Albemarle's (ALB 3.68%) stock is down nearly 50% from the highs it reached in late 2017. Although production increases have kept the world's leading lithium producer's earnings heading higher, investors have soured on the lithium story. The reason is simple: Supply of the key battery metal is outstripping demand. Yet Albemarle continues to expand its operations. A year from now, the company's production capacity will be even bigger. Here's why that is likely to be a good thing despite what Wall Street thinks.
Building and building
By early 2021, management expects to have completed projects that will up its potential lithium output by nearly 50%. And it won't be done -- by early 2022, it plans to have doubled its production from 2019's level.
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That rapid growth rate is actually slower than Albemarle had previously planned -- management has noted it has the ability to boost output by another 30% beyond that early 2022 goal. But it pulled back on its production capacity expansion because the supply of lithium is outstripping demand. The oversupply has naturally put pressure on prices: In the third quarter of 2019, lithium prices were off by about 30% year over year, and down roughly 12% from the second quarter of 2019. Albemarle expects the price weakness to last into 2020.
So Albemarle is getting bigger at what looks like a pretty rotten time. Fortunately, the company makes heavy use of long-term contracts, so its top and bottom lines have remained relatively strong. And those production increases have helped to offset much of the impact of lithium's price weakness. In fact, management expects to report full-year 2019 earnings up by as much as 14%. But the weak lithium market has left investors worried about the longer-term situation for the company.
The important question
So the big question that astute investors should be asking is: Why keep building in the face of a weak market?
The answer is that demand for lithium is growing incredibly fast. When the final numbers for the year are in, Albemarle expects to see that sales of electric vehicles increased by 25% in 2019, and that the average size of the battery packs used to power them expanded by about the same amount. Management's current projection is that the extra industry capacity built in 2018 will be worked off by the end of 2020. In other words, new production capacity will be needed in short order if Albemarle is right about the future of electric vehicles.
That's not the endpoint, either. Albemarle projects that demand for lithium will grow from its 2018 levels at an incredible 20% or so annualized rate through 2025, increasing demand by about 3.7 times. That rise will largely be driven by the electrification of transportation.
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The interesting thing is that a lot of lithium producers are pulling back on their production growth plans. Albemarle, for example, pared its budget for expansion by $1.5 billion in 2019 because of market concerns about low lithium prices. Wall Street can be fickle and no longer wants to see the company grow, grow, grow. The market's current desire is for Albemarle to be free-cash-flow positive, a goal the company now expects to reach in 2021. So it is trying to balance growth with demand and investor sentiment right now while keeping its options open for a future in which lithium demand keeps increasing. That's an intense juggling act!
Bigger is better?
The simple answer here is that, in one year's time, Albemarle will be further down the path of producing more lithium. Investors aren't so excited by that prospect because lithium prices are weak today. However, if management is right about the future of electric vehicles, then increasing production now in preparation for a looming uptick in demand is the right call. Wall Street doesn't seem to like the idea, but that could be an opportunity for income investors on the hunt for dividend growth.
Albemarle's 2% dividend yield is modest on an absolute basis, but is near its decade high. The company has increased its payout annually for 25 years with recent increases in the high single-digit percentages. And given that its payout ratio is below 30% and its financial-debt-to-equity ratio is a modest 0.26, there's little risk of a dividend cut. In fact, with earnings still rising, it appears there's plenty of room for further increases. Albemarle may still be out of favor in a year because of the short-term impact of its expansion plans, but for long-term dividend growth investors, that isn't really bad news.
