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In response to input regarding the prior SA article (click here), I thought it would make sense for a follow-up to address several specific comments and the material news flow related to CF Industries (NYSE:CF) that has occurred since.

Topics covered in this follow-up:

- Shareholder payouts - stock repurchase vs. dividends - how should CF be directing its shareholder payouts?

- Natural gas price progression since the April/May highs (read through to CF)

- Trends in corn futures and fertilizer pricing (read through to CF)

- Mosaic's (NYSE:MOS) and Potash's (NYSE:POT) results (read through to CF)

- Impact of the dissolution of the Belarusian Potash cartel

- Relevance of Third Point (Dan Loeb) hedge fund investment in CF

Shareholder payouts - stock repurchase vs. dividends - how should CF be directing its shareholder payouts?

By way of background before managing money, I spent 15 years on Wall Street in various disciplines and firms including Credit (at Goldman), Debt Capital Markets (at Deutsche Bank and DLJ), Equity Capital Markets (at DLJ and Credit Suisse) and in a group called the Buy-Side Insights Group at Credit Suisse. The Buy-Side Insights Group (where I spent seven years) advised companies on how to maximize shareholder value by focusing on returns on investment, capital allocation, cash flow generation, business dispositions and acquisitions, and working to understand investor expectations. While I am no longer in the corporate advisory business, my views on shareholder payouts are formed by each of those prior experiences, but most importantly from my times conducting credit analysis and in the Buy-Side Insights group.

Based on my experience, the answer to the question of how CF should be deploying its shareholder payouts from an investor standpoint boils down to two criteria: investor's hold period and stock valuation.

Let's assume for illustrative purposes that CF has the same level of free cash flow less dividends going forward as it did in 2011 and 2012 ($1.75bn). Let's further assume that CF dedicates 100% of after-dividend FCF to share repurchases. Given that CF's market cap of $10.7 billion as of 7/26 is about 6x FCF, it would take a mere six years at CF's current share price for the company to retire all its outstanding shares. Now in this highly improbable scenario if one were to hold one's shares for the entire period (refuse to tender them into the buyback program) and the stock price did not move over the period, not only would one end up owning the company, one could then elect to direct all future free cash flows (by then say $2bn+ per year) to dividends. See table below.

Illustrative Analysis on CF - Dedicating 100% of ex-dividend FCF to Buybacks

2012 YE

2013 YE

2014 YE

2015 YE

2016 YE

2017 YE

2018

YE

Avg Share Count

64.7

58.4

48.9

39.3

29.6

19.9

10.3

'12 FCF ex-Div in years '13 and beyond used for buybacks

$1,750

$1,750

$1,750

$1,750

$1,750

$1,750

$1,750

EPS

$28.76

$31.68

$37.77

$47.07

$62.45

$92.73

$180

YoY EPS growth

29.6%

10.1%

19.3%

24.6%

32.7%

48.5%

94.2%

2012 Dividend

$103

$103

$103

$103

$103

$103

$103

Div per Share

$1.60

$1.76

$2.10

$2.62

$3.47

$5.15

$10

The point of the above table is meant to highlight three major points:

  1. with CF management's stock buyback bias and if management dedicates a significant portion of FCF to buybacks, the stock will not remain at its current price and should increase dramatically
  2. long-term investors should highly favor a company like CF which has conservative leverage, an inexpensive valuation (especially vs. its peers) and generates significant FCF, focusing on stock buybacks and
  3. significant stock buybacks will lead to the potential for dramatically higher per share dividends over time.

The issue with this approach is it often takes time before the average shareholder really appreciates what is going on and bestows credit on the company for this strategy. The truth about the average shareholder in the current environment (especially the institutional shareholder who is worried about providing alpha every quarter or risk being made redundant) is the Street typically takes its time to appreciate what a company like CF is doing. Thus the long-term investor has a definite advantage by getting in before the Street realizes the value the company is creating.

Notwithstanding the above, if the goal is to maximize the company's near term valuation (i.e. if the company has a nearer term objective of driving its stock price higher - company motivation to be discussed in the next paragraph) it is virtually undebatable that CF should combine an aggressive share repurchase program with significant annual increases in its dividends per share. There is a tremendous signaling effect of materially increasing dividends on a consistent basis. CF has a lackluster history in this regard. While CF does have a history of significant increases in its dividend whenever it institutes an increase (a 5x increase in February 2008 from $0.02 to $0.10 per share per quarter and then a 4x increase in August of 2011 from $0.10 to $0.40), they represent only two increases in the last 5+ years. Those who focus on dividends and specifically the signals that dividend policy can convey (a high degree of confidence in either sustained high levels or improving levels of profitability), look at the infrequent increases in dividends and the current sub 6% dividend payout ratio (dividends as a percent of TTM EPS) as a lack of management's confidence in CF's future profitability. Dividends, by many, are viewed as a de facto contractual obligation. If CF cannot commit to a higher payout, then ipso facto they are not confident that they could make good on a higher dividend commitment. A further mark against CF to the dividend oriented investor is that CF has the lowest dividend yield of any of its major competitors (and especially vs. any of the Nitrogen MLPs). The dividend oriented investor would argue that the current dividend policy is not consistent with the message that CF management has been highlighting - that CF's nitrogen fertilizer business outlook is characterized by "higher highs {and} higher lows" (see page 97 of CF's Investor Day presentation).

When you weigh the two perspectives (long-term vs. short-term) and the constant barrage management receives on the shareholder payout issue, it leads the querying investor to speculate on what really motivates this management's behavior. This entails some second level thinking. The skeptic would look at the prima facie evidence and say that there is too low a dividend, inconsistent (not quarterly) stock repurchases, and overly conservative capitalization. Thus CF's management must be concerned that its best days are behind it. I would argue that this is incorrect.

There is a real tension between the increasing dividends strategy and the stock repurchase strategy. If CF is trying to maximize the value of its share repurchase program, they want to buy the stock back as inexpensively as possible. Why would CF desire to set a more compelling dividend policy that would presumably create more demand for the stock, when CF would like to buy back stock at the most inexpensive price? When you look at it from that perspective, one could also speculate about the other things that CF does to structurally limit interest in the stock. Why should CF split its stock to make it more desirable to retail investors when that may just cause more demand for the stock? Why would CF want to stoke retail demand just to have to compete against it in its share repurchase efforts? Further, consider management compensation. If management is bullish and highly constructive on the prospects for the company, would they rather amass inexpensively valued shares for as many years as possible or would they rather have less shares awarded at higher valuations each year? They would by definition want to be compensated with the inexpensively valued shares for as long as possible before benefiting from an ultimate spike in the Company's valuation.

This is not to suggest that management purposely attempts to retard stock price appreciation, but the point is to highlight the inherent tensions between different types of stakeholders and especially the short-term vs. long-term investor.

For the reasons listed above, at the current valuation and from a long-term perspective, I would prefer that CF management direct all available free cash flow to accelerated share repurchases. But if management has any interest in driving its shares higher in the short term, they should also supplement that with a dividend increase to, say, $1 per quarter from the current 40 cents. Further, they should follow that up with meaningful dividend increases on an annual basis thereafter (say 25 cents more per quarter each year) for the next few years until the dividend yield arrives at 3% or higher. To give a sense of CF's capacity to deliver a 3% dividend, CF could elect to do so overnight and the approximate $6 per share per annum would represent an approximate 20% dividend payout ratio based on 2012 EPS. A 20% dividend payout ratio would be considered by many to be conservative.

To round out discussion on this topic, let's go back to the illustrative scenario and make it, arguably, more realistic. As discussed in the prior article, based on public filings I estimate that the purchase of the minority CFL stake will be ~$175mm accretive to operating income on an annual run rate basis (assuming profitability in 2013 and beyond as in 2012). Let us further assume that CF borrows any remaining monies it needs to complete its expansion projects and that between those borrowings and the recent $1.5 billion debt offering that all incremental debt service costs approximate the added cash flow from buying in the remaining CFL stake. The recent debt offering resulted in about $65mm of annual pre-tax interest expense. Let's further assume that CF engages in another $750mm of share repurchase in 2013 (@$185 per share), $1.5bn of share repurchase in 2014 (@$230 per share - 25% higher than $185 - completing its announced program two years early) and another $1.5 billion of share repurchase in 2015 (@$285 per share - 25% higher than $230). This would all be taking place in advance of 2016 when CF's and most of the others' expansion projects are slated to start coming online. Finally, let's assume that CF starts increasing its dividends per share every year but keeps the amount dedicated to dividends constant. Effectively increasing the dividends per share just to reflect the lower share count each year.

Taking the above scenario, by the start of 2016, CF's dividend would be 40% higher ($0.56 per share per quarter vs. the current $0.40). CF's EPS would be ~$40 in 2015 (a 12% CAGR from 2012). And at $285 / $40 in estimated EPS, the company would still be trading at 7x TTM earnings. Even in this scenario, the stock price CAGR is an attractive 20% per annum and these are arguably conservative assumptions in terms of CF's stock trading at a continued material discount to the market for three more years. In this scenario, if you held the stock you would end up owning approximately 37% more of the company without purchasing another share as the repurchase program shrinks the shares outstanding and increases your percentage ownership. The linchpins of this analysis are a) what will FCF be over the next few years and b) at what price can the shares be repurchased. That is a good segue to the next few topics.

Natural Gas Price Progression since the April/May highs

As discussed in the prior article, CF's management highlighted at its recent investor day that natural gas costs are up to 70% of the cash costs of nitrogen fertilizer production. So how have natural gas prices progressed of late? The answer is very positively for CF.

As may be observed from the CME website (screen shot below), near term natural gas futures are trading sub $3.50 per MMBtu. This is a far cry from the $4.50+ per MMBtu that Goldman predicted back in April when they made a significant market moving call (Bloomberg article "Natural Gas Jumps to 20-Month High as Goldman Boosts Outlook"). By and large, domestic natural gas prices have come in significantly from April's low-to-mid $4 per MMBtu range. While CF highlighted how strong its profitability can be even at $5 per MMBtu at its investor day (see page 97 of CF ID presentation), the lower the natural gas prices the better. In the current environment, CF should be able to lock-in natural gas at sub-$4 per MMBtu through late 2014.

(click to enlarge)

Corn Futures and Nitrogen Fertilizer Prices

This would seem to be the biggest cause of anxiety for the fundamentally driven fertilizer stock investor. As discussed in the prior article, there is clearly broad concern that we will be having an all-time record corn crop and that will take a heavy toll on corn prices resulting in weak fertilizer pricing.

There is no question that corn futures have suffered a significant decline. The September corn futures contract has declined 20% since mid-June (see CME chart below). Even more concerning, the September contract suggests that prices may be down about 1/3 from the $7 per bushel farmers received in June 2013 (prices received for Corn USDA). Interestingly, corn silking is running dramatically behind last year's progress at this time of year. At this time of year last year in the top 18 states representing 92% of the corn acreage, 93% of the corn acres were silking - this year its 71% (USDA Crop Progress Report). The five year average is 75% by this time of year. In terms of where the corn crop is with respect to its "dough" stage (click on the attached for an explanation of the relevance of these various stages), last year as of July 28, 35% of the crop was at the dough stage while this year only 8% of the crop is at the dough stage. The five year average is 17% at this time of year. This all speaks to a late (and potentially challenged) crop that undoubtedly suffered some stress from the high temperatures of a couple weeks back. What works against corn futures pricing is that 63% of the corn crop is in either "Good" or "Excellent" condition this year vs. only 24% in those two categories this time last year. There are anecdotal accounts that both the bulls and bears are alluding to that corroborate each of their contentions: that either this will be a blow out crop or that this crop will not come in nearly as bountiful as the USDA is forecasting.

(click to enlarge)

The way corn futures have been trading have every hallmark of fear (of a blowout harvest) and negative speculation (about continued weak corn prices) ruling the day. Buying the fertilizer stocks, and CF in particular, is one of the most straightforward ways to be a contrarian on recent corn futures price action.

What is also worth keeping in mind is what % of farmer costs are fertilizers. Potash Corp included a helpful chart in its recent Q2 earnings presentation (see slide below - CF has a similar slide on p. 29 of its ID presentation). According to POT, fertilizer represents somewhere between 13-17% of farmer corn revenue depending on where corn is priced in the range of $4 per bushel (~17%) and $6 per bushel (~13%). Is approximately $5 per bushel September corn going to lead to a dramatic decline in fertilizer prices? While there is recent evidence of weak fertilizer pricing in certain parts of the country (Weekly Fertilizer Review on July 26 sums it up nicely "Farmers aren't interested in fertilizer yet"), we are now well past the Summer fertilizer application season with farmers mostly anxious about how their harvests will come in. Presumably buying fertilizer after they just bought and applied it two months ago in a late application year is not top of mind.

Read through to CF on Mosaic's and Potash's recently released results

Mosaic released results on July 16 and Potash Corp did so on July 24th.

To sum it up, fertilizer sell through (# of tons) was robust at both Mosaic (record volume) and Potash Corp., but average pricing was down in the most recent quarter for both companies across all major categories of fertilizer: N, P, and K for Potash Corp and just P and K for Mosaic (they do not have nitrogen fertilizer production capacity).

Avg Price per Ton

Most Recent Quarter

Same Quarter 2012

Difference

Mosaic - Potash

$368

$455

-19%

Mosaic - Phosphate

$483

$494

-2%

PotashC - Potash

$356

$433

-18%

PotashC - Phosphate

$517

$552

-6%

PotashC - Nitrogen

$406

$436

-7%

The red flags were potash pricing for both companies (ytd) and guidance on potash volumes for the remainder of 2013. Notably, this was before the news this week of OAO Uralkali (the world's largest potash producer) busting up its cartel (the largest global potash cartel) and planning to hike supply dramatically (presumably unless its main partner in the cartel comes back in line).

Mosaic, which derives a mere 35% of sales but a whole 62% of operating profits from potash (see Fiscal 2013 10-k), indicated that they were already planning to reduce their potash operating rate to less than 75% in the next quarter from 95% in the prior quarter to "match production volumes to market demand" (see Q4 2013 earnings release). Potash Corp, which derives 39% of revenues and 57% of gross margin from potash (based on 2012 annual report), indicated in their most recent earnings release that potash volumes would be ~8% lower in the latter half of 2013 (assuming mid-point of guidance) than in the second half of 2012. Again, this was before the OAO Uralkali news which would lead one to believe that sales volumes will only go lower than last week's guidance for the balance of 2012.

Summary Numbers:

Of special note is how significantly Potash Corp missed and reduced guidance for full year 2013 (a ~14% reduction in full year EPS vs. the guidance just three months prior).

In sum, the read through for CF is that volumes of fertilizer sold should be at record levels and natural gas costs should be comparable with last year (see prior article), but we should expect to see average sales prices down 6-7% per ton. Given that CF had announced the repurchase of over 6% of its stock early in the quarter and closed on the CFL minority interest buy-in at the end of April, I estimate that CF's EPS will be comparable (if not superior) to last year's Q2 EPS of $8.71. Consensus first call is at $7.63 (a 12% decline from last year's Q2). Lack of potash exposure on top of the aforesaid factors should put CF in position to deliver the best year-on-year comparable quarter amongst its large cap fertilizer peers.

Read through on CF of the dissolution of the Belarusian Potash cartel

There are (were?) two major potash cartels. The Belarusian Potash Corp (made up of Belaruskali and OAO Uralkali - the world's largest potash producer) and Canpotex (which is wholly owned by its three member producers - Potash Corp, Mosaic, and Agrium). Between the two cartels they are estimated to account for in excess of 70% of the world's potash supply (the OPEC oil cartel only accounts for approximately one third of global supply). Apparently OAO Uralkali has elected to break up its cartel because they were displeased with various activities of its partner. According to OAO Uralkali's CEO (click here), OAO Uralkali plans to take its annual run rate to full capacity (which would represent 3.6mm additional tons of production injected into the world market) and expects potash prices to decline from $400 per ton for the contract Belarusian Potash Corp signed in 2012 to somewhere between $270-$300 per ton.

If prices for potash indeed drop to $300 or $270, the impact on Mosaic and Potash Corp would be dramatic. Conducting an illustrative analysis on Mosaic:

Fiscal 2013

Actual (MM)

Pro Forma @ $300 per Potash ton

Pro Forma @ $270 per Potash ton

Potash Sales

$3,529

$2,614

$2,353

Potash COGS

$1,918

$1,918

$1,918

Potash Gross Margin

$1,611

$696

$435

Phosphate Gross Margin

$1,162

$1,162

$1,162

Total GM ex-eliminations

$2,774

$1,858

$1,597

% GM Decline vs. Actual

N/A

-33%

-42%

The read through to CF is very interesting. As nitrogen fertilizer is not "banked" in the soil (like potash and phosphates), nitrogen needs to be applied annually to insure strong crop yields. This leads to fairly consistent and slowly increasing (with global population growth) demand for nitrogen fertilizers. As potash and phosphates can be banked, some farmers (and countries) decide to forego applying (or subsidizing) potash or phosphate fertilizer in certain years. One of the biggest challenges potash has had in 2013 is that India decided to focus subsidies on nitrogen fertilizers at the expense of potash subsidies (see Potash and Mosaic earnings call transcripts on seeking alpha). Farmers in India have lapped up nitrogen fertilizer but Potash imports to India have been negligible. It is fair to assume that if Potash prices drop to $270-$300 per ton that potash sales volumes will increase as farmers/countries use the price decline as an impetus to bring K in the soil up to optimal levels and potentially to build up stock. It is also fair to assume that there will be some negligible-to-moderate impact (5%?) on phosphate and nitrogen fertilizer demand as farmers take advantage of the potential blue light special on potash.

The second level thinking here is more interesting. If this OAO Uralkali situation is deemed by the Mosaics, Potash Corps, and Agriums (NYSE:AGU) of the world to be something more than a short-term disruption to the Potash markets, they are going to be highly desirous of diversifying away from potash and more towards the other two fertilizers with better economics and prospects. This is analogous to what has been transpiring for years in both big cap tech and or large cap pharma. In both industries when there is concern about disruption to their past cash cow businesses (or specifically drugs going off patent in the pharma industry), we have often seen companies go on the hunt for acquisitions:

  1. Oracle with PeopleSoft, Siebel, Hyperion, BEA, RightNow, Taleo, Acme Packet, etc
  2. HP with Mercury Interactive, EDS, 3Com, Palm, 3Par, Autonomy, etc
  3. Pfizer with Warner-Lambert, Pharmacia, Wyeth, and King Pharma, etc
  4. Novartis - formed from the combination of Ciba-Geigy and Sandoz, purchased Hexal, Eon Labs, Chiron, Alcon, etc.

Given the three + year construction time horizon, increasing costs, and potential damage to industry economics of taking on major incremental nitrogen fertilizer expansion projects, it would seem highly logical that Mosaic, Potash Corp and even Agrium may be more incentivized now (than ever) to buy existing nitrogen fertilizer producers. There is no less expensive (in terms of EV/EBITDA) and better strategically positioned North American nitrogen fertilizer producer than CF. Further, an acquisition of CF would be substantive enough for any management team as a potential acquirer to be able to credibly argue that they are making a significant investment in nitrogen fertilizer and are lessening their shareholders' relative exposure to potash. There is no question that CF (see discussion on the topic in my prior article) is more than a capable adversary. CF presumably has little interest of being sold (unless offered a handsome price) and should be able to effectively spurn unwanted suitors. But whereas the primary incentive for a takeout of CF, prior to this OAO Uralkali news, was arguably, merely that CF had attractive assets and traded at an unwarrantably low valuation; now there is a real strategic imperative for those over-reliant on potash to increase exposure to low cost nitrogen fertilizer manufacturers (i.e. CF).

Relevance of Third Point (Dan Loeb) Investment

This being the last topic for this lengthy follow-up article, this will be kept short and to the point. As discussed in my prior article, I believe that one of the primary reasons that CF trades at a (still) material discount to peers is a lack of ardent institutional support. Unlike Potash Corp. and Agrium, CF is not a Canadian company and does not benefit from firm (but lately bruised) Canadian institutional support for their national champion fertilizer companies. CF does not have the Cargill related Mac Trusts (that own 30% of Mosaic) or Temasek (the sovereign wealth fund of Singapore) that owns ~5% of MOS.

CF now has Dan Loeb and Third Point. Third Point has a well-earned reputation as an astute investor and brings some attention to a company (and a stock) that has been under-appreciated for far too long. Something I and some others have appreciated as we have been building positions in the company over the last 18 months.

With Third Point's coming public on their investment and bringing more attention to this under-followed and under-appreciated company/opportunity, one cannot help but think that CF's last 18 month discount to peers is less likely to persist.

Next week CF will deliver its Q2 results. With anxiety levels particularly high due to the Belarusian Potash cartel dissolution and weak US corn futures pricing, EPS of $8.50 per share or higher (if achieved) should be received with a sigh of relief and enthusiasm. Beyond whatever Q2 results turn out to be, the investment community will be looking for CF management to convey confidence on the outlook for the back half of 2013 and beyond and ideally more action by management on the shareholder payout front. While clouds and uncertainty hover over CF's potash exposed peers, prospects for CF's shareholders appear highly constructive.

CF EV / EBITDA TTM Chart

CF EV / EBITDA TTM data by YCharts

Disclaimer: All information gathered from sources believed to be accurate, but the accuracy of the information cannot be guaranteed. Past performance is no guarantee of future results. Investors should not rely upon the above analysis when making their own investment decisions.

Disclosure: I am long CF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: CF Industries: Buying $1 For 40 Cents - Follow-Up