Riskier PotashCorp Is A Buy Now

| About: Potash Corporation (POT)

Summary

Current debt level is manageable.

In a worst-case scenario, potash break even price is estimated at $260 per ton.

The company has great stewardship and will be able to withstand the potash market's downturn.

Note: All figures are in USD unless otherwise stated. PotashCorp trades primarily on the NYSE as POT.

Potash inventory, source: WSJ.

I recently read an article claiming that it was time to go short on PotashCorp (NYSE:POT). This is no simple task. Indeed, this is the biggest potash maker of the world with just under 20% of world production, with one of the best cost profile of the industry and with an history of great company stewardship.

Still, there is a point to be made. The stock lost a lot of value from last summer to today.

Click to enlarge

Source: StockCharts.com

What has gone wrong with this stock? Trouble in the potash market is one. Since the breakout of the Belarus Potash Company in 2013, the potash market is tough. It should be, going from a duopoly to true competition isn't very good for a price conscious company like PotashCorp.

Furthermore, more recently, the US dollar has increased in value tremendously making potash very expensive for emerging markets, notably in southeast Asia and especially in Brazil, a major importer of potash.

The fat dividend is another problem. The company's stock price decreased because of fears that the dividend would be cut. In my opinion, the potash market or the strength of the USD isn't the major reason for the share price decline. The company's huge dividend is the problem. Not only does fear of seeing it being cut is dragging the stock, but it is also a great source of financial stress for the company.

Some thought that the dividend was enough to keep the share price high, or that the dividend yield will keep investors from selling their shares. Therefore, despite the promise by management that PotashCorp's dividend is sacrosanct, the market think it's not. This is also known as the Kinder Morgan Syndrome.

Before digging in the numbers, let's first take a quick look at the debt of PotashCorp.

Debt level and balance sheet

However, the company won't go in the sink. Indeed, consensus FY 2016 EPS is currently of $1.59 per share. Long-term and short-term debt was $4.2B versus EBITDA of $3.1B for 2014, which is manageable. Total debt-to-equity stood at 0.48 in the latest quarter, which is also manageable. Let's take a look at historical figures.

Source: PotashCorp and my own work.

Debt-to-EBITDA increased gradually for the last years generally because of lower earnings. Indeed, total debt has decreased from $5.6B in 2010 to $3.9B in 2013 and $4.2B in 2014. Total debt stood at $4.1B in Q3 2015.

In conclusion, the balance sheet is somewhat average right now and debt level is manageable.

Potash vs. phosphate vs. nitrogen

Let's take a look at the operations of PotashCorp.

Source: PotashCorp and my own work.

Source: PotashCorp and my own work.

At first, we can say that the company's nitrogen business is becoming more and more important for its bottom line, especially from 2011 to 2014. It is not entirely true. This is due to a combination of different pricing performance and changing production volume for these commodities.

Furthermore, the gross margin of potash operations are way higher than the phosphate and nitrogen business and therefore contribute more to the bottom line. As such, one should always focus at the potash business of the company.

Cash flow analysis

Now, the key here is cash flow: earnings does not matter here. What matters is will the company be able to fund its huge dividend without adding debt? In another words, depreciation and amortization isn't cash.

According to the presentation made by PotashCorp, the company will need a potash price of $200 or more to fund its dividend and its maintenance capex. Let's verify this crucial claim with two scenarios for next year. I'll use the lower bound of the 2015 guidance to make it more conservative.

Source: PotashCorp.

Source: PotashCorp and my own work.

First, take a look at the assumptions that I made in the first scenario:

  • The phosphate and nitrogen business gets slashed by $200M again this year to $800M ($1.2B in 2014 to an estimated $1B in 2015)
  • G&A expenses are constant
  • Financing costs are constant
  • Dividend and earnings income gets slashed by $55M again this year to $110M ($220M in 2014 to an estimated $165M in 2015)

Next, how can we choose the gross margin of potash operations? Let's check the historical gross margin of potash operations.

Click to enlarge

This is the last variable we need. Choosing the gross margin for our estimate is crucial. I will be using a gross margin of 50% for potash operations for the entire year.

Potash price estimation

Source: PotashCorp and my own work.

If we assume potash sales volume of 10MT, the company will barely breakeven in terms of cash. Indeed, if the company's phosphate and nitrogen business weaken, a potash price of $260 per ton is required to break even. This is dangerously close to today's potash price. However, if all operations of the company remain constant, we find almost the same breakeven potash price given in PotashCorp's presentation of $200 per ton. I will use a break even price of $210 per ton as a minimum from now on.

Therefore, either the price of potash strengthen to its current level and provide a cushion should the phosphate and nitrogen business weaken again. On the other hand, the company will need a potash price of at least $210 per ton should its phosphate and nitrogen business performance as well as in 2015.

Conclusion

I can't say that the dividend is safe, obviously I am not the CEO. They could cut the dividend for numerous reasons, even if we find it sustainable:

  • Cut the dividend to fund an acquisition.
  • Cut the dividend to prevent the adding of debt to the balance sheet and therefore preserving the good quality of the bonds.

However, the claim made by the company that its dividend is sustainable for a potash price of $200 per ton is partially true, considering that the other business segments are as strong as said in the current 2015 guidance. I found that a price of $210 per ton is able to fund the dividend. It is nicer to say $200 per ton. Looks better also right? Should the market for nitrogen and phosphate weaken, break even potash price would jump to $260 per ton.

What to look for when investing in this company? What are the risks? What can benefit the company? What will send the share price up?

  • Obviously, one should look at potash price. The Chinese negotiated potash price is worth looking for. The potash price negotiated for delivery in China is typically negotiated before the Chinese new year. This changed recently as Chinese importers were comforted by their inventory and made exporters more nervous.
  • Crop prices will also affect the fertilizer demand. The more money the farmers get for their crop, the more they can spend on fertilizer.
  • Gross margin of potash operations, as this will help the company's bottom line directly.
  • Volume of potash sales.
  • The strengthening of the US dollar versus the loonie is beneficial for the company.
  • The strengthening of the US dollar versus the currencies of major importers of potash (China, Brazil and India for example) isn't beneficial for the company.
  • The review of Saskatchewan's royalty structure for potash production is a concern for the company. However, there hasn't been much news on the subject since spring 2015.
  • The debt level of the company is manageable as of now. Should the price of potash deteriorate further, the company could still take more debt to fund the dividend. This would be a negative move by the company however.
  • The breakup of the potash duopoly might make historical comparison skewed as margins and profits could be affected.
  • The company has great stewardship and has an average return-on-equity of 28.6% for the last 10 years.
  • The company can try to control potash price at the expense of its market share in the industry.

As you can see, there are significant risks when investing in this company while other situations are beneficial.

On another note, I was surprised to see the stock of PotashCorp hold steady on heavy volume when every headline was made around the drama in China last week. Concerns about the Chinese economy should affect the potash industry, but still, the share price didn't move.

At last, here is my strategy. I don't see the dividend being cut as I estimated a breakeven price of $260 per ton of potash as a worst-case scenario. This is why I opened a small position on January 7.

However, I don't see why the potash market would move significantly in the short-term. The next big thing will be the negotiated potash price for Chinese importers. As soon as this price is known, depending on the reaction I will either wait on bad news or buy more on good news. This is expected in the beginning of February. More cautious investors could also wait until the Q4 2015 earnings results late January.

I believe management did push the dividend a little too far in retrospect. If the duopoly would be still intact, it wouldn't be a problem. Given the new situation in the potash market, the dividend is a drag on the stock and is making a once rock-solid investment substantially more risky now. The dividend cut fear will be present in the short to medium-term. This is also why I took a smaller position in PotashCorp compared to my other big cap positions.

Happy New Year to all!

Disclosure: I am/we are long POT.

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.