The fertilizer industry is asset intensive, meaning firms must operate near full capacity. The cost of operations is closely aligned with the cost of natural gas, whose high prices can shut down many of the weaker players. The threat of low cost producers abroad has altered the profitability profiles of some, but not all players. Formidable barriers to entry and oligopolistic conditions (95% of the market is controlled by 10 firms) lead us to conclude that the threat of new entrants is minimal. Lead times and capacity gluts are paramount, however.
The fertilizer industry is reaping the benefits associated with a shortage of grain in China. Demand for potash was over 50M tonnes in 2005. The bull case for potash producers like Potash Corp of Saskatchewan (POT) revolves around Asia, since its predominantly agrarian economy calls for consistent and affordable crop yields. Needless to say, crops need fertilizer to live.
Growth Drivers and Investment Properties
The boom in fertilizer stock prices is a result of an attractive supply/demand narrative that originates in the cornfields of the US as much as it does in the economics of farming in developing nations such as China and India.
The cultivation of corn is the largest use of fertilizer in the US. In order to meet the demand for alternative energy sources like ethanol, corn acreage projections have dramatically risen over the last year. Corn is nitrogen-intensive, which dovetails right into Potash’s business line. We see corn prices floating in the $3.40-$3.60 range throughout the next 12 months, in line with Street consensus. A large increase in corn production is anticipated for the next 12-18 months, with major crop acreage jumping by 5M acres (source: CIBC World Markets). Soybean yield, which is negatively correlated to corn production, is expected to fall in FY07.
Feed grain volume is also being fueled by mushrooming meat consumption in the Asia Pacific region. In China alone, meat consumption is up 200% over the last 20 years (source: Barrons).
Without surprise, China has become both the #1 producer and consumer of nitrogen fertilizer. (Nitrogen is the largest volume nutrient.) Certain regions in Latin America, like Brazil, also represent outstanding growth opportunities for the world’s leading fertilizer players. These markets represent the key to the industry’s growth since they possess little to no indigenous potash production infrastructure (source: Standard & Poors).
As a defensive play, fertilizer stocks catch our eye: while not as negatively correlated with the broad market, as say, timber, our interest remains nevertheless piqued by the fertilizer group’s attractive investment properties, which comprise high barriers to entry, favorable demand characteristics, and in the case of Potash, above-average returns on capital.
The Bull Case for Potash Corp.
Potash Corp is the world’s largest potash producer, the world’s 3rd largest phosphate producer, and the world’s second largest nitrogen producer. The Canadian firm commandeers a vast transportation network that includes train, barge, ocean vessels, and warehouses, all of them positioned in major consumption zones. Insiders own 3% of the 105M shares outstanding and earnings are expected to climb 36% in 2007. Shares are up 82% YTD, ~30 percentage points higher than the Fert-Index’s return for 2006. Additionally, POT threw off $900M in free cash flow in 2006, which it deployed to repurchase stock in the open market.
Potash controls 75% of the world’s excess potash production capacity, arguably the most bullish facet of Potash’s attractive investment profile. This is significant as it enables POT to ramp up production quickly in times of high demand. Because it would take a potential entrant 5 years and approximately $1.5B dollars to bring capacity online (source: Morningstar), we deem this a core competency of Potash and believe this is why POT trades at a slight premium to its peer group.
Global potash volumes are projected to increase 10-12%, by most estimates, due to heightened demand in China and India. Exports to India were down in 2006, but are expected to climb back in 2007. Previous inventory issues sabotaged volumes there, but with India’s government currently seeking to enhance wheat yield, we believe the risk/reward scenario has been skewed in favor of mature industry leaders like Potash. Additionally, the loss of Uralkali’s Berezniki mine, which garnered 3% of worldwide potash demand (~1.2M tonnes), should benefit Potash Corp. Should nitrogen supply fail to come on line at projected volumes, POT could see even greater upside.
While Potash Corp’s nitrogen and phosphate segments are not exhibiting as much growth as the potash category, we are consoled by the fact that Potash’s management has taken notice and is gradually refining the contours of its product mix. On June 15, 2007, POT will mature a $400M 7.125% note, resulting in a lower interest payment thereafter.
Risks include higher natural gas prices as well as higher grain yields, both of which can adversely redefine the revenue profiles of firms in the fertilizer space. Environmental remediation costs also serve as overhang on the stock. As commodities, fertilizers see their prices gyrate heavily, and we urge investors to closely monitor natural gas price forecasts, as well as those of ammonia, before positioning themselves. Lastly, regulatory risk should also be followed closely: government intervention in China and India could impinge on our top and bottom line forecasts.
Valuation and Conclusion
85% of US potash consumption is used for fertilizer. Improving corn fundamentals and higher consumption volumes lead us to believe that Potash is a stock to hold in 2007. Potash could earn as much as $8 per share in 2007, which reflects our most optimistic scenario. On a relative valuation basis (applying a 17 P/E), we arrive at a fair value estimate and price target of approximately $136. With shares slightly priced above our target value, we recommend investors wait patiently for pullbacks.
Disclosure: At the time of publication, neither the author nor his family owned shares in any of the securities mentioned.