CF Industries (NYSE: NYSE:CF) is one of the largest manufacturers of nitrogen-based fertilizers and nitrogen products in the US. The company has struggled with weak fertilizer pricing as a result of lower natural gas prices, and disappointing 3Q 2015 earnings led to a sell-off. The market is understandably concerned with CF's ability to maintain pricing power in a commoditized industry, demand from India, China, and Russia, and the recent increase in Chinese anthracite-based fertilizers in the US market as a result of lower shipping costs.
While investors were preoccupied with these macro-market concerns, CF executed two transactions that promise to grow the business and deliver value back to shareholders that were largely ignored by the market. In early August, CF and OCI (EA: OCI), a Dutch fertilizer manufacturer, agreed to a merger that would grow system-wide capacity to over 12.5mm tons at closing (2Q 2016), growing per share capacity by 18% for CF investors (Source: CF 8-K 8/6/15). The merger would also move the company's headquarters to the UK, and reduce corporate expense for the combined company.
Despite political positioning against such tax-inversions, the deal received U.S. clearance on Nov 2 - the deal still requires approval from both shareholders. A few days later, CF Industries entered into an agreement with CHS, a farming and agricultural cooperative (CHSCP), to supply 1.7mm tons, or 8.9% of system capacity (pre-OCI merger) and sell a minority stake in its nitrogen business for a combined $2.8bn (Source: CF 8-K 8/11/15). The transaction allows CHS to reap producer economics through dividends, while freeing up cash for CF shareholders. Despite the announcement of these two transactions, the stock has traded down 19.5% YTD on weak nitrogen pricing.
Although we are mindful of the market's nitrogen pricing concerns, we are confident in CF's core franchise and recent strategic transactions. Moreover, because information related to the CF-OCI merger was not released through the CF Investor Relations or OCI Investor Relations pages, but rather filed with the SEC under Darwin Holdings, the UK shell for New-CF, we believe the market may have missed the information release and may have a delayed reaction to the transaction specifics. We believe the combined company is worth $71, a 62.7% upside for current shareholders.
Nitrogen-Based Fertilizers Market
CF is one of the largest manufacturers of nitrogen-based fertilizers. Nitrogen is a key component of chlorophyll - the chemical responsible for photosynthesis - and the nucleobases in DNA. However, Nitrogen - in most forms - is not readily accessible to plants; they benefit from nitrogen fixing bacteria and legumes that turn gaseous N2 in the atmosphere into usable NH3 (ammonia). Nitrogen-based fertilizers accomplish the same process synthetically.
The Haber-Bosch process uses natural gas (CH4) to supply the hydrogen and nitrogen (N2) readily available in the air, and passes both of them through powdered metal catalysts at high temperature and high pressure to break the strong bonds of the N2, this process creates ammonia, which is the building block of all nitrogen-based fertilizer products.
Another method involves burning anthracite coal to release H+ ions, and then using a similar process to combine N2 and H+ into ammonia. This process is incredibly wasteful and uncommon in the United States. Rather, anthracite-based production is the primary mode of production in China, and the cost of anthracite coal establishes a global floor on the price of fertilizer products.
Source: CF Industries 3Q 2015 Earnings Presentation
Nonetheless, US producers have benefited from low natural gas prices, which have placed them at the bottom of the cost curve. The $250-$285 cost floor per short ton was far lower than historical averages, largely due to the Chinese Yuan devaluation, less expensive coal and freight costs.
Although foreign importers can set the price floor at the market, US producers will always have a structural advantage over foreign importers because of inland transportation costs from Gulf stations to farms/terminals. The CF network has the largest distribution network in the US with over 6,000 rail cars, 32 river barges, and two company-owned pipelines that move 1.0mm tons.
This structural advantage is incredibly important when considering the competitive dynamics of the US fertilizer market: because CF and other US producers can always beat importers on inland pricing given lower inland transportation costs, they are unlikely to face excess supply concerns as the market can always absorb their production in lieu of purchasing more expensive imported products.
Of particular note in the international market is China's 2017 cap-and-trade program. Targeted towards industrial production, including chemicals, the program could have the effect of reducing the usage of coal in fertilizer production and either increase marginal cost because of the additional cost of emission cap credits, or force the market to transition to more expensive natural gas production: either way, the cap-and-trade program may drive long-term price increases if it is effectively administered.
Management is anticipating a stronger planting season, and has already booked orders for ammonia and UAN that support the expectation of stronger 2016 demand.
OCI N.V. Merger
OCI is a Dutch manufacturer of nitrogen-based fertilizers with 8.4mm metric tons of capacity. The proposed merger would give CF shareholders an interest in OCI's Geleen, Netherlands and Weaver, Iowa nitrogen production facilities, Beaumont, TX ammonia and methanol production complex, and global distribution facilities and business in Dubai, UAE - collectively known as the "ENA" businesses, as well as the option to purchase 45% of Natgasoline - a greenfield methanol project in Beaumont, TX under development. The deal would exclude some of OCI's other businesses. The merger would give the combined company over 25.1mm tons of capacity in 2017, and supply 31% of US fertilizer demand (Source: CF Industries/Morgan Stanley Chemicals and Agriculture Conference 11/9/15).
The deal is accretive to CF because of operational synergies and growth opportunities. The merger will leverage the scale of both companies' existing production businesses, and allow CF a greater foothold into the international market. OCI's Dubai distribution center and European operations complement CF's recent acquisition of GrowHow, a UK-based fertilizer manufacturer - creating organic growth runways into the European market. The expanded international presence and production expansion - from both the OCI merger and plant expansions at CF's Donaldsonville and Port Neal facilities - will further CF's growth. Management has announced $500mm in after-tax annual run-rate synergies (Source: CF 8-K 8/6/15).
According to CF's transaction announcement, OCI will contribute its European, North American, and Dubai-based distribution businesses to the New-CF in exchange for 25.6% of New-CF and $700mm in a mixture of cash and New-CF shares. New-CF will also have the right to purchase 45% of Natgasoline (OCI's methanol production facility in Beaumont, TX) for $500mm in cash. CF's management anticipates that current CF shareholders will own 243.3mm shares out of 324.2mm shares in New-CF (72.3%), with the final split dependent on the price of CF's share price (Source: CF 8-K 8/6/15) and price of OCI's 3.875% convertible bonds (Source: Darwin S-4 11/6/15). The S-4 filing indicates that current CF shareholders will own 71.9% of New-CF before adjusting for OCI's convertible bonds. Goldman Sachs' analysis indicates that CF is paying 7.6x EV/2016E EBITDA including expected synergies, and 11.6x EV/EBITDA excl. synergies.
The S-4 filing presents an unaudited pro-forma combined income statement for New-CF, including the effects of the GrowHow JV acquisition and CHS deal as if they had taken place on January 1st. The transactions incorporated into the pro-forma combined statements also increase the company's 1H2015 net debt from $3.8bn to $4.8bn ($14.74/unit to $13.87/unit), but also increase cash from $809.9mm to $3,490.5bn ($3.16/unit to $10.02/unit). For Y/E 2014, the combined company would have generated $7.2bn in annual sales, $2.2bn gross profit (31.4% margin New-CF vs. 35.8% CF incl. GrowHow), and $1.9bn operating profit (26.0% margin New-CF vs. 32.6% CF incl. GrowHow, excl. sale of phosphate business).
These pro-forma figures do not include any synergies from the transaction, although management expects $500mm of annual synergies by 2018 from cost savings, capital structure savings, and tax benefits. CF's financial advisors suggested that the equity value of the synergies through 2019 could be worth between $4.2bn and $7.2bn (Source: Pg. 97 Darwin S-4 11/6/15). Given the benefits of the transaction,
Morgan Stanley and Goldman Sachs calculated a range of illustrative values per New CF ordinary share on a pro forma basis after giving effect to the transactions and the synergies of $75 per share to $117 per share [at the end of 2019] … and a range of implied present values of … $67 to $106 for New CF on a pro forma basis (Source: Pg. 97 - 98 Darwin S-4 11/6/15)
The private side of the market understands CF's long-term value, despite short-term pricing pressures, and assigns a 53% to 141% premium. This analysis is tucked away in a 700+ page document, instead of on the front page of an equity research report, which explains why it has not received more coverage or acknowledgment from the market.
Independent Valuation
The private market assigns a far higher value to CF Industries than the public market does. We believe this is because CF's financial advisors have a better understanding of the business, have an intimate understanding of the merger and potential synergies, and more access to management than equity research analysts. Nonetheless, we believe some of the assumptions made in these calculations are optimistic, and we have generated our own projections for the value of the business.
The driver behind CF's earnings is its ammonia production capacity: CF can offer lower all-in cost because of its in-land US network, which reduces transportation costs to end-users. In comparison, buyers of international fertilizer products have to pay for additional shipping from the Gulf terminal. For this reason, we believe the ceiling on CF's earnings is established by production capacity and price.
The combined capacity of CF and OCI in 2015 is 21.2mm short tons, which we project will grow to 29.0mm short tons by 2017, given management's projections (Source: Pg. 289 Darwin S-4 11/6/15). At our projected price of $325/short ton in 2017, a 21% tax rate, and our own projections of 16% synergy realization and 38% Operating Margin, we project $2.2bn in post-tax earnings, or a present value $56 share price assuming no growth and a 10% discount rate. This represents a 28% premium with no growth and prices below their long-term average.
Management has indicated that returning capital to shareholders is a priority for them through 2019. Oversupply in the fertilizer market makes it a poor time to reinvest cash into plants, and management expects to execute additional share buybacks using unallocated cash (CHS Announcement Conference Call Presentation). Management expects to have $10.0bn of unallocated cash, after CapEx (Source: CF Industries/Morgan Stanley Chemicals and Agriculture Conference 11/9/15), but we anticipate that this number is generous given the company's growth aspirations. We adjusted this number downwards to $3.5bn, given management's pro-forma estimate cash on hand as of June 30, 2015 (Source: Pg. 280 Darwin S-4 11/6/15). If management repurchases $3.5bn of stock at $50.00/share, we believe the intrinsic value of each share increases to $71 - this represents a 63% upside.
If we do accept management's estimate of $10.0bn unallocated cash - which is incredibly optimistic, and management repurchases $3.5bn of stock and distributes the remaining $6.5bn as dividends, the stock will be worth $97 - if the company repurchases an aggregate of $10.0bn stock, the stock will be worth $146. However, we believe these assumptions are too aggressive, and are comfortable with our $71 estimate.
Investment Considerations
We believe there are three main investment considerations to examine before purchasing CF Industries: first, if long-term coal prices remain low in China, the Urea cost curve will remain depressed; second, merger synergies may not materialize; and third, as highlighted by Citigroup in a recent report, new IRS rules regarding inversions may limit the company's ability to achieve a lower tax rate.
Long-term coal prices may remain lower than the historical average; as growth tempers to < 7% YoY, Chinese demand for anthracite coal will slow. The slowing demand for coal, and decline in prices, will inadvertently place downwards pressure on the global price floor. This may be moderated by 9.4% YoY coal demand growth in India, and the implementation of a cap-and-trade system in China.
Estimated 16%-18% merger synergies may not materialize, but we feel confident in Morgan Stanley and Goldman Sachs' analyses. Our analysis projects 16% synergies in 2017, but we believe that management, which has a long track record of delivering value to shareholders (CF has returned 1100% to shareholders since inception), will be able to deliver on the projected synergies.
Citigroup highlighted recent changes to the IRS rules regarding tax inversions, which may affect CF's ability to reincorporate in the UK, as neither company is British. The new IRS rules,
1) Places limits on U.S. companies combining with foreign companies using a new foreign parent located in a "third country," 2) Limits the ability of U.S. companies to bypass the 80-percent ownership rule (in the proposed deal, CF would own ~72% of the new company and OCI ~28%); and 3) Requires the new foreign parent to be a tax resident of the country where it is created or organized. Additionally, and retroactive to 2014, the IRS will limit the benefits of transferring assets to foreign parent companies tax-free. (Source: Citigroup 11/20/15)
Although this is a material risk, we believe that CF could reincorporate in the Netherlands, where the corporate tax rate is 25% - higher than the UK's 21%, but lower than the US's 35%. We believe that at a 25% tax rate, the company would be worth a present value of $53 without share buybacks and $68 with share buybacks, still a 21% premium over Friday's close.
Conclusion
Post-merger, CF Industries will be the largest fertilizer manufacturer in the world - and despite pricing pressures that have captured market attention in the short term, the company is on-track to generate $6.78 2017E EPS, nearly twice TTM $3.80 EPS. We believe that the market is concerned with short-term pricing pressures, and ignoring the long-term strategic strengths of CF Industries. More importantly, the private market is valuing CF for 71% to 141% of its current price, and we believe the market is ignoring this information.
Altogether, we believe that CF Industries is worth $56-$72, with downside protection considering the $3.5bn projected post-merger cash position and standalone CF's strong cash generation, which will help management return value to shareholders if the merger falls through. CF is an asymmetric return opportunity given the discount at which investors can enter the standalone business, 11.6x TTM P/E, which is itself one of the world's largest fertilizer producers with numerous competitive advantages in the US market and a strong pipeline of new supply. CF is a strong buy for us, and we expect to realize 70%+ return over the next 24 months.
