Description

Summary

CF is a US-based nitrogen commodity producer with a cost advantage that has historically allowed it to generate free cash through all points of the cycle. Recent declining nitrogen prices coupled with rising natural gas costs provides for an opportunity to invest in CF at a mid-cycle 7.0x FCF, 2.5x Net Debt / EBTIDA and 0.4x replacement value. From this entry price, normalized historical multiples suggest ~70% upside. CF is in the midst of returning capital to shareholders. Above a small portion of capital flagged for deleveraging and commitment to its current dividend (~4% yield), CF intends to use all excess cash generation for share repurchases.

Based on management’s commentary and all observable commodity inputs, I expect CF to generate $1.4bn in EBITDA this year, translating to ~$800mm in FCF or ~$550mm in excess FCF. Therefore, based on CF’s current share price, CF should be able to buyback ~8% of its float this year (in addition to ~4% dividend coming to investors). This is very attractive for a business that is still earning below a mid-cycle level of profitability and ~40% below last year’s level of FCF generation.

As a further testament to the underlying value of CF, Koch Industries has recently started accumulating a stake in the business. Outside of CF, Koch knows the value of these assets better than anyone else as it is currently heavily involved in the nitrogen business with five urea plants in North America, representing ~15% of total North American capacity.

All-in-all, I believe CF is a very attractive opportunity. CF’s valuation can be rationalized on current cash flow metrics and its go-forward capital allocation policy is extremely shareholder-friendly. There is further significant upside should we see a steepening in the energy curve (discussed in this write up). Moreover, Koch has started taking a position in the business. Koch knows the value of these assets better than anyone else and has built a minority ownership position above the current trading price.

Overview

CF is the largest North American nitrogen fertilizer producer with a leading low-cost position. Nitrogen (urea is the most common nitrogen product) is an essential element for plant growth and crop yield. Unlike other fertilizers, nitrogen must be applied annually to farms, creating for stable demand volume trends. 

Competitive advantage

CF’s low-cost position is derived from two primary structural advantages: a feedstock advantage and a transportation advantage. First, CF’s seven manufacturing facilities have access to abundant low-cost North American natural gas, the primary feedstock into nitrogen fertilizers. North American natural gas is the cheapest nitrogen feedstock in the world with a cost advantage versus middle east gas fertilizer producers and Chinese coal fertilizer producers. Second, CF is by far the strongest player in the US with the largest distribution network. It has 24 owned plus additional leased distribution facilities. Urea tons from other production centers like the middle east and China require several incremental legs of transportation (e.g. barge, rail and ocean vessel).

Urea Supply / Demand Fundamentals

In 2014, global urea utilization peaked in the low 80% area and the tight conditions led to a strong price environment. In turn, this environment incented significant capacity additions. New supply hit the market in 2017, crashing urea prices to historic lows and driving industry utilization to mid-70% area. Since 2018, demand has started outstripping supply providing for a strong rebound in urea prices. I believe a continuation of these tightening fundamentals will persist.

It typically takes four years (or more) to build new production capacity. We currently have visibility that urea production capacity will grow ~1% annually over the foreseeable future.

Demand is forecasted to grow above global capacity additions. The primary driver of this growth is a global increase in per capita consumption of grains, fruits, vegetables, etc.

Overall crop prices do have an impact on fertilizer demand; however, nitrogen demand has historically been very stable as nitrogen is very difficult to thrift and lacks substitutes. For example, the largest year-over-year decline in global urea volumes ever experienced over the last 20-years was only 3%.

There are approximately 14mm tons of urea consumed per annum in North America, while there is only nameplate capacity for 12mm tons. Therefore, the US is net importer of ~2mm urea tons per year. Given this dynamic, while essentially all of the US production is consumed locally, the price of urea is set globally based on the cost structure of the marginal producer exporting to the US. Based on a global cost curve, the current marginal urea producers are based in China and use anthracite coal as their primary feedstock to produce nitrogen fertilizers.

US nitrogen capacity is expected to continue to operate fully utilized as there are no capacity additions expected. The last major project to come online in the US was OCI’s Wever, Iowa facility in 2017/2018, which was built for an estimated $2000 / t. I estimate this facility is earning below a 3% ROIC in the current pricing environment. Using this capacity addition as a build precedent, I estimate CF is trading at less than ~40% of replacement value, further indicating that additional capacity is highly unlikely for the foreseeable future. 

Assuming demand growth remains firm and there are no further capacity additions in the US, over time the US will continue to be dependant on an even greater amount of higher-priced imports, pressuring urea prices to move higher.

Current Situation

Nitrogen pricing has rapidly deteriorated on the back of Chinese thermal coal pricing. Spot urea prices (New Orleans benchmark) have declined from $275 / t to a current low of $225 / t. As a result, CF’s share price has declined by ~40% YTD.  In addition to this challenging price environment, CF’s primary input cost, natural gas, is forecasted to increase driven by a decline in US oil production. One-eighth of total US natural gas production is estimated to be a by-product of shale oil wells. This has caused uncertainty around the spread CF has been able to historically enjoy.

While there is no question CF’s spread will face near-term cyclical pressure, my view is that CF will generate FCF through the entire cycle. In addition, I believe once coal and natural gas markets normalize, CF will revert towards earning an attractive spread. The market is not currently discounting an appropriate mid-cycle earnings level for CF.

Chinese Coal

I believe we are approaching a trough in Chinese thermal coal markets, with a current setup that feels very similar to the last cycle between 2013 and 2019. During 2013 – 2015, coal prices in China declined rapidly and this led to the marginal cost of nitrogen production to fall. By the end of 2015, it was estimated that only 10% of the Chinese thermal coal mining industry was operating profitably at RMB 350 / t. In 2016, to support the mining industry and bail out the banks, China’s main state planner (the NDRC), enacted strict controls on domestic coal mines, limiting their operations and in turn, restricting supply to support thermal prices around RMB 550 / t. At the start of 2017, in an effort to further promote coal price stability in China, the NDRC set an "acceptable" range for coal at RMB500-570 / t, known as “the green zone”.

Urea consumes a combination of thermal coal and more energy dense coal called anthracite coal. Anthracite coal didn’t start recovering towards the end of 2016 as it had become too cheap relative to thermal coal, leading to substitution. Eventually in 2017 anthracite coal prices recovered, increasing the marginal cost of urea production and supporting a higher global urea price. CF’s realized urea pricing troughed in 2017 at $223 / t, but recovered to $270 / t and $277 / t in 2018 and 2019 respectively.

Today, weak Chinese thermal coal fundamentals are causing global nitrogen pricing to rapidly decline once again. Chinese domestic thermal coal prices dropped in April / May 2020 to RMB470 / t, trading below the green zone for the first time since its introduction. Below this green zone price, it’s estimated that one-third of Chinese thermal coal mines are unprofitable. The NDRC has yet to intervene but on April 20, 2020, China’s major coal producers, including state-controlled China Energy Investment, China Coal, Datong and privately run Yitai, have signaled for a price floor at current levels. Similarly, China's influential government-backed coal transportation and distribution association (CCTD) called for domestic coal producers to cut production to support prices and restore order to the market.

The combination of an industry that is structurally unprofitable below green zone pricing and rationalization signals from various state / private coal producers indicates that Chinese thermal coal pricing is near the trough. As the Chinese market begins to recover from the economic devastation of COVID-19 and electric utility demand normalizes, I expect coal pricing to return to their 2018/2019 levels, implying global urea prices should be set to recover from their current $225 / ton towards $275 / ton.

US Natural Gas

CF will only get to enjoy the strong operational leverage associated with higher nitrogen prices should US natural gas prices not materially increase. Natural gas costs represent approximately one third of CF’s cash costs. Despite concerns of falling associated gas production from shale oil wells, I believe gas in the ~$3.00/mmBTU area or below is sustainable over the medium-term.

U.S. natural gas consumption and production reached a record high in 2019. US natural gas consumption averaged 85 bcf/d while production averaged 99 bcf/d. Supply excess US consumption was primarily transported to Mexico via pipeline or globally via LNG terminals (nearly evenly split).

Demand growth has primarily been driven by electricity generation, as US natural gas continues to displace coal. Today, US natural gas accounts for 38% of total electricity generation. Demand from the commercial, residential and industrial sectors has been relatively flat.  

Production growth has been driven by increased drilling activity across major shale formations (e.g. Permian, Bakken, Eagle Ford). Most importantly, The EIA estimates that ~12 bcf/d is from associated gas (natural gas from oil wells)

This suggests that should shale oil production completely fall away, there is 12 bcf/d at risk. The demand destruction from COVID-19 is estimated to be in ~3 – 6 bcf/d area, leaving an estimated worst-case shortfall of ~6 – 9 bcf/d in production.

This potential supply / demand imbalance could create a temporary spike, however, longer-term there are still gas reserves with latent takeaway capacity. There’s an estimated 4-5 bcf/d in the Marcellus and 2-3 bcf/d in Haynesville. These two formations have sufficient takeaway capacity and the marginal cost for this molecule is estimated to be in the $2.75 / mmBTU area. Should we require incremental takeaway capacity, the Fayetteville formation has sufficient incremental takeaway capacity for an incremental 4-5 bcfd at an incremental $3.50 mmBTU, albeit requiring this production is highly unlikely.

Therefore, as suggested by current henry hub future prices, $3.00 / mmBTU or lower long-term natural gas feels appropriate. I’d also note that an argument can be made that this price it too high because it does not take into account substitution or high inventory levels. It’s estimated that every $0.25 / mmBTU price change, there’s a 1 bcf/d impact to natural gas demand. In addition, natural gas is storable. According to the EIA, we currently have ~200 bcfs of natural gas inventory which is well above the adjusted seasonal average

CF Valuation

CF segments its business across its main nitrogen products: Ammonia, Granular Urea, UAN, AN and other. Pricing between these products are related and can by and large be substituted for one another. Since urea is the only real globally traded nitrogen product, we use urea prices as a benchmark to set local price of nitrogen products in the US. The urea price realized by CF has been on average ~$10-20 / t higher than the global price due to freight costs from global delivered prices at the port, to in-land delivered prices where CF competes.

                Trough Scenario

Bringing our trough assumptions all together, assuming a cyclical low $225 / t urea price and a cyclical high $3.00/mmBTU natural gas cost, I estimate CF should generate $1.00 per share in FCF (versus $30.00 share price today). Not only is CF cash flow positive under this draconian scenario, but nitrogen pricing should prove unsustainable at this level given the aforementioned Chinese thermal coal fundamentals.

                Current Scenario

Using the current observable $240 / t urea price (current trough nitrogen pricing plus ~$15 realized CF pricing premium) and current $2.10/mmBTU normalized natural gas cost, I estimate CF should generate ~$4.00 per share in FCF. This figure squares with management's guidance of $1.4bn in 2020e EBITDA. 

                Normalization Scenario

Using pre-COVID urea pricing of $275 t / ton, which was and can still be supported by Chinese coal pricing, and $2.75 / mmBTU natural gas cost which is rationalized by our analysis of US natural gas pricing, CF can generate ~$6.00 per share in FCF. This scenario will require IPP demand for coal in China to revert towards pre-COVID levels. Thus, at CF’s current trading price of ~$30.00, there is a realistic scenario where we can see CF trading at 5.0x FCF.  

                Leverage

CF’s outstanding net indebtedness is $3.7 billion or 2.0x LTM Net Debt / EBITDA. Its outstanding bonds do not have any financial covenants. CF currently has excess cash of ~$250 million and access to a $1 billion revolver. Therefore, CF’s balance sheet does not pose as a concern.  

                Capital Allocation

CF has committed to retiring $250 million of debt over the next two years and paying $265 million in dividends per year ($1.20 dividend per share). All excess free cash generation above this commitment will be used for share repurchases.

All-in-all, I believe CF represents an extremely compelling risk / reward. The nitrogen market is tightening, Chinese thermal coal appears to be at a cyclical low and a structural increase in US natural gas costs appears unlikely. Meanwhile, the market is discounting an inadequate mid-cycle earnings figure for CF and CF has committed to buying back shares. Sophisticated fertilizer players have taken notice of this opportunity as can be seen by recent open market purchases by Koch Industries. 

Catalyst

Higher nitrogen prices