Research from Water Tower Research, Water Tower Research

Water Tower Research

Water Tower Research is a leading equity research firm that provides research on micro, small and mid cap companies.

Water Tower Research was founded by Wall Street veterans after witnessing a fundamental shift in the investment research industry with the result being a declining knowledge base among investors, a lack of awareness and a shrinking pool of fundamental research being conducted on companies across the small-cap and micro-cap spectrum. The same issues are now increasingly occurring in the mid-cap space. This sea change within the investment community is impacting not only the companies themselves but also current shareholders and potential investors. With significantly less active sell-side sponsorship by Wall Street, a substantial information gap has developed between companies and various constituents in the financial community. The net result is fewer channels for insight and information to flow between companies and investors.

Research from Water Tower Research

Equity Research Firm

Thematic (Sector/Industry)

Multiple Countries / Thematic (Sector/Industry)

<h3>KEY HIGHLIGHTS</h3>
<ul>
<li>WTR-CMI last year.&nbsp;The year ended on a mixed note, with broader market indexes posting less than a 0.5% improvement for the week, while our WTR-CMI market cap-weighted index of 30 chemicals and materials technology companies posted a modest 0.5% decline. Overall, the market posted sustained losses for much of the year, with the S&amp;P 500 losing 19.4% and the broader Russell 2000 shrinking 21.6%. Against that, our WTR-CMI index declined 15.1%, materially outperforming the broader market and once again demonstrating the resilience of the sector and its ability to outperform in most economic environments, which, combined with the growing roles these companies play in the current megatrends of sustainability, the circular economy, and zero-carbon, make these stocks an appealing investment for mid- to long-term focused investors.</li>
<li>And the winners are.&nbsp;Six of our stocks finished the year higher, led by crop chemical and seed makers AVD and CTVA, as well as FMC, along with companies that were quick to benefit from 2H22 declines in commodity chemical prices and more resilient end-markets, such as HXL, IOSP, and PKE.</li>
<li>Hardest hit names.&nbsp;EAF posted the steepest loss in 2022, with its price declining almost 60% due to higher energy/production costs, declining demand from the steel production market, and manufacturing disruptions at its plant in Mexico. AVNT’s dependence on the automotive and consumer electronics sectors and the rapid increase in raw material costs, as the prices of basic resins increased dramatically in 1H22, resulted in margin pressures that even the sale of the distribution business and the purchase of a composite fiber business could not overcome. ECL’s 38% decline was likely driven by the difficulty in passing through higher prices and declining demand in the restaurant and hospitality sectors.</li>
</ul>
<h3>WTR-CMI WEEKLY PERFORMANCE</h3>
<figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/318/476/original/image_44510200721672877018466.png?1672877021" class="editor-image img-responsive" data-smartkarma-image-id="318476"></figure>
<div class="content-remarks">
<p>Source: Y-Charts as of December 30 close</p>
</div>
<h2>Ag-Tech &amp; Bio-Ag</h2>
<p>A year that tested the industry’s mettle.&nbsp;The crop chemicals industry enjoyed a strong 2022 due to increased demand, as farmers sought to enhance their yield and take advantage of higher crop prices, as well as offset the sharp increases in their input costs, including crop chemicals, whether pesticides or fertilizers. During the year, the industry had to deal with higher energy costs and reduced supply of intermediates from China, as that country struggled with zero-COVID government policies, while also being curtailed by energy costs and availability, and reduced production capacity due to environmental concerns. The start of Russia’s war on Ukraine and subsequent Western sanctions against Russia and Belarus resulted in significant supply disruptions both to grain markets (causing other regions, such as North America and LATAM, to pick up the slack) and to the supply and availability of fertilizers, with both sanctioned countries being major producers and exporters. Strong demand combined with higher production and logistics costs resulted in substantial price increases for crop protection chemicals and fertilizers, which in turn drove stronger results for public companies participating in these markets, including FMC, AVD, and CTVA. The high cost of traditional synthetic crop chemicals and fertilizers also drove strong growth of alternative products, as farmers looked for ways to improve yield while controlling costs. Consequently, emerging bio-based crop protection companies and the bio-based ag products market overall continued to grow at faster rates than the overall market, which we see as a continuing positive for BIOX and BHIL, as well as other bio-based innovators.</p>
<p>What to expect in 2023.&nbsp;Over the course of last year, we frequently highlighted the impact of the war in Europe on grain production and shipments and ongoing concerns with food security for many countries, especially those in the Third World that are reliant on imported grain and foodstuff to feed their populations. Food security will remain an issue in 2023. Curtailed wheat, corn and seed oil shipments from Ukraine due to Russia’s control of Black Sea ports, poor harvest in the country due to the war, and underwhelming planting projections for 2023 suggest food shortages may get more acute as we exit the winter months and we see a greater-than-expected drawdown in corn and soybean carryover in the US and LATAM as stockpiles are depleted to meet real-time demand, given the shortfall in harvests in other parts of the world. Therefore commodity crop prices will remain elevated, which should help US farmers handle stubbornly high input costs. Nevertheless, with higher “fixed costs” such as land rents, equipment, and fuel, as well as higher borrowing rates, farmer income may decline in 2023 compared with 2022, and that may drive continuing efforts by farmers to minimize the use of crop chemicals and fertilizers, either by switching to alternatives (such as manure), reduce applications, or employ other strategies to improve yield, such as soil conditioning, nitrogen fixing, and utilization of different seed hybrids. Consequently, we see volume growth for both fertilizers and crop protection chemicals slowing compared with last year and lower energy and raw material costs and the stockiness of price increases realized in 2022 will be the main drivers of performance for such companies as CTVA, FMC, and AVD. Growth in non-chemical crop products, such as bio-based pesticides, vertical and controlled environment farming, and drought resistant seeds will continue to enjoy strong market demand, benefiting such emerging innovators as BIOX and BHIL, among others.</p>
<h2>Automotive &amp; Transportation</h2>
<p>Don’t look for 2023 to be materially better.&nbsp;Throughout 2022, the automotive industry struggled with supply chain disruptions, be it from the lack of semiconductor production capacity, wire harness supply disruptions due to the war in Ukraine, the exit from the Russian market, or the frequent, prolonged, and unpredictable COVID-related shutdowns of production in China. Consequently, automotive production volumes declined in 2022 Y/Y and remain well below 2019 levels globally. While automotive companies were able to deliver positive results despite volume shortfalls by prioritizing high-margin models and benefiting from strong pricing on recovered demand and lack of adequate supply, upstream automotive suppliers, including companies in our index, such as PPG, AXTA, FUL, AVNT, HXL, RPM, and SHW, to name a few, suffered from lower demand from this important end-market, as their volumes are tied more to automotive production than to the specific mix of models being produced. Unfortunately, as several automotive CEOs pointed out, the chip shortage may not be fully resolved until well into 2023, and while China seems to be doing away with its zero-COVID policies, helping with supply, global demand for new vehicles may slow, driven by higher prices (as companies passed through increased raw material costs of everything from steel to composites to plastics to paint) and slowing demand, as recessionary fears grow in Europe, China, and North America.</p>
<p>Margin recovery may trump volume concerns.&nbsp;It will be another challenging year for the auto industry and its suppliers, including the companies in our index that we mentioned above. Fortunately, the chemicals and materials technology industry’s profitability is driven more by price-cost delta than volume growth (or lack thereof). With commodity chemical prices beginning to soften in 2H22, we see margin relief as a driver of investor sentiment in 2023 that may help the stocks of these companies to recover some of the ground lost in 2022, despite a still-struggling end-market.</p>
<h2>Energy &amp; Battery Technology</h2>
<p>Market reaction to record metal prices.&nbsp;There was an unprecedented increase in demand and therefore price of battery metals, particularly lithium, nickel, and cobalt in 2022. The market has also seen the beginnings of a price appreciation in graphite, as that critical metal experienced demand increase from the EV market that for the first time exceeded the demand from its historically largest end-market—steel production. While customers (cell and battery manufacturers) had to grit their teeth and bear the burden of skyrocketing metal costs, market forces appear to be doing what market forces do—adjust demand to meet available supply at a given price. Consequently, as 2022 was coming to an end, we’ve seen the market react to the&nbsp;first ever increase in battery pack prices, driven primarily by lithium costs.</p>
<p>Inventory overhang sets up for a slower 1H23.&nbsp;Past expert analysis predicted EVs reaching price parity with ICE vehicles when battery costs decline to $100/kWh. However, the increase in battery costs seen in 2022 has pushed off the timetable for that achievement from 2024 to 2026. Furthermore, higher metal and therefore battery costs are making it more difficult for&nbsp;“entry level” EVs to gain a foothold in the market, which may slow EV sales in emerging economies, as well as raise barriers to entry for new EV consumers in developed regions. The results of these trends is the slowing growth of EV adoption and signs of inventory build in lithium materials for battery production,&nbsp;as flagged by China’s BYD.</p>
<p>Little room for improvement.&nbsp;It is therefore not surprising that the lithium market has taken a bit of a break from its unrelenting upward march through 2022. While&nbsp;lithium prices are likely to stay elevated, at least through 2023-24, until additional capacity is brought online globally, the metal price may have reached a new plateau for the time being, which may take the wind out of the valuation levels of some of the lithium producers, particularly companies still in the development stages. Combined with continuing regulatory and environmental NGOs’ resistance to metal projects, be it mining, converting, or even recycling, pre-revenue metal developers, such as PLL, LAC, WWR, NMG, and TMC, have seen their stock prices deflate mid-teens to mid-double digits in 2022. Even Tier 1 lithium suppliers, such as ALB and LTHM, lost ground in 2022, despite record demand and lithium price levels.</p>
<p>Graphite may be the story for 2023.&nbsp;For 2023, we expect a slowing in EV deliveries (recent TSLA results being an indication), as high prices and economic uncertainty keep consumer demand muted. While we continue to expect the EV market to grow by double digits, the pace may be slower than that being envisioned by investors. China’s retreat from its zero-COVID policy may stabilize consumer demand in the country, as well as result in more stable and predictable production of critical materials for the industry. However, spreading economic malaise may more than offset these improvements. Consequently, while lithium and nickel price curves may flatten in 1H23, the graphite market will continue to experience the shift to EVs as the primary driver of demand and given the expected shortage of graphite relative to projected battery demand in 2023, graphite prices may continue to increase, benefiting current producers, such as EAF (synthetic graphite) and SYAAF (natural graphite), as well as improve valuations of late-stage pre-revenue companies, who are on pace to begin production of graphite materials in North America in 2023-24, such as WWR and NMG.</p>
<h2>Chemicals &amp; Materials Technology</h2>
<p>“Specialty” means not having to compete on price.&nbsp;This definition of the specialty chemicals and materials market was articulated to us by a specialty chemicals company CEO years ago. While price competition is always a factor, the point the CEO was trying to make was that specialty chemicals and materials are not always fungible and typically involve industry and/or customer-specific design specification that can provide a “moat” for entrenched suppliers and allow for pricing power during times of inflating raw material costs. Another characteristic of our industry is the relatively low level of fixed costs within COGS, meaning that high asset utilization levels and, therefore, volumes are of secondary importance when it comes to gross margins. In fact, a typical specialty materials and chemicals company spends close to half its revenue on raw materials, which often make up as much as 80% of COGS. Consequently, the delta between raw material costs and selling prices is the main driver of gross and EBITDA margins and these in turn have been closely correlated with their stocks’ valuation multiples.</p>
<p>Margin inflection may offset volume challenges.&nbsp;The knock against specialty chemicals and materials companies has been their perceived lack of pricing power, as these companies typically operate between much larger suppliers in a consolidated oligopolies, such as commodity chemicals and basic plastic resins, making it difficult for them NOT to accept price increases form their supply base, and much larger customers, such as automotive and consumer products OEMs and big box retailers, which makes it difficult to pass through higher raw material costs. Given the aforementioned, it is not surprising that many companies in our industry saw their margins compress significantly in 2021-22, with higher profits being offset by shrinking valuation multiples, resulting in stock price declines over the last 12 months. However, the pricing discipline developed by the companies in our sector over the last several raw material inflationary cycles has resulted in more aggressive price passthroughs that led to 2021-22 witnessing mid-teens to 20%-plus price increases across multiple markets, including paints and coatings, intermediates, composites, and engineered plastics.</p>
<p>While our companies’ selling prices have trailed raw material cost on the way up 2H22 witnessed a pullback in prices of oil &amp; gas as well as basic petrochemical commodities. In the meantime, price increases implemented over the past 12 months are continuing to gain traction as customer contracts are renegotiated. We therefore expect gross and EBITDA margins, which improved in 2H22, to continue to do so in 2023, possibly accelerating to the point of becoming positive on Y/Y comps by 2Q23 for most of the companies in our index. Given past experience, we see this as a material driver of investor sentiment that may lead to valuation multiple expansion that may offset slower volume growth, higher interest and labor-related expenses and negative FX to result in modestly positive stock performance that can outpace the broader market and position the chemicals and materials technology sector as an attractive investment alternative for short- to mid-term investors.</p>
<h2>Recent Reports</h2>
<p>Westwater Resources, Inc. (WWR) – Management Series Report – Graphite Inflection Point is Here</p>
<p>Westwater Resources, Inc. (WWR) – Fireside Chat: VP of Sales &amp; Marketing Jay Wago, December 13, 2022, at 11:30 am EST</p>
<p>TMC the metals company (TMC) – Management Series Report – Collecting Nodules and Scientific Data as Regulation Timeline Nears</p>
<p>TMC the metals company, Inc. (TMC) – Initiation of Coverage – Tapping Untapped Resource to Address Unmet Need</p>
<p>Westwater Resources, Inc. (WWR) – Company Update Report – Steady Progress Deserves a Closer Look</p>
<h3>DISCLOSURES</h3>
<p>Water Tower Research (“WTR”) is a professional publisher of investment research reports on public companies and, to a lesser extent, private firms (“the Companies”). WTR provides investor-focused content and digital distribution strategies designed to help companies communicate with investors.<br><br>WTR is not a registered investment adviser or a broker/dealer nor does WTR provide investment banking services. WTR operates as an exempt investment adviser under the so called “publishers’ exemption” from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940. WTR does not provide investment ratings / recommendations or price targets on the companies it reports on. Readers are advised that the research reports are published and provided solely for informational purposes and should not be construed as an offer to sell or the solicitation of an offer to buy securities or the rendering of investment advice. The information provided in this report should not be construed in any manner whatsoever as personalized advice. All users and readers of WTR’s reports are cautioned to consult their own independent financial, tax and legal advisors prior to purchasing or selling securities.<br><br>Dmitry Silversteyn, who is the writer of this report, covers the BioEconomy and Chemicals &amp; Materials Technology sectors for WTR. Mr. Silversteyn and members of his household have no personal or business-related relationship to the subject company other than providing digital content and any ancillary services WTR may offer.<br><br>Unless otherwise indicated, WTR intends to provide continuing coverage of the covered companies. WTR will notify its readers through website postings or other appropriate means if WTR determines to terminate coverage of any of the companies covered.<br><br>In certain instances, including this report, WTR will write research covering non-clients. Readers should assume that WTR may seek to turn these non-paying companies into paying clients. Likewise, WTR may seek to transform these non-clients into paying clients of it or of its affiliate, which provides services such as presenting at sponsored investor conferences, distributing press releases, advising on investor relations and broader corporate communications and public relations strategies as well as performing certain other related services (“Ancillary Services”). The companies that WTR covers in our research are not required to purchase or use Ancillary Services of WTR or an affiliate might offer to clients.<br><br>The manner of WTR’s potential research compensation and Ancillary Services to covered companies raise actual and perceived conflicts of interest. WTR is committed to manage those conflicts to protect its reputation and the objectivity of employees/analysts by adhering to strictly written compliance guidelines.<br><br>The views and analyses included in our research reports are based on current public information that we consider to be reliable, but no representation or warranty, expressed or implied, is made as to their accuracy, completeness, timeliness, or correctness. Neither we nor our analysts, directors, officers, employees, representatives, independent contractors or agents shall be liable for any omissions, errors or inaccuracies, regardless of cause, foreseeability or the lack of timeliness of, or any delay or interruptions in the transmission of our reports to content users. This lack of liability extends to direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, losses, lost income, lost profit or opportunity costs.<br><br>All investment information contained herein should be independently verified by the reader or user of this report. For additional information, all readers of this report are encouraged to visit WTR’s website www.watertowerresearch.com.</p>

KEY HIGHLIGHTS

WTR-CMI last year.&nbsp;The year ended on a mixed note, with broader market indexes posting less than a 0.5% improvement for the week, while our WTR-CMI market cap-weighted index of 30 chemicals and materials technology companies posted a modest 0.5% decline. Overall, the market posted sustained losses for much of the year, with the S&amp;P 500 losing 19.4% and the broader Russell 2000 shrinking 21.6%. Against that, our WTR-CMI index declined 15.1%, materially outperforming the broader market and once again demonstrating the resilience of the sector and its ability to outperform in most economic environments, which, combined with the growing roles these companies play in the current megatrends of sustainability, the circular economy, and zero-carbon, make these stocks an appealing investment for mid- to long-term focused investors.
And the winners are.&nbsp;Six of our stocks finished the year higher, led by crop chemical and seed makers AVD and CTVA, as well as FMC, along with companies that were quick to benefit from 2H22 declines in commodity chemical prices and more resilient end-markets, such as HXL, IOSP, and PKE.
Hardest hit names.&nbsp;EAF posted the steepest loss in 2022, with its price declining almost 60% due to higher energy/production costs, declining demand from the steel production market, and manufacturing disruptions at its plant in Mexico. AVNT’s dependence on the automotive and consumer electronics sectors and the rapid increase in raw material costs, as the prices of basic resins increased dramatically in 1H22, resulted in margin pressures that even the sale of the distribution business and the purchase of a composite fiber business could not overcome. ECL’s 38% decline was likely driven by the difficulty in passing through higher prices and declining demand in the restaurant and hospitality sectors.

WTR-CMI WEEKLY PERFORMANCE


Source: Y-Charts as of December 30 close

Ag-Tech &amp; Bio-Ag
A year that tested the industry’s mettle.&nbsp;The crop chemicals industry enjoyed a strong 2022 due to increased demand, as farmers sought to enhance their yield and take advantage of higher crop prices, as well as offset the sharp increases in their input costs, including crop chemicals, whether pesticides or fertilizers. During the year, the industry had to deal with higher energy costs and reduced supply of intermediates from China, as that country struggled with zero-COVID government policies, while also being curtailed by energy costs and availability, and reduced production capacity due to environmental concerns. The start of Russia’s war on Ukraine and subsequent Western sanctions against Russia and Belarus resulted in significant supply disruptions both to grain markets (causing other regions, such as North America and LATAM, to pick up the slack) and to the supply and availability of fertilizers, with both sanctioned countries being major producers and exporters. Strong demand combined with higher production and logistics costs resulted in substantial price increases for crop protection chemicals and fertilizers, which in turn drove stronger results for public companies participating in these markets, including FMC, AVD, and CTVA. The high cost of traditional synthetic crop chemicals and fertilizers also drove strong growth of alternative products, as farmers looked for ways to improve yield while controlling costs. Consequently, emerging bio-based crop protection companies and the bio-based ag products market overall continued to grow at faster rates than the overall market, which we see as a continuing positive for BIOX and BHIL, as well as other bio-based innovators.
What to expect in 2023.&nbsp;Over the course of last year, we frequently highlighted the impact of the war in Europe on grain production and shipments and ongoing concerns with food security for many countries, especially those in the Third World that are reliant on imported grain and foodstuff to feed their populations. Food security will remain an issue in 2023. Curtailed wheat, corn and seed oil shipments from Ukraine due to Russia’s control of Black Sea ports, poor harvest in the country due to the war, and underwhelming planting projections for 2023 suggest food shortages may get more acute as we exit the winter months and we see a greater-than-expected drawdown in corn and soybean carryover in the US and LATAM as stockpiles are depleted to meet real-time demand, given the shortfall in harvests in other parts of the world. Therefore commodity crop prices will remain elevated, which should help US farmers handle stubbornly high input costs. Nevertheless, with higher “fixed costs” such as land rents, equipment, and fuel, as well as higher borrowing rates, farmer income may decline in 2023 compared with 2022, and that may drive continuing efforts by farmers to minimize the use of crop chemicals and fertilizers, either by switching to alternatives (such as manure), reduce applications, or employ other strategies to improve yield, such as soil conditioning, nitrogen fixing, and utilization of different seed hybrids. Consequently, we see volume growth for both fertilizers and crop protection chemicals slowing compared with last year and lower energy and raw material costs and the stockiness of price increases realized in 2022 will be the main drivers of performance for such companies as CTVA, FMC, and AVD. Growth in non-chemical crop products, such as bio-based pesticides, vertical and controlled environment farming, and drought resistant seeds will continue to enjoy strong market demand, benefiting such emerging innovators as BIOX and BHIL, among others.
Automotive &amp; Transportation
Don’t look for 2023 to be materially better.&nbsp;Throughout 2022, the automotive industry struggled with supply chain disruptions, be it from the lack of semiconductor production capacity, wire harness supply disruptions due to the war in Ukraine, the exit from the Russian market, or the frequent, prolonged, and unpredictable COVID-related shutdowns of production in China. Consequently, automotive production volumes declined in 2022 Y/Y and remain well below 2019 levels globally. While automotive companies were able to deliver positive results despite volume shortfalls by prioritizing high-margin models and benefiting from strong pricing on recovered demand and lack of adequate supply, upstream automotive suppliers, including companies in our index, such as PPG, AXTA, FUL, AVNT, HXL, RPM, and SHW, to name a few, suffered from lower demand from this important end-market, as their volumes are tied more to automotive production than to the specific mix of models being produced. Unfortunately, as several automotive CEOs pointed out, the chip shortage may not be fully resolved until well into 2023, and while China seems to be doing away with its zero-COVID policies, helping with supply, global demand for new vehicles may slow, driven by higher prices (as companies passed through increased raw material costs of everything from steel to composites to plastics to paint) and slowing demand, as recessionary fears grow in Europe, China, and North America.
Margin recovery may trump volume concerns.&nbsp;It will be another challenging year for the auto industry and its suppliers, including the companies in our index that we mentioned above. Fortunately, the chemicals and materials technology industry’s profitability is driven more by price-cost delta than volume growth (or lack thereof). With commodity chemical prices beginning to soften in 2H22, we see margin relief as a driver of investor sentiment in 2023 that may help the stocks of these companies to recover some of the ground lost in 2022, despite a still-struggling end-market.
Energy &amp; Battery Technology
Market reaction to record metal prices.&nbsp;There was an unprecedented increase in demand and therefore price of battery metals, particularly lithium, nickel, and cobalt in 2022. The market has also seen the beginnings of a price appreciation in graphite, as that critical metal experienced demand increase from the EV market that for the first time exceeded the demand from its historically largest end-market—steel production. While customers (cell and battery manufacturers) had to grit their teeth and bear the burden of skyrocketing metal costs, market forces appear to be doing what market forces do—adjust demand to meet available supply at a given price. Consequently, as 2022 was coming to an end, we’ve seen the market react to the&nbsp;first ever increase in battery pack prices, driven primarily by lithium costs.
Inventory overhang sets up for a slower 1H23.&nbsp;Past expert analysis predicted EVs reaching price parity with ICE vehicles when battery costs decline to $100/kWh. However, the increase in battery costs seen in 2022 has pushed off the timetable for that achievement from 2024 to 2026. Furthermore, higher metal and therefore battery costs are making it more difficult for&nbsp;“entry level” EVs to gain a foothold in the market, which may slow EV sales in emerging economies, as well as raise barriers to entry for new EV consumers in developed regions. The results of these trends is the slowing growth of EV adoption and signs of inventory build in lithium materials for battery production,&nbsp;as flagged by China’s BYD.
Little room for improvement.&nbsp;It is therefore not surprising that the lithium market has taken a bit of a break from its unrelenting upward march through 2022. While&nbsp;lithium prices are likely to stay elevated, at least through 2023-24, until additional capacity is brought online globally, the metal price may have reached a new plateau for the time being, which may take the wind out of the valuation levels of some of the lithium producers, particularly companies still in the development stages. Combined with continuing regulatory and environmental NGOs’ resistance to metal projects, be it mining, converting, or even recycling, pre-revenue metal developers, such as PLL, LAC, WWR, NMG, and TMC, have seen their stock prices deflate mid-teens to mid-double digits in 2022. Even Tier 1 lithium suppliers, such as ALB and LTHM, lost ground in 2022, despite record demand and lithium price levels.
Graphite may be the story for 2023.&nbsp;For 2023, we expect a slowing in EV deliveries (recent TSLA results being an indication), as high prices and economic uncertainty keep consumer demand muted. While we continue to expect the EV market to grow by double digits, the pace may be slower than that being envisioned by investors. China’s retreat from its zero-COVID policy may stabilize consumer demand in the country, as well as result in more stable and predictable production of critical materials for the industry. However, spreading economic malaise may more than offset these improvements. Consequently, while lithium and nickel price curves may flatten in 1H23, the graphite market will continue to experience the shift to EVs as the primary driver of demand and given the expected shortage of graphite relative to projected battery demand in 2023, graphite prices may continue to increase, benefiting current producers, such as EAF (synthetic graphite) and SYAAF (natural graphite), as well as improve valuations of late-stage pre-revenue companies, who are on pace to begin production of graphite materials in North America in 2023-24, such as WWR and NMG.
Chemicals &amp; Materials Technology
“Specialty” means not having to compete on price.&nbsp;This definition of the specialty chemicals and materials market was articulated to us by a specialty chemicals company CEO years ago. While price competition is always a factor, the point the CEO was trying to make was that specialty chemicals and materials are not always fungible and typically involve industry and/or customer-specific design specification that can provide a “moat” for entrenched suppliers and allow for pricing power during times of inflating raw material costs. Another characteristic of our industry is the relatively low level of fixed costs within COGS, meaning that high asset utilization levels and, therefore, volumes are of secondary importance when it comes to gross margins. In fact, a typical specialty materials and chemicals company spends close to half its revenue on raw materials, which often make up as much as 80% of COGS. Consequently, the delta between raw material costs and selling prices is the main driver of gross and EBITDA margins and these in turn have been closely correlated with their stocks’ valuation multiples.
Margin inflection may offset volume challenges.&nbsp;The knock against specialty chemicals and materials companies has been their perceived lack of pricing power, as these companies typically operate between much larger suppliers in a consolidated oligopolies, such as commodity chemicals and basic plastic resins, making it difficult for them NOT to accept price increases form their supply base, and much larger customers, such as automotive and consumer products OEMs and big box retailers, which makes it difficult to pass through higher raw material costs. Given the aforementioned, it is not surprising that many companies in our industry saw their margins compress significantly in 2021-22, with higher profits being offset by shrinking valuation multiples, resulting in stock price declines over the last 12 months. However, the pricing discipline developed by the companies in our sector over the last several raw material inflationary cycles has resulted in more aggressive price passthroughs that led to 2021-22 witnessing mid-teens to 20%-plus price increases across multiple markets, including paints and coatings, intermediates, composites, and engineered plastics.
While our companies’ selling prices have trailed raw material cost on the way up 2H22 witnessed a pullback in prices of oil &amp; gas as well as basic petrochemical commodities. In the meantime, price increases implemented over the past 12 months are continuing to gain traction as customer contracts are renegotiated. We therefore expect gross and EBITDA margins, which improved in 2H22, to continue to do so in 2023, possibly accelerating to the point of becoming positive on Y/Y comps by 2Q23 for most of the companies in our index. Given past experience, we see this as a material driver of investor sentiment that may lead to valuation multiple expansion that may offset slower volume growth, higher interest and labor-related expenses and negative FX to result in modestly positive stock performance that can outpace the broader market and position the chemicals and materials technology sector as an attractive investment alternative for short- to mid-term investors.
Recent Reports
Westwater Resources, Inc. (WWR) – Management Series Report – Graphite Inflection Point is Here
Westwater Resources, Inc. (WWR) – Fireside Chat: VP of Sales &amp; Marketing Jay Wago, December 13, 2022, at 11:30 am EST
TMC the metals company (TMC) – Management Series Report – Collecting Nodules and Scientific Data as Regulation Timeline Nears
TMC the metals company, Inc. (TMC) – Initiation of Coverage – Tapping Untapped Resource to Address Unmet Need
Westwater Resources, Inc. (WWR) – Company Update Report – Steady Progress Deserves a Closer Look
DISCLOSURES
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Mat-Chem Notes For the Week Ended December 30, 2022