By Elizabeth Collins, CFA
Unfavorable weather events are hurting Compass Minerals' (CMP) near-term earnings. This company has strong and sustainable competitive advantages for the production of highway deicing salt and sulfate of potash specialty fertilizer. Its rock salt mine in Goderich, Ontario, is the world's largest and has access to a deep-water port, which allows Compass to deliver salt cost-effectively to customers throughout the Great Lakes region. Further, its Great Salt Lake solar evaporation facility allows the company to produce sulfate of potash specialty fertilizer at a much lower cost than most other producers that use ore mining or a chemical process. The Great Salt Lake facility is one of only three in the world.
We think the stock is currently depressed because near-term profitability will be weighed down by a trio of unfavorable weather events: tornado damage costs and production interruptions at Goderich, rainfall-related production shortfalls at the Great Salt Lake facility, and mild winter weather in the Midwest that has hurt demand for deicing salt. Compass' earnings should grow long term as these issues are resolved and as the company expands its sulfate of potash fertilizer production and grows into its expanded rock salt capacity. Long term, the main valuation uncertainty is sulfate of potash prices. We look for prices to trend down in the long term as global potash producers ramp up brownfield expansions, but we think Compass' sulfate of potash earnings will grow as its production increases. The stock is trading at an attractive discount to our fair value estimate.
Resources Make a Moat
Compass has strong and sustainable competitive advantages as a result of its world-class, low-cost rock salt and sulfate of potash specialty fertilizer resources. The Goderich rock salt mine is the largest in the world. The deposits are 100 feet thick, compared with most competitors' mines, which access deposits that are 20-30 feet thick. This allows Compass to use more-efficient mining techniques and get more salt for each foot of advance. Goderich is on a deep-water port that can accept the largest ships on the Great Lakes, which gives Compass a shipping cost advantage. In 2010, Compass completed a $70 million project to expand the annual capacity of Goderich to 9.0 million tons from 7.5 million tons. This will give the firm the opportunity to capture more than its share of internal market growth as well as opportunistic spot sales when winters are especially harsh. The Winsford rock salt mine in Cheshire is the largest in the United Kingdom. Its size enables efficient mining. Further, the mine's stability and closeness to the surface allow for alternative uses of unused caverns. Compass uses these caverns for its document storage and hazardous waste management businesses. This effectively lowers the cost of rock salt mining at Winsford.
Compass' energy-efficient Great Salt Lake solar evaporation facility gives the firm an edge in the production of sulfate of potash. As a result, SOP margins have been quite handsome. Its plant is one of only three all-natural solar SOP plants in the world; the others are in Chile and China. We believe Compass has the lowest-cost source of SOP for the markets it serves in the Western and Southeastern United States, based on its efficient production facility and close proximity to markets.
Salt Is the Breadwinner
The vast majority of Compass' revenue and profits comes from the salt segment. While volume can swing wildly from year to year with the severity of winter weather, salt prices remain relatively stable. Highway deicing salt sells for about $50 per ton, so shipping costs make up a significant portion of total delivered costs. Therefore, markets tend to be very regional. Historically, highway deicing salt prices have grown at a 3%-4% annual pace on average. Most cities, counties, and states secure their winter salt supply through a contract bid system, with no negotiation. All bids are made public on the bid-open date, and the contract is awarded to the lowest bidder. Most U.S. customers guarantee a minimum purchase volume and require a maximum volume delivery (typically 80%-120%). As a result of this system, prices will not change during the winter. We've seen a weak winter result in flat pricing in the subsequent summer as customers reduced their bid volume because they had leftover inventory; likewise, pricing gains have been as high as 8% in a bidding season after an especially harsh winter. While winter weather will create wide swings in demand for highway deicing salt, volume is essentially recession-resistant. Cities and states prioritize keeping streets and highways free of ice after snowfalls.
The salt segment sells highway deicing salt to customers in North America and the U.K. and consumer and industrial salt to folks in North America. Beyond deicing, applications include culinary salt, water conditioning, pool care, chlorine and caustic soda production, animal nutrition, and fishery management. Salt competitors include Cargill, K+S (Morton), American Rock Salt, Detroit Salt, Texas Brine, US Salt, and United Salt in North America and Irish Salt and Cleveland Potash in the U.K. We think Compass has strong competitive advantages in the production of highway deicing salt thanks to its Goderich and Winsford mines, and Goderich is likely to receive the majority of Compass' capital investments in the salt segment. In August 2011 a tornado hit Goderich's salt mine and mechanical evaporation facility. Tornado damage will hurt Compass' production and costs into 2012, but much of the loss should ultimately be recovered through insurance.
Winter weather is the primary determinant of deicing demand. Our long-term profit forecasts assume normal weather. The company provides investors with enough information about weather patterns and volume that normalizing deicing assumptions is a fairly straightforward task. Over the past several years, the market has become more accustomed to looking through Compass' weather-driven volume variability.
While Compass' consumer and industrial salt assets are not as clearly advantaged as the Goderich and Winsford rock salt mines, this business still has some attractive characteristics. Volume and prices tend to be relatively steady compared with other commodities. Further, Compass' consumer and industrial business benefits somewhat from its vertical integration with the Goderich mine and the Great Salt Lake solar evaporation ponds, which produce evaporated salt in addition to sulfate of potash. Consumer and industrial sales do not crimp the performance of Compass' salt segment, whose margins surpass those of K+S, which produces a variety of salt products in Europe and the Americas.
SOP and MOP
Sulfate of potash is closely related to muriate of potash. SOP is a substitute for MOP, and MOP is a feedstock for the world's highest-cost SOP producers. Therefore, MOP prices are the key determinant of SOP prices. SOP typically trades at a premium to MOP, as SOP is used primarily on higher-value crops that cannot withstand the chloride content of MOP. For some crops, such as potatoes, SOP improves the yield and quality enough relative to MOP that farmers favor the application of higher-priced SOP. Key SOP crops include potatoes, tree nuts, citrus fruits, grapes, turf, tobacco, and sugar cane.
Our long-term MOP price forecast is $375 per metric ton, compared with $535 today. Producers of potash benefit from an industry oligopoly, which we think will allow potash prices to remain well above marginal costs of production over the long term. The prospects for new entrants to materially penetrate the market are fairly low, with BHP Billiton the most notable possibility. If this mining giant is able to bring meaningful production to market or acquire a large incumbent, it could put downward pressure on potash prices by operating at full capacity without regard to market conditions. But major greenfield development projects still have hurdles to cross, with large projects currently scheduled for the back half of the decade. The marginal utility of potash for farmers should also provide support to potash prices above production costs. However, we don't think potash prices will run north forever; we predict a contraction from current levels as potash supply growth (bolstered by both brownfield and greenfield projects) outpaces demand growth. Further, we think crop prices will come down and farmers will be less willing to accept elevated prices for potash, despite its utility.
The company recently implemented the first phase of an expansion at the Great Salt Lake solar evaporation facility. This project enhanced the plant that processes the mineral mix recovered through solar evaporation. Phase II development is now under way. The company will add 220,000 tons of annual capacity without expanding its current solar pond footprint by adding barrier walls to reduce subsurface brine loss--increasing production capacity per pond acre. Compass' magnesium chloride capacity should also increase materially with the Phase II expansion. Magnesium chloride is sold by both segments, as a highway deicer and specialty fertilizer. In 2011, magnesium chloride revenue contributed about 6% of the companywide total. Given that Compass' Great Salt Lake facility is one of only three of its kind in the world, we acknowledge that there is project development execution risk.
However, Compass has one more alternative to producing sulfate of potash. It can purchase muriate of potash from the global potash producers, combine it with its solar harvest, and process it in its plant to create more SOP. This is more expensive than the company's own production methods, and there is more input cost uncertainty. However, we estimate that given the premium for SOP, this alternative production method can make economic sense if Compass needs the extra volume to meet customer demand. In May and June 2011, rainfall was 50% above typical levels, which will curtail supply from the solar evaporation ponds and result in fixed-cost deleveraging through 2012 because of the length of Compass' production cycle. Management reports that about one out of every seven years will see rainfall of 33% above normal. As with Compass' deicing business, we believe the company should be valued based on "normal" volume and costs driven by "average" weather. We've incorporated weaker near-term results into our discounted cash flow model, but we assume that the current problems will ultimately be resolved. Given that Compass' advantaged assets will be around for the long run, we don't think shareholders should mind sticking around for operations to improve.
Compass' solar evaporation method gives it a significant cost advantage relative to the chemical process SOP producers that must purchase MOP and sulfuric acid. Solar evaporation opportunities are limited. For example, Compass is the only company able to access the highly concentrated brine at the north end of the Great Salt Lake.
Strong Management Enhances Compass' Advantages
As earnings improve, Compass' managers will have more cash at their disposal, but we are not too concerned about future dilutive actions, given the team's strong record. When CEO Angelo Brisimitzakis joined Compass Minerals in 2006, he inherited a company with strong competitive advantages that was using excess cash flows to deleverage and return cash to shareholders in the form of dividends. After the leveraged buyout in 2001, these were the most prudent uses of cash. As Compass' earnings grew, more cash was available, and Brisimitzakis' implicit job was "first, do no harm." He knew he was running an impressive company with advantaged assets, and he had to make sure that excess cash flows were invested in opportunities that didn't erode existing competitive advantages.
Fortunately for shareholders, Compass' investments over the past several years have only enhanced its existing strengths. Under Brisimitzakis' tenure, the company has bought a document storage business that leverages unused storage capacity at its U.K. salt mine and invested in capacity expansions at the Goderich salt mine in Ontario and the Great Salt Lake solar evaporation facility for the production of specialty fertilizer. In 2011, Compass acquired Big Quill Resources, a fellow SOP producer, for an attractive valuation. The company continues to work on an expansion at its Great Salt Lake facility, a high-return investment proposition, by our calculations. We think Brisimitzakis has taken a company with attractive assets and enhanced its competitive advantages, as indicated by our wide economic moat rating.
Shares Look Attractively Valued
Our fair value estimate is $93 per share. Compass' profits should increase materially over the next several years as the company grows into its recently expanded capacity at Goderich and develops Phase II of the Great Salt Lake expansion. Magnesium chloride volume will also increase with the Great Salt Lake expansion. Profit margins should improve with operating leverage and once weather-driven issues are resolved, from 25% in 2011 to 31% in 2016. Risks to our view include much lower SOP prices or weak salt volume. The main risks to our thesis are permanently depressed highway deicing volume because of low snowfall and much lower SOP prices than we currently envision. In a low-SOP-price scenario, we think the company is worth $76 per share. Adding a low-deicing scenario (lower volume, slightly weaker prices) would reduce our fair value estimate to $71 per share.