Trapped Value. At least that is our opinion. With the dramatic pps decline witnessed a month ago (-25%), following an announcement by fellow potash producer Uralkali (OTC:URALL) of a looming price-war, Potash Corporation of Saskatchewan (POT) entered into value investment territory. We're convinced of the merits of an investment in POT for a number of reasons. First, its balance sheet is pristine with low leverage. Second, it generates adequate cash flow and dividend coverage even if there were a big reduction in potash prices. Lastly, our analysis indicates the stock trades at or below book value, as we discuss below and, with a secure dividend yield of about 4.5%, it offers a decent income stream. We should note that the stock is trading up today based on rumors that Uralkali may be forced to alter its "stranger-than-fiction" tactics regarding potash prices. But even so, with a solid long-term macro theme (higher populations demanding higher crop yields), we believe Potash will perform well going forward.
POT has net debt of $3.4 bn as of the end of 2Q13. Its stated EBITDA for the 1H13 was just over $2bn, implying a net-debt to EBITDA ratio of 82%. That is very low leverage with most commodity companies (e.g., O&G, E&P) comfortably running somewhere in the 2s. It is not surprising to us that Potash recently announced a $2bn buyback plan and will move forward with it even if debt increases slightly. Even if POT's EBITDA were to suffer through a 25% decline in potash prices - from $400 per metric ton to $300 - POT's leverage would only increase to about 1x EBITDA, still remarkably low. Other measures, such as its total liabilities to capital at 43% indicate a balance sheet that is in a very strong position. No goodwill and very little intangibles gives us comfort that POT has not binged on acquisitions to fuel growth. In fact, POT has made very few acquisitions in its history as most of its assets are booked at cost when the crown holdings were de-nationalized. It has made equity investments in other potash interests but those are presented on the balance sheet at $3.3bn, which is below market value. All told, our view is that POT's balance sheet is in a strong position to not only withstand a potash price decline, but can also capitalize on any disruptions caused by lower prices on more leveraged players.
For the first six-months of the year, Potash generated $1.7bn in operating income (41% margin) and nearly $2bn in operating cash-flow. It had significant capital expenditures of $860mn, but those are slated to decline dramatically in 2014. Even so, what we call free-free cash flow of $1.1bn was more than adequate to pay the dividends, even assuming today's higher 35c per share quarterly payout (~$600mn for six-months). It had plenty of cash flow to pay down debt and increase cash slightly. Of course, that is with an average potash price of $390/mt. We should note that potash is not the only line of business for POT. If potash prices declined by 25% on July 1st (which did not happen), to say $292/mt, then operating margin would decline to 35% but free cash flow would still be $1.2bn. While covering the dividends easily, the expected capital expenditures for 2H13 would require an increase in net-debt of $225mn. As we mentioned before, capital expenditures will be minimal in 2014 and, so far, the big price decline in potash has not been seen. But even so, it is nice to see that POT's balance sheet would be far from strained in the event of a large price decline and share buybacks would most likely continue, albeit at a potentially reduced rate.
Potash's balance sheet at end 1H13 implies a diluted book value of roughly $11.50 per share, well below its current share price. However, its Potash (and Phosphate) reserves are booked at historical cost, which goes back to 1993 when they were acquired, plus the capitalized expenses associated with rendering those assets producible. As such, book value is understated. Based on POT's reserve report, industry standard recovery probabilities (e.g., 90% for proven, 70% for probable), and other data, we estimated the PV-10 (present value at 10% discount) of its potash reserves at about $23bn. This assumed a 23% recovery, 75 year useful life, and a margin of $100/mt over cost. Given POTs all-in cost of about $175/mt, this implies a low sale price for its potash reserves. Coupled with its phosphate holdings, we estimated its reserves are worth about $28.5 per share. Even if we assigned no value to other assets (e.g., nitrogen producing), we conservatively place book (replacement) value at about $27/share and its current share price would imply a slight premium. However, a more realistic assessment on reserve probabilities, other assets, and a margin of $150 that is more in line with current prices, would place book value north of $40/share, where it was trading pre-Uralkali. While estimating book value is a necessarily imprecise exercise, we feel reasonably confident that POT is not trading at an excessive premium to true book and, if anything, is at a discount.
All told, we find it hard to poke holes in the investment thesis of owning POT. A good dividend yield with more than adequate coverage. A solid balance sheet that can weather and take advantage of a price war (if it comes to fruition, which we doubt). And a large reserve base that supports the share price at replacement value. Short-term results will necessarily be impacted by potash prices; if prices were to collapse to $200/mt, there would surely be pressure on the share price. However, we find such dire predictions as lacking any substance -- they may come true, but one can say that of any commodity. All told, we feel investors will be handsomely rewarded owning POT for the future to come.