CF – Analysis Suggests Dividend Can Be Sustained – Attractive Long Term Buy

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 8th, 2016

CF – Analysis Suggests Dividend Can Be Sustained – Attractive Long Term Buy

  • CF’s cautious outlook for the nitrogen market through 2017 has the stock down significantly, creating a potentially intriguing entry point
    • Yield at the current price is over 5% – so the key questions is whether the dividend is at risk!
    • At cash from operations for 2017 and 2018 of $1.5 million and $1 billion respectively, cash balances even after dividend payment would be $3.2 billion at end 2017 and $2.7 billion at end 2018; for these cash balances to be reduced close to zero by 2018, cash from operations would have to be 75% lower than current estimates imply
    • Avoiding penalty payments to CHS require investment grade rating to be maintained and this may impact the decision on the dividend – on balance we feel that under all reasonable scenarios the company will be able to continue to support the dividend at its current level and would encourage management to reaffirm this given the low yield environment as it would put a solid floor under the stock
  • CF is far better positioned today than POT was in early 2016 when it made the decision to cut its dividend (the first time) – in our view if CF cuts its dividend it will be because of choice (signaling much more caution on the market that it has stated)
    • The company has built cash from the CHS deal, indicated reductions in capital spending, and has no major maturities due until 2018, and has a sizeable tax refund coming
    • CF occupies an advantaged position on the global urea cost curve, even as natural gas pricing has risen year to date – margins remain strong
    • As a contributor to industry overcapacity, cash flow should be positively impacted in 2H 2016 through increased volume – likely at lower returns on capital investment than planned
  • The major risks to the CF investment thesis:
    • Rising natural gas (notably relative to inland China coal prices) negatively impacts CF’s competitive positioning by flattening the urea cost curve – margins should remain positive
    • The company’s expectations of improved market conditions are based on the notion that capacity additions will virtually cease after 2017 – new major capacity announcements would be poorly received, but are unlikely given that no-one today is making an adequate return

Exhibit 1

Source: Capital IQ, Company Presentations, SSR Analysis

Investment Conclusions

Unlike potash, we believe that urea pricing is at a logical break-even level – as dictated by the shape of the global cost curve and we have written about this in the past. For potash we believe that lower cost producers are constraining production rates and effectively keeping some higher cost producers in the game, setting pricing above the theoretical break-even. This suggests downside risk to potash pricing should the low cost companies push rates up and squeeze out the higher cost guys.

So for CF the current pricing environment is lousy but does not have material downside risk. CF’s EBITDA risk comes from rising costs in the US (natural gas) against a fixed top end to the curve based on low China coal prices and assisted by much lower global LNG prices. The positive for CF is that urea demand grows and grows fairly steadily each year – so we can look at the curtailment of new capacity adds in 2016 early 2017 and expect global operating rates to improve thereafter. At current pricing and costs there is almost zero incentive to build any capacity of size anywhere in the world today.

CF is cheap by all historic measures and has significant volume leverage as new capacity starts up in the US this year. If we use an average return on capital for CF of 12.5% (the mathematical average since the company went public is 14.5%) we see the stock as 3 SD cheap (a 62% discount from normal value – Exhibit 2. If we assume that the CHS deal dilutes returns because it gives up income without reducing capital and we take the ROC down dramatically to 9% the stock is still 32% below normal value and this is without adjusting for the capital increase that will come from the US expansions.

Exhibit 2

Source: Capital IQ, SSR Analysis

Faced with the natural gas risk and the possibility of further negative revisions, we would normally be cautious on a stock like CF, but as we have summarized in Exhibit 1 and as expanded on below, CF has ample cash to maintain its dividend, generating a current close to 5% yield and we think that this is the right strategy for the company. New and existing owners of the stock should make it very clear that the own the stock in large part because of the floor created by the dividend. While CF might consider some share buybacks, it should not risk the cash needed to pay dividends and should adopt the Lyondell strategy of keeping the dividend high and opportunistically buying back stock when cash flows are positive enough to safely do both.

We think the dividend here is safe and we would buy the stock for near-term volume leverage and improving urea trends from 2018.

Base Case Cash Projections – What Estimates Imply

Using reported figures as of Q2, revised dividend payments (POT), pending debt maturities, and consensus expectations for operating cash flow and capital expenditures (or company guidance where provided), we map out the potential year end cash balances for the major North American fertilizer producers in Exhibit below. CF appears best positioned and looks like it should retain a comfortable cash balance through 2018, by which time the company expects nitrogen market conditions to improve.

CFs cash is a consequence of the CHS deal struck early in the year and it does give CF a significant cushion, which should help maintain the company’s ability to pay its dividend right through a prolonged downturn in urea pricing

Exhibit 3

Source: Capital IQ, Company Presentations, SSR Analysis

Exhibit 4

Source: Capital IQ, Company Presentations, SSR Analysis

Exhibit 5

Source: Capital IQ, Company Presentations, SSR Analysis

Exhibit 6

Source: Capital IQ, Company Presentations, SSR Analysis

Exhibit 7

Source: Capital IQ, Company Presentations, SSR Analysis

Stress Testing the Dividend – The Austerity Case

Using a more austere set of assumptions, we stress test for critical levels of dividend paying ability. MOS and POT were marginally more constructive on their fertilizer markets (mainly potash and phosphate) while CF was less optimistic about conditions in the nitrogen market through 2017. At any rate, given the trends in recent years and the inherent volatility of the industry, it is not unreasonable to expect further estimate cuts. Reduced capital spending is a potential offset, but POT and CF are already largely guiding to sustaining levels (~$600-800 million for POT, ~$400-450 million for CF). MOS appears to have maneuverability here versus what consensus is implying (over $900 million in capex estimated in 2017 and 2018 while company has indicated ~$600 million is sustaining level). Perhaps all three companies could trim an additional $50-100 million with their backs to the wall (though it does not appear that CF, at least, will need). If we bring projected capex down as such and assume the savings are offset by current forward free cash flow forecasts that are a hypothetical 25% too high, the situation becomes less tenable for POT, but CF and MOS to lesser extent show sufficient coverage.

Exhibit 8

Source: Capital IQ, Company Presentations, SSR Analysis

Exhibit 9

Source: Capital IQ, Company Presentations, SSR Analysis

Even if current cash flow estimates prove to be too high by 50%, and using the same capex assumptions as above, CF still looks to have a reasonable cash buffer to maintain its dividend payments.

Exhibit 10

Source: Capital IQ, Company Presentations, SSR Analysis

Exhibit 11

Source: Capital IQ, Company Presentations, SSR Analysis

When to Cut – What POT Was Facing in Early 2016

When POT made the decision to trim its dividend earlier in the year, it was faced with a small margin of error for its 2017 cash balance based on $500 million in debt coming due. The decision to reduce the dividend may therefore have been driven by conservative cash management. There may also have been some skepticism about the company’s ability to pay the dividend given the subsequent trend of revisions in Exhibit 9, which the company might have anticipated to a certain extent.

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. 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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