Description

Potash Corp is the world's largest fertilizer producer with the majority of its assets in North America.  While the company generates revenues selling potash, phosphate, and nitrogen fertilizer, its presence in the potash industry has been the primary focus for investors.  I am of the opinion that Potash Corporation is an overvalued equity in transition from a specialty to a commodity valuation.  While the stock has been a significant underperformer YTD, earnings declines have actually led to multiple expansion.  The market has taken the view that much of the decline in earnings is temporary and likely to improve materially over the next several years.  Contrary to market expectations, this commodity is no different from many other commodities such that substantial oversupply in the industry is likely to result in pricing set by marginal cost.  To the extent this occurs over time, Potash Corp will experience a significant contraction in earnings from current levels as well as multiple compression to a level comparable to other commodity businesses.  Under the assumption that pricing in the industry is set by marginal cost and the today’s current cost curve holds (Far from certain), Potash Corp could earn $1.60/share.  To the extent new capacity pushes much of the higher cost players off the cost curve, earnings could fall significantly more.  Overall, many investors have rotated into this space following the big decline in August in hopes of a cartel revival.  While the announcement of the dissolution of the Russian consortium did shock the markets, it is likely all it did was accelerate the inevitable.  Others have posted on these events to the extent you want to reference the history.

Thesis:

1. Significant downside risk on earnings
2. Stock trades at premium multiple despite poor industry outlook
3. 2014 projections suggest the company may have to borrow to fund the dividend
4. New supply is set to materially outstrip demand over the next several years
5. New corn & soy hybrids could significantly reduce the need for potash

Background:

From 2000-2007 potash pricing averaged approximately $165/mt.  The pricing was relatively steady in the low $100s until the great commodity boom in 2007 and into 2008.  Even in 2007, pricing averaged ~$240/mt FOB China.  Interestingly, Potash Corp’s stock price averaged $8/share during that period, before appreciating a few hundred percent as spot pricing reached $1,000/MT prior to the great recession.  These historical datapoints emphasize that this has not always been a high priced commodity.  Just like many other commodities (met coal, iron ore, copper, etc.), the boom period of 07-08 led to capital deployment decisions that are impacting the market today and over the next several years.  From an industry standpoint, demand has actually declined since 2007 (57mm mt in 2007 and 2013 is 53.5mm mt), and supply is set to increase materially over the next several years.  As a result, already low utilization rates of ~79% today could decline to 72-79% when assuming demand growth of 1.5-5.5%.  Given the fact that most of the capacity projects are brownfields and likely to come online, it would appear difficult to see pricing L-T above the marginal cost.  Ironically, both nitrogen and phosphate fertilizer are currently being set by the marginal cost to produce, while potash remains priced at a level that is still attractive for all global producers.  Point being, the potash exposed equities are currently being supported by cartel bulls, when in fact it does not seem possible even a cartel could hold pricing.  It is also worth pointing out that even cartels don’t always dictate pricing. In 1986 crude oil prices dropped by close to 50% as Saudi Arabia increased production by 45% YoY.  Similar to potash, oil production was increasing from competitors in a period where demand was not supportive. 

Supply/Demand:

Industry demand is currently 53-54mm tons as in a global market of 68mm tons, suggesting capacity utilization of 79%.  Over the next three years, 11.5mm additional tons are expected to come online.  This significant level of additional capacity, driven by brownfield additions from many players, implies a required 7% annual industry growth rate to maintain current utilization.  While demand has been stagnant for the past several years, a 3% growth rate suggests utilization will fall to 74% over the next several years. 

If one takes a detailed approach to the capital cost and required IRRs to move forward with these capacity additions, it seems likely all of these projects will come online.  Potash corporation has always touted the astronomical costs of building a Greenfield site.  While this is likely accurate, the key point to highlight is that the brownfield opportunities have been so abundant that brownfield returns will be the driver to capacity additions in the industry for years to come.  In fact, the majority of the projects that are expected to come online can generate a 12% IRR at $260/ton pricing for potash (See recent Bernstein report).  Even looking at the three US players emphasizes this point.  AGU, MOS, and POT are brining on capacity as levels that are below greenfield economics.  When you think about the fact that their cost/ton is in the $130-$140 range, even at current pricing of ~$300, they are generating an attractive IRR.

Cost Curve:

What the players in the industry often omit in their presentations is that the industry’s high cost producers could get pushed off the supply curve if demand falls short of supply over the next several years.  Currently the high cost producers in the industry break-even at approximately $250-$275/ton FOB china (MOS analyst day actually has a couple greats slide on the cost curve http://phx.corporate-ir.net/phoenix.zhtml?c=70455&p=irol-investorEducation p44).  The problem is they only represent a couple million tons of capacity.  If these high cost producers were to be displaced, the marginal producer in the industry could easily drop to low $200s and possibly into the $175/mt range.  If one assumes 3% industry growth and 90% of new capacity comes online, supply will exceed demand by upwards of 5mm tons.  Given new capacity coming online actually has a very low production cost/ton, mathematically one can argue the pricing in the industry should be set in the low $200s range. For comparative purposes, I estimate approximately 59mm tons of capacity today has a FOB mine marginal cost of $170/ton.  This production cost will drop to $162 over the next several years as inexpensive capacity enters the market.  Below is a quick sensitivity table that highlights the eps impact under numerous pricing scenarios for POT. 

Multiple Premium:

Historically, Potash Corp has commanded a significant valuation premium in the market, largely attributed to the consolidated market structure.  Since the effective dissolution of the Russian cartel, pricing & volumes have materially declined and POT now expects to earn $2.00-$2.20/share for 2013 earnings, well below the $2.75-$3.25/share provided in January.  When considering the full brunt of the market changes have not been realized in 2013 #s (Uralkali announced occurred during Q3), it is likely 2014 earnings will decline from 2013.  Point being, 15x 2013 P/E with downward pressure going forward does not sound particularly attractive.  Given other fertilizer companies (CF, Agrium, and Yara) trade at ~10-11x forward earnings, it would not be surprising to see Potash Corp shift to a commodity like multiple over time.  It is also worth pointing out that POT’s earnings are now much more exposed to nitrogen fertilizer, largely as a result of the deterioration in potash profitability.  In fact, N exposure represents anywhere from 30%-50% of the above profitability depending on the assumed price of potash.

Long Term Demand Risk:

Technological advances present a risk to the long term demand for potash.  Iowa State University recently concluded that new corn hybrids remove substantially less phosphate & potash from the soil (http://www.extension.iastate.edu/Publications/PM1688.pdf).  This suggests 15% & 27% less nutrient application for phosphate and potash, respectively.  While it is difficult to ascertain how farmers’ may change their purchases from one study, this is a concerning statistic & one that highlights the risk that technology can erode the value of potash over time.

Dividend:

The company currently offers an attractive yield of 4.5%, or $1.40/share.  This yield was determined during a period of better market discipline, much higher prices, and the expectations of an acceleration of demand.  As it stands today, it is likely the company will have to raise debt to fund/maintain its current dividend yield.  Cap Ex of $1.5B this year exceeds D&A substantially and should continue to be a drain on cash flow into 2014.  Assuming $1.2B of cap ex in 2014 & the dividend of $1.225B, EPS required to self-fund the dividend would be just over $2.00/share (assuming no change in WC).  This provides little room for error and becomes a far greater problem to the extent pricing erodes from here.

Summary:

Overall, POT carries a premium valuation selling a product that is no different from other commodities.  The industry is currently in oversupply and likely to get worse as new capacity comes online.  There have been many companies that go from growth stocks to value stocks. The problem is that after the initial decline (usually due to an event), the gap in valuation is so great that there is little in terms of support for that equity until 1) earnings deterioration comes to an end and 2) multiple compresses to that that may entice value investors.  It is not out of the realm of possibility that the potash industry prices its product at marginal cost and POT is ascribed a valuation that reflects the volatility and risk inherent in those returns.  At 12-13x P/E POT could be valued at approximately $20/share.

Catalyst