Shareholders of CF Industries Holdings (CF) have been rewarded with a return of over 40% this year. This return represents a growth of around $3 billion in shareholder value and it has been accentuated by a small, but consistent dividend. Through this analysis, I will present the case that despite this year's excellent returns, further growth is entirely possible.
A History of Growth
A primary method of evaluating the strength of an organization is to examine its growth rates. Specifically, and analyst should be concern with how effectively management uses shareholder equity and how efficiently the firm uses assets to generate revenue. Two metric which encompass these issues are return on equity and return on assets. In the chart below, the return on equity, return on assets, and the market cap for the previous 5 years is shown for CF Industries.
The chart shows three items: return on assets, return on equity, and market cap. These three items explain how effectively the management uses shareholder investment, how efficiently the firm uses assets, and how much the market values the firm. For the previous 5 years, CF has maintained a strong history of returns. During the past 20 quarters, CF has only experienced 6 quarters in which return on assets was less than 10% per quarter. Likewise, during this same time period, CF only experienced 4 quarters in which return on equity was less than 10% per quarter. This essentially means that for every $100 that was directly invested into the organization, the organization typically generates more than $10 in net income to the firm. Similarly, for every $100 in assets the firm owns, it normally generates over $10 in profit.
These ratios are very strong but what is more noteworthy than the actual number is both the trend of the growth rates and how the market has historically responded to the ratios. In the chart above, it can be seen that the years leading up to 2008 conveyed a consistent message - as CF became more effective at utilizing its assets and direct investments, the market responded by valuing the organization at higher levels. In the first quarter of 2008, both return on assets and return on equity reached a temporary peak and the market responded by lowering the value of the company. This value to growth rate relationship was fairly consistent until the beginning of 2009 (when the entire market bottomed out after the financial crisis). Following the beginning of 2009, CF increased in market value by over 400% and it has consistently become more valuable on a yearly basis since the trend began.
It is my belief that CF will continue its upward trend. I believe that the organization has demonstrated that it is more than capable of utilizing direct shareholder equity and corporate assets to generate revenues for the firm. Additionally, CF has shown that it is able to become more efficient in these two key areas as time progresses. Between 2008 and the end of 2009, CF experienced a decrease in organizational returns. This decline was ignored by the market and the market value of the organization increased nearly 100%. I believe that this decoupling was due to CF benefiting from overall market trends rather than CF-specific performance. Beginning in the middle of 2010 however, organizational returns began to grow once again.
It is very interesting to note that during the years in which return on assets and equity were increasing (2010 - 20012), the market added $8 billion in market value to CF. Compare this $8 billion with the previously discussed time period in which return on assets and equity were decreasing yet market value of the stock was increasing (2008-2009) - the market only added $2 billion in value to the organization. Essentially, this means that when the firm is fundamentally becoming better both from a return on assets and equity standpoint, the market tends to add value at greater rates. Since we are currently in a period of time in which the firm is rapidly becoming more effective with equity and efficient with assets, we can continue to expect a continued upside momentum. For this reason, I maintain a bullish stance on the stock.
CF is in an excellent growth phase. It is progressively becoming better at utilizing assets and shareholder equity with each quarter and the stock price is correctly responding. Despite the fact that a harmonious relationship is clearly present, I believe that we should exercise caution prior to participating in CF. The below chart and accompanying annotation explain my thinking.
The chart shows the weekly price performance of CF for the past 2 years. This time period represents the quarters in which the market value of the firm has grown concurrently with returns on assets and equity. The stock is undoubtedly in a strong uptrend from both a technical and a fundamental standpoint. There is cause for concern, however. Within the past two months, price has challenged the top boundary of the current trend. This type of challenge has historically resulted in share price falling over the next 3 to 4 weeks. As can be seen above, in 4 of the 5 instances in the past few years in which price has attempted to overtake the upper boundary of the trend, share price has fallen. The average extent of these declines in share price has been nearly 25% over the next month! Since we have just tested the upper barrier of the trend, we have a very high likelihood of prices declining over the next 3-4 weeks. For this reason, I do not advocate purchasing shares of CF immediately. I suggest that individuals wishing to purchase the stock wait for a month before considering a purchase. In a month, if price is lower than $190 per share (the middle of the trading range), then I believe a purchase is warranted. If however prices have fallen such that they have collapsed outside of the lower portion of the range, then I believe that the uptrend has ended and the market no longer agrees with my fundamental thesis. In other words, as long as price stays above $160 per share in the near-term future, I view this bullish analysis as valid.