Mike Ashton, of Walnut Creek, Calif.-based Insight Capital Research and Management, is portfolio manager for the firm's Large-Cap Growth Portfolio, and co-manager for the Small-Cap Growth, Concentrated Growth and Small/Mid-Cap Growth Portfolios. He previously worked in the Venture Capital Services Group at Deutsche Bank Alex. Brown.
If you could only hold one stock position in your portfolio (long or short), what would it be?
A long position in CF Industries (CF). The company is a producer of nitrogen and phosphate fertilizer, and is leveraged to the increase in fertilizer prices that has occurred as a result of higher agricultural commodity prices. Sales volumes should benefit from an increase in planted corn acreage in 2011 given a currently depressed stocks-to-use ratio in the U.S. Additionally, increased production of natural gas from shale gas plays is providing a favorable cost environment for the company's primary feedstock, which should continue to benefit the company's margin profile.
Tell us more in detail about the company behind the stock.
CF Industries is the second-largest publicly traded nitrogen fertilizer company globally and the third-largest publicly traded phosphate fertilizer company globally. The company's customers are primarily farm cooperatives and fertilizer distributors in the U.S. Its product mix is heavily weighted toward nitrogen fertilizer products, which accounted for 80% of total sales and 83% of gross profit in the third quarter of 2010.
By segment, the company's nitrogen products include ammonia, urea, urea ammonium nitrate (UAN) solution and ammonium nitrate (AN). Phosphate products include diammonium phosphate (DAP) and monoammonium phosphate (MAP).
CF acquired competitor Terra Industries in April 2010 after outbidding Yara International (OTCPK:YARIY), which had initially announced its intention to acquire Terra in February 2010. The cash-and-stock deal totaled $4.6 billion and doubled CF's nitrogen fertilizer capacity, and management expects to realize cost synergies of approximately $135 million from the deal.
What makes its overall situation so good?
The company currently operates in a favorable environment for its products due to a number of factors. First, the prices of agricultural commodities have increased significantly over the prior 12 months. As grain prices have increased, fertilizer prices have followed, as farmers’ revenue has improved and allowed room for input cost increases. In the fertilizer space, CF’s management pointed out that fertilizer as a percent of farm revenue stood at around 15% as of November 2010. Between 2005 and 2009, that number fluctuated around 20% to 25%, so there remains room for additional price improvement for fertilizer as grain prices continue to drift higher.
Another favorable condition for the company has been the increase in natural gas production from shale plays, which has worked to keep gas prices low in the U.S. Since natural gas accounts for over 50% of the company’s manufacturing costs for nitrogen fertilizer, this has been a tailwind for the company.
How does your choice reflect your fund's investment approach?
Insight's three-step investment process begins with a quantitative screen that ranks all publicly traded stocks based on risk-adjusted returns over the preceding seven months. After using the screen to identify a potential portfolio addition, we perform fundamental analysis to identify the drivers responsible for the historical outperformance and to determine if that outperformance is likely to continue in coming quarters. The third step examines recent trading behavior to ensure that we enter the stock at an appropriate buy point. It also contributes to our risk management process at the individual stock level once we have taken a position.
Specific to CF, the stock has outperformed the market in recent months and is highly ranked within our quantitative screen due to the strong and sustained increase in selling prices for the company’s fertilizer products. As agricultural commodity prices have rebounded and moved toward prices last seen in 2007 and 2008, fertilizer prices have also increased significantly, which has had a positive impact on both revenue and earnings. We expect the favorable trends impacting the stock to remain in place, and likely strengthen, and therefore believe the likelihood of additional upside in the stock price is high.
How much is your selection based on CF's industry, as opposed to a pure bottom-up pick?
The fertilizer industry revolves around three primary nutrients: nitrogen, phosphate and potash. CF produces both nitrogen and phosphate fertilizers, but does not participate in the potash fertilizer market. Other publicly traded nitrogen and phosphate fertilizer producers include Yara International, Potash Corp. of Saskatchewan (POT), Mosaic (MOS), Agrium (AGU), Israel Corp., K+S (OTCQX:KPLUY), and Sinofert (OTC:SNFRF).
Nitrogen fertilizers depend on natural gas as a feedstock to produce ammonia, which then is utilized either as a fertilizer itself or further upgraded to urea, urea ammonium nitrate (UAN) solution, or ammonium nitrate (AN). Because of the use of natural gas in nitrogen fertilizer production, producer economics can vary considerably based on prevailing natural gas prices in various geographies. And because natural gas is a relatively abundant feedstock globally, U.S. nitrogen fertilizer producers can sometimes face significant margin pressures due to international competition.
However, Eastern European fertilizer producers’ natural gas costs are indexed to the price of crude oil, and so CF currently finds itself in a favorable competitive situation relative to its Eastern European competition. Yara, CF, Potash and Agrium are significant producers of nitrogen fertilizer.
Phosphate resources for the production of fertilizer are relatively limited on a global basis, with production limited to a handful of regions globally. In addition to phosphate rock, producers must have access to both sulfur and ammonia to produce phosphate fertilizers. Those producers with the highest levels of integration across these inputs are able to generate the highest margins when input prices increase. While declining reserves and permitting for mining of new reserves are issues for some North American producers, such as Mosaic, there is new capacity scheduled to come on line in the next several years. This new capacity is located primarily in the Middle East and North Africa, and could have an adverse impact on phosphate prices if global demand does not increase at least as quickly as new supply. Mosaic, CF, Potash and Agrium are significant producers of phosphate fertilizer.
Our stock selection process is bottom-up. However, in the case of a company operating in a commodity business, we believe it is important to understand the industry dynamics as well as the macroeconomic drivers of supply and demand. In the case of CF, for example, we began by analyzing the company's operations and company-specific earnings drivers, and then moved to the industry level to understand the intensity of competition, barriers to new entry and the likely future supply environment. From a demand perspective, we looked at trends in grain prices, demographic trends and data from the USDA's World Agricultural Supply and Demand Estimates (WASDE) reports to inform our opinion of how grain and fertilizer prices are likely to develop in the future.
So how is CF positioned with regard to competitors?
Because CF manufactures a commodity product, price is the primary driver of demand. Given its size as the second largest producer of nitrogen fertilizer globally as well as a favorable domestic natural gas price environment, the company is well positioned to compete on price. Given the degree of new natural gas exploration and the increasing utilization of horizontal drilling, we expect natural gas prices to remain at levels favorable to CF's margins for at least the next two to three years.
Finally, within the U.S., distribution infrastructure can often constitute a competitive advantage. In CF's case, the company owns what management believes is the largest ammonia distribution network in North America. This network enables the company to direct a significant amount of its ammonia production to the agricultural market, which allows it to capture better margins than if the ammonia were to be sold to industrial customers.
How does the stock's valuation compare to its competitors?
On a 2011 EV/EBITDA basis, the North American fertilizer group (Potash, Mosaic, Agrium, Intrepid (IPI), CF) trades at an average multiple of 10.3. The range of valuations is 6.4x at the low end for CF to 14.0x at the high end for Potash.
On a 2011 P/E basis, the group trades at an average multiple of 17.7. The range of valuations is 11.7x at the low end, for CF, to 25.6x at the high end for Intrepid.
In general, multiples within the group vary based on resource scarcity and industry structure. For example, potash assets are the most scarce and have a highly concentrated industry structure, and thus command the highest valuation multiples. Phosphate assets generally receive a lower multiple than potash. And nitrogen assets receive the lowest multiple given the reliance on natural gas as a feedstock and the resulting perception that barriers to entry are lower than both potash and phosphate. In general, historical valuations are approximately 10 times EBITDA for potash assets, eight times EBITDA for phosphate assets and six times EBITDA for nitrogen assets.
Further, the cyclical nature of fertilizer demand suggests that stocks should trade at depressed multiples during periods of peak earnings and at above-average multiples during periods of depressed earnings. This is a good dynamic to keep in mind when considering valuation for the group, as the potential for multiple compression is certainly a risk.
However, it is also notable that during the last surge in grain and fertilizer prices in 2007-2008, the group’s valuation multiples generally trended higher. While the potash producers seemed to be the greatest beneficiaries of this effect, CF traded at an average P/E of 17.7 times forward earnings and Terra traded at an average P/E of 15.6 during calendar 2007. This is in contrast to CF’s 2011 P/E of 11.7 based on the current price of $145.79. While inconsistent with traditional cyclical valuation trends, the peak valuations in 2007-2008 likely resulted from a combination of factors, including higher valuations for potash assets given resource scarcity and expectations that a structural increase in demand was under way for agricultural commodities, driven by the growth of emerging economies. Another factor likely impacting valuations was ethanol policy implementation within the U.S., which continues to be a source of demand into 2011.
So how do CF's multiples look under different outcomes?
Given CF’s 83%/17% mix of nitrogen/phosphate gross profit, the stock’s current 6.4x multiple is in line with the traditional industry valuation approach of 6x EBITDA for nitrogen assets and 8x EBITDA for phosphate assets. Assuming the stock’s multiple does not adjust higher to account for the possibility of a structurally higher demand environment, upside for the stock price will be realized by increases to earnings estimates and limited or no compression in the stock’s valuation multiple.
In the event that the valuation multiple does compress, CF’s reasonable absolute valuation and its valuation discount relative to peers should limit downside. With respect to relative valuation, peers currently trade above their historical EV/EBITDA multiples as suggested by the 10x/8x/6x guideline when factoring in business mix among potash, phosphate and nitrogen. For example, Potash trades at 14.0x EV/EBITDA versus a mix-implied 8.9x; Mosaic trades at 10.2x versus a mix-implied 8.7x and Intrepid trades at 12.8x versus a mix-implied 10.0x.
In the event that grain and fertilizer demand conditions remain firm, earnings estimates increase and valuation multiples expand modestly, the stock could see a fair amount of upside. For example, a 7.0x EV/EBITDA multiple on $2.2 billion of 2011 EBITDA would generate a price target near $190.
CF's on-again, off-again bid for Terra was quite a thing to watch - and CF was both hunter and hunted, considering Agrium's bid for CF. With all of that pressure, is there likely to be more consolidation in the sector? Or are values getting too high?
We believe consolidation within the industry is likely to continue. While there are only a handful of publicly traded companies available to acquire, and a limited number of acquirers large enough to undertake such acquisitions, fertilizer assets remain attractive given resource scarcity and increasingly stringent regulatory hurdles surrounding new plant construction and mine development. While fertilizer valuations are higher than in recent years, we believe ongoing consolidation within the coal industry is a good indicator that acquirers of natural resources production remain willing to commit capital to M&A, even at today’s higher prices.
Does your view on CF stock differ from consensus?
Current sentiment on the stock is relatively positive, but given the number of variables that impact the company's revenue and earnings, as well as the unpredictability of some of those variables, there is a wide range of earnings estimates. The Thomson Reuters consensus EPS for 2011 stands at $12.47, but individual estimates within the consensus vary by over 50% from $10.04 at the low end to $15.56 at the high end.
Our view is that earnings for 2011 will turn out to be at or above the high end of the range. Corn prices continue to trend higher, fertilizer prices have remained firm, natural gas prices remain attractive, the fall fertilizer application season was favorable for farmers and CF's management expects planted acres to increase by approximately four million acres in 2011. We believe these conditions create the likelihood of better than expected earnings results throughout 2011.
Does CF management play a role in your selection?
Management plays a role in our stock selection to the extent that we will have more conviction in a stock if management has a consistent track record of execution on its own strategies as well as relative to the market's expectations. For Insight's process, this typically means that management has a history of under-promising and over-delivering on revenues and earnings. It is also important that management demonstrates judicious use of capital for purposes such as M&A and capital spending.
CF management's decision to engage in a bidding war against Yara for control of Terra has proven to be an excellent use of the firm's capital. The acquisition was extremely well timed relative to the recovery of the fertilizer markets, and management has executed well on the expected cost synergies to date. Overall, we believe that management has performed very well and should continue to do so.
What catalysts, near-term or long-term, could move the stock significantly?
Higher grain prices, especially corn, are a significant source of potential upside in the near term due to their positive impact on farmers' profit margins. As grain prices increase and farmers' profit per acre improves, fertilizer producers have more ability to increase product prices to share in the improved economics. As Potash's CEO pointed out on that company's fourth-quarter earnings reports, corn farmers can currently earn $430 more per acre than this time last year, while fertilizer prices have increased only $30 per acre. In addition, higher selling prices for fertilizer should boost not only revenue, but also margins, as the company is able to leverage its operating costs.
Another near-term catalyst is the likelihood of increased planting of corn acres, as the USDA has estimated 2010-2011 corn stocks-to-use of 5.5%, the lowest since 1995-1996. CF management estimates that 92 million acres of corn will be planted this year, up more than 4% from the 88 million acres planted last year. Longer-term, the increase in global population and the rise in living standards within emerging economies is likely to drive demand for increased exports of U.S. agricultural commodities.
What could go wrong with your pick?
Grain prices could decline, with corn being the most important grain to watch. Declining grain prices would have an adverse impact on farmers' economics and would likely decrease the prices that farmers would be willing to pay for fertilizer. As fertilizer prices declined, CF's revenues and margins would likely decline in turn.
Additionally, because natural gas represents over 50% of cost of goods sold within the nitrogen segment, the company's margins would decline if natural gas prices increase significantly. Other risks for the stock include the potential for new capacity to enter the market more quickly than demand increases, adverse weather conditions during planting periods and unfavorable changes to government policies, especially with respect to ethanol subsidies in the U.S.
Do you think a (seasonally adjusted) rise in natural gas prices is likely anytime soon?
There are a few potential events that could push natural gas prices higher in the near term. First, additional winter storms and extremely cold weather in the Northeast and Midwest could cause a drawdown in natural gas inventories and push up prices over the next two months. Second, industrial demand for natural gas could be stronger than expected and create competition for supply. Recent trends in the ISM manufacturing index suggest this is a possibility.
And lastly, higher crude oil prices could incentivize additional extraction of crude oil at the expense of natural gas, thereby reducing natural gas supply to the market. However, we believe a sharp increase in prices due to any of these variables is a relatively low-probability event, and with natural gas futures trading well below $5.00 throughout 2011, we believe the near-term risk of natural gas prices adversely impacting CF’s results is low.
Thanks, Mike, for sharing your thesis here.
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