Fertilizers – Looking for Green Shoots

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 5th, 2016

Fertilizers – Looking for Green Shoots

  • The fertilizer sector is currently as unloved as any in the chemical space given the poor and well-documented fundamental outlook
    • Crop prices are low despite a recent bounce and the outlook points to continued price pressures due to high inventory levels and plantings
    • Net farm incomes in the US were estimated to be down 27% in 2015 and the USDA is forecasting another 2.5% decline for 2016
    • Structural changes in the industry have contributed to oversupply – notably the collapse of the BPC potash cartel in the former Soviet Union and production builds in China
    • New capacity is still coming to the market, particularly for potash
  • This negative outlook could already be reflected in deteriorating earnings estimates and stock performance, offering an opportunity for analysis for contrarian investors
  • Looking through the poor fundamentals for value on an asset based approach:
    • MOS, POT, CF, and AGU are all below multi-year price/tangible book multiples – discounts most pronounced for MOS and POT
    • Stocks look less attractive on current P/E and EV/EBITDA measures but we note earnings estimates have historically been poor indicators for actual earnings in this industry
    • Normalized analysis is problematic due to the structural changes noted above
  • Need to make sure companies can survive a prolonged downturn
    • Unlike what we are seeing with many other commodity companies, there has been a mismatch between stocks and bonds for the fertilizer companies – while stocks are down, fertilizer company bonds are indicating little stress, suggesting no large concerns of cash flows and/or high quality asset coverage
    • Cash flow analysis favors MOS
  • Valuations generally favor MOS as does balance sheet work
    • POT has similar valuation and leverage metrics but its cash flow situation is precarious and the dividend could be further challenged
    • The phosphates market is more concentrated and inventories/shipments appear in better shape compared to nitrogen/potash, and MOS has the largest degree of phosphate exposure
  • Possible green shoots:
    • Continuation of recent rally in crop prices
    • Weaker US dollar given Fed suggestion of slow pace of rate hikes
    • Potential transition in weather patterns from El Niño to La Niña (dry conditions coming)
    • Fertilizer affordability indices are supportive of increased application
    • Earnings reports have generally indicated a robust demand outlook for 2H ’16

Exhibit 1

Source: USDA, Company Reports, Bloomberg, Capital IQ, SSR Analysis

Fundamental Fertilizer Outlook (Mostly) Poor

Below we overview the factors influencing the current negative sentiment towards the fertilizer group.

Crop Prices

Crop prices have staged a rally in recent weeks, but have trended steadily downward since peaking in 2012.

Exhibit 2

Source: Capital IQ, SSR Analysis

Farm Incomes

Farm incomes have fallen accordingly. Estimates from the USDA indicate farm incomes were down substantially in 2015, and forecasts for 2016 do not show any improvement, in fact calling for a further 2.5% decline.

Exhibit 3

Source: USDA, SSR Analysis

Plantings

The near term outlook for US planted acreage of corn and soybeans, the two largest and most fertilizer intensive crops, is generally unsupportive of higher prices. Planted corn acreage is estimated to be up more than two million acres in 2016 – soy is off a million acres (~1%) but from record levels. At the same time, more acres planted suggests more fertilizer needed.

Exhibit 4

Source: USDA, SSR Analysis

Inventories

Reliable inventory data is not readily available on a monthly basis but end-2015 levels indicated domestic inventories were elevated relative to historical averages.

Corporate commentary has been cautiously optimistic on this front, while generally acknowledging somewhat elevated inventories not only in the US but globally as well.

Exhibit 5

Source: Fertilizer Institute, SSR Analysis

Industry Structure

The 2013 breakup of BPC, the Eurasian potash exporting consortium (cartel) removed a major source of price stability in the industry. The potash price decline since that point in time (~45%) has been more than twice as severe as the declines for nitrogen and phosphates (~20%). New potash capacity is still scheduled to come on line, compounding the supply problems.

The rise of China has also significantly impacted the fertilizers market, accounting for growing shares of production and consumption. The country is still a net importer of potash (partially a geological phenomenon) – its annual contract price is seen as a benchmark, but China has yet to reach an agreement with suppliers as prices have continued to decline.

Outlook Reflected in Earnings Estimates and Performance

The confluence of negative factors and indicators have been reflected in significant negative revisions to EPS estimates.

Exhibit 6

Source: Capital IQ, SSR Analysis

An index of these fertilizer stocks has markedly underperformed the chemicals sector and the broader Industrials & Materials space in 2016 to date.

Exhibit 7

Source: Capital IQ, SSR Analysis

Valuation

An application of our normalized earnings framework to the fertilizer industry is hindered by the changing dynamics – the breakup of the BPC potash cartel for instance makes the longer term return on capital history for POT less relevant in determining a normal earnings figure.

The stocks look unattractive, in fact expensive, on earnings multiples given the level of recent estimate cuts. That said, estimates have not historically been the best indicator for this group, as actual earnings have been highly volatile versus initial estimates over the past decade. MOS does not have sufficient history to qualify here.

Exhibit 8

Source: Capital IQ, SSR Analysis

Even if earnings are under pressure at the moment, these companies’ assets still have value. Valuing on an asset basis, most of the fertilizer stocks look inexpensive – price/tangible book discounts are most pronounced for MOS and POT (more than one standard deviation below average).

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

Surviving a Prolonged Downturn

Balance sheet health is a key area of focus with POT having cut its dividend recently – the motivation was understandable as the company has a very tenuous cash position. MOS is the best funded on this basis.

MOS also screens well on debt levels – lowest leverage among peers, only small maturities through 2020, and reasonable debt composition of enterprise value. CF is the most levered and its cash flow is challenged in the near term by planned capital expenditures in 2016.

Exhibit 11

Source: Capital IQ, SSR Analysis

Exhibit 12

 

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

Exhibit 14

Source: Capital IQ, SSR Analysis

Possible Green Shoots

Continued Rally in Crop Prices

The recent rally in crop prices has not yet been reflected in higher fertilizer pricing but bodes well for farm incomes and contributes to improved fertilizer affordability (more on this below).

Exhibit 15

Source: Capital IQ, SSR Analysis

Weaker US Dollar

After an extended period of significant dollar strengthening, the recent trend has been toward a weakening of the dollar relative to most major foreign currency pairs, supported by a slower than anticipated pace of rate hikes from the Federal Reserve.

Exhibit 16

Source: Capital IQ, SSR Analysis

Changing Weather Pattern

The inevitable end of the current El Niño weather pattern, and the emergence of a La Niña, could come sooner rather than later – the Bureau of Meteorology in Australia pegs the odds of La Niña developing over the next six months at 50%. La Niña produces dry conditions in the Western Hemisphere, which could have a significant impact on corn and soybean crops from the US Corn Belt to Brazil and Argentina.

A better Indian monsoon is expected for 2016 than was seen in 2015, and this should also be supportive of fertilizer application.

Affordability Indexes

Below we show versions of a fertilizer affordability index – often these are shown on a blended nutrient basis but here we break out individual fertilizer prices versus relevant crop prices. The affordability index is calculated simply as the fertilizer price divided by the crop price, indexed to a date (we use January 2010). The recent upturn in crop prices, combined with continued weakness in fertilizer pricing has left these affordability index near multi-year lows, suggesting greater incentive to apply on the margin.

Exhibit 17

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 18

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 19

Source: Capital IQ, Bloomberg, SSR Analysis

Earnings Reports Indicated Strong 2H Demand and Positive Indicators

The affordability of fertilizers has been propagated consistently by the fertilizer companies and this was reiterated on Q1 earnings calls by both POT and MOS.

Both companies also cited accelerating global demand in 2H ’16, which should drive operating rates higher and costs lower. MOS expects the dollar to moderate versus other currencies.

POT was hopeful for higher potash prices as lower priced 2015 inventory makes its way through the market. It is also expected that there is pent-up demand as the market waits for the settlement of China’s potash price contract.

MOS and POT saw better demand and shipment results in their phosphates segment, which is also supportive of a positive view on MOS given its greater proportional exposure here.

©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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