Gross Margin Drivers at Potash Corp. (Part II)

See: The Better Performing Half of Potash Corp. (Part I)

In order to better understand Potash Corp. (POT), it's necessary to dig deeper down to the level of, what I call the gross margin drivers and what Potash Corp calls gross margin contributers. I agree ,of course, that they contribute, but I think they contribute so much that, they either drive the company forward, or hold it back, drastically. These drivers are not the mobile machine operators that work deep down in the Potash mines, but rather the impacts of volume and price modified by the cost.

Starting with Potash, in 2007, the total gross margin increase was 351.2 million as we know from part one. This number now needs to get broken down into it's four underlying parts. Volume contributed 215.6 or 52%; Price contributed 199.5 or 48%; "Other" contributed 0.7 or 0%, rounded down. These three parts add up to 415.8 or 100%. In order to get back to the starting number, 351.2, the cost (64.6) must then be subtracted.

The "other", I'm told, reflects net impact of volume/price/cost on purchased and miscellaneous products. All these numbers have to add up correctly, or your knuckles will get whacked with that ruler, and both your ears will get pulled by my 6th grade math teacher, like mine allways did, until I learned to get it right.

The nitrogen segment reported a gross margin increase of 220.5. This breaks down to 85.5 or 30% attributed to Volume; 194.5 or 68% for Price; 7.1 or 2% for "other" to equal 287.1 or 100% for the subtotal, minus the cost of (66.6) to get back to 220.5. Meanwhile, the Phosphate segment reported 307.5 in gross margin increase, which gets broken down to 27.7 or 8% for Volume, 315.0 or 91% for Price, 3.6 or 1% for "other" to equal 346.3 or 100% for the subtotal, minus the cost of(38.8) to get back to 307.5. The combined segments are not relevent here, so they are just left out. The totals for the three segments are 328.8 or 31% for Volume, 709 or 68% for price, and 11.4 or 1% "other" to equal 1049.2 for the subtotal, minus 170.0 in cost to equal 879.2 or 100% of the total gross margin increase in the year 2007, a number mentioned in part one.

So, what do all these numbers tell us? Among other things, the curious fact that in the year 2007, the primary driver of the Potash segment increase was attributed to Volume not Price. Yet, all the big, bad Potash bears and bulls (I might add) have been telling us all along, that it's all about the price of Potash, while the volumes of Potash in 2007 have never even been mentioned! Simply amazing. What do these Potash bears and bulls eat for breakfast? Does anyone got a handle on that? The big price driven increases, once again never mentioned, were in Nitrogen and Phosphates, not Potash. What happened to the big Nitrogen and Phosphate bubbles?

Comparing apples to oranges to bananas, the Potash share of the total volume increase is 65.5%, Nitrogen 26%, and Phosphates 8.5%, to equal 100%. The Potash share of the total Price increase is 28%, Nitrogen 27%, and Phosphates 45%, to equal 100%. The "other" consists of 6% to Potash, 62% to Nitrogen, and 31% to Phosphates to equal 100%. So not only did Potash volumes drive the Potash segment increases, they also drove the volume increases of the entire company. In Price, it's Phosphates that was the primary driver, for the whole company. In the "other" department, it's Nitrogen that's in the driver's seat. So what kind of a company is this anyway? All we hear about is Potash.

Please notice that the percentages in the Nitrogen segment, apples to apples, closely resemble the percentages of the whole company. That means that the Nitrogen segment's effect is "neutral" when compared to the to the whole company, and can therefore be left out, in an apples to oranges comparison. Therefore comparing Potash to Phosphates, 89% of their COMBINED volume segment increases goes to Potash, while 11% goes to Phosphates. Price increases gets divided up into 39% for Potash, and 61% for Phosphates. The "other" increases go 16% to Potash, and 84% to Phosphates. So, what is driving this company?

By taking the total amount of 879.2 in gross margin increases in the year 2007, and breaking that down into the nine different drivers you get : 1) Phosphate Price at 315.0 or 30% 2) Potash Volume at 215.6 or 20%, 3) Potash Price at 199.5 or 19% 4) Nitrogen Price at 194.5 or 19%, 5) Nitrogen Volume at 85.5 or 8% 6) Phosphate Volume at 27.7 or 3%, 7) Nitrogen "other" at 7.1, 8) Phosphate "other" 3.6, and lastly 9) Potash "other at 0.7. The last three add up to 1% to equal 100%.

In light of all this, I have just one more question to ask, and will someone please answer. Is the market pricing this stock correctly or not?

Disclosure: Author holds a long position in POT

Comments

[raman kandola:]

I think POT is not priced correctly... we need food, and fuel rather than luxury items !

2008 Jul 06 05:07 AM

[User 181515:]

What is raman talking about? Certainly not Potash. If he says we need food, then crops need fertililizer. And if we need fertilizer, then we need Potash. As to price, as long as pricing power and volume continue to grow as they have, then this is a very compelling story. As soon as one or both of those items stop or slow down significantly, then the pricing will change significantly. That is the whole "pricing" story. Very simple, nothing complicated, the same principles as any other stock. However, my personal opinion is that because pricing and volume have been locked in for the next two years, then one should reap the near-term rewards at least until further contracts are secured.

2008 Jul 06 08:05 AM

[Clavis:]

Very, very interesting, probably the most valuable writing that I have read in the last three months concerning the fertilizer biz.
I will indeed have to read this import several times again but instantly the result; reinforced by my other reading; is phosphates, not potash per se.
I thank you.

2008 Jul 06 03:50 PM

[messy:]

For POT...the phosphate is made into green SPA, which is fertilizer and also the phosphate is sold for animal feed in pellets that brings in huge profits. The potash is secondary these days and Raman above knows almost nothing about the industry. There are large factories in both Florida and North Carolina making this stuff.

2008 Jul 06 04:33 PM

[JJTERRITO:]

The article makes sense.From my readings the demand is outstripping the supply.I don't see that picture changing because hunger is a basic drive in human world.Once people get the taste of food from developed nations it's kind of difficult to go back the primitive days.Supply without demand goes nowhere but demand greater than supply is the winning formula.

2008 Jul 06 07:16 PM

[R. Richard ...:]

THERE MAY SOMETHING CALLED THE "ELASTICITY OF SUPPLY" AT WORK HERE AFFECTING THIS INFORMATIVE ANALYSIS.

PRODUCTION OF NITROGEN AND PHOSPHATE(S) CAN RESPOND RATHER QUICKLY TO INCREASED DEMAND. NOT SO EASY FOR POTASH. IT WILL TAKE A FEW YEARS OF SUSTAINED INCREASES IN DEMAND TO BRING ON NEW SOURCES, THOUGH SOME HAVE STARTED. IT TAKES A FEW YEARS TO OPEN A NEW "MINE."

2008 Jul 06 09:11 PM

[R. Richard ...:]

Oh! and I first learned about the distinct need for Potash working on a farm in DeKalb County, IL. back in the 30's. The lessons apply to most of Iowa and Nebraska as well.

2008 Jul 06 09:14 PM

[rogf:]

will they u something , price and volume will come , potash has secured equipament and needs for the further 5 mln tons of extra capacity that thy have announced on the coming 4 years.
Its the only company that is able too expand on greenfields and browmfield , russians are not reliable, they will bring capacity but that takes at least 5 years for all the infrainstructure along with the mine.
China doesnt have enough stock , and sooner or later they will have to come and renew further contracts, max december when the one that they have in place expire.
Third reason simple cause Food is Food , whatever is missing people will not stop eating , thats the simple argument of why we see this company trading at 11 times P/E for 2009 and we should see some at least 30% multiple expansion for the next year.
if u think its extremely expensive , pls just dont do the msitake of shorting the shares. It can add for u 5% to 10% gain , but if u miss the boat will ripp at least 20% on the way back.

2008 Jul 06 09:25 PM

[bullet:]

so is it priced correctly or not?if not where?

2008 Jul 07 02:28 AM

[bullet:]

so should it be higher or lower?

2008 Jul 07 02:29 AM

[mythoughts:]

I'm with ROGF. Don't short the fertilizers.

2008 Jul 07 02:03 PM

[akjj:]

While I understand the point of this article, I also think it is misleading. The whole reason potash is so valued is because of the barriers to entry for would-be competitors... something nitrogen producers don't have (like what Mr. Schweitzer spoke of above). Also, nitrogen production relies heavily on nat gas... something that could be dipping into profits. Furthermore, because of the forward contracts that dictate potash prices, POT hasn't yet reaped the full benefit of higher potash prices... this was especially true in 2007. Now that spot prices are rumored to approach $1000/MT sometime this year and confirmed contracts with China lock in $576/MT for the rest of 2008 already (a $400 increase over 2007), the real earning potential of POT won't be seen until 2009 and 2010.

So while nitrogen and phosphates may have driven POT's earnings in 2007, what distinguishes it from TRA, TNH and others is it's potash... something that--at least for the next two or three years--should keep it moving forward, barring only a collapse in global grains prices.

2008 Jul 07 06:13 PM

[Illinois_Alum:]

Forgive me guys...maybe I am being naive or I dont understand basic math. But if 351.2 million is the gross margin "increase" for Potash then doesnt it mean that costs are already taken out before calculating this number? Then where do the numbers 215.5 million and 199.5 million come from? Am I missing something here?

2008 Jul 10 10:16 PM

[Think-About-It:]

AKJJ, thanks for the pricing information. That may be enough to persuade me to get a long position going in POT

2008 Jul 11 01:02 AM