The small-cap battery bubble and how to play it

At 8pm on 1 December, Jadar Resources (ASX: JDR) announced a change of name to EV Resources (ASX: EVR). The following day the stock price rose by 20%.

One question we are often asked by potential investors and friends is “is it a good time to invest in the market?”

According to equity risk premia, the market appears to be fair value. However, this belies some truly extraordinary valuations in certain sectors or thematics. The battery materials sector is one prominent example of this.

We are bulls on EVs

At Firetrail we have long been bulls on electric vehicles, and not only because of their environmental credentials. Price parity is here, range anxiety is diminishing, and the performance capability is second to none. EV uptake will continue to outperform consensus expectations.

The energy transition requires more metals

The transition to electric vehicles and decarbonisation more broadly will require raw materials for storage and transmission of electricity.

Over the next decade, we estimate the world needs to increase lithium supply by about six times, rare earths by about 2.5 times and nickel by about two times (Figure 1).

To invest, resources companies require an “incentive price.” That is a price that delivers an appropriate financial return (typically double-digit the internal rate of return).

Because of the demand likely to be experienced over the next decade, we believe that commodities such as lithium, rare earths, nickel and copper can trade sustainably above incentive pricing.

Many companies that produce these commodities look set to generate strong returns. Additional supply is needed and those companies with viable projects are likely to attract the necessary funding to bring these into production.

Which companies should we invest in? 

Against this backdrop, there is a clear case for investing in companies exposed to the clean energy thematic.

As valuation-based fundamental investors, we believe we should invest in companies that will be successful in execution and are trading at a discount to fair value.

There are many stocks that have significant execution/technology risk and are trading at huge premiums to fair value (even assuming 100% successful execution). Novonix (ASX: NVX) is one stock that, in our view, is potentially in bubble territory.

Unpacking Novonix

Novonix has increased by 904% so far in 2021

Novonix has a market capitalisation of $5.9 billion and an enterprise value of about $5.6 billion. It is the fourth largest stock in the S&P/ASX Small Ordinaries Index. In the 12 months to June 2021, Novonix generated $5.1 million of revenue.

Battery technology solutions

The current (revenue-generating) business is a battery testing and equipment sales business called Battery Technology Solutions. This is a good business with blue-chip clients.

Assuming some generous growth and margin assumptions, this business could be worth $100 million. Where is the other $5.5 billion of enterprise value coming from?

Anode materials business

Using the intellectual property gained from their battery testing business, Novonix are planning to produce synthetic graphite material that forms part of battery anode. This is the part of the business that the market is excited about. Here it is in a nutshell:

• The company is yet to move into commercial-scale production, however plans to scale up a facility to 10 thousand tonnes per annum (ktpa) of capacity by 2023
• The battery synthetic graphite market is a 230ktpa market growing strongly, like all battery-related raw materials
• The market is highly competitive and dominated by low-cost Chinese supply with significant excess capacity
• NVX plans to produce 40ktpa by 2025
• If NVX is successful with commercialisation, building the plant, ramping it up, and selling the product, at best practice industry margins, then we estimate they will produce $130 million of EBITDA in 2024-25
• From a valuation perspective, this puts Novonix on an EV/EBITDA multiple of 43 times. This compares to battery materials peers of 10-15 times (Figure 2).

Novonix does have advantages 

The company has a US-based supply chain, access to plentiful, low priced, (relatively) low emission gas, and an IP advantage gained from an established battery technology business.

But even factoring in the most optimistic case, we believe the market weighing machine has some heavy lifting to do.

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