target of $65 a share that implies the shares will not only regain their former highs, but run right past them -- and deliver investors an 18% profit along the way.
Why does JP Morgan think this? Because of supply and demand.
Supply...
Supplies of lithium metal on the market today "remain tight," reports JP in a note covered by TheFly.com today. And so long as supplies are tight, that should support high pricing power (and high profit margins) for Sociedad Quimica y Minera.
JPMorgan's assessment of the market, by the way, aligns with what we learned from investment banker UBS last month, when it too averred that there is "no change to the outlook for lithium." Between now and 2025, UBS forecast that demand for lithium will triple, continuing to support prices and profit margins for lithium suppliers even if supplies increase no faster than that.
And speaking of increasing supplies, SQM has just struck a deal with Chile's Corfo development agency, which could enable SQM to quadruple its production quota for lithium by 2026, and permit it to supply a greater proportion of global demand for lithium, gobbling up market share.
...and demand
As for the demand side of the equation, as already mentioned above, UBS sees incredible growth in demand for lithium metal as more and more electric cars (powered by lithium-ion batteries) populate the world's roads. One particular source of demand for SQM's lithium became apparent last month, when Tesla (TSLA -1.06%) was reported to be in talks about making a direct investment in SQM's home country, Chile.
As Financial Times reported, Tesla is discussing the idea of building a processing plant in Chile itself, there to process lithium as it is produced by SQM. FT described Tesla's offer as a move by Tesla to "lock in" lithium supply for its own use, and at the same time cut processing costs by availing itself of cheap Chilean solar power. (Chile has some of the cheapest rates for solar-produced energy in the world.)
From SQM's perspective, this deal would also have advantages. It would secure demand for its product from one of the world's leading consumers of lithium. At the same time, it would reduce SQM's shipping costs to deliver product to its customer, by bringing the customer right next door to SQM's production facilities.
Bonus thing: Valuing Sociedad Quimica y Minera stock
All of which sounds like good news for SQM (and for Tesla) -- but it still leaves us with the question: Is Sociedad Quimica y Minera stock cheap enough to buy?
After selling off more than 10% in the market rout, SQM stock currently sports a market capitalization of $14.1 billion, with minimal net debt. Valued on the company's less than $400 million in trailing net income, that gives SQM stock a rather expensive-seeming price-to-earnings ratio of 35.4. However, if you look a bit closer, you'll see that SQM generates significantly more cash profit than its income statement reflects -- $547 million in free cash flow over the past 12 months, versus only $398 million in reported net income.
Granted, even valued on free cash flow instead of GAAP earnings, SQM's P/FCF ratio of 25.8 isn't exactly cheap. But given that analysts on average expect to see SQM grow its profits at better than 28% annually over the next five years (according to data from S&P Global Market Intelligence), I think the company's high price is justified by its even higher growth rate.
And if a deal with Tesla helps to foster growth, lower SQM's costs, and boost SQM's profits even faster? That will just make Sociedad Quimica y Minera an even better buy in my book.
