K+S (OTCQX:KPLUY) is one of the world's leading suppliers of standard and specialty fertilizers headquartered in Germany. In the salt business, K+S is a global leader with production sites in Europe as well as North and South America. K+S exposure can be gained via American depositary receipts trading over the counter. Two ADRs are equivalent to one ordinary share. I believe K+S offers a great investment opportunity given the recent sell-off in potash stocks. The analysis provided below refers to shares traded in Germany and relates to Euros. However, the underlying business value is reflected in Level 1 ADRs traded in the United States.
K+S operates three main business segments: Potash and magnesium products (accounting for 63% of group revenues), salt (33% of revenues) and complimentary activities (4%). The potash segment continues to be the dominating business for K+S. The company competes with other firms such as Potash Corp. (NYSE:POT), Mosaic (NYSE:MOS), Uralkali (OTC:URALL) and Compass (NYSE:CMP).
Uralkali's announcement in July to increase potash supply led to an entire sector meltdown. Uralkali announced that it would exit from the BPC sales organisation jointly operated with Belarusian Belaruskali. It further asserted its intention to increase supply without providing any specifics. K+S responded to this announcement with a designated section in its H1 2013 report and a special statement. The relevant paragraph from the H1 report reads [emphasis added]:
The company (Uralkali) plans to market its products through its own organisation in the future. This announcement and further statements on the part of Uralkali as well as speculation concerning future trends in the price of potash caused considerable irritation on the capital market and substantial declines in the share prices of all potash suppliers. The prices being reported for potash fertilizers are incomprehensible to us and, from our point of view, in no way correspond to the current supply and demand situation. The positive medium- and long-term trends in the potash fertilizer business remain valid. Our broad product portfolio makes us more resilient to an environment that is potentially getting more and more competitive.
Russian potash producer OAO Uralkali ("Uralkali") announced its exit from the sales organization Belarusian Potash Co. ("BPC"), which it has jointly operated since 2005 with Belarusian potash producer JSC Belaruskali. News of Uralkali's exit from BPC, and its expressed intention to increase production by 2.5 million tonnes next year, has had an inordinate negative effect on potash stocks. We agree with a statement made by K+S Aktiengesellschaft ("K+S") that the pricing for potash fertilizers being spread by the media are unjustified and that they do not reflect the current supply and demand situation in the potash market. We also agree with K+S that the positive medium and long-term trends for potash fertilizers should remain unchanged.
While an increase in short-term supply certainly has implications for the industry as a whole, K+S and Passport Potash explicitly doubt that Uralkali's actions would have a meaningful long-term impact on industry profitability. Are potash producers interesting candidates for long-term oriented investors then? I believe so. I think the market seriously overreacts to recent developments. I have seen irrational sell-offs frequently in the last couple of years. A few examples: Healthcare companies were said to be doomed because of Obamacare but bounced back nicely after the market recovered from its psychotic hangover, the financial sector was pronounced dead in 2009 but also recovered nicely and BP (NYSE:BP) was thought dead after the Deepwater Horizon oil spill in the gulf of Mexico. Folly offers opportunity. It ultimately comes down to this: Fundamentals matter more than hysteria. And the fundamentals, in my opinion, make K+S and other potash producers very attractive investments in the long-term.
K+S lost more than 40% of market capitalization
I do not believe that a fairly unsubstantiated claim to increase supply should wipe off 40% of the company's market capitalization in a matter of a single month. As a contrarian investor I also believe that it is time to buy when uncertainty peaks and investors are panicking.
What's it all about?
Industry profitability is impacted by higher supply levels and lower average prices. While Europe's potash and magnesium volumes were up 4.7% in Q2 2013 compared to Q2 2012, volume is down 20% from Q1 2013. In addition average prices declined from €340.8 per ton in Q2 2012 to €309.4 in Q2 2013: an overall minus of 9.2%. Overseas average $-prices have decreased by 12.4% compared to Q2 2012 but are up 3% compared to Q1 2013. The following breakdown for the potash segment says it all:
Share prices reflect market hysteria
Not surprisingly, a bleak profitability picture affected the share prices of K+S and its competitors very negatively. Clearly, those charts are not pretty:
Facts should matter more than excitement or fear
K+S is a well-positioned global leader in potash and salt production with decades of performance and great access to the US and European core markets. Contrary to what bears want you to believe, the industry is not going to die because of short-term headwinds. I do not deny the challenges the industry faces, but I believe that diversified businesses with profitability records will be able to adjust their product offerings and deliver for shareholders in the long-term.
Revenues have decreased 12% y-o-y influenced by a very strong Q2 2012. EBITDA is down 17% to €227 million, EBT is down 25% and net income 29%. Though the picture is not nice on first glance, K+S brings great value to the table.
I believe the performance depicted above does not tell the full story. Quality fertilizers are needed in all regions of the world to increase farm efficiency. At the same time supply of agricultural land is limited which will strengthen demand for quality fertilizers to increase crop yields. This long-term business driver is currently discounted by the market as it concentrates solely on short-term results and potash supply levels. I consider the market reaction to Uralkali's announcement to be hysteric.
Cash flow generation remains strong
While it is true that earnings took a hit in H1 2013 it should also be acknowledged that cash flow generation was particularly strong. Operating cash flow increased 56% to €554 million in H1 2013 compared to €336 million in H1 2012 driven by increased net working capital efficiency. Free cash flow grew an impressive 36%.
Low debt in the capital structure
K+S has low debt ratios and is adequately positioned to withstand pressure on its balance sheet. The net debt to EBITDA ratio shows a multiple of only 0.8 for Q2 2013. While it is higher than in Q1 2013 it remained steady compared to 2012. Its equity ratio of above 50% demonstrates a strong capital position and low leverage as well.
K+S operates another important business to mitigate potash price risk: Salt
While the market indiscriminately punishes all companies that are in the potash business, the market does not accurately value the diversified product mix K+S brings to the table. About 1/3 of revenues are generated from the salt segment that is unlikely to be impacted by Uralkali's decision to increase potash production. Average salt prices per ton are either flat or uptrending over the last year.
I believe the market reacts irrationally to Uralkali's supply announcement and to the recent drop in share prices. The long-term fundamentals favor an investment in potash and salt companies. The shortage of agricultural land in the future is undeniable. K+S in particular has strong free cash flow generation and a strong balance sheet with low debt ratios. It generated €281 million in free cash flow in the first six month 2013 alone: This equates to €1.47 per share or a current free cash flow yield of 7.6% based on a current share price of €19.30 and based solely on results for the first six month. K+S aims to pay out 40-50% of profits which I estimate could lead to a €1-1.2 dividend next year (dividend yield above 5%).
I believe K+S offers a great reward/risk ratio for long-term oriented investors who like to snatch up a cheap stock in an attractive industry. I do not think that the extremely pessimistic scenario should be the one reflected in prices for these securities. A concentration on the potash segment neglects the company's diversified market position, its solid finances and its extremely highly free cash profitability. I believe that when a focus on fundamentals returns to the market K+S can reasonably trade at pre-crisis levels of €40 a share giving the stock the potential to double.
Supply levels could be massively increased and prices could fall correspondingly leading to a deteriorating industry outlook. Given the extreme hit that potash producers have already taken I believe that the worst case scenario is already priced into stocks.