4Q19 results missed consensus due to the bigger-than-anticipated recognition of the ESS fire-related provision (KRW300bn). EV batteries reported a slight loss. The yield of the Polish plant appears to be normalizing.
In 1Q20, profitability is expected to worsen due to the coronavirus outbreak and an escalating fixed cost burden stemming from the aggressive capacity expansion for rechargeable batteries. For our target EV/EBITDA multiple for the rechargeable business, we applied a 30% discount to peer CATL’s multiple. We raise our target price to KRW470,000 while presenting the company as our conviction call.
The discount on the rechargeable battery business will rapidly disappear. Improving cash flow, Europe, and Tesla (TSLA) are the key.
1) LG Chem’s (OTCPK:LGCLF) rechargeable battery asset depreciated over a six year period which is very conservative. The depreciation cost for 2020 will rise to KRW1.6tn. Capex reached its peak in 2019. From 2021 onwards, EBITDA should surpass capex, helping to lift the discount on the business.
2) Despite concerns over a potential slowdown of the cylindrical battery market, LG Chem is set to enjoy a YoY sales increase of over 30% in 2020 thanks to growing EV and LEV (light electric vehicle) battery orders from Tesla. Its relatively bigger exposure to small batteries vs. EV batteries has been a major discount factor so far but we expect that discount to gradually diminish going forward.
3) Model Y, set to be produced in Tesla’s Chinese factory, shares the same platform with Model 3. Accordingly, we expect LG Chem to receive Model Y-related orders too. According to Reuters, CATL will supply Tesla as well but the timeframe of the deal is from July 2020 to June 2022 and the volume will be decided depending on the battery needs at the time. In the meantime, LT Chem will supply most of the volume required by Tesla.
Europe’s portion of rechargeable battery sales continues to increase, helped by strengthening CO2 regulations in the region. LG Chem stands to benefit from having European OEMs as major clients.
Share price outlook and valuation
The cash flow of the battery business should improve greatly from this year. We estimate the value of rechargeable batteries at KRW34tn, which is reflected into our valuation. Our target EV/EBITDA multiple of 20.3x may look demanding but we expect the valuation burden to decrease as we believe 2020 EBITDA will balloon to KRW2.7tn.
There are doubts about when the Polish plant’s yield will normalize. However, short-term earnings uncertainties provide a great entry point, in our view. LG Chem’s EV battery capacity has grown tenfold in the last four years (from 10.5Gwh in 2016), and the operation of massive capacity is bound to be unstable at an early stage, which will be temporary. Tesla also suffered in ‘production hell’ in 2018 and its shares have rebounded since. We see LG Chem’s share price following a similar path on the road to vehicle electrification and recommend investors take advantage of the current price weakness to position themselves for growth.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Hyundai Motor Company is a passive shareholder in our bank.
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