CF Industries, Terra: Earnings Concerns Misplaced

 |  Includes: CF, TRA
by: Ranjit Thomas, CFA

CF Industries (NYSE:CF) and Terra Industries (TRA) are fertilizer companies with multi billion dollar market caps, but much smaller than the better known names in the industry, such as Mosaic (NYSE:MOS) and Potash Corp. (NYSE:POT). CF manufactures nitrogen and potash based fertilizers, while TRA is primarily a nitrogen based manufacturer.

Fertilizer companies have seen their earnings soar in recent years, and there is concern that the good times are about to end. I think this concern is misplaced, and that earnings should continue to be robust.

On the demand side, there is no let-up in the shifting of diets in large parts of the world towards meat, which requires feed in the form of corn and soybeans. Corn-based ethanol has also been a driver, with the high price of oil and the focus on renewables.

The major raw material input in the making of nitrogen based fertilizers is natural gas, whose price has come down substantially in the last few months. Also, there have been major discoveries of natural gas deposits in the continental US in shale rock. There have been a lot of news reports devoted to the Fayetteville, Marcellus, and Haynesville shale plays. These assure an increasing supply of natural gas at reasonable prices in the United States. Natural gas is hard to transport and expensive to store. Thus, these increasing supplies are likely to be beneficial to US based users like CF and TRA.

Both companies have no net debt, and in fact, CF has $20 of net cash per share. At the recent stock price of $39 for TRA and $110 for CF, they are trading at 6-7x '08 EPS. Free cash flow generation is tracking earnings, and so the FCF multiple is also in the high single digits. TRA is buying back stock, while CF is hoarding its cash right now.

On the flip side, CF is more diversified. I think there is about 80% upside in both stocks. The stocks, however, are quite volatile and not for the faint of heart. They tend to move in tandem with the commodity complex, which has exhibited a lot of volatility (along with a downward trend) of late.

One interesting aside is that the stock prices of these companies are positively correlated with the price of natural gas. One would logically expect a negative correlation as natural gas is a major input. It looks like investors move in and out of all commodities and commodity related stocks at the same time.

Fair value for CF stock: $200 (12x multiple on '08 EPS of $16.40)

Fair value for TRA stock: $73 (11x multiple on ‘08 EPS of $6.63)

Disclosure: Author has a long position in CF and TRA