CF Industries (CF) is a leader in the fertilizer industry and one of the largest distributors of Nitrogen and Phosphate fertilizer products in the world. The company distributes both nitrogen and phosphate fertilizer products through numerous wholly owned facilities in North America. The company also has a 75.3% ownership stakes in Terra Nitrogen Company, L.P. (TNCLP), a publicly traded limited partnership, as well as interests in other ventures.
The company has sales of approximately $6 billion dollars annually, of which just over $5 billion (84%) came from Nitrogen products, and the remaining from Phosphate.
Below I outline my thesis of why this is a good company but has not yet met my criteria for purchase.
Note: I won't go into detail here, but for more information on my investing philosophy please check out my profile or website linked above. The two most important criteria for me are the magic formula and my circle of competence for the business/industry. Each of these has a maximum score of 2 points, whereas the other criteria listed below a maximum of 1 point each. Total possible score is 10 points. In my system I advocate buying companies which score at 8 points or above.
The first item to check in my system is whether the company is a magic formula stock or not. CF is currently on the 50 over $50 million magic formula screen. For those who are not aware of what the "magic formula" is, this is a stock ranking system created by value investor Joel Greenblatt and was first described in his The Little Book that Beats the Market. Details about his methodology, including the screens, can be found on his website. I won't go into detail here on the methods described in his book, but the basic premise is to find companies with a high earnings yield (measured by EBIT/EV) relative to the return on invested capital (NASDAQ:ROIC) that they produce. This means you are screening for "good" companies at "bargain" prices. If you check out the website above, you can sign up (for free) and view the current top 50 stocks over $50 million in market cap using this methodology, and you can also change the market cap to whatever number >$50 million you want. Following my philosophy, I check the 50 over $50 million and the 50 over $1 billion screens as a starting point for stocks to analyze.
Given that CF is currently in the 50 over $50 million screen, I score this criteria with 2 points.
Circle of Competence
This criteria I use to determine how familiar I am with a company/industry, and whether I feel I know enough about it to make reasonable and accurate estimates on future earnings and business prospects. Staying within your own circle of competence is key I believe to long term investment success.
This is how I derive a circle of competence score for companies I evaluate (score value between 0 and 2):
- When looking at a company to determine whether it's within my circle of competence, I first do a very simple practical check - I go to one of the popular finance websites (e.g. Yahoo) and I read the Profile description of the company. It's almost always the first step I take. If I give it one or two reads and still have no clue what the company does or industry is, then I would score this a 0 and in 99% of cases move on.
- If however the description is simple and easy to understand from my perspective, I will score this criteria already at a 1 out of 2.
- I'll give a 1.5 if I feel I have some relevant practical experience in the industry to have sufficiently developed my own detailed perspective on it.
- A coveted 2 score I'll only give if I really have a deep understanding of the company through personal experience with it directly.
In the case of CF, for me the basic principles of the business are easy and understandable. So I can score this at a 1. In the past I've had some exposure to the agricultural industry, but my overall understanding of the fertilizers industry is not a core competence of mine. I therefore don't have any compelling reason to score this above 1 point, as there will be some inside dynamics to the industry which I am not fully competent in.
Good Business Prospects
My thesis for the growth of this business is very simple - the world population continues to grow and will reach somewhere between 7.5 and 10 billion people in 2050. Most estimates are for an average of around 9 billion people. Today in 2012 the world has approximately 7 billion people. This continued steady population growth means simply that more food will be needed. More food means more fertilizers to successfully grow crops. I therefore see continued steady growth of the business. The growth rate on population alone is not that high (1-2% per year), however much of this growth is coming in developing countries where the farming techniques and technology used (including application of fertilizers) is much less developed than in the Western world. It is therefore reasonable to assume higher growth rates, say of approximately 5% per annum in the coming decade. Some years could be exceptional due to certain weather conditions or other intangibles requiring more fertilizer. Some years could also trend downward for similar reasons. But overall the long term demand is clearly positive for the industry. Being one of the largest players in the world in this industry, with good past results CF Industries is well positioned to succeed in this growing market. I therefore give this a full score of 1 point.
CF Industries is the world's 2nd largest nitrogen fertilizer company according to its website, and the 3rd largest phosphate producer among public companies. The company shows very high profit margins of greater than 27%. Gross Margin and Operating Margin are also significantly higher than industry averages, This in itself indicates some competitive advantages over competition. I feel confident to also give this a full score of 1 point.
The company has an active Share Repurchase Program, and a small dividend. The payout ratio is a very small 6%, so plenty of room for growth of the dividend. I have not seen any evidence to point towards a management that is not shareholder friendly. I can also feel confident then to score this at 1 point.
The company has a total debt / total equity ratio of 29%, with total debt of 1.60B. The current ratio however is very good at 3.60, and the interest coverage is a whopping 62, so the company is extremely well positioned financially, so again a top score of 1p
When looking at the EPS figures for the past 10 years on this company this is definitely one of the weaknesses which probably warrants further investigation. Clearly this is a cyclical nature to the business, and earnings have fluctuated quite substantially. They took a significant jump in 2011 to 21.99/share, and this is related to the recent acquisition of a controlling ownership stake in Terra Nitrogen Company, L.P. (TNCLP). Overall this puts a degree of uncertainty on calculating the margin of safety. Cyclical businesses are much harder to accurately estimate earnings growth, and in this case I feel this must be scored at 0.
Margin of Safety
Taking my standard approach of conducting a simple DCF, I have taken the following assumptions:
- 5% growth over 10 years
- 0% terminal growth
- 21.99/share current EPS
- Discount rate of 6%
- confidence in estimates: 50%
Using these inputs I arrive at an intrinsic value of $271/share. With a current market price of $215.90 at time of writing, this implies on upside of about 25%. I would prefer a margin of safety of 50% or greater. For this reason I will score this only 0.5pts. Due to the lack of predictable earnings or my strong competence in this industry, I cannot justify a higher valuation at this point.
Conclusion: Not a buy.
CF has not met my criteria to make it onto the buy list. I believe it is still a strong business in a growing industry, but at the current price level I cannot justify with enough certainty that the company is significantly undervalued. I would advise to wait a few months to see if there is a pullback in the price to the $180/share range, which would then constitute a much larger margin of safety (50%). This would cause me to change my total score to 8pts.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.