Small Caps | Jul 17 2019
Lithium producer Galaxy Resources is at the mercy of weak fundamentals for spodumene, which comprises all of its production output.
-Difficulties perceived in running down inventory over the next year
-Market imbalances likely to weigh on pricing and sentiment
-Cost reductions key to minimising margin compression
By Eva Brocklehurst
Strong production in the June quarter has created a problem for lithium producer Galaxy Resources ((GXY)), which now has to sell its output over coming months into a heavily over-supplied market.
Mount Cattlin spodumene production was up 35% in the June quarter versus the prior quarter, at 56,000t. 2019 production guidance is unchanged at 180-210,000t. Concentrate grade was also higher, at 5.9%, which improves marketability and realised pricing versus benchmark.
Credit Suisse points out that higher concentrate grade comes with further structural recovery decline. On the other hand, strong results for unit costs in the quarter are evidence of what can be achieved if recoveries continue to improve, as it offsets the inevitable grade decline.
Macquarie also notes the company is now prioritising product quality to the detriment of recoveries. Cost reductions remain key to minimise margin compression, the broker asserts, given the weak spodumene pricing environment.
The company now expects recoveries of 60-65% and expects to wind down around -59,000t of inventory over the second half of 2019. Macquarie is more cautious, assessing a sell-down of around -30,000t over the second half is more likely, with a further -9,000t in the first quarter of 2020. Canaccord Genuity estimates it will take around 15 months for inventory to return to more normal levels.
Morgan Stanley will be looking for a return to normalised shipment schedules at Mount Cattlin in the current quarter, also noting a significant uplift in shipments will be required to reach the mid point of 2019 production guidance.
Sales guidance for the September quarter is for 60-70,000t and there is 120,000t of committed second half sales but Credit Suisse finds it difficult to share management's conviction this will be achieved, given the macro weakness. While growth options are a good problem to have, the broker is cautious about deploying a large amount of capital to fund these projects, given long-dated periods over which to recover capital in the current climate.
Sal De Vida
The Sal de Vida development remains the core catalyst for the company, the broker adds. Citi agrees, from an earnings and valuation perspective, that finding the right partner for a stake in Sal de Vida would provide upside to valuation.
Nevertheless, the broker points out spodumene has the weakest fundamentals within the lithium supply chain because of low barriers to entry and the dependence on conversion capacity as well as near-term oversupply.
Noting an updated project delivery plan and timeline is expected in the December quarter, which should provide some clarity for medium-long term growth, Canaccord Genuity currently assumes construction commences in 2021 with first production in 2023.
The broker, not one of the seven monitored daily on the FNArena database, expects imbalances in the lithium concentrate market will weigh on pricing and affect sentiment. Still, in the longer term, the broker continues to believe the asset base has strategic and inherent value that is well in excess of the current valuation, maintaining a Buy rating with a target of $2.65.
The company's current earnings are 100% exposed to spodumene and this presents downside risk to Citi's forecasts. The broker expects a lower-for-longer lithium price scenario and downgrades the stock to Neutral/High Risk from Buy/High Risk.
Citi reduces it its risk weighting for Sal de Vida and James Bay to 50% from 75%, in light of the weak macro backdrop for funding within the lithium sector. This could affect the timing of a final investment decision and the commissioning of these two projects.
Credit Suisse highlights analysis that shows the pace at which lithium demand is building is slower than supply. The broker notes Galaxy Resources and Pilbara Minerals ((PLS)) are selling less concentrate than they are producing, a clear sign of demand weakness. This comes despite neither operations being at full nameplate production rates.
Sales challenges are expected to persist through the remainder of 2019, as production builds up and new material comes on line. This has led to a multi-year low for spodumene pricing with the latest spot reading from China around US$615/t. Credit Suisse envisages downside risks to this price in the second half and into 2020.
FNArena's database shows two Buy ratings, three Hold and one Sell (Macquarie). The consensus target is $1.74, signalling 29.0% upside to the last share price. This compares with $2.13 ahead of the quarterly. Targets range from $1.30 (Macquarie) to $2.50 (Credit Suisse).
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