[CF – CF Industries] Global N Fertilizer Supply But Pricing Recovery Priced In

I was pitched this stock recently and thought it sounded interesting enough to write about (I like industries where supply and demand curves are shifting in big ways), although I think upside from a recovery in nitrogen fertilizer prices is largely baked into the current valuation.

Substantial new capacity from China, lower freight costs (to move nitrogen-based fertilizer to the US, currency devaluation), and depressed crop prices have conspired to send nitrogen-based fertilizer prices realized by CF careening 40%-45% over the last 3 years.  The price of US Gulf Urea has declined from ~$450/ton in 2012 to around low-$200s today.  The supply situation was exacerbated by changes in buyer behavior last quarter.  In North America, buyers delayed purchases, deciding they’d rather not take on inventory risk since the application season was still several months away (TX and OK start applications in Feb; the Midwest starts in March and April) and new domestic capacity (including CF’s) would be coming online soon.

Nitrogen fertilizer is an important agricultural nutrient that must be applied every year, which makes for stable and growing demand, but it’s also a commodity whose whose input costs are unpredictable and exogenous, which can result in harrowing profit swings.  [If you’re curious, the nitrogen fertilizer product complex is built like this: methane from natural gas is converted to hydrogen, and hydrogen is mixed with nitrogen to produce ammonia (a gas), which serves as the basic building block for other nitrogen-based fertilizers: so, ammonia + carbon dioxide = urea (a solid); ammonia + nitric acide = ammonium nitrate (solid); urea + ammonium nitrate = UAN (a liquid)].

CF is one of the largest nitrogen-based fertilizer manufacturers and distributors in the world and has the largest ammonia capacity market share (36%) in North America.  Nitrogen-based fertilizer is a commodity whose market price is set by the global marginal cost producer, which in this case is anthracite-coal fed Chinese competitors.  CF’s relative advantage rests in its access to low-cost natural gas and ownership of a dense logistics network in the US, giving it a significant cost advantage over Chinese and most other overseas competitors exporting to the US, and allowing the company to generate ~50% EBITDA margins over the last 5 years.  The company has experienced several major portfolio shifts, including the activist-prodded sale of its phosphate business to Mosaic in 2013 and two terminated tax inversion deals, that has shrunk and expanded the company to varying degrees.

In November 2012, CF announced major expansion projects in Donaldson, LA and Port Neal, IA through a JV in which the company invested $2.4bn of capital (45% of the total capital cost for rights to 60% of the production), which will increase the company’s annual production volume by nearly 25%.  Now, 4 years and nearly 40% over initial cost estimates later (this is common for the industry, where North American fertilizer projects have on average exceeded budget by close to 60%, and if it’s any consolation, the $1,050 per product ton cost is still the lowest of all plants recently built in North America), the projects are completed and capex will step down from $2.3bn in 2016 to maintenance levels of $400mn-$450mn.  While management has tempered the projects’ returns from announcement, the company is still expecting ~15% IRR (well above its ~8% cost of capital), assisted by greater than expected capacity, lower gas prices, and bonus depreciation.

US producers don’t manufacture enough nitrogen-based product to meet domestic demand (~70%+ of nitrogen consumption comes from the agricultural sector), which must be partially met with imports.  These imports have come from higher marginal cost producers (that is, operators who price at their marginal cost of production) who, by virtue of their higher MC of production + cost to transport fertilizer to US ports and ultimately to the middle of the country where it is needed, establish a lofty price umbrella for low-cost domestic producers.

So, domestic producers need continued imports from marginal cost producers to sustain this favorable price-to-cost spread.  Prior to CF announcing Port Neal and Donaldsonville, 25 projects with 15mn nutrient tons (nutrient tons represent the tons of nitrogen within the product tons; ammonia has 82% nitrogen content, granular urea 46%) were announced in North America, of which 7 projects with about 4.5mn of capacity (including PN and DV) are or will be producing.  According to CF, there was close to 12mn imported tons in 2015, so this added domestic capacity will still leave around 7.5mn tons (12mn import demand less 4.5mn of new domestic capacity that crowds out imports) that must be met by imports from marginal cost producers.  There have been no new projects announced in North America since PN and DV.  It’s possible that more of these announced projects come back online, collapsing the price advantage that domestic producers currently enjoy, though management claims that DV can act as an export release valve and has already seen attractive netbacks (price less production less transportation costs) moving product to Argentina, Uruguay, and parts of Europe.

To put the cost curve in perspective, US Gulf producers have the lowest cost of production at ~$120/st (short ton), so even with $200 urea prices, they’re still generating robust cash margins.  Meanwhile the majority of Chinese anthracite-based producers who make up around 50%-60% of the installed capacity in China and sit at the highest end of the global cost curve (~$225/st delivered to the US Gulf), have been operating at or below marginal cost.  (While a rational operator will scale back production when the prices it realizes falls below variable costs, it may still produce with the hope that prices rebound and will stop production only when that hope dies or cash dries up.  Without a significant price recovery that delivers the cash flow necessary to fund restart capex, that shutdown turns into a permanent retirement after around 9 months as equipment deteriorates from neglect).

Now the rail, electricity, and feedstock subsidies that these plants have relied on are being curtailed or eliminated (resulting in a  $25-$30/st cost increase for some) as the government gets real about the environmental damage caused by these facilities.  There is a growing consensus that significant capacity will be taken out of China over the next few years, with the Chinese Nitrogen Fertilizer Association calling for smaller, older plants to be phased out by 2020, which would reduce China’s ammonia and urea capacity by 10mn and 13mn tons / year, respectively, representing about 5%-6% of global ammonia production.  2015 marked the first year that plant reductions exceeded new adds, dramatically reducing the amount of Chinese fertilizer available for export in 2016.   Meanwhile, global nitrogen consumption (agricultural demand constitutes ~80% of consumption) will continue to grow by ~2%/year as it has for the last 15 years.

Rationalized capacity has sparked firmer pricing entering 4q16.  In November, Chinese urea port price per metric ton increased from $194 at the end of September to $220 while the average US Gulf price for urea barge was $30-$40 higher per short ton vs. 3q (when it was at $180), drifting higher again in December.  Pricing in the next few quarters should also get a boost from better seasonal demand as buyers come back (as mentioned above, North American buyers have pushed fertilizer purchases closer to application season).

But we still have to contend with CF’s balance sheet and liquidity.  I wrote in my last CF post:

At the end of 3q, CF had $1.5bn in cash and an undrawn revolver.  It expects to collect another $800mn in cash (tax refund) in 3q17 and has made progress cutting SGA and direct manufacturing costs.

CF recently got an amendment on its revolver subject to certain conditions (cut the facility size from $1.5bn to $750mn and provides credit enhancement to lenders) that allows it to continue paying dividends. 

As background, the company issued private placement notes back when it though it was going to acquire OCI [this was a foreign tax inversion play that was scrapped], but these notes (2022, 2025, and 2027 maturities) have private placement covenants that don’t work for the standalone company in the current environment, so CF is going to prepay these and replace them w/ financing that has covenant terms more suited to the co.’s cyclicality.  The plan is to get back to investment grade.

Post 3q, the company replaced these private placement notes with long-term secured debt that gave it breathing room under new covenants.

Pro-forma for the post-3q secured debt issuance, CF has $5.9bn in gross debt, implying gross and net leverage of 5x and 3.7x trailing EBITDA.  Maturities are well laddered, with the nearest, largest, and most expensive maturities coming due in 2018 ($800mn paying 7.3%) and 2020 ($800mn paying 7.5%).  Between the $1.6bn in cash on the balance sheet and $800mn in tax refunds this September, the company seems well-positioned to cover these two maturities if the debt refinancing markets shut down.  Current earnings are no help though: LTM EBITDA ($1.2bn) after taxes ($170mn), interest payments ($315mn), maintenance capex ($425mn), and dividends ($280mn) leaves almost nothing left.

So yea, it’s somewhat tenuous at current fertilizer prices, but the bet here is that pricing continues its current positive trajectory in the wake of China’s capacity reduction.  However, even assuming a recovery to $300 urea (and $3 natural gas), about where it was in 2014, we’re looking at about $1.9bn in EBITDA including production at PN and DV (vs. $1.2bn LTM), a level of profitability that implies a still unremarkable 10%-11% return on tangible capital (I exclude CHS’s investment in DV and PN from the denominator).   This EBITDA trickles down to $3.40 in maintenance free cash flow per share (that is, EBITDA – normalized taxes – interest – maintenance capex).  So the stock is trading at ~11x recovered mFCFE, which seems like a fair multiple for what is ultimately a commodity producer, stable demand and advantaged cost position notwithstanding.  It’s also about the multiple the stock carried during 2014/2015, so the market seems to have already priced in a significant recovery, though of course I have no clue where urea prices ultimately settle.