Fertilizers – Fundamentals At or Close to Trough – Attractive Risk/Reward

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

November 8th, 2016

Fertilizers – Fundamentals At or Close to Trough – Attractive Risk/Reward

  • There are finally some small green shoots in the fertilizer industry:
    • Producers are generally talking about prices bottoming – signaling firmer prices in October and in the case of urea, higher costs in China as coal prices rise.
    • There remains a supply overhang in potash, and new urea capacity in the US is not yet operating fully, so it may not be plain sailing from here but conditions are in place for a turn in the cycle.
  • In the commodity world stocks start to discount recovery before we can confirm a fundamental trough – if that is the case this time, the stocks appear to be setting up for an attractive risk/reward as we head into 2017.
    • Underlying growth prospects remain robust as food demand rises, cost pressures are rising for marginal producers and price talk has come around to price increases rather than further declines.
  • Urea is the easiest to model, because supply additions are known, demand growth is predictable and the cost curve is fairly well understood.
    • The wild card is the changing trade balance required to absorb new US capacity and how the battle between US producers and importers will pan out.
    • However, US pricing has already spent months at or below break-even for importers and domestic producers alike – maybe the rules of engagement are now understood.
  • Following the POT/AGU deal we may see further consolidation moves and these will likely help market structure and defend against the more competitive international markets.
    • LSB Industries (small cap ammonia producer, LXU) is talking about strategic alternatives, which is probably another sign that we are close to the bottom.
  • From a valuation perspective, we think that CF and MOS remain the most interesting though neither is without specific risk.
    • For CF, it would be a cut in the dividend – not needed from a cash flow perspective and even with recent debt downgrades and increased payments to CHS we see this as unlikely.
    • For MOS it is about M&A and whether the company will buy the Vale assets and for how much – it is also possible that MOS could be part of other consolidation moves.

Exhibit 1


Source: USDA, Capital IQ, Bloomberg, SSR Analysis

Overview and Q3 Summary

We have been watching this sector with interest for a while now as we have been hitting some extreme pricing lows for both urea and potash, caused by different drivers. Estimates have crumbled across the board and the stocks have done very poorly as a result – MOS is down 20% over the last two months and POT and CF are down 10% – this following an already very weak 12-18 month period.

Q3 has marked, in our view, a possible turning point, with comments focusing on lows in pricing and possibly inventory, peaks in capacity additions and possible changes in competitive cost structures outside the US – some relevant quarterly comments are summarized in Exhibit 2.

Exhibit 2

Source: Capital IQ, Company Presentations, SSR Analysis

As we think about the two most important products – nitrogen and potash – the recent company results have highlighted the following:

  • Nitrogen
    • Supply
      • Worst has passed with major capacity additions of 2016 either running or starting up
      • Reduced output (exports) from China because of cost increases and increased local demand
    • Demand
      • Tough quarter for CF and others as US buyers played “wait and see” on the new capacity front
      • POT saw higher volumes
      • AGU doesn’t see significant impact on its nitrogen business from potentially lower North American corn acres next season
    • Pricing
      • Appears to have stabilized as per AGU and CF
    • Inventories
      • Low as per CF
  • Potash
    • Supply
      • Tight – Canpotex maxed out for duration of the year
      • MOS indicated some rationalization of higher cost capacity
    • Demand
      • POT and AGU both indicated “significant” improvements following contracts with India and China
      • MOS confirmed continued solid demand
    • Pricing
      • POT saw recovery from lows of early ’16
      • AGU was positive on pricing moving forward
    • Inventories
      • Universally described as lower

The quarter showed some very poor revenue surprises from the nitrogen producers as prices hit multi-year lows, and slightly better revenue numbers from the potash guys. On the earnings front AGU missed horribly, but others managed to produce surprises based on lower than expected costs – in Exhibits 3 and 4 we show the 4 fertilizer stocks but also include data for the other Ag related companies we follow.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Catalysts – Crop Production Increasing, Fertilizer Inventories Low and Affordability High

The low inventory levels indicated during earnings reports coincide with estimates for robust increases in crop production in the 2016/2017 growing season – Exhibit 5.

Exhibit 5

Source: USDA, SSR Analysis

Affordability indices also remain supportive of increased fertilizer demand – for both urea and potash, affordability is hovering near 25 year lows – Exhibit 6.

Exhibit 6

Source: Bloomberg, Capital IQ, SSR Analysis

Fertilizer Pricing – Upside if Q3 Commentary Indicative of a Turn

Following a sustained period of stability from 1990 through the mid 2000s, fertilizer pricing was highly volatile in and around the time of the financial crisis. Several small rallies since the fall from the 2008 pricing peaks have failed, and prices are below the average of the past 15 years – Exhibits 7 and 8.

Exhibit 7

Source: Bloomberg, SSR Analysis

Exhibit 8

Source: Bloomberg, SSR Analysis

Given that North American nitrogen supply is based primarily on natural gas feedstock, the price of fertilizer can be looked at on a relative basis to gas pricing – Exhibit 9. The rise in natural gas pricing in recent months has outweighed the small rebound in urea pricing, and the ratio is roughly at its lows since 2010 – Exhibit 10. We have seen a concurrent and equally significant rise in Asian coal pricing – Exhibit 11 – which should increase costs for the marginal producer (China). Several of the fertilizer companies noted the reduction in Chinese output and exports on Q3 earnings calls. Importantly, urea production is skewed towards the coastal regions of China where the higher price of imported Newcastle coal is more likely to have an impact versus the inland provinces where domestic coal inventories at Chinese mines remain abundant. Conversely, potash production in China is concentrated in the furthest inland provinces – see recent research.

Exhibit 9

Source: Bloomberg, Capital IQ, SSR Analysis

Exhibit 10

Source: Bloomberg, Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis


Yield & Cash Flows – CF Has the Biggest Buffer

POT once boasted the largest dividend in the sector but now trails its peers – the 2.5% yield in Exhibit 12 is based on the newly lowered $0.10 quarterly dividend. CF’s dividend yield has offered valuation support and the company appears to have adequate liquidity to maintain it – Exhibit 13. The cash flow outlook for MOS and POT has deteriorated somewhat since we last updated these charts at the end of Q2. AGU looks better positioned than it did at that time.

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, Company Presentations, SSR Analysis

Exhibit 14

Source: Capital IQ, Company Presentations, SSR Analysis

Exhibit 15

Source: Capital IQ, Company Presentations, SSR Analysis

Exhibit 16

Source: Capital IQ, Company Presentations, SSR Analysis

Leverage & Credit Ratings – Major Maturities Out-Year Events

Debt metrics are perhaps most concerning for CF, relative to expected cash flows, but the maturity schedule is important to note. CF’s major maturities do not begin until 2018. POT has the largest impending maturity, with $500 million coming due at the end of 2017.

Exhibit 17

Source: Capital IQ, SSR Analysis

Exhibit 18

Source: Bloomberg, SSR Analysis

Downgrades have made headlines recently, particularly for CF. MOS also saw its credit rating lowered by Moody’s in recent months. AGU again benefits from its retail business – the positive outlooks stand out in the field of negatives seen for peers.

Exhibit 19

Source: Bloomberg, SSR Analysis

Revisions

AGU had the most disappointing Q3 of these fertilizer companies, but 2017 estimates have held in best – likely due to the relative stability of its retail operations, which the other fertilizer manufacturers lack.

Exhibit 20

Source: Capital IQ, SSR Analysis

Valuation

In Exhibit 21 we show return on tangible capital for companies in the Ag space. There is usually a tight correlation between ROTC and a measure of valuation relative to capital employed and this sector is no exception. Stocks below the line of best fit show the potential for upside while stocks above the line have potential downside. CF is the only outlier among the fertilizer stocks – position on the plot indicates relative upside.

Exhibit 21

Source: Capital IQ, SSR Analysis

On forward EBITDA multiples the stocks are tightly bunched, with POT a few multiple points above its peers.

Exhibit 22

Source: Capital IQ, SSR Analysis

Risks

  • POT and MOS have most short-term cash flow risk – small cash buffers estimated for end 2017 could turn negative if cash flow estimates prove too high as we have seen in the past
  • Magnitude of CF’s expected $800 million tax refund in 2017 could be lower depending on the timing of when facilities come online
    • Rising natural gas prices in the US, lower coal prices in Asia would also pressure CF’s cost position
  • New capacity announcements – nitrogen looks safe for the time being, but additions are expected in potash in 2017, which could offset the benefits from pent-up demand in India and China after the atypically long contract negotiations of ’16
  • Potentially reduced planting intentions could lead to a less robust demand picture than expected
  • POT/AGU tie-up has been approved by shareholders and Canadian regulators but could generate noise in the share prices

©2016, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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