Potash Corp.: Poised to Soar Once Hedge Fund Worries Subside

If you want to understand why Potash Corp. (POT) has been such a solid performer over the past year or so, all you have to do is look at simple supply and demand. Moreover, Potash has done just that in its Market Analysis Report that was released on August 29. It has assembled a slide show of charts that illustrate the very pricing power the company is seeing in its industry.

Demand is rising and supply is falling. This industry is easily one of the strongest groups fundamentally right now because of secular trends. However, due to hedge fund redemptions/liquidations and the commodity sell-off, this name has been inexplicably sold off along with any and all energy or commodity related names. In a market where logic and fundamentals have been thrown out the window, it may be best to stand aside and let the chaos pass. However, when/if/should normalcy return to the financial markets, POT is poised to benefit simply because the company actually has a strong fundamental story behind it.

Such strong fundamentals have been illustrated with charts extracted from Potash's latest Market Analysis Report:

First, we see Global Grain production and fertilizer use increasing.

 

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Second, we see worldwide fertilizer demand growth:

Recognizing that without sufficient potash they cannot raise their yields – no matter how much N and P they apply – farmers have raised their potash consumption an average 5.6% per year for the past five years. This compares to 2.7% for N fertilizer and 3.8% for P. Over the past five-year period cumulative world fertilizer growth has been greater than adding a market the size of the US or India, the second and third largest fertilizer markets.

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Third, we see that potash ending inventory has decreased each year for the past three years.

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Some additional commentary from its Market Report reads:

Potash is used on a diverse group of agricultural commodities. Wheat, rice, corn, soybeans and sugar cane consume roughly 50% of the world’s potash. This diversity means that global potash demand is not highly dependent on the market fundamentals for any single crop or growing region. US use of corn for ethanol has grown in recent years but this segment of market accounts for only 2% of world potash consumption. The global potash industry is operating at historically high rates to meet the significant growth in potash demand. With the industry running at or near full capability, world production in 2008 is expected to be limited to an increase of only 2.0-2.5%. This (production) is well below the 5.6% demand growth rate of the past 5 years.

Therefore, simply put, fertilizer demand is outpacing supply.

In addition to the supply/demand equation tilting in Potash's favor, the company is also seeing more favorable input costs. Natural Gas is one of the main agricultural input costs, and as we saw this summer, natural gas prices have fallen hard 40%. Therefore, this can only further POT's bottom line.

If, for some reason you still need further reassurance that the agriculture boom is still in play, just turn to analyst comments from Morgan Stanley (MS). They say that the selloff in these names is "unfounded" and that they expect peak earnings around 2011. They rate Potash "Overweight" with a $297 price target (POT is currently trading at $180).

Additionally, NotableCalls mentioned (re: Morgan Stanley analyst comments) that:

Fertilizer prices will stay higher for longer: i) A global economic slowdown is unlikely to affect fertilizer demand; ii) US farmers are still earning a ~60% ROIC on fertilizer purchases and are thus unlikely to reduce fertilizer application; iii) Emerging market farmers are very low on the yield response curve (i.e., increased application pays for itself); iv) NPK prices have yet to catch up to commodity prices (i.e., record US farmer profits despite higher NPK prices); and v) They believe capacity increases will simply meet underlying demand rather than flood the market and force lower prices. Valuation extremely compelling: 2009e EV/EBITDA of 2-5x; FCF yields of 10% to 20%. Minimal balance sheet leverage (in some cases none) should allow for substantial share repurchases and dividend payments. POT has the most leverage to potash, the nutrient with the greatest pricing power and barriers to entry.

Therefore, the real dilemma here is trying to decide whether to enter POT at these levels given the market uncertainty. Hedge funds, such as the Ospraie Fund are closing their doors and are being forced to sell their positions, so if these funds are heavily invested in fertilizer/energy/commodity names (as many of them are), you can guess what that means for the stocks. Given the fact that we have seen numerous commodities and macro hedge funds negatively affected by the commodities sell-off, one would have to think that further hedge fund redemptions or liquidations are in store, as I wrote about here.

Nouriel Roubini also seems to think the next step of the crisis will be the de-leveraging of hedge funds. However, it would still be hard to envision a commodities selloff as great in magnitude as the one we recently saw, given the already vast depreciation in equity prices.

Trading at just an 8.37 forward PE, POT is very compelling here. The bulk of the gains come from solid operating margins of 41.29% and return on equity of 37%. The company is seeing year over year quarterly revenue growth of 102.30% and year over year quarterly earnings growth of 216.80%, both massive figures to say the least. The only major negatives would be their $2.27 billion in debt, compared to $269 million in cash. However, one could easily argue that since POT is essentially printing cash with their business, that their debt is not worrisome at all. In the end, their debt/equity ratio comes in at around 0.34. Lastly, we see that institutions hold around 77% of shares.

Among those institutions are numerous hedge funds we track here at Market Folly:

1.      First, as we noted in our recent hedge fund tracking piece, the $10 billion global macro hedge fund Moore Capital Management (run by Louis Bacon) owns POT.

2.      POT is also owned by $10 billion Maverick Capital (ran by Lee Ainslie), whose portfolio holdings we analyzed here.

3.      We also noted that George Soros had been purchasing Potash Corp.

Now, I don't believe these funds are in jeopardy of massive hedge fund redemptions/liquidations as I referenced earlier. However, at the same time, anything can happen these days and there are undoubtedly numerous highly leveraged funds out there waiting to explode/de-leverage.

As a result, we really are at a crossroads here. On the one hand, as the supply and demand picture is squeezed even more, (since new potash cannot be brought online for years) the fundamentals are screaming, "buy." However, at the same time, you run the inherent risk of POT being sold off ridiculously hard again should a bunch of hedge funds facing redemptions or liquidations as many are forecasting. The inherent risk here is neither company nor sector specific, but instead is financial market specific.

The fundamentals are intact and that's all that matters. However, with some hedge funds teetering on edge, things can swing either way. Value investors and deep fundamentalists will tell you that even if you have to go down through a valley before getting to the mountaintop, it's still worth going through for the opportunity. However, given the recent market volatility and unpredictability, exercising some caution can never be a bad thing. If the saying holds true that fundamentals trump all, then buying POT now could payoff large come 2010 and 2011. This must be what it feels like to be a value investor, huh?

Disclosure: None

 

Comments

[User 226404:]

Agreed. Price is determined by supply and demand.

2008 Sep 23 09:00 AM

[old guy:]

Fantastic article !!!!!

2008 Sep 23 09:24 AM

[alligator b...:]

definitely a fantastic company -- no argument from me. problem is that the momentum guys are selling, the growth guys are selling and the value guys don't find it cheap enough. might drift lower for a while. company will put up a monster 2009 eps number but that is largely priced into the stock. see my blog for another interesting commodity-based idea.

2008 Sep 23 11:03 AM

[bookman4:]

potentially bad pr fallout from the price-fixing allegations, not to mention the ongoing strike. short-term volatility is always rough with this stock, but the long-term prospects are still incredibly compelling.

2008 Sep 23 02:08 PM

[Urbane Gori...:]

Just wanted to point out that POT is at $164 right now and dropping before my eyes... Whoops... Make that $162.45 ...Hmmmm $158.50 might be a good entry with a tight stop..

jegan ;-)

2008 Sep 23 03:48 PM

[Market Folly:]

jegan,
exactly, things don't look so great in the near-term, hence my suggestion to stand aside until things stabilize. comes down to trading the perception versus the reality. reality is they've got great fundamentals, but perception is the world is slowing, no one is going to eat, etc etc. and then you toss in the whole hedge fund redemption/liquidation picture.

short term there will be headwinds, long term great fundamentals. hence why i compared it to being a value investor... even if this name isn't quite as cheap as value investors would typically pounce on. just depends on what you can stomach

2008 Sep 23 05:34 PM

[material guy:]

Yes, POT is the best company in the fertilizer industry. But the notion that a global economic slowdown would not affect fertilizer demand is false. People still eat, of course, but they can't afford as much meat. It is the quality of their diets which is the real driver of demand. If you don't believe me, just go back 10-12 years, when POT and other fertilizer stocks were on a similar tear. It was all derailed by the "Asian contagion" of '97-'99.

2008 Sep 23 07:37 PM

[puddi:]

" We also noted that George Soros had been purchasing Potash Corp. "

The same article notes that Soros also purchased $180m Lehman Brothers!

2008 Sep 23 09:17 PM

[Poor me:]

POT is ready for another up swing.

2008 Sep 24 01:57 AM

[Poor me:]

What happened?

2008 Sep 24 02:01 AM

[Urbane Gori...:]

Market Folly ... ended back here after reading your 'There are no triple bottoms' article... Pretty good call.. Oddly, many of the books and articles I have read point to a triple bottom as 'evidence of an upturn'. Guess they were wrong ..

And $158 sure was a wrong call .. POT is at $128 today... My, my, my! I wouldn't have bought anyway... I tend towards Stochastic upturns...

Anyway .. Great articles... jegan ;-)

2008 Oct 01 10:05 PM

[Market Folly:]

yup.. which is why I said numerous times in the article to exercise caution with this name to begin with. because the near-term headwinds are out of our control.

2008 Oct 01 11:21 PM

[cjct:]

This thing is sinking like the titanic. That's the problem with "hot" stocks all the clowns who pumped it to ridiculously high levels all try to leave at the same time and send it to rediculously low levels...This sellof in POT is not over...the fertilizer story is dead...its a cyclical it cannot stay strong in a global economic slowdown...people have to admit that a fertilizer stock like POT at 240 was a little idiotic...i thought for a little while that they had found the cure for cancer with the excitement that some people had over owning this stock.

2008 Oct 03 02:52 AM