Description

CF Industries is the largest producer of nitrogen fertilizer in the North America with ~7.4mm tons of ammonia capacity and downstream production in urea, UAN, and ammonia nitrate.  While this is inherently a commodity business, CF benefits from an elevated cost curve that is so steep that an attractive investment thesis can be made based on marginal cost pricing in the market (ie high cost producer sells product at the marginal cost).  In the last ten years, CF has undergone a significant transition from a smaller high cost producer run by a co-op to that of a low cost dominant producer.  Given ~75% of the cash cost to produce nitrogen fertilizer is based off natural gas or coal, CF maintains a sustainable competitive advantage due to the emergence of low cost shale gas in North America.  This has been bolstered by increased market share of the US market (+/-40% depending on product) which trades at a premium to the global market due to its net import situation and substantial cost of transportation.  What makes CF particularly interesting today is that it is currently undergoing a significant capacity expansion (25%+) while at the same time aggressively redeploying cash back to shareholders.  If one models out the 2.0-2.5x net debt to EBITDA target on current pricing, CF can earn $35-$40/share once the expansion is fully operational.

Brief Overview on Nitrogen Fertilizer:

Nitrogen fertilizer, along with potash and phosphate are three nutrients that farmers use annually.  It is most intensely used in corn plantings, but also used for the production of soybeans, wheat, palm oil, etc.  Of the three fertilizers, nitrogen fertilizer is the most inelastic nutrient (ie. If you don’t put nitrogen in the soil there is no crop).  The demand environment has been extremely resilient and grows in line with global grain consumption (1.5-2.0%).  In 2008, demand for nitrogen declined by.8% and grew in 2009 by 1.5%.  The inelasticity of the product is extremely important in today’s low crop environment because a farmer may opt not to purchase a tractor or certain insecticides, but has no choice but to buy nitrogen.

The cost to manufacture nitrogen in the US is tied to the price of natural gas.  At ~$4.00 natural gas, a US player can produce urea at ~$170/ton.  Chinese producers of nitrogen fertilizer from anthracite coal are the high cost producers on a global basis and require pricing of ~$300/ton to break-even.  Over the past several years as pricing has approached marginal cost, producers have historically acted rational, shuttered capacity and balancing the market. Interestingly, the Q3 Yara earnings call highlights this dynamic.  The company pointed out that Chinese exports were down from 2.8mm to 2.4mm tons YoY in 1^st two months of the third quarter and stated that “If China continues to struggle with cash costs, going forward, that can have a significant tightening and positive effect on the global nitrogen market.”

Capacity Expansion:

Given the low cost position of shale gas in the US (<$4.00/mmbtu v $10+ globally), nitrogen fertilizer profitability is at record levels domestically, but low on a global basis.  This has resulted in a large number of announcements of new capacity for the US market.  However, these announcements came at the same time as other major E&C projects such as new builds for ethylene plants, LNG export terminals, methanol plants, etc. thereby driving replacement costs to record levels.  This has benefitted CF for two reasons. 1) CF was an early mover in building its own capacity and is able to increase its production at a significantly discounted cost, and 2) the rapid cost escalation has resulted in cancellations of numerous projects such that oversupply is no longer a concern.  It has also dramatically increased the value of CF’s own replacement cost, which one can argue is in excess of $400/share on current greenfield estimates. CF is building 2.1mm tons of ammonia + downstream capacity for a total cost of $3.8B, implying a price of ~$1,800/ton.  This compares to a recent announcement from CHS in September of 2014 at ~$3,400/ton.  The details of the expansion, which is pulled from the 2013 analyst day slides, are pasted below.  From a timing perspective, some of the capacity is expected to start in the back half of 2015 with full operational capacity by mid-2016.  These projects are expected to add meaningfully to the company’s cash flow generation and earnings power of the business.

Capital Return and Shareholder Friendly Management Team:

In the back half of 2013, CF announced that Steve Wilson, the previous CEO, was retiring and Tony Will would take the role in January of 2014.  I view this change as material because it resulted in a significant shift towards shareholder friendly actions from management.  In the Q4 2012 earnings call when asked about capital allocation, CF’s former CEO noted that “a nitrogen fertilizer stock is never going to be a yield stock”.

Since then, CF sold its phosphate business for $1.4B (non-core asset), increased its annual dividend from $1.60/share to $6.00/share (2.3% yield), noted discussions to evaluate an MLP structure (Citi conf last Dec), and provided to the street appropriate leverage targets of 2.0-2.5x EBITDA on mid-cycle earnings.  The final datapoint is particularly meaningful because it likely set forth the aggressive share buybacks we have seen YTD.  CF Industries has repurchased ~11.5% of its market cap in the 1^st half of 2014, or 23% annualized.  Of the 2,400 companies in the US with a market cap greater than $250mm, CF ranks #9 on the buyback list.  Additionally, management announced another $1B buyback authorization in August and declared its shares a “screaming value” in the Q2 2014 conference call.  It is my opinion that the rate of buybacks is likely to continue at this aggressive pace until these leverage targets are met or the stock more appropriately reflects fair market value.

Yara/CF Talks:

On September 23^rd, CF issued a press release noting they were in merger discussions with Yara, a Norwegian nitrogen fertilizer company with assets mostly across Europe.  On the face of it, the deal did not make much sense.  CF has lower cost assets, a substantial growth profile, and a strategy that is likely to result in substantial appreciation in the shares over time.  It was speculated by some analysts that CF was exploring this opportunity as the likely target.  While the sequence of events that occurred during these discussions were out of the ordinary (Yara’s incoming CEO turned away the job when discussions started & the existing CEO subsequently resigned), a deal did not come together.  CF announced on October 16^th that the merger discussions had been terminated.  With the merger discussions terminated, the company is now in a position to resume its capital allocation strategy.

Overall, I believe this is a simple story.  The market is too short term focus and not appropriately looking at the earnings power pro-forma for the re-levering.  If one takes $300/ton urea, $500/ton ammonia, $4.00 natural gas and assume 2.25x leverage, one can generate ~$37/share in eps, $40/share in FCF once the expansions are complete.  Even assuming a 10x multiple, CF presents a 26% compounded return over a two year period.   

Catalyst