Understanding Agrium: Is Jana Right About Retail?

| About: Agrium Inc. (AGU)

The battle between Canadian agricultural giant Agrium (NYSE:AGU) and its largest shareholder, Jana Partners LP, seems to be escalating in recent days as Agrium dismissed calls to break up the firm to realize shareholder value. Jana Partners, who own over 4 percent of Agrium, suggested on Wednesday that Agrium is unfairly handling the discussion.

"We have watched in disbelief over the last few days as the management of Agrium Inc. has taken a scorched earth approach to avoid any reasonable discussion of our proposals," said Barry Rosenstein, founder of Jana.

As predicted in my previous article, "Agrium: A Bearish Play on Natural Gas," the Canadian fertilizer producer has performed strongly in the second quarter, up 16 percent from the publication date of the article. This compares very favorably to Agrium's peers, such as Potash Corporation, which is only up 3 percent in the same period. Agrium is clearly no laggard in the sector, so why the hedge fund pressure?

Jana believes that spinning off Agrium's retail distribution business will unlock value for shareholders. Having Agrium focus on its highly successful nitrogen fertilizer business seems like a good strategy, but what do the numbers say? Is Agrium stronger without their retail business lines?

The first place to look for guidance is Agrium's second quarter financial statements. Here, we see that Agrium derives the majority of its sales from its retail segment. Agrium had $7.6 billion in retail sales in the first six months of 2012, compared to $2.9 billion in wholesale fertilizer sales. On these sales, Agrium earned a profit of $613 million on the retail segment in comparison to a much healthier profit of $960 million in the wholesale segment. Clearly, the margins are much more favourable in the wholesale segment, but there are some other factors to consider.

One question I received when writing the first Agrium article was why Agrium has such extensive inventories compared to their peers. Agrium had $2.4 billion in inventory on June 30, 2012. This represents significant working capital tied up in inventory, money that Jana wants to see returned to Agrium shareholders in a more business focused more strictly on wholesale fertilizer. Again, this seems to be an element that supports Jana, freeing up such amounts of working capital would be favourable for Agrium.

With these two elements in mind, let's really consider what is at play here. Agrium is a company with a market capitalization of approximately $15.4 billion. It trades at a trailing P/E multiple of 9.55x, which is substantially lower than its more focused peers such as Potash Corporation of Saskatchewan (NYSE:POT) or Mosaic (NYSE:MOS), which trade at 15.15x and 13.24x respectively. This seems to really be the cornerstone of Jana's argument, that the retail business is having a major drag on the valuation of the wholesale fertilizer business.

The retail segment does have some value, however. The fertilizer business is a volatile game, and wholesale margins can be quickly squeezed. Agrium is primarily a producer of nitrogen fertilizer, which is heavily reliant on natural gas as an input feedstock. Natural gas prices are dragging along at historical lows, and accordingly, Agrium wholesale margins are at historical highs. If natural gas prices begin to climb, Agrium would be squeezed significantly on the wholesale front. The retail segment offers a counterweight to this, as Agrium would be able to recover some of the lost margin through higher end consumer prices in some markets. This is an advantage that Agrium has over its peers, it captures the entire value of fertilizer from fuel to the field, whereas other firms are beholden to retailers, including as it stands Agrium, to set wholesale prices.

While I do have some sympathy for Jana's position in the short term, I do think the retail business does have value for the Agrium shareholders that are in it for the long haul. There is an advantage to being vertically integrated, and as a result, I believe Agrium is a less risky play than some of its peers due to the retail segment. Shareholders may see lower margins and have less capital returned to them in the short term, but being able to be a player in setting wholesale prices from both the producer and retailer perspective certainly adds significant power to Agrium's position.

How to Play the Jana Proposal

I believe Agrium's share price has some room to grow yet, beyond the strong performance of the first half, towards a P/E of approximately 11 or 12 times earnings. Again, this reflects a slight discount to its pure play peers. With a 2012 consensus forecast of $9.82, this would put the company at a range of $108 - $118 by the end of the year. As natural gas feedstock prices are expected to remain low, and food prices expected to climb due to ongoing drought in North America, there may even be some room beyond this range if earnings come in ahead of analyst estimates.

If Jana is successful in forcing Agrium to spin off its retail business, there would be substantial value seen in the short-term. These proxy battles tend to play out over quarters and years rather than weeks and months though, so buying now solely with the expectation of a major announcement is unwise. However, if the current valuation is appealing in of itself, and I believe it should be, there is potential for two upsides to Agrium in the short-term, both the climb in share price based on results and potential developments from the discussions with Jana.

If the stock was to move significantly on news of a strategic decision to spin off retail assets, I would look to realize gains at that point. I believe Agrium is a stronger long term play because of its retail operations and not based on its operating ability in the wholesale segment, where other firms have stronger margins and would become a better option at that time. Agrium is stronger long term with retail as part of the firm's portfolio, but with or without it, the company remains an attractive investment opportunity.

Disclosure: I am long AGU, POT.