"Take a deep breath, relax, everything will be just fine." - Bill Doyle, CEO of Potash Corp (POT), responding to investor concerns related to Uralkali's announcement.
In my last article, I wrote about how turmoil in the potash industry is creating investment opportunities in potash names like Potash Corp , Mosaic (MOS), Agrium (AGU), and Intrepid Potash (IPI). This article adds color on how recent events will impact POT in particular - and the conclusion is a key reason why I am long POT.
If you have been following the recent developments in the potash industry, then you know that Uralkali, one of the biggest potash producers in the world, has caused turmoil in the potash industry by announcing that it will leave the BPC potash cartel and abandon its price-over-volume strategy in favor of producing at full capacity. Since the potash industry is dominated by two cartels, BPC and Canpotex, and since cartel members deliberately produce under capacity in order to support prices, Uralkali's decision, if actually carried out, will significantly impact global potash prices.
The current situation remains highly uncertain, and no one but Uralkali insiders have any visibility on short-term potash prices. Besides getting insider information from a friendly Russian billionaire, the next best thing to do is to piece together the available information and come up with a best estimate.
Is This The Death of Potash Prices?
Currently, potash companies are priced as if Uralkali will actually start producing at full capacity and send potash prices plunging to $300 per metric ton - we will take this as the base scenario.
As of right now, there is no indication that any other company besides Uralkali is abandoning the rational price-over-volume strategy in favor of the volume-over-price strategy, so the focus is on how Uralkali's additional production will impact potash prices.
Prior to the strategy change, it looks like Uralkali is on track to produce approximately 10.5 million metric tons of potash in 2013. The question is how much more Uralkali will produce if it produces at full capacity.
Let's consider a few key points:
- While Uralkali's stated capacity is 13 million metric tons, most (including me) believe that actual capacity is something lower. For example, JPMorgan estimates that Uralkali's effective capacity is more like 12 million metric tons. If Uralkali's true capacity is 12 million metric tons, than changing strategies means an extra 1.5 million metric tons of potash in the market place.
- In a recent interview, Uralkali's CEO indicated that it will not carry out further capacity expansions beyond raising production to 14 million metric tons while it produces at full capacity. (Note: no color on when or how this extra million will show up.)
- In the same interview, Uralkali's CEO said that he expects global potash demand to increase by 10% in 2014, up to 60 million metric tons, and then resume a growth rate of 3-4% annually.
Given the assumptions above, the question is how much an extra 1.5 million metric tons of potash will impact global prices when global demand is an expected 60 million metric tons in 2014? Let's say JPM is wrong and that Uralkali can actually produce the full 13 million metric ton stated capacity (this is unlikely since cartel members are incentivized to inflate capacity… and this is the same CEO that denied any insider trading occurred), then how much will an extra 2.5 million metric tons of potash impact global potash prices?
If this doesn't sound like the death of potash prices to you, it doesn't sound like it to me either.
How Will All This Impact POT?
To understand POT's exposure to Uralkali's actions, let's take a look at POT's 2012 Annual Report and 10-K:
- Potash gross income is 58% of the company's total gross income, so that means 42% of the company's gross income won't be impacted at all by Uralkali's actions.
- Uralkali is not a significant competitor in North America, POT's biggest market. Uralkali is only listed as a competitor for Asian and Latin American markets. While Uralkali's actions will impact global potash prices, the price impact in North America will be much more muted. Since 45% of POT's potash revenues come from North America, this portion is somewhat protected as well.
- This leaves only 23% of POT's total revenues exposed to non-North America potash markets.
- Although I do not have the numbers, I suspect that the impact on gross income will be less than 23% since potash prices are generally higher in North America than in Asia and Latin America (North American farmers prefer premium-priced granular product over the standard product more typically consumed offshore) and lower shipping cost.
However, we must keep in mind that POT has significant investments in offshore fertilizer companies. As of 7/24, the combined market value of APC, ICL, SQM, and Sinofert is $8 per POT share. Let's adjust this down to $5 per POT share given the recent market crash. I won't get into how much each of these names is exposed the potash market and I won't get into the relative merits of using market capitalization vs. equity method in assessing the impact on POT - the key point is to understand that there is some exposure here as well.
Without building a precise model that will spit out a precisely wrong answer, given the analysis above, I hold the view that POT is not as exposed to Uralkali's actions as most would believe. However, JPM did run the numbers and their conclusion is this: the effects of Uralkali's actions will lower POT's EPS from $2.50 per share to $2.35 per share for 2013E (31 July 2013 research note). I'm just satisfied with the belief that POT shares are undervalued due to market panic.
I agree with Belaruskali's CEO: "Uralkali's ability to influence the market is overestimated." Given this overestimation and the general market panic, I believe POT is somewhat undervalued. For this and reasons related valuation considerations (not covered here in detail), I have taken a small position in POT. In the short-term, I believe there is still significant downside risk in POT shares, which is why I have only taken a small position and left cash sitting on the side to average down.
Please share your thoughts and let me know if you are interested in any related, follow-up articles. I would love to hear from you. Please leave your comments below or contact me through my website. Thanks for reading!