Terra Nitrogen Or CVR Partners: Terra Nitrogen Valuation

Includes: CF, CVI, TNH, UAN
by: Chris Damas

Here is the fourth (of five) installments of our special report comparing two very popular fertilizer investments: Terra Nitrogen (NYSE:TNH), formerly a subsidiary of Terra Industries but now controlled by CF Industries (NYSE:CF), and the recent upstart, CVR Partners (NYSE:UAN), which is controlled by CVR Energy (NYSE:CVI). Please check out part 1, part 2 and this article.

Terra Nitrogen Valuation

Terra Nitrogen Company L.P., the Master Limited Partnership trading on the NYSE under symbol TNH, was reorganized on September 1, 2005.

The 2% General Partner interest was converted into a 1% GP override on "Available Cash" plus a 0.025% interest in each of the two partnership levels (Partnership and Operating Partnership) as well as 184,072 Class B common units (or 0.985% of the Limited Partnership interest).

If you add up these last three percentages, they amount to 2%. Hence, the reorganization caused no change in the economic interest of TNCLP's General Partner, which is owned now by CF Industries. Any increase in the GP's economic interest would have had to have been ratified by the LPs.

Each of the parties (Common Units, Class B Units, GP) receives a different portion of TNCLP's cash flow and in the case of a liquidation, merger or takeover, net asset value.

The Class B common units are similar to the TNH common units but they get a different share of the operation's cash flow and are owned 100% by the GP.

Since the formula for distribution payout is a sliding scale, the valuation of TNH, representing the 18,501,576 or 98.99% majority of the common units, is not obvious. Over a certain threshold, TNH receives only half of Verdegris cash flow.

Here is a chart and table showing the distribution of Quarterly Available Cash - QAC - between the two parties.

TNCLP Quarterly Available Cash Split
QAC ($millions) 11.40 25 50 75 100 125 150
GP ($millions) 0.20 4.30 16.80 29.3 41.8 54.3 66.8
TNH ($millions) 11.20 20.70 33.20 45.70 58.20 70.70 83.20

What investors should note is that if TNCLP quarterly available cash declines to $11.40 million (60.5 cents per common unit), the GP gets only a token payout of $200K. But if the quarterly AC rises then the GP would receive more, and over a $1.045 cent level, receives 49.5%. For example, with QAC at $150 million, $66.8 million or 44.5% would go to the GP.

The 60.5 cent minimum quarterly distribution target is cumulative to unit holders. That is why in 2008, the TNH units received $15.01 as the units were being caught up with cumulative unpaid distribution.

Here are TNH's financials for the 2005-2010 period, as well as our estimates for the last two quarters of 2011 and full year 2011.

We are estimating a $13.70 total distribution for 2011, with a final $3.75 payment for the last two quarters. Note Terra Nitrogen reports its Q3 earnings and distribution on November 1st after the market closes, in conjunction with CF.

Terra Nitrogen does not hold a conference call for investors and analysts.

We are estimating a $15.01 net earnings per common unit result for 2011, versus a total net income of $27.03 per unit, which is calculated as if there weren't a substantial allocation to the GP.

Since the former unit is the most relevant, at the current price of TNH of about $165, the units are trading at 11 times our 2011 estimated net earnings.

The distribution of $13.70 was skewed higher by approximately $1.60 estimated one-off payments when CF changed the way TNH would receive its revenues.

As of Jan 1, 2011, TNH receives the forward booked prices for ammonia and UAN that CF arranges, as the product leaves the plant gate several months later. The main substantial changes to TNH's numbers from this arrangement are that freight is no longer received from customers and does not enter into revenue, so revenues are less than historically all things being equal.

The other change is that TNH will no longer have to keep large amounts of working capital as accounts receivable, as it is paid immediately by CF. This should serve to reduce some of the volatility in quarterly available cash and hence TNH distributions.

Therefore the adjusted estimate for 2011 distribution would have been $12.10 and TNH is currently trading at a 7.33% pre-tax adjusted 2011 estimated yield.

FY 2005 FY 2006 FY 2007 FY 2008 FY 2009 FY 2010 Q1-11 Q2-11 Q3-11e Q4-11e FY 2011
TNH Revs $454.8 $424.7 $635.5 $902.60 $507.00 $564.00 $195.80 $198.20 $216.0 $217.00 $827.00
TNH COGS $392.3 $372.0 $414.6 $470.8 $346.8 $347.0 $70.9 $65.8 $86.4 $86.8 $309.9
TNH Less Freight $352.6 $323.1 $362.6 $408.2 $291.0 $284.7 $70.5 $65.5 $86.0 $87.2 $309.9
TNH GM $63.2 $53.1 $221.6 $432.20 $160.90 $217.60 $125.10 $132.80 $129.6 $130.2 $517.70
TNH%GM 13.9% 12.5% 34.9% 47.9% 31.7% 38.6% 63.9% 67.0% 60.0% 60.0% 62.6%
TNH OI $55.5 $44.5 $200.5 $416.5 $143.9 $201.9 $120.9 $128.0 $125.0 $125.0 $498.9
TNH%OI 12.2% 10.5% 31.5% 46.1% 28.4% 35.8% 61.7% 64.6% 57.9% 57.6% 60.3%
TNH NI $55.94 $46.19 $205.78 $422.40 $144.30 $201.60 $120.90 $128.90 $125.0 $126.00 $500.00
TNH%NI 12.3% 10.9% 32.4% 46.8% 28.5% 35.7% 61.7% 65.0% 57.9% 58.1% 60.5%
TNH Com $54.74 $45.27 $201.67 $275.71 $100.00 $148.20 $66.60 $73.10 $68.8 $69.3 $278.00
TNH%Com 97.9% 98.0% 98.0% 65.3% 69.3% 73.9% 55.1% 56.7% 55.0% 55.0% 55.5%
TNH NI/UNIT $3.02 $2.50 $11.12 $22.83 $7.80 $10.90 $6.53 $6.97 $6.76 $6.81 $27.03
TNH EPS $2.96 $2.45 $10.90 $14.90 $5.41 $8.01 $3.60 $3.95 $3.72 $3.75 $15.01
TNH S/O 18.50 18.50 18.50 18.50 18.50 18.50 18.50 18.50 18.50 18.50 18.50
TNH CF $24.80 $83.90 $347.60 $448.50 $161.10 $218.90 $124.70 $138.00 $100.0 $90.00 $452.70
TNH Dist Com $2.95 $1.92 $7.64 $15.08 $8.92 $5.01 $1.36 $4.84 $3.75 $3.75 $13.70
Freight/Ton $18.13 $23.28 $22.00 $27.40 $27.00 $27.16 $0.60 $0.44 $0.61 -$0.61 -$1.57
TNH Cost/Ton $178.97 $176.97 $175.53 $206.22 $167.70 $151.26 $102.46 $113.45 $140.49 $142.30 $124.11
TNH Cost/Ton $160.84 $153.70 $153.53 $178.82 $140.70 $124.11 $101.86 $113.01 $139.88 $142.91 $124.11

A key takeaway from the above table should be the recognition that Terra Nitrogen's gross margins have really taken off, with Q1 2011 at $125.1 million, and Q2 2011 at $132.8 million versus $217.6 million for all of 2010.

This is a result of consistently higher ammonia and UAN prices through 2011, with subdued natural gas prices. The latest fertilizer reports I have seen suggest that Midwest ammonia, urea and UAN prices are topping out here. Having said that, reported revenues reflect fertilizer sales booked at prices made a few months ago, so results can continue to trend higher even though spot prices have already changed.

On the cost side, Terra Nitrogen receives a discount on natural gas relative to NYMEX pricing due to its location in a natural gas rich area with substantial supply available from various suppliers. TNH had hedged 9.6 million BTU of natural gas as of June 30, 2011. The hedges are in the form of swaps and a premium is paid over NYMEX prices, which have been trading in the $3.60 area but for December are offered at $4.48. Therefore natural gas costs will rise during the winter. The company's average gas cost was $4.30 in Q1 2011 and $4.19 in Q2 2011 versus $4.63 for all of 2010.

As each ton of ammonia requires about 33 BTU, Verdegris uses about 32.4 million BTU of NH3 per year and was 29.7% hedged as of the end of Q2 2011. The company's policy is to only hedge natural gas as customer orders require, thereby locking in margin as opposed to betting on the future price of natural gas.

Is TNH a cheap stock given this information?

As a fertilizer equity TNH should be compared to its closest peers such as CF.

But as a distribution paying instrument, its after-tax yield must be compared to other MLPs, including CVR Partners.

Finally, the fact that TNH receives all the cash flow if it declines to a rate of $2.42 per unit, on a cumulative basis, serves as an "out-of-the-money" put option, adding value to common unitholders. The value of this put and the downside protection it currently affords is low, given the units are trading based on distribution rates that are much higher than this minimum threshold level.

TNH's 2011 estimated P/E ratio of 11 is much higher than CF's which analyst consensus median estimates have at 7.3 times $21.53 at a $157 stock price.

Consider this the price of having the comfort of receiving a higher distribution than CF common equity, which is currently 40 cents per quarter. Each investor must examine their own tax position to decide the relative retention of income from the MLP distribution versus a common equity dividend. Investors receive annual K-1 forms from Terra in determining their filings for federal income taxes.

On a net asset value basis, since TNH has no debt so the limited partnership interest in the assets is currently valued at the TNH market capitalization of $3.08 billion. TNCLP owns Verdegris which is the main asset but also owns two ammonia terminals. But these are currently leased to CF Industries and have relatively little value.

Therefore, at $165, TNH units value Verdegris at about twice this or $6 billion, given the LP receives only 50.5% of cash flow over the base level, as well as only 50.5% of the assets in a liquidation or merger scenario. Given the 1.1 million ton NH3 production should be valued somewhere around $1,500 to $2,000/ton, it seems that's a lot of extra value being assigned to nitrogen assets in the U.S. currently. Note that new ammonia plants are being built in places such as Egypt and most recently, are being planned in places such as Cameroon.

For more see here.

Much controversy has surrounded the possible "take-under" of the TNH minority unit holders (24.7%) by majority and controlling owner (75.3%) CF Industries, which has an option to buy out the units at a price based on the lagging 20-day trading price.

My opinion is CF, which is a new owner and therefore could have different plans from prior TNH owner Terra Industries, would not buy out the TNH units when the market for ammonia assets is high. They would wait until the cycle was low.

Secondly, why buy the cow when you can get the milk for free? Between its three quarter interest in the Common Units, The Class B Units, and its position as General Partner, CF Industries already receives the bulk of Terra Nitrogen's prodigious cash flow. I estimate the multiple CF would pay for its own stock is much lower than the multiple it would currently have to pay to buy out TNH.

Therefore, the fears of a take-under are unfounded.

Stay tuned for our financial analysis of the units of CVR Partners and our final wrap on what is the better fertilizer investment, TNH or CVR?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.