Elkem: Looking For An Eventual Reversal, Still A Buy (OTCMKTS:ELKEF)

Dear readers/followers,

Elkem (OTC:ELKEF), a basic materials company based in Norway, has seen a significant drop in its stock price but still has a potential upside. I have a speculative position in the company, and I’m not fundamentally worried about this position or its long-term prospects. However, it’s a speculative level because this investment has a higher-than-typical risk/reward ratio, which warrants more care.

Since my last article on Elkem, we’ve seen 3Q23 reported and the company moving into 4Q. Much like all other chemical and cyclical basic materials I cover and invest in, this company has significant volatility. The last quarter was no exception to this.

This is an updated article – and you can find my last article on Elkem and what the company offers you here.

It’s important to note that the yield numbers you can see on some data services for the company are unlikely to materialize in the next year. When investing in Elkem, you’re investing for the reversal – this complicates the thesis somewhat.

Let’s look at what we can expect from Elkem this year, after 3Q.

Updating on Elkem – 3Q23 was predictably volatile

Elkem is, in large part, a silicone-based materials provider and due to this, has experienced an increased level of operational and result-related volatility. This is an expected development given that the broader market has seen exactly the same sort of trend. Many companies that I invest in, including Evonik (OTCPK:EVKIY) and BASF (OTCQX:BASFY) have seen similar levels of ups and downs.

As a general rule, this does not frighten me. Chemical companies move from lows to highs over the course, generally, of several years. Observing valuation-related logic means that you usually can note when a company is cheaper, or more expensive, and it enables you to act accordingly. While not a chemicals company, HeidelbergCement (OTCPK:HDELY), a volatile concrete company, was a good example of where I bought cheaply and sold less than 1.5 years later at a profit of triple digits inclusive of dividends.

This is my strategy for Elkem as well, though I expect the cycle to take far longer in this particular case.

3Q23 was not a quarter that was likely to provide a reversal potential, as we also saw in the fundamental results. The company generated about 530M NOK worth of operational EBITDA, but the results were still heavily impacted by weakness in core areas, silicones, due to lower commodity prices in all regions and sales segments.

When trends are like this, you can only expect the results to go “one way” – and that way is negative.

The company’s smaller segment, Carbon Solutions, delivered good results despite these weaknesses due to pricing strength.

However, perhaps most significantly, the company had to write down 220M NOK worth of inventories related to Co2 compensation and inventory writedowns due to the overall macro.

As I’ve written before, when the company begins its earnings report/material by providing you with ESG/injury data, you know that the operational data might not be as great as some expected – and this is exactly what Elkem did as of this quarter.

What exactly is happening across the market?

Well, first off Chinese recovery is taking longer time than expected. This one factor has serious implications for this company, China-heavy as it is, and its recovery potential and valuation.

In fact, the company’s negative impacts were higher than I expected them to be (obviously, I wouldn’t have invested if I expected a double-digit decline, and I’d be very dubious about any analyst that claims such a development is “part of the plan”.)

So what exactly is the company doing to combat this?

A few things, as it turns out. Elkem has begun a comprehensive strategy for cost and CapEx, especially the challenges in Silicones being addressed. This aims at reducing CapEx by more than 2B NOK, with ongoing improvement programs costing around 1.5B NOK. It also includes immediate hiring freezes, optimization of organizations, and reduction of third-party services and logistics and warehousing costs and structures. In short, nothing that other companies in similar problematic situations are not doing. We’re also talking about CapEx improvements and operational efficiencies. At this point, if you follow my work, you should be fairly acquainted with what levers companies can pull to address and achieve some efficiencies here.

The company has also taken the proactive decision to accelerate its maintenance schedule given the current macro trends, a decision I applaud.

It’s also attempting to expand production and improve its cost position(s) in China, with expansions of plants which will of course be a favorable trend if and when things turn around here.

Also, as an additional headwind, we’re seeing that the company’s home nation, Norway, is making changes to its CO2 compensations, which will hurt over 200M NOK on an annual basis compared to the previous year’s level. This is also why the company has written down the quarterly results, reflecting the impacts of this proposal and acknowledging the likelihood of this passing muster in the relevant political channels.

The ongoing weakness in both construction, infrastructure, and automotive is the main headwind that makes the company’s results as bad as we’re currently seeing. This is a non-trivial issue, because it marks weak demand in a market rife with oversupply, in both inventory and capacities. In fact, prices in China for silicones recently reached a 10-year low back in 2023 August and have only recovered marginally since then. That we’re likely to see the sort of highs we saw in 2021 is very unlikely.

The company’s positive is the carbon market – demand for carbon products does vary, but is overall still at very healthy levels.

To see how bad the results were, we only need to look at a comparative basis for the company’s results in the first 3 quarters – despite not being YoY, this is a history of decline.

However, at the same time, I don’t have any reason to give the company specific criticism of its strategy here. Elkem is handling a macro downturn as well as it can, and I daresay, better than some other companies here. Elkem cannot influence the global macro. It’s a ship in a storming ocean, and it needs to wait once again for calmer seas, to give you an analogy here. All that the “crew” can do is to shore up riggings, strike the sails, and do their best to survive.

That is, as I see it, what the company is doing.

Let’s look at the risks and upsides here.

Risks & Upside

The obvious set of risks for Elkem is continued declining macro trends. At the same time, there is only so much fundamental impact that this can have. As you can see above, while the company does see declines, it nonetheless generates positive profit, yet it’s trading as though it’s being viewed as garbage.

I, quite obviously, do not share this view. While the risk to the companies of a significant earnings decline of over 90% presents itself for this year, this is then followed by an eventual upside. (Source: FactSet).

The upside is the exact opposite of this. If the reversal comes and you’re positioned at an attractive price, the upside you can generate here is non-trivial. Both in terms of yield, because Elkem has shown that it’s no stranger to large dividends, but also capital appreciation.

let’s look at valuation to see what this could look like.

Valuation

I already called the company “cheap” in my last article and gave it a speculative sort of “BUY” rating in my last piece. I’m doubling down on this rating as of this particular article, and in this case, I see a significant potential upside for this company at the right sort of price.

Fundamentally speaking, Elkem has very solid equity ratios and safety fundamentals. Down only 6% from its highs, it’s still above 47% at this time. While leverage is increasing due to a mix of factors, I’d still call it conservative enough here, with 1.6x based on an LTM EBITDA of 5B NOK per year, with a well-balanced maturity profile with no significant expirations over 2B NOK until 2026E at the earliest.

The upside here in the case of reversal is material. Even if you were to expect no more than an 8.5x PÅ/E, this company has the potential to annualize 31%, or over 75% in less than 3 years, implying a share price of 28 NOK with estimated EPS of 1-3 NOK in 2024 and 2025E (Source: FactSet). The company currently trades at around 11x. This would generally imply that the company has room to move down south in terms of valuation, which it might if 4Q23 turns out relatively negative as well.

However, the company is currently at an attractive price from a long-term perspective, that’s a stance that I find hard to argue with here.

I continue to believe that Elkem remains undervalued here – and while I’m sticking to my lower PT, I may add slightly more to my growing position in the company here.

That being said, much like I pointed out in my previous piece, I’ll never be fully comfortable investing in something with this degree of Chinese ownership. In the end, it’s acceptable to me because it’s a company with a Norwegian history and over 50% of its assets and exposures in Europe. After this consideration, the value or what we’re expecting is all related to both macro and mathematics.

I believe there’s more than 35% annualized upside to an eventual turnaround here – and that’s why in the end (and while my position remains small on a comparative basis), I retain my positive “BUY” rating here.

The following is my thesis for the company.

Thesis

• I consider Elkem to be a very interesting chemical play, perhaps somewhat impaired by its majority of owners from China. The upside is a very diversified production base, with favorable exposure to low-cost environments, and also being a market leader.
• The downside is the company’s size, cyclicality, and limited lifespan with its current operations, making forecasting or giving the company a fair value tricky.
• Still, at this time, I give the company the equivalent of a long-term 10x P/E as a PT, which comes to 41 NOK/share. That means that there’s an upside and a “BUY”. I can now, as of December 2023, also call this company “cheap”.

Remember, I’m all about :

1. Buying undervalued – even if that undervaluation is slight, and not mind-numbingly massive – companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.

2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.

3. If the company doesn’t go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.

4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are my criteria and how the company fulfills them (italicized).

• This company is overall qualitative.
• This company is fundamentally safe/conservative & well-run.
• This company pays a well-covered dividend.
• This company is currently cheap.
• This company has a realistic upside based on earnings growth or multiple expansions/reversions.

I now call Elkem cheap and consider the company a significant “BUY” with a good upside here.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.