By Elizabeth Collins, CFA
While 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. The company's rock salt mine in Goderich, Ontario, is the world's largest and has access to a deepwater port, which allows Compass to deliver salt cost-effectively to customers throughout the Great Lakes region. Further, the company's Great Salt Lake facility -- one of only three solar evaporation operations in the world -- 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.
We think the stock is currently depressed because the company's 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 is hurting 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 as global potash producers ramp up brownfield expansions, but we actually think Compass' sulfate of potash earnings will grow as its production increases. The stock is trading at a 20% discount to our fair value estimate of $93 per share and it certainly could get cheaper as the extent of the mild winter weather's impact on profits plays out. We'd view this as an opportunity to add to a position in one of the highest-quality companies in our Basic Materials coverage universe.
Salt Directs Compass
The vast majority of Compass Minerals' revenue and profits come from the salt segment, and highway deicing salt makes up the bulk of this segment's revenue. While volumes can swing wildly from year to year based on 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.
Compass sells highway deicing salt to customers in North America and the United Kingdom 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. In North America, Compass' salt competitors include Cargill, K+S (Morton), American Rock Salt, Detroit Salt, Texas Brine Company, U.S. Salt, and United Salt; in the U.K., rivals are Irish Salt and Cleveland Potash. We think Compass has strong competitive advantages in the production of highway deicing salt thanks to its Goderich and Winsford mines.
A Winter of Discontent?
Winter weather is the primary determinant of deicing demand. Cities and states prioritize keeping streets and highways free of ice after snowfalls, so the number of snow days in the U.S. and Canada has a direct correlation on the amount of highway deicing salt sold. So, the main near-term question for Compass, in our view, is how much this past mild winter and the resulting increase in deicing salt inventories hurts prices during the bidding season, when contract prices between highway deicing salt producers and government entities are determined for the next winter.
If history proves correct, customers likely will reduce their bid volumes for 2012-13, resulting in pricing that is below the 3%-4% average increase that the industry typically sees. Winter weather was significantly below average in 1999-2000 and 2009-10 and in the bidding seasons following these periods of weak demand for highway deicing salt, prices were down 1% in 2000 and flat in 2010. Since the winter of 2011-12 had the fewest snow events in more than 15 years, pricing during the bidding season of 2012 could end up even worse than in 2000. However, we think that a period of strong demand for highway deicing salt can make up for a period of weak pricing. After 2007-08, when winter weather was significantly above average, bidding prices were up 20% in 2008.
Therefore, our longer-term view of highway deicing prices is unchanged. Our profit forecasts assume normal weather. The company provides investors with enough information about weather patterns and volumes that normalizing deicing assumptions is a fairly straightforward task. During the last several years the market has become more accustomed to looking through Compass' weather-driven volume variability.
An Envious Set of Assets
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. Its deposits are 100 feet thick; most competitors' mines access 20-30 feet thick deposits. This allows Compass to use more efficient mining techniques, getting more salt for each foot of advance. Goderich is located on a deepwater 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 Compass the opportunity to capture more than its share of organic market growth as well as opportunistic spot sales when winters are especially harsh. And Goderich likely will continue to receive the majority of Compass' capital investments within 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 in 2012, but much of the loss should ultimately be recovered through insurance.
The Winsford rock salt mine in Cheshire, England, is the largest in the United Kingdom, and its size enables efficient mining. Further, the mine's stability and closeness to the surface allows for alternative uses of unutilized 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 (SOP). As a result, SOP margins have been quite handsome. Great Salt Lake 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 U.S., based on the firm's efficient production facility and its close proximity to markets. And 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.
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 -- it contributed an estimated 32% of Compass' total revenue in 2011. Volumes 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. In short, consumer and industrial sales do not crimp Compass' salt segment performance. Salt operating margins have averaged a solid 23% over the five-year period between 2006-10, beating closest comparable K+S' (a producer of a variety of salt products in Europe and the Americas) average of about 12% during the same time frame.
Probing Into Potash
Sulfate of potash (SOP, potassium sulfate, K2SO4) is closely related to muriate of potash (potash, KCl, potassium chloride). 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. Along with potatoes, key SOP crops include tree nuts, citrus fruits, grapes, turf, tobacco, and sugar cane.
Our long-term potash 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 (BHP) as the most notable possibility. If this mining giant is able to bring meaningful production to market (or acquire a large incumbent), the company could put downward pressure on potash prices by operating at full capacity without regard to market conditions. That said, major greenfield development projects still have hurdles to cross; large projects currently aren't scheduled until the back half of the decade.
In addition to the oligopolistic nature of the industry, the utility of potash for farmers should provide support to potash prices above production costs. However, we don't think potash prices will run north forever, and we're actually predicting 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 potash prices (despite potash utility).
Despite our price forecast, we still think Compass' SOP profits will grow thanks to capacity expansion. The company has recently implemented the first phase of an expansion at the Great Salt Lake solar evaporation facility, and 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. Simply put, Compass is increasing the production capacity per pond acre. Also, Compass' magnesium chloride capacity should 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 company-wide 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. The company can purchase muriate of potash from global potash producers, combine it with its solar harvest and process it in its plant to create more sulfate of potash. Compass' management likes to downplay this alternative because it's higher cost than the company's own production methods and there is more input cost uncertainty. However, we estimate that given the premium for sulfate of potash, this alternative production method can make economic sense if Compass needs the extra volumes 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. Just as with Compass' deicing business, we argue that the company should be valued based on "normal" volumes and costs driven by "average" weather. Given that Compass' advantaged assets will be around for the long run, we argue that shareholders shouldn't mind sticking around for operations to improve.
We Think Compass Shares Are Undervalued
Compass' profits should grow 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 volumes also will 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. The main risks to our thesis are permanently depressed highway deicing volumes 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 volumes, slightly weaker prices) would reduce our fair value estimate another $5 to $71 per share.
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