CF Industries Is An Attractively Priced Fertilizer Company With Strong Margins

CF Industries Holdings (NYSE:CF) is the largest producer of fertilizers in North America, with a sales volume of roughly 13,000 tons of nitrogen fertilizer and roughly 2,000 tons of phosphate fertilizer in 2011. Furthermore, the company is on course to match that achievement in 2012. CF Industries sells a vital input into the agriculture sector and presently offers a free cash flow yield of 13.25% based on full-year 2011 results, while the year-to-date 2012 results are equally promising.

Recent economic conditions, specifically the cheapness of natural gas and the current high acreage of corn planted in the United States, have served to expand CF Industries' gross and net margins in its nitrogen business over the past few years and convinced the firm of the wisdom of an expansion of productive capacity. To that end, in 2010 the company acquired Terra Nitrogen, which approximately doubled the firm's nitrogen fertilizer capacity, and the company also recently announced a further capital expansion plan that is projected to increase fertilizer capacity by potentially an additional 4,000 tons per year. The bulk of CF Industries' operations are in the Midwestern region of the United States and Canada, apart from the phosphate mine located in Florida. The company also has an interest in two joint ventures to produce nitrogen, one located in the United Kingdom and the other in in Trinidad and Tobago, and another joint venture in a fertilizer trading company in Europe.

The primary input for the production of nitrogen fertilizer is natural gas, which accounted for 45% of the cost of production in 2011. The cheapness of natural gas in the United States has resulted in substantial margin improvements over the last few years. These improvements may be expected to persist under two conditions: Either natural gas stays cheap in the future, or the fertilizer industry is capable of passing on inflation to its customers. Furthermore, over the short term CF Industries has a forward sales program that allows its customers to arrange forward delivery of fertilizers at an agreed-upon price, which in turn allows CF Industries to lock in its margins by purchasing natural gas hedges. Also, CF Industries engages in its own program of natural gas hedging for its production that has not been sold forward. As a result of these factors, investors may enjoy a greater confidence in future margin stability than is common in cyclical industries.

CF Industries' phosphate fertilizer division is smaller in terms of sales volume and profits, while its primary inputs, primarily sulfur and ammonia, have no organized forward market. As a result, margins in this sector show greater variability. The phosphate rock mine owned by CF Industries has 13 years of permitted reserves remaining at current production volumes, and the company is attempting to secure permits to expand its allowed mining area, which would extend the lifespan of its reserves by an additional 10 years.

Turning to the figures, the latest balance sheet for CF Industries indicates $2.221 billion in cash, plus $41.7 million in auction-rate securities for which no liquid market exists, but from which the company realized $31 million in sales or maturies in year-to-date 2012. CF Industries' total current assets have a balance of $3.015 billion, and its total liabilities total only $1.194 billion, of which $618 million consists of advance payments on forward sales. Therefore, in theory the company has perhaps $2 billion in excess cash on the balance sheet. If that cash were treated separately, the firm's market cap would be reduced from its present $13.1 billion to $11.1 billion and the calculated free cash flow yield would improve from 13.25%, based on full-year 2011 results, to 15.64% -- a very impressive figure. However, the nitrogen fertilizer expansion project mentioned above has a projected capital budget of $3.8 billion. The company reported in its latest conference call that it has not ruled out the possibility of accessing the capital markets, and that its metrics are consistent with an investment-grade credit rating. Even so, the company may prefer to direct some or much of its cash to the expansion project, which means that investors should not count on the excess cash balance as being separable from the company.

In terms of income and free cash flow, in 2011 the company's sales were $6.078 billion and cost of sales, net of unrealized derivative losses, were $3.125 bilion, producing a gross margin of $2.953 billion and a gross profit margin of 48.4%. Other operating costs totaled $155 million, offset by $55 million in earnings from operating affiliates, producing operating earnings of $2.484 billion. Depreciation was $416 million and capital expenditures were $247 million, producing operating cash flow of $3.095 billion. Interest expense was $147 million, which leaves $2.948 billion in pretax cash flow. Applying an estimated tax rate of 35%, which approximates the company's average income tax provision rate over the last few years, produces an after-tax free cash flow of $1.916 billion. Subtracting $222 million for minority interests and adding back $42 million in the equity of non-operating affiliates, produces a free cash flow to common shareholders of $1.736 billion and a net margin of 28.6%.

CF Industries Sales and Free Cash Flow Estimates, 2006-11

	2011	2010	2009	2008	2007	2006
Sales	6078	3965	2608	3921	2757	2033
Nitrogen Fertilizer Volume* (1,000 tons)	13002	11461	5851	6141	6914	6310
Cost of Sales, as reported	3202	2786	1769	2698	2087	1886
Unrealized Derivative Gains/(Losses)	(77)	10	88	(64)	13	(31)
Gross Margin	2953	1179	751	1287	653	178
Gross Margin Percentage	48.4%	29.7%	28.8%	32.8%	23.7%	8.8%
Operating Costs	155	149**	160	73	68	76
Depreciation	(416)	(395)	(101)	(101)	(85)	(95)
Capital Expenditures	247	258	236	142	105	60
Income from Operating Affiliates	(50)	(11)	0	0	0	0
Operating Cash Flow (not including changes in working capital)	3095	1178	456	1173	565	137
Interest Expense	147	135***	2	2	2	3
Pretax Free Cash Flow	2948	1043	454	1171	563	134
Est. After-tax Free Cash Flow (35% rate)	1916	678	295	761	367	87
Income from Non-Operating Affiliates	(42)	(27)	0	0	0	0
Minority Interest	222	92	83	76	35	19
Est. After-tax Free Cash Flow to Common Shareholders	1736	613	202	685	332	68
Free Cash Flow Margin	28.6%	15.5%	7.8%	17.5%	12.0%	3.3%

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(All figures in $millions unless otherwise indicated.)

* During the years reported, CF Industries also sold phosphate fertilizer in amounts ranging from 1,787 and 2,249 tons per year, with an average of 1,985 tons.

** Does not include $145 million in acquisition costs pertaining to the Terra Nitrogen acquisition. As CF Industries is not a serial acquirer, I have elected to treat these acquisition costs as nonrecurring.

** Does not include $85 in early amortization of debt issuance costs.

I would point out that conditions in 2008 and 2009 were atypical, comprising a speculative boom and later a bust in commodities including natural gas, and then the financial crisis. Even so, the expansion in nitrogen fertilizer capacity made possible by the Terra Nitrogen acquisition in the first half of 2010. Plus, the improvement in North American natural gas prices in that period seem to have allowed for substantial improvement in the company's margins, making a return to the conditions (and margins) of the pre-2010 period seem unlikely.

2012 is shaping up to be an excellent year as well, with sales increasing 6%, gross margins as adjusted for unrealized derivative losses improving by 4.8%, and free cash flow to common shareholders improving by 5%. The company attributes these results to an increase in the selling price of nitrogen fertilizer coupled with a decrease in the cost of natural gas, offset by a decline in the gross margin of the phosphate fertilizer business owing to lower selling prices. However, in the third quarter of 2012 there was a 3% decline in tons of nitrogen products sold as compared to the third quarter of 2011, partially offset by a 1% increase in prices.

CF Industries 2012 YTD Results Compared to the Same Period in 2011

	Quarters 1-3 of 2012	Quarters 1-3 of 2011
Sales	4623	4380
Nitrogen Fertilizer Volume (1000 tons)	9690	9658
Cost of Sales, as reported	2457	2030
Unrealized Derivative Gains/(Losses)	(61)	28
Gross Margin	2396	2058
Gross Margin Percentage	51.8%	47.0%
Operating Costs	153	110
Depreciation	(319)	(315)
Capital Expenditures	261	169
Income from Operating Affiliates	40	41
Operating Cash Flow (not including changes in working capital)	2341	2035
Interest Expense	105	115
Pretax Free Cash Flow	2236	1920
Est. After-tax Free Cash Flow (35% rate)	1453	1248
Income from non-operating Affiliates	(49)	(35)
Minority Interest	190	159
Est. After-tax Free Cash Flow to Common Shareholders	1312	1024
Free Cash Flow Margin	28.4%	23.4%

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(All figures in $millions unless otherwise indicated.)

During CF Industries' latest conference call, the firm announced that its level of maintenance capital expenditures in future was estimated to be between $350 and $400 million per year. This is significantly higher than the level of expenditures in 2011, but consistent with the levels in 2012, and this level of expenditure does not seem to have imperiled the free cash flow yield.

So, if the current level of nitrogen fertilizer and natural gas pricing continues, or if CF Industries firm is capable of passing any inflation on to its consumers, the firm's current level of profitability is fairly safe. Furthermore, with a free cash flow yield of 13.25%, even a significant (e.g. 20%) decline in free cash flow would provide current investors with an impressive free cash flow yield. As a result, and taking into account the possibility that the expansion project may result in increased free cash flows in excess of the firm's cost of capital if the current pricing regime remains stable, I can confidently recommend CF Industries as a candidate for portfolio inclusion.

Sources: CF Industries' Q3 2012 conference call, Q3 2012 10-Q, 8-K Filing (dated Nov. 1, 2012), 2011 10-K, and 2008 10-K.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.