CF Industries Holdings (CF) is one of the world’s largest nitrogen fertilizer producers after its acquisition of Terra Industries in 2010 and is the #3 producer of phosphates in North America. The company operates several nitrogen facilities in North America and holds joint-venture interests in further production capacity in the United Kingdom. CF is a vertically integrated producer of phosphate fertilizers with a phosphate rock mine in Florida. The Company is focused on integrating nitrogen assets acquired from Terra and also diversifying its raw material base.
We have been bullish on agriculture fundamentals due to:
- Key grain inventories remain very lean compared with historical averages (US corn stocks-to-use at 5.3% vs. a ten-year average of ~13%
- Emerging market demand for food and grains has held up well amid macroeconomic uncertainty as China continues to import large quantities of soybeans and is beginning to import substantial amounts of corn, and
- Farmers in the US are poised to have their most profitable year on record with net farm income increasing 31% to $104B in 2011.
Following the Terra acquisition in 2010, CF is now the largest North America nitrogen producer. Approximately 85% of the cash cost of producing ammonia is based on natural gas prices. CF has benefited markedly from low natural gas costs in the US and the company’s natural gas costs have dropped from more than $8 in 2008 to $4.35/mmbtu in the most recent quarter. While the company does hedge some of its gas costs based on forward sales, higher natural gas costs would still negatively impact earnings.
With North American gas oversupplying the market, producers have meaningfully moved down the global cost curve. Therefore, if gas prices remain below $5/mmbtu through 2014, CF can run full out as the low cost producer and become a price taker because prices are set by marginal cost producers in Europe and Asia.
This kind of competitive advantage is based upon the US gas market. We don't expect gas to be any cheaper than what it is today. The process for global price conversion is already happening as US gas infrastructure continues to build up.
Because of this, we see limited short-term upside following a recent steep appreciation in the shares. Moreover, in the last quarter, CF shares have outperformed fertilizer peers by +20%, reflecting much of the positive news in Ag fundamentals, in our view.
Secondly, China is a major high-cost swing urea exporter and accounts for 37% of global urea capacity. This year China enacted a sliding-scale tariff policy on urea in July and DAP in June to: 1) help keep more fertilizer production inside the country; 2) depress domestic prices in order to incentivize farmers to apply more and boost yields, and 3) to accelerate the exit of smaller, higher cost and less efficient plants.
Lower corn production in the US, increased demand from ethanol, and growing corn imports from China are all supporting grain prices. Indeed, outside of the increase in corn demand from ethanol, the evolution of grain demand in China has been one the biggest changes to the marketplace over the past decade. Since the mid-2000s China has transitioned from a corn exporter to a corn net importer as increased demand has outpaced production gains. According to the USDA, China will import 2mmt of corn (~2% of global imports) during the 2011/12 crop year. However, with corn demand growing 4% over the past decade, China will need to ramp up domestic production or look to import more from the US, both positive developments for US fertilizer demand.
In nitrogen and phosphate, CF competes with many companies that are state-owned or government-subsidized. Government controlled companies are more likely to produce quantities in excess of demand, disrupting supply/demand balances. One of the major uncertainties in global phosphate supply/demand is the impact recently started production at the Ma’aden project in Saudi Arabia will have on Phosphate (DAP) supply. Following several delays, which cumulatively pushed back initial production by nearly 3 years, the facility started production in mid-2011 and is expected to ramp up production over the next 18 months.
Exports for the remainder of this year may be limited but we expect Ma’aden will be a major low cost producer globally, due to low cost natural gas (all Saudi Arabian industrial producers currently pay $0.75/mmbtu for natural gas, although this price may increase in the future) and sulfur costs (direct access to inexpensive sulfur from Saudi Aramco), its own phosphate rock source and proximity to India. Once fully operational, the facility will have approximately 20% of global DAP trade.
Our price target of $228 is based on 10x our 2012 EPS estimate of $22.80, which reflects “peak like” nitrogen demand growth in 2012. Investors should note that nitrogen has typically led the fertilizer cycle – both on the way up and down. We have already seen urea prices and CF shares lead this cycle, and at this point we prefer potash names. We make following key investment points on CF:
- Abundand cheap and stable North American gas supplies.
- China accounts for ~40% of global urea capacity. This year China enacted a sliding-scale tariff policy on urea in July and Phosphates in June to: 1) help keep more fertilizer production inside the country; 2) depress domestic prices in order to incentivize farmers to apply more and boost yields, and 3) to accelerate the exit of smaller, higher cost and less efficient plants.
- Given record planted acres of corn for 2012, we expect farmers to experience pricing pressure.
Steve Wilson, Chairman and CEO of CF Industries (Q3 2011 - Earnings Call Transcript):
Good execution also was visible in our production levels. Our team was able to run the nitrogen system at 100% of our stated capacity for the third consecutive quarter and our phosphate operations at 99%. The result of good execution under very favorable market conditions was record Q3 EBITDA, as I mentioned earlier...
We expect strong agricultural markets to continue to drive a tight supply/demand balance for all products over the next 2 quarters, supporting attractive prices and margins. Our solid forward book of business reflects this strength.
We do believe margins will remain high for the remainder of the year. Nitrogen gross margins for CF in 2Q were 52%, compared with an average of ~33% for the same quarter from 2006-2010. Global supply is strained and this is good for business and hence CF's stock price. Deleveraging after the Terra deal has left a strong balance sheet and net debt to capital of 4%. We expect incremental cash flows to fund expansions and stock buybacks. Given the cyclicality of the nitrogen business and our view that demand growth could peak in 2012 or 2013.
CF generates strong cash flow. For full year 2011 we model free cash flow of nearly $2.1B. To utilize some of this cash, the company increased its quarterly dividend 4x to $0.40 and authorized a $1.5B stock repurchase program, effective until December 31, 2013. As of now, we estimate it has bought back $1.1B of that already.
All of this leads us to believe that CF will indeed outperform the market in the medium/long-term.