SIR #3: Fertilizer Stocks Poised for Growth

August 14, 2010
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EXECUTIVE SUMMARY:

A growing world population means increasing demand for agriculture products.

• Emerging markets such as China and India are dealing not only with population growth, but rising incomes which means more resource-rich diets.

• Fertilizers such as potash and phosphates are needed to ensure crop yields line up with the growing demand.

• Three fertilizer companies are benefiting from demand while institutional investors are beginning to buy into the long-term prospects:

  • Potash Corp. (POT)
  • Mosaic Co. (MOS)
  • Agrium Inc. (AGU)

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To say that the world population is rapidly growing certainly isn’t a novel concept.  But as a growing population places higher demand on the world’s supply of resources, global agriculture markets are facing an important inflection point. The amount of production historically available from the world’s arable land simply won’t keep up with expanding needs.  Greater amounts of fertilizer and better farming techniques are needed to keep up with with the coming epic growth in demand.

People Everywhere!

The figures are pretty alarming…  By 2050, the global population is expected to grow to 9.1 billion from its current estimate of 6.8 billion.  Much of that growth will come from emerging markets such as China and India which are not only experiencing a population increase, but also a rapid shift towards a middle-class consumer.

These consumers have a higher level of demand for resources as the middle class diet includes more protein such as poultry and beef.  Feedstock necessary to raise livestock and poultry places even more strain on the agriculture infrastructure.

As you can see in the accompanying chart, China’s protein consumption has already surpassed the US with significantly higher expectations for the coming decades.  India is a bit behind China as far as demand is concerned, but the overall trend has a similar pattern.

China’s growing food demand is compounded by a lack of water availability.  This creates both a need to import agricultural commoditiesand China has only recently become a net importer of corn – as well as a need for better farming techniques that make efficient use of the water that is available.

Food, Fiber & Fuel…

On top of the nutritional demands of a growing population, agricultural markets are also rising to meet other important global needs.  When oil prices peaked a few years ago, the biofuel industry created huge demand for corn and other crops which were used for ethanol production.  The demand has backed off a bit as traditional energy prices have weakened over the past two years.

But a rebound in global economic growth is sure to drive demand for energy – and alternative energy markets are already starting to see both demand and prices reverse higher.

Increasing agricultural demand from textile markets, fuel production as well as rapidly expanding nutritional needs combine to produce what many economists are calling a “supercycle” trend.

One of the primary investment areas that is most likely to benefit from this trend is the fertilizer industry.  Farmers across the world are increasing their use of various fertilizer products to boost crop yields.  As a result, prices for phosphates as well as potash are increasing, leading to higher profit margins and increased revenue for many of the well established market participants.

We have identified three fertilizer companies most likely to yield significant trading gains.  As always, price action dictates our trading.  In recent weeks, these three stocks have established positive trading patterns – offering us an attractive environment to pick spots to establish long positions…

Potash Corp. (POT)

The largest global producer of Potash, meeting demand on multiple continents.

Strong global demand for potash is driving attractive pricing along with increased volumes.

Company is generating positive cash flow while still investing heavily in new production.

Management has been increasing profit forecasts leading to investor confidence.

Potash Corp. is uniquely situated to meet rising global demand for fertilizer.  As the number one producer of potash fertilizer, the company exports product to a number of different countries on multiple continents - providing investors with a stable and diversified customer base.  As emerging markets increase the number of tons of fertilizer needed for expanded crop growth, Potash is keeping up with demand and seeing its shipment levels increase.

During the second quarter conference call, management announced that they expect 2010 global demand for potash to reach 50 million tons in 2010 and grow 10% to 55 million tons in 2011.  The company will likely ship 7.5 to 7.8 million tons this year and will certainly participate in the global market growth in the coming year.

As demand picks up, pricing is expected to remain firm and could rise sharply if there is a real or even perceived disruption in supply.  Pricing is subject to governmental controls and China usually sets it’s “official price” for potash each spring.  This year analysts were pleasantly surprised with the relatively high price China was willing to pay for fertilizer – and the robust price implies that China is determined and even possibly desperate to build inventory and secure enough supply.

Mining potash is a capital intensive business and Potash Corp currently has a balance sheet which includes $3.7 billion in debt.  That level sounds overwhelming, but consider the fact that during the second quarter, POT added $67 million to its cash balance while still plowing $437 million into capital expenditures.  Assuming these capex projects are accretive, the company should realize even greater profits in coming quarters because of the investments currently being made in developing expansion projects.

Potash recently increased it’s profit projection for this year – guiding investors to expect earnings of $5.00 to $5.50 per share (previous projections had been for earnings of $4.50 to $5.25 per share).  Analysts are currently projecting earnings of $5.39 for this year and expect a 40% increase in 2011 to $7.52 per share.  Earnings this year will represent roughly double the profits from last year.

Considering the growth in production along with the improving pricing dynamics, it’s probably not unreasonable to assume that POT could see its Price Earnings multiple peak at over 30 in the next 12 to 18 months.  However, using a more conservative estimate of 20 times earnings – with the current 2011 expectations, a $150 price target seems like a very easy target to hit.

Since the stock only recently crossed $100, sharp traders should be able to capture a good bit of the roughly 50% profit likely to accumulate over the next several months.

Mosaic Co. (MOS)

Only large-scale producer to supply critical mass of both potash and phosphate products.

Ample expansion opportunity with existing mines as well as potential acquisitions.

• Company estimates 100 years of future production from its high-quality mines.

• Unique “K-Mag” fertilizer includes a mixture of nutrients not offered by competitors.

Mosaic benefits from many of the same global trends, and is uniquely positioned to add a healthy amount of supply to the market.  The company is spending billions to increase its production of both phosphate fertilizers as well as potash.  In fact, the company expects to reach an annual production level of 17 million tonnes by 2020. This year Mosaic will spend between $1.0 and $1.2 billion in capital expenditures.

Despite, the massive investment, the company actually has a very healthy balance sheet.  At the end of 2009, Mosaic was sitting on $1.3 billion dollars in debt – which means that the company reduced long-term debt by more than $100 million since the end of 2008. What is even more impressive is that the company was sitting on $2.2 billion in debt at the end of 2007.

To put those numbers into context, the net equity for shareholders sat at $8.5 billion at the end of 2009, compared to just $4.2 billion two years prior.  So in 24 months, management doubled shareholder equity while reducing debt by nearly 70%! The stronger balance sheet will allow Mosaic to have flexibility in pursuing growth during a key time when customers are demanding more product – and willing to pay a premium price.

Mosaic operates on a May 31 fiscal year end.  So at this point we are still waiting on Q1 (2011) to wrap up before getting updated data from management.  But the stock’s price action is much more closely tied to the current macro environment and the growing realization of just how important the fertilizer market will be as emerging markets struggle to meet their growing agricultural needs.

Still, it’s helpful to look at the fundamental data to see just what traditional money managers will be willing to pay to own shares of this secular growth play.  The consensus estimate for earnings in fiscal 2011 currently sits at $3.50 which represents an increase of 81% from last year’s figures. Of course a growth rate of 81% isn’t sustainable for the long-term, but the company’s future earnings should be supported by three primary issues:

  • Massive capital spending targeted at increasing annual production
  • Growing global demand which should persist for decades
  • A supportive price environment for fertilizer products

With these broad trends likely to continue to drive attention (and capital) towards the space, it’s not unreasonable to expect mutual fund managers and pension funds to pay up to 25 times current year earnings to gain exposure to this important industry.  Assuming the consensus expectations are correct (a bold assumption, but the numbers are conservative in my opinion) MOS could see a price of $87.50 in the next few months.

That price may seem a bit aggressive considering the stock is currently near $50, but in 2008 when agriculture stocks were in focus, the stock eclipsed $150 per share.  Of course savvy traders will make sure to pick attractive entry points and manage risk carefully – but there will likely be many opportunities to capture profits from Mosaic as the agriculture story pans out.

Agrium Inc. (AGU)

The only major company that is integrated from mining and production through selling to growers.

Diversification into professional turf and ornamental markets gives the company an additional revenue source for its products and expertise.

An acquisition strategy has allowed the company to take advantage of dislocations resulting from economic turbulence.

Strong cash flow metrics increase investor confidence.

Agrium is a very diverse company which allows management to take advantage of market shifts in various regions and industries.  The firm’s primary business is producing phosphate, nitrogen and potash fertilizers.  But in addition to selling its production to the global industry titans, the company is also active on the distribution front – with farm centers actually distributing product directly to individual farmers.

Based out of Calgary, Agrium is affected by farming trends in North America, but is also very active in South America and recently acquired 24 farm centers and a chemical plant in Argentina.  South America is turning out to be a major player in the global agriculture market and Agrium has an established South American presence which is likely to benefit growth in coming years.

The second quarter was a stellar period for the company – representing the second highest earnings in the history of the company - as investments in growth began to pay off in a strengthening agriculture market.  For the quarter, Agrium collected revenue of $4.37 billion and produced earnings of $3.16 per share.  Analysts had been expecting earnings of $2.77 per share and since the report have been increasing their full year estimates.

Management noted that rising crop prices along with lower inventory levels would likely increase demand for crop inputs in the second half of the year.  Investors cheered the news, bidding the stock higher before the recent market weakness led to a slight pullback in the stock.

A highly liquid balance sheet has allowed management to take advantage of opportunities and over the past five years the company has committed $3.5 billion dollars to various acquisitions.

As a result of this aggressive approach, the company is expected to increase earnings by 52% this year and in 2011 growth is expected to moderate to a still-impressive 30% level.  If there are significant price spikes as a result of global production and distribution disruptions these earnings estimates could turn out to be very conservative.

Using a multiple of 20 times 2011 estimated earnings, AGU could easily see its stock price north of $115.  With a growth rate of 30% in 2011, investors may be willing to place a higher multiple – especially considering the increasing attention institutional investors are giving the sector.

Over the past week, AGU has pulled back near its level from before the earnings announcement.  But with the stock well above key moving averages and a growing trader confidence in the importance of the agriculture theme, the pullback should offer skilled traders a chance to work into exposure with minimal risk.

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2 Responses to SIR #3: Fertilizer Stocks Poised for Growth

  1. rolf johnsen on September 13, 2010 at 6:16 pm

    I like your recommendations-all seem to be in the sweet spot for longterm growth. How about SQM?

  2. [...] Management said they expect global demand to reach 55 million tons for Potash fertilizer this year. [...]

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