Terra Nitrogen: Super-Stock or High-Yield Villain in Disguise?

Co-written by Robert Gordon

It’s a bird! It’s a plane! No! It’s super Terra Nitrogen (TNH)!

And just like all great superheroes, Terra Nitrogen has superpowers and sidekicks. In the case of TNH, these superpowers are the ability to defy gravity and escape the capital asset pricing line. As far as sidekicks go, TNH has super-cheerleader Jim Cramer as well as hordes of wall-street brokers paying homage.

While I’m admittedly a huge fan of the Master Limited partnership (“MLP”) structure, there is something about Terra Nitrogen Company, L.P. that just doesn’t add up. How can a single fertilizer manufacturing plant located in Oklahoma have a market capitalization over $2.3 billion?

Better yet, how can a fertilizer MLP be down less than 13% from the high, including dividends, when the rest of the fertilizer industry, other MLPs and practically all risky assets are down over 25% to 50%?

It just doesn’t add up. Perhaps TNH is another example of exceptional salesmanship on the part of the brokerage community akin to mortgage REITs just a few years ago. Here are the top three reasons why I believe TNH isn’t a super-stock, but just another sucker’s bet on high current yield.

1. The Magical 6% Yield.

TNH is a thinly-traded MLP that produces K-1 distributions to its investors. These distributions have been quite generous over the last few years. However, cash distributions are not guaranteed. TNH is required by contract, not law, to distribute 100% of its “available cash”. Available cash is affected by profitability, changes in working capital, capital expenditures and discretionary reserves.

With demand for agricultural products down over the last year and expected to continue to decline as global economies sort themselves out, it is only logical to expect that demand for the fertilizer that TNH produces to drop significantly going forward.

So why is TNH hovering in all-time high territory? One likely explanation is that retail investors are under the impression that future cash distributions of around 6% are somehow a certainty. Investors are reaching far and wide for higher yields in this low interest rate environment and, unfortunately, many of those investors are ignoring risk. How else can you explain so much hype over a fertilizer facility in Oklahoma?

History suggests that the currently yield levels are an anomaly rather than the rule. Figure 1 shows the historical distributions for THN going back to 1992.

This figure clearly illustrates 4 main points: the actual cash distribution is highly variable, the range is very wide with a spread from $4.50 per unit down to $0.00 per unit (in fact, the distribution is now 50% of its level just 6 months ago.) Lastly, as the fertilizer industry goes, so goes the distribution. In 1999, a year when the fertilizer industry was in a slump, TNH made no distributions at all. As if no distribution wasn’t enough, the units traded as low as $3!

Is it so unbelievable that the massive profitability in the last few years hasn’t created a build up in infrastructure which will create an over-supply of nitrogen based fertilizer similar to 1999? TNH is an MLP with highly variable cash distributions. THN is not a bond with a secured payout. It is possible and equally probable that TNH will need to decrease their cash distributions in the not too distant future. TNH’s stock price will move in lock step down.

2. The Magic of the MLP Structure.

Perhaps the secret to TNH’s superpowers lies in the perfect mix of being in the fertilizer industry as well as having the MLP structure. Corpor companies such as Terra Industries Inc. (TRA), Agrium (AGU), CF Industries Holdings (CF) and Potash Corp. of Saskatchewan, Inc (POT) are in the fertilizer industry and most of them are down over 40% from their highs. MLPs are a fairly diversified group but in general most are down more than 20%.

By contrast, TNH is only down XX% as of this writing. If it is the MLP structure combined with the unique aspects of the fertilizer industry that have shielded TNH from the carnage of the last 18 months, why haven’t the other fertilizer companies converted to MLPs?

Just to note, TRA owns 75% of the common units of TNH as well as a 50% ownership of a UK fertilizer company and 5 other fertilizer plants in the US. On May 5^th 2009, the market capitalization for TRA was $2.67 billion and for TNH was $2.36 billion. This means all the other assets of TRA are only being valued at $0.90 billion, see table 1.

Table 1:

TRA Market Cap = 0.75% (TNH) + 50% UK + 5 US plants

THN Market Cap = $2.36 billion

TRA Market Cap = $2.67 billion

So the Market Cap for the remaining 50% UK + 5 other US plants = $0.90 billion

Now it is possible that TNH is being way over valued and it is also possible that the other assets of TRA are being way under valued. It’s impossible to say. But what I can say for sure is that if so much share holder value is created simply by restructuring a fertilizer facility into a MLP, then TRA and its competitors would have structured all of their plants a long time ago, but they haven’t.

There are two alternative ways to consider TNH’s market cap of $2.36 billion (as of this writing): replacement value of the plant and net present value of the future cash flows. I am suspect of most discounted cash flow valuation models because they rely so heavily on estimates (read guesses.)

However, the replacement value approach might be offer some independent insight. Of course, this approach ignores the “intrinsic business value.” Why not look at the pay back period.

Essentially, if the TNH is worth $2.36 billion and first quarter net income was $43.3 million. This means it would take $2,360 million / ($43.3 million/quarter) = 54 quarters or 13.5 years to get 100% return of capital with no investment gain.

When you consider that a MLPs are typically utilized for depleting assets, you should recognize that this facility will not be able to sustain this level of capacity for that long with out significant capital expenditure. You might find it interesting to go to Google maps and take a look at the $2.36 billion fertilizer plant. The actual address for the facility is 6606 E 540 Rd, Claremore, OK 74019

3. The Magic of a Good Story and Little Supply.

I’m afraid to admit it but I think the real story here is one of supply and demand – of the actual units. Fixed income yields are at historically low levels and investors are struggling to find securities the deliver good yields. These are dangerous times for yield-oriented investors. Generally speaking, they will unjustifiably sacrifice protection of principal to obtain a slightly higher current yield. These investors become susceptible to the siren call of brokers who proclaim that they have investments paying over 5%.

So what is a good stock broker to do? Sell a hard story like Citigroup (C) or an easy one like TNH? Combine this natural yield inclination with the low levels of liquidity and supply of these partnership units and you have the perfect mix for rising prices.

Specifically for TNH, less than 25% of the common units are publicly-traded. 75% of the common unit shares are held by TRA. Of the outstanding float, less than 10% is held by institutions and mutual funds. So there are very few shares in the hands of the trading public and many share units in the hands of sophisticated insiders – namely TRA.

While this can be seen as a good thing, this can also mean that there is ample opportunity for insiders to be trading on non-public information

Conclusion

MLP structures as a whole can be excellent cash generators for investors but they come with many risks and many caveats. Specific to TNH, these “risks” do not appear to be fully included in the current trading price of the units. Popular market pundits, who shall remain nameless, continue to promote TNH units as if the current situation will last forever. No doubt TNH may continue to pump out cash distributions for sometime, but sooner or later, it will have to end.

And when it does, you better hope you aren’t still holding the bag and the last to leave the party.

Disclosure: Neither Jason Whitby nor Robert Gordon have a position in any securities listed in this article.

Comments

[scfranklin94:]

Jason and Robert - you guys are exactly right. 95% of the cost of fertilizer is natural gas. The only reason that Terra Nitrogen didn't have huge losses last year when NG reached $13/MMBtu is that ethanol production kept corn prices at all time highs, therefore farmers would pay for more expensive fertilizer.

If the gov't returns to it's senses (admittedly that's a big IF) and reduces or cancels the ethanol subsidies (the program produces no net reductions in hydrocarbon or CO2 emissions - it's just welfare for farmers), and in the meantime NG returns to higher prices in 2010 as demand returns, Terra Nitrogen will be in a bind like it was earlier in the decade and it won't be making any distributions to its partners.

Anyone selling Terra Nitrogen partnerships as stable income should be indicted for fraud; the company's cash flows are extremely volatile.

May 15 09:49 AM

[sliman:]

TRA must be a screaming buy. CF Industries is trying to buy them. Any comments?

May 15 10:13 AM

[koolsool:]

TRA is tremendously under valued because of the amount of TNH they own. CF Industries understands that value, that is why the take-over bid. And that is why TRA says CF has undervalued their company and will not sit down with them. TNH should always pay a good yield as long as there is world demand for fertilizer & fairly low nat gas prices. But TRA and CF are the better values and probably highly undervalued right now.

May 15 03:18 PM

[NR:]

Good discussion guys... when I saw a fertilizer company growing fast and offering high yield, I have been suspicious..

One thing I could not understand is revenue growth.. how does a single plant in Oklohoma grow revenue from $300M to $900M in three years? Is that all related to Ethanol demand?

May 24 09:04 PM

[User 22633:]

I am impressed with you research and conclusions regarding TNH. It came up on Wachtel's series of articles on high yld stocks. Was surprised to see it was also in OK( I am in OKC) and only had one plant. The numbers just did not make sense to me. Have family in KS that are wheat, corn, and
cattle farmers. They have cut back on amount of N2 used recently. They would rather risk lower crop yields with less use of credit needed to buy nitrogen. Thanks for a great article

Jul 16 04:31 PM