Potash Only Has 8% Upside

Mar.27.12 | About: Potash Corporation (POT)

With all of the uncertainty surrounding chemicals, basic material investors are eyeing gold. But I find that they can reap significant gains from backing smaller under-followed agricultural companies. Rentech (NASDAQ:RTK) and China Agri Business (OTCPK:CHBU) are two significantly undervalued companies. As an investor relations consultant, I expect meaningful gains from improving press coverage. Towards that end, I plan on writing a focus piece on the two businesses at a later time.

In the meantime, a disproportionate amount of attention will be placed on larger agricultural chemical producers like Potash (NYSE:POT). In this article, I will run you through my DCF analysis on the firm and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Mosaic (NYSE:MOS) and even gold producer Yamana (NYSE:AUY).

First, let's begin with an assumption about revenues. Potash finished FY2011 with $8.7B in revenue, which represented a 33.3% gain off the preceding year: deceleration. Analysts model a 13.8% per annum growth rate over the next half decade. I think this is reasonable in light of it being 200 bps higher than what is the expected for the S&P 500 despite stronger growth in the recent past.

Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 45% of revenue versus 3.3% for SG&A and 20% for capex. Taxes are estimated at 35% of adjusted EBIT (accounting for non-cash depreciation expenses).

We then need to subtract out net increases in working capital. I expect this to hover around -4% of revenue.

Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9% yields a fair value figure of $50.45, implying 8% upside. This is not strong enough, in my view, to merit calling Potash a "value play" right now.

All of this falls within the context of strong investments and improving momentum:

Our cash flow from operations rose to a record $3.5 billion. We spent $1.6 billion in our potash expansion program and have now completed more than 70% of the capital spending on multi-year projects that are expected to make a lasting contribution to future earnings.

In 2011, we took a number of steps to enhance our transportation and distribution system, which is a critical component of our business that is often overlooked. We purchased 1,000 new high-capacity rail cars and announced plans to build a major potash distribution center in the U.S. Midwest.

From a multiples perspective, Potash is fairly attractive. It trades at a respective 13.3x and 12.1x past and forward earnings versus 11.2x and 11.3x for Mosaic and 22x and 10.5x for Yamana. Assuming a multiple of 14x and a conservative 2013 EPS of $3.84, the rough intrinsic value of Potash's stock is $53.76.

Consensus estimates for Mosaic's EPS forecast is that it will grow by 8.6% to $4.79 in 2012, and then by 8.6% and 12.3% in the following two years. Assuming a multiple of 12x and a conservative 2013 EPS of $5.15, the rough intrinsic value of the stock is $61.80. Potash producers are largely cutting back on supply in order to improve margins. While Mosaic has guided for an overly high domestic application season, its 13% share of phosphate production grants it an opportunity to penetrate the market. Vertical integration further enables the company to be meaningfully efficient as it improves scale.

Gold producer Yamana offers greater safety than both firms due to inflationary government spending. I like how management has switched to cheap production at the Chapada and El Penon operations. El Penon's 10% gold grade improvement further makes now the right time for an investment. Assuming a multiple of 13x and a conservative 2013 EPS of $1.48, the rough intrinsic value of the stock is $19.24.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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