Wednesday, August 7, 2013

This Cash-Cow Nitrogen Fertilizer Business is Cheap

Dan Loeb, the famous hedge fund manager, has successfully delivered sweet long-term returns for his investors by investing in attractive event-driven equity and credit opportunities around the world. Since its inception in December 1996, his fund, Third Point Offshore Fund, has generated a 17.8% annualized return, outperforming the S&P 500’s return of only 6.6%.
According to his second quarter letter to shareholders, he initiated a long position in CF Industries Holdings (NYSE: CF) in the second quarter. Right after the news, CF Industries experienced a significant daily rise at nearly 12%. Should we follow Dan Loeb into CF Industries? Let’s take a closer look.
Low cost producer with low dividend payout ratio
CF Industries is considered one of the biggest nitrogen and phosphate fertilizer products manufacturers and distributors, owning five nitrogen fertilizer-manufacturing facilities in the U.S., a 75.3% stake in Terra Nitrogen, a 66% economic interest in the biggest nitrogen fertilizer complex in Canada and other nitrogen and ammonia joint ventures around the world. The two biggest revenue contributors are UAN, with nearly $1.89 billion in revenue, and Ammonia, with $1.68 billion in 2012 sales.
What I like about CF Industries is its historical consistent positive cash flow generation. Its operating cash flow has increased from $344 million in 2004 to nearly $2.38 billion in 2012, while the free cash flow rose from $311 million to more than $1.85 billion during the same period. Since 2005, the company also offered growing dividends to shareholders, from $0.02 per share in 2005 to $1.60 per share in 2012.
However, the dividend yield is very small because of the very low payout ratio. CF Industriesis trading at $202.30 per share, with the total market cap of around $12 billion. The current dividend yield is only 0.90%, with the payout ratio of only 5%.
Sustainable cash flow and cheap
Dan Loeb liked CF Industries because it was one of the lowest-cost producers in the world. He thought that its structured cash flow generation strength was not recognized by investors and proposed that the company’s management should increase dividend payments to shareholders. CF has the advantage of having access to low-cost North American natural gas, the main input for nitrogen fertilizer manufacturing. Assuming the input cost was $5 Henry Hub/natural gas and $275 per ton nitrogen fertilizer price, Dan Loeb estimated that the annual free cash flow could be around $1.2 billion. Thus, CF Industries is trading at around 10% free cash flow yield.
Moreover, if the demand for nitrogen fertilizer is higher than the supply, CF will benefit further, generating higher cash flow than the above assumption. With the conservative cash flow multiple of 4, every $25 change in nitrogen price above the cost floor (the breakeven price for nitrogen manufacturers) will generate an additional $15 value per share. In addition to the increase in dividend payments, Dan Loeb also suggested the company to execute the remaining $2.25 billion share buyback, creating an additional yield of nearly 19%.
Agrium and Potash are more expensive, with higher dividend yields
Its peers, Agrium (NYSE: AGU) and Potash of Saskatchewan (NYSE: POT), offer investors much higher dividend yields and have a much higher valuation than CF Industries. Agrium is trading at $91.50 per share, with the total market cap of around $13.70 billion. Agrium has a much higher valuation than CF Industries, at 6.4 times its trailing EBITDA. At the current trading price, Agrium’s dividend yield is 2.30%, with the payout ratio of around 16%.
Agrium was also the activism target of JANA Partners. JANA Partners thought that Agrium’s full value potential was not realized because of its conglomerate structure with two different businesses: a volatile fertilizer business and a stable farm product distribution business. Thus, JANA proposed that it should separate the retail business via a tax-free spin-off transaction and reduce excessive unallocated corporate expenses. Afterwards, it should release excess working capital and increase cash return to shareholders via dividends and share buybacks. JANA estimated that the business restructure could unlock as much as $50 value per share for Agrium shareholders.
Potash has the highest valuation among the three. It is trading at $37.90 per share with a total market cap of $32.90 billion on the market. It is valued at as much as 10.1 times its trailing EBITDA. Potash offers the highest dividend yield at 3.80% with the highest payout ratio at 33%. Potash is the global leading company in crop nutrients. The company ranks number one, accounting for 20% of the global potash capacity, while it is the third largest player in the world in nitrogen and phosphate.
Looking forward, Potash is well-positioned for the global growth in fertilizer consumption. Inthe period of 2012-2016, the annual growth in potash, nitrogen and phosphate came in at 3.5%, 1.3% and 2.7%, respectively. Potash estimated that it could account for 42% of the new global operational capacity in 2012-2016, and 23% of the global operational capability in 2016. In the next three years, the company expects to generate stronger cash flow but reduce capital spending so that it could have more financial flexibility.
My foolish take
CF Industries seems to be a good nitrogen long-term stock for patient investors due to its low payout ratio, strong cash flow, low-cost operational structure, and low valuation. Furthermore, under the pressure from activist investor Dan Loeb, investors might expect that CF Industries could take action in the near future to unlock shareholders’ potential value. 

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