Credit: Shutterstock photoBy Center for Social and Economic Research :
By Bryane Michael
Overview
What could be less sexy than fertilizer? While companies like Twitter ( TWTR ) and Alibaba ( BABA ) grab the headlines, investors looking for long-term growth and income could well make fertilizer stocks like Terra Nitrogen ( TNH ) a core part of their portfolios. Back in October, fellow SA writers like Bob Ciura wrote glowingly about the company. Other SA writers like Chris Damas have described the political events affecting the nitrogen-based fertilizer market - particularly in Eastern Europe. Does Terra Nitrogen's price slide over the last quarter of about 17% (from $150 per share to $120) reflect industry fundamentals? Company specifics? Or something else?
Why is the fertilizer industry a stable bet?
The economics of the fertilizer industry suggest rapidly growing revenues over the long term. Readers unfamiliar with the nitrogen fertilizer value chain can see the Centre for European Policy Studies' excellent brief . Succinctly and simplistically, companies like TNH take chemicals from natural gas and convert them - on the demand side - into corn, soybeans and wheat and other staple crops. According to IbisWorld , a research firm, revenue for the nitrogen-based fertilizer industry should increase by about 3% per year until 2020. Yet, Figure 1 shows why we should see a jump in revenues in the medium term. Natural gas and input costs should remain relatively flat(ish) over time. The quantity of demand (and thus supply) of fertilizer should grow steadily over time. Consumer prices of the agricultural products that fertilizers make - like corn - should rebound toward their historically average prices. Price growth of around 2%-3% per year and steady demand increases of 3%-4% mean "equilibrium" (trend) profits should grow by 4%-5% per year.
The overall trend hides three important forces guiding the industry. First, nitrogen demand has outgrown phosphate and potash demand by 2-to-1 (with 30 year growth at 1.6% versus the others' 0.6% compound growth rate). Such growth means that demand for companies' products like CF Industries ( CF ), Agrium ( AGU ), OCI Partners ( OCIP ) and of course TNH should outstrip demand for rivals like Potash Corporation of Saskatchewan (POT) and Mosaic (MOS). Second, the US imports roughly 45% of its nitrogen-based fertilizers. With demand from other countries amounting to at least $60 million, US producers can absolutely takeglobal marketshare away from other countries. Figure 2 shows such demand, with Malaysia and Western Europe representing major markets for bulk nitrates (we don't show trade figures for smaller consignments). While the US uses nitrogen fertilizers for corn, nitrogen also could serve as a fertilizer of choice in the future for rice consuming countries like India and China. Third, US nitrogen-fertilizer producers have a cost advantage over foreign producers. As shown in Figure 3, at least in the global urea segment, US costs come to almost half of rivals in Eastern Europe.
Fertilizer companies of various hues and stripes transform sales into profits at differing rates. In figure 4, we show the way that nitrogen fertilizer companies have transformed revenues into profits over time. Despite their competitive advantage, US firms seem - on average - to shrink profits as they grow revenues. In economics language, most nitrogen fertilizer companies' profit elasticity with respect to revenue fluctuates wildly and generally stays negative. In simple language, US nitrogen fertilizer companies tend to grow at the expense of profits - leaving room for innovations which make profit-enhancing growth more frequent. Terra Nitrogen provides no exception - with profits falling on average 4.5% for every 1% increase in revenues since 2003.
Terra Nitrogen as Quasi-Yieldco
Terra Nitrogen, incorporated as a partnership, represents the broader trend among energy and materials companies to "spin off" pieces as partnerships (including limited partnerships), yieldcos, business development companies and other tax advantaged structures. This particular yieldco-like partnership produces nitrogen fertilizer products -- anhydrous ammonia (ammonia) and urea ammonium nitrate solutions. In other words, farmland fertilizers. Its "parent" CF Industries Holdings (actually its general partner), represents a far larger concern. As shown in Figure 5, CF Holdings spans the US and centres around the US corn belt. Terra Nitrogen's plant in Verdigris, Oklahoma represents only a small part of this larger fertilizer empire.
Despite CF Industries' relatively solid performance, Terra Nitrogen has fared far less well. Figure 6 shows the share performance of CF Industries and Terra Nitrogen. Up until mid-2013, changes in Terra Nitrogen's performance almost mirrored CF's performance. Whereas the parent (general partner's) share price has doubled since the beginning of 2010, Terra Nitrogen's price has collapsed. This price divergence corresponds roughly - and probably co-incidentally with the break-up of the Belarussian potash marketing cartel . Yet, potash markets do not have such a large impact on nitrogen fertilizer markets. TNH's price slide also probably does NOT reflect investors' disappointment with third quarter revenues earned by Terra Nitrogen's parent and general partner.
Three theories fail to explain this divergence. First, investors could seek to short the "yieldco" - with its focus on one productive asset. Investors have shorted less than 1% of Terra Nitrogen's float - suggesting no temporary speculative bubble has caused the recent price fall. Indeed, a cursory look at the company's third quarter earnings statement suggests investors have gone crazy. Terra Nitrogen has continued its relatively solid performance. Second, increasingly difficult economics of corn - a theory offered by CF Industries - also fails to explain the divergence. As shown in Figure 7, corns stocks have declined and returns to corn production have diminished as well. Yet, despite returns to all crops falling (almost certainly temporarily), CF Industries' share price has risen. Moreover, falling corn prices have not seemed to translate into falling nitrogen fertilizer prices - which exhibit a long-term trend upwards. Third, if we believe recent share price behavior, the company must have suffered from some kind of shock -- which has lowered its long-term profit earning potential. Yet, a Westlaw and Factiva search on Terra Nitrogen fail to reveal any such serious "shocks." Nothing in its EDGAR filings - such as a major sell or other materially adverse event -- jumps out at the reader.
Has the market gone crazy (like usual)? Investors who have sold shares in the last 12-24 months will know better than us. However, looking at the company's fundamentals suggests that the share price of the security underlying this Verdigris plant could recover. Figure 8 compares Terra Nitrogen with CF Industries. Terra Nitrogen runs a far tighter ship than its parent (general partner). Terra Nitrogen's profitability exceeds CF's, its returns higher, and it has lower indebtedness. The crux of the issue thus revolves around its negative earnings growth rates and its higher dividend. Together, these data suggest investors think that TNH's negative earnings growth rates could put its high dividend yield at risk. Indeed, its price premium likely reflects shareholder demand for its high dividend yield.
Yet, TNH's cash flow suggests that investors have unfairly penalized the company. Figure 9 shows the major items from the company's cash flow statement. Net income over the last 4 quarters has undeniably fallen - with operational cash flow exceeding net income. If the industry trends play out as we have noted above (and barring any serious event in Verdigris), net income should recover. The major 'negatives' (in quotes) consist of increases in capital expenditure and dividends - which have significantly lowered its cash balance. Short-sighted investors penalise a company for making productive investments and paying out cash. In the language of economics (and assuming we haven't missed something), these trends suggest that the current price fall represents a technically (or emotionally) backed deviation from long-run the stock's equilibrium price trend based on the company's fundamentals.
Assuming Terra Nitrogen benefits from any of the trends we have described in this brief, the price should rise to easily over $200 per share. In theory, using a simple discounted cash flow model (with earnings per share at 12.82 and growth of 6% annually for 5 years before stagnation) produces a whopping estimate price per share estimate of roughly $420 per share. No one believes such an abstract theoretical calculation. But recovering agricultural prices, continued nitrogen fertilizer price growth, potential for export, and other factors clearly portend well for the company. If Terra Nitrogen simply follows the trend in its broader industry, the share price should recover (move back to its equilibrium long-run growth path) and grow after that.
Conclusion
In this brief, we have argued that Terra Nitrogen's share price - barring exceptional market-wide events or a catastrophe in Verdigris - should approach $200 in the upcoming 3-5 years... even after taking into account the massive cash leakage in dividend payments. At a minimum, such a move would restore the stock's price toward its historical average. Even assuming the company's operations do not revert back to its past ways, strong industry pressures militate toward higher revenue growth and profitability in the future. Market factors have likely driven the stock's price away from its "equilibrium" price determined by fundamentals. It's now up to Terra Nitrogen's management to help us see that value.
Disclaimer: The material in this brief represents my views alone. I do not offer investment advice, solicit investment-related business and have no standing licenses to do so. I confirm receiving no money for this article, so please keep that in mind if you find typos or other inaccuracies. I rely on much of the cited material on a fair-use basis (as recognised by most countries' copyright law). For a fuller working paper outlining our model (with maths and econometrics), seehttp://www.case-research.eu/
Disclosure: The author is long TNH. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
