Terra Nitrogen (NYSE:TNH) has experienced a sharp drop in its share prices. It is already established that we will see an oversupply situation within the next few years, but the reaction of the market to this negative news is perhaps a bit too much.
The oversupply situation will change after around 5-7 years, but the question is whether TNH will survive in a battle of the fittest.
I suggest that we take a look first at the overall fertilizer industry worldwide trends, and then compare it to Terra's specific circumstances.
After the macro trends are described, let's take a look at specific fundamental metrics for Terra. For this purpose, let's use earnings per share (EPS), share price and dividend to see if the current market price is correct in factoring the imminent threat to Terra's profitability.
A Few Macro Economic Factors...
There are more than 30 companies planning to construct nitrogen fertilizer plants in North America. It remains doubtful, however, if all of them can actually do as they say. A few of them will undoubtedly be able to move forward with their plans, resulting in the oversupply of fertilizer in the next few years.
We have no question of the negative effects of excess supply capacity, but let's see how much damage Terra can possibly take while waiting for a change in market conditions.
A couple of competitors planning to expand capacity
Koch Fertilizer plans for an additional 90,000 metric tons a year for ammonia, with facilities to be completed in late 2015.
PetroVietnam plans to add 90,000 additional metric tons of ammonia to increase its 450,000 tons to 540,000 tons capacity.
It also plans to add 250,000 tons of additional capacity for a combination fertilizer known as NPK (nitrogen phosphorus potassium).
These are hard to directly relate to Terra Nitrogen's profitability, however, as they are just a few of the known ones planning to add to their production capacity.
Also, it is important to note that these expansions individually are simply a drop in the bucket. The total projected increase in fertilizer on a worldwide scale is 21.8 million tons by the end of 2015.
It is rather hard to create a tally for each individual company and try to trace how many would directly reduce the sales figure of Terra Nitrogen. These news tidbits are simply to show how each individual firm out there is trying to expand its capacity relative to its local business environment, and for us to get a feel of the overall big picture.
The important thing to note is that Canadian and American farmers import 11 to 12 million tons of nitrogen fertilizer a year. We just need to figure out how much additional capacity is created, versus actual demand.
After that, let's compare the calculated decrease in demand, versus the decrease in Terra Nitrogen's share price, to determine whether investors have overreacted or not.
Ammonia's Share Increase for 2011-2015
It is important to take note that for North America, ammonia will increase by 2.3%. Let's use that to compare Terra's production to get a feel for the company's reduced sales.
According to the International Fertilizer Industry Association (IFA), 58 new urea plants will start operating within 2011-2015, 17 of which will come from China.
The additional capacity will create 21.8 million tons of fertilizer, up from 134.5 to 156.3 million tons.
Very Rough way of Establishing Sales Decrease
(for the sake of Discussion Only... to gain a better feel)
I humbly suggest this simplistic point of view only as a rough way of determining our expected decrease in sales. There are better ways to do this, but the amount of effort might not be palatable for some investors.
Let's just use the figures above cited by IFA to compute a rough percentage of sales reduction. The 21.8 million tons of newly-created capacity will be divided by 134.5 million tons, which is the original capacity of world urea manufacturing. The result is 16.2% of a decrease in sales.
Let's use this 16.2% figure as the starting point on how much Terra would suffer in terms of a sales decrease.
We are assuming that the entire new capacity will not be coming from Terra, hence, to be totally subtracted from the company's annual revenue levels.
We are also assuming the new capacity will be evenly distributed throughout the whole fertilizer industry, so we can justify using the simple percentage in new capacity as the same percentage for the reduction in sales. In this case, it is a 16.2% reduction in sales.
Of course, it won't be the only thing we will look at to get some sort of objective means to determine what is fair pricing for Terra Nitrogen's stock.
Finally, hard metrics to determine Overreaction or Not
Take a look at the chart below to compare Terra's share price with normalized diluted EPS and see if it's in line with the recent decrease.
One chart uses 1-year TTM and the other one uses 5 years as scale for us to get a proper comparison.
This one below shows the 1-year range.
The one below is the 5-year range.
Although the two pictures are quite different because of their difference in time range, it is clear that the 5-year range gives us a better view of how to see the EPS compared to the drop in the stock price.
The stock price has dropped too much compared to the drop in EPS. It is still undervalued, despite the drop in earnings.
You can clearly see somewhere between 2010 and 2011 that the EPS figures are clearly below the stock price, indicating the stock is fairly valued to a little bit overvalued at that time.
The recent events this year 2014, however, has caused the stock price to drop too much compared to its drop in profitability.
If you are a long-term investor with a time horizon of 5 years and above, you would do well to get in a position now before the price starts hiking up again.
In Connection to Macro Economic Factors
If you take a look at the first graph for EPS versus share prices, the decrease in EPS is roughly 16%, because it became $20 EPS from $23 EPS originally at the start of 2014.
The decrease in share price, however, is roughly 25%. The figure comes from near the end of 2013 share price of $200 to the current levels of around $150-$157 share price.
It is very simple, a 16% decrease in EPS resulted in a 25% decrease in share prices.
It simply is too much of a reaction, in my humble opinion.
The oversupply expected from the increase in fertilizer production is a good reason for the lowered share prices.
However, even a rough gauge of the decrease in earnings indicates it's only a little.
The stock, however, moved too much, too far below, to the point that it is still very much undervalued at this price range.
At this point in time, investors might do well to consider getting more shares because of the cheaper price. Regardless of the expected decrease in sales levels, the lowered share price will fully compensate you for it, and even more.
Disclosure: I am long TNH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.