LoneRngr's  Instablog

With potash prices deflating around the globe like stale party balloons, one might expect to see Potash Corp (POT) adopt a more humble tone in the earnings release Thursday morning.  If history is any guide this seems unlikely.  POT has firmly opposed potash price cuts for some time now, suggesting that this would not stimulate demand in a meaningful way and would only erode future margins.  For the last few years this strategy seemed to work well, and the potash oligopoly succeeded in keeping prices high to spur record profits.  The global financial crisis however changed all of this.  Despite numerous studies that indicate potash application (even at high prices) makes strong economic sense, farmers have collectively thumbed their noses at the potash producers and have decided to take their chances with lower application rates.  Demand has fallen off a cliff with some estimates indicating that potash consumption will be down about 30% this year.  And now, whether desperate to generate revenues to satisfy financial obligations or merely attempt to resurrect moribund demand, producers are rushing to cut prices and grab a part of this smaller market (i.e. Silvinit).  The fallacy of POT’s strategy has been exposed, as a supposedly inelastic demand for potash, an essential plant nutrient, has been shown to be surprisingly elastic in the near term.  Farmers are choosing to forgo potash application and are instead attempting to “mine” the soil.  The effects of this large scale experiment remain to be seen.  While potash in soil likely can be mined for a year or two, over the longer term soil nutrients will need to be replaced.  The problem for investors is that the effects of this experiment likely won’t show up until the 2010 harvest.  As a case in point, the USDA makes no mention of the possibility of lower yields due to reduced fertilizer application rates in their latest crop reports, citing weather instead as the probable catalyst.  With the Midwestern crop season shaping up far better than it was even a few weeks ago (as reflected in the corn, wheat and soy recent price drops), this suggests that yields could hold up this year and cause farmers to conclude that their experiment was indeed successful. 

It looks like GM has tentatively agreed to sell its Saturn brand, only days after agreeing to sell its Hummer brand to a Chinese company.  Finally it seems GM is taking steps in the right direction, shedding non-core assets and brands and closing dealerships.  I’m sure that the current economic crisis and the heavy hand of government played no small part in helping encourage these transactions.  The question of the day is, “Why didn’t they do this sooner?”.  I’m by no means an expert on the subject but it seems obvious that the auto industry has been in trouble for years.  Anecdotal stories of unsold cars piling up in parking lots, 0% financing, cash back incentives, free OnStar/satellite radio, years of free warranty coverage, etc, have been used for some time now to move cars from the factory floor into the hands of consumers.  These do not seem to be signs of a healthy industry, poised to relive the glory days at any moment.

I'm not a bank analyst but I'm interested in comments on some rough numbers.  US banks were levered about 33:1, and as we all found out that number was clearly too high.  Not surprisingly, since that means that  only $3 in equity backed $97 in debt.  Said differently, this allowed only a 3% "cushion" to absorb any extraneous losses, and as we know the write-downs were far greater than 3%. 

Therefore, what is the "proper" leverage number for an average "new" bank?  It's probably not zero, or even 1X.  Maybe 10X?  If we assume 10X leverage, the new capital base is $33. (assuming $3 in equity + $30 in debt). 

Let's then say a bank made $1.00 per share in profits on an "old" capital base of $100.  If we strip out $97 in debt and replace it with $30 instead (the "new" 10X leverage factor), and keep profit level the same (say 1% for simplicity, or $1.00 per $100), this implies $0.33 in earnings.  Keeping P/E multiple the same, which we assume to be 10X for simplicity (arguably a stretch since the sector is now out of favor and is no longer considered a "growth" industry) and this implies a $3.30 stock price.  (which is down from $10 previously (10X $1.00 EPS), which is a haircut of 67%)