Albemarle Stock Initiated at Sell: What You Need to Know

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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...

Week after week, Tesla keeps ramping up production of its new Model 3 electric car -- even as rival electric models from Jaguar and Audi begin to reach the market. Which of these companies will win the electric car wars remains to be seen, but one thing at least is clear: At the rate things are going, the world's going to need a whole lot more lithium produced to make batteries for all these electric cars.

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Oddly, one analyst thinks this is bad news for Albemarle (NYSE: ALB) -- despite the fact that it's one of the world's biggest producers of lithium.

Here's what you need to know.

Why lithium fans are worried

Before we get into the specifics of yesterday's sell rating, it's worth scrolling back a few months to March 2018, when equity research firm Vertical Research published a massive 30-company report covering all the major (and not so major) players in the global lithium industry.

As Vertical Research explained at the time, production of lithium carbonate equivalent (LCE) by the industry's top three suppliers (Sociedad Quimica y Minera, FMC Corporation, and Albemarle) is currently approximately 140 thousand tons per annum (KTPA). It's expected to more than double, though, to 330 KTPA by 2021, with Albemarle accounting for half that production -- 165 KTPA.

And that's just for the industry's top players. If you consider expected production increases among the next couple dozen smaller lithium concerns, globally, Vertical Research predicts a 184% increase in lithium supply over the next three years (from 243 KTPA to 691 KTPA) -- versus an increase in lithium demand of only 71% (from 219 KTPA to 374 KTPA).

The obvious conclusion Vertical draws from this is that, although there's great demand for lithium metal to build batteries today, and strong prospects for growth over the next few years, supply is growing so much faster than demand that lithium prices are sure to drop as production ramps up.

Why Vertical Group is concerned about Albemarle in particular

As I say, this is what Vertical Research was worried about six months ago -- a crash in lithium prices that will make it very difficult for lithium producers to earn profits even if they nearly triple lithium production in three years.

Six months on, another firm with a similar name -- investment banker Vertical Group -- is out with a report targeting Albemarle stock in particular. In a note covered yesterday on StreetInsider.com (subscription required), Vertical Group explains that according to its estimates, both current lithium production (214 KTPA) and current lithium demand (205 KTPA) are a bit weaker than Vertical Research previously estimated. This implies a tighter market, with lithium supply outpacing demand by only 4%, rather than 11%.

Vertical Group, incidentally, has a longer-range forecast for future lithium supply and demand. Peering out as far as 2025, Vertical Group estimates that seven years from now, the world will be producing 881 KTPA of lithium, but consuming only 662 KTPA. At that point, LCE supply will exceed demand by a whopping 33%, driving down lithium prices quite forcefully. (Indeed, the analyst warns that supply could peak even earlier than this -- in 2023, to be precise -- so the price crash could happen sooner rather than later.)

Supply contracts won't save Albemarle

Now, some Albemarle fans may point out that the company's practice of entering into long-term lithium supply contracts at fixed prices may help to insulate Albemarle from falling lithium prices -- but Vertical Group isn't so sure about that.

Citing the example of Chinese producer Jiangxi Ganfeng Limited (a $5 billion Chinese chemicals manufacturer that Vertical Research dubbed a "wild card" in its March report), Vertical Group notes that "Ganfeng just signed contracts with LG Chem & Tesla that define vols., but not prices."

If this practice becomes the norm in the lithium industry, it will tend to permit buyers to purchase lithium at (falling) spot prices rather than pay higher, contracted prices that Albemarle has managed to negotiate. In such a scenario, warns Vertical Group, "Albemarle's contract prices are not 'fool proof' (indeed, the real risk is whether long-term contracts break)" and Albemarle is forced to accept lower prices for its lithium -- or lose business to its rivals.

What it means to investors

So what's the upshot of all this for investors?

Current tightness in the lithium market is tending to support Albemarle's profits, which surged 193% last quarter on a 16% increase in sales. Yet even now, lithium supply outstrips lithium demand, and the long-term trend in this market is for that gap between LCE supply and demand to widen even further -- pressuring Albemarle's profit margins.

With Albemarle stock selling for 34 times earnings, and priced at an even more expensive 140 times free cash flow (based on S&P Global Market Intelligence's tally of Albemarle's trailing free cash flow), this stock is priced for perfection now -- but its future looks far from perfect. Even if everything goes right, and the company manages to grow its profits at the 11.5% annualized rate that Wall Street expects, Albemarle stock looks priced to fall -- and Vertical Group is right to warn investors away from it.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends TSLA. The Motley Fool has a disclosure policy.