It's always tough to come up with hard evidence that a market is in bubble territory. Unless the price chart starts going parabolic, we're generally forced to rely on anecdotal evidence, such as sky-high rhetoric and a rash of IPOs priced at lofty multiples.
We've witnessed all of the above in the fertilizer space, leading many market commentators -- including one with whom I entrust some of my retirement assets -- to declare fertilizer stocks wildly overvalued.
I was similarly uncomfortable with the debut pricing of Intrepid Potash (NYSE: IPI ) , a firm that has cut its 2008 production outlook and touched new lows this week. The emergence of potash exploration and mining startups in Canada convinced me that we were witnessing an all-out Potashapalooza. I keep wrestling with the bubble question to this day.
But the overvaluation argument has since lost a lot of its "oomph," now that two factors have played out this year. First, stocks like Mosaic (NYSE: MOS ) and Chemical & Mining Co. of Chile (NYSE: SQM ) have sold off hard, along with the rest of the commodities complex. Second, earnings have risen rapidly.
CF Industries (NYSE: CF ) , for instance, reported more than 200% growth last quarter. Thus, the typical fertilizer stock's P/E ratio -- as blunt a valuation tool as they come -- has seen the "P" pull back and the "E" explode. Price multiples of next year's anticipated earnings are downright paltry -- hence PotashCorp's (NYSE: POT ) big buyback.
Earnings estimates are useless if they're based on faulty assumptions, so let's take a quick peek at the forces underlying these forecasts.
Fertilizer demand is driven by grain production, so we need to form an outlook not only for the fertilizer price, but for crop prices as well.
The most fundamental driver of grain prices, in my understanding, is the global stocks-to-use ratio. Grain inventories now represent less than two months' supply -- a multidecade low. For grain prices to fall meaningfully from here, we would need to see rising stockpiles driven by excessive production, weakening consumption, or some combination of the two.
Overproduction seems a remote possibility, since record crops have done nothing to bump up inventories.
As for consumption, many commodities will see weakening demand in the face of the unfolding global economic slowdown. However, cutting back on zinc or rubber is one thing. Reducing food intake is quite another.
As far as crop-derived fuel demand goes, Europe recently slashed its biofuels mandate, but India and other emerging economies appear to be moving forward with aggressive national targets. It's unclear how big a part biofuels will play in the future, but I suspect that some countries were sufficiently shaken by the latest oil shock to embrace fuel diversity, even in the face of an oil slump.
All told, a weakening world economy will likely constrain the upside for grain, but a mean reversion doesn't appear to be in the offing, as long as inventories remain stretched so thin.
Speaking of stretched...
That brings us to fertilizer supply. I'm going to focus on potash, because it's the simplest (and most compelling) product market to analyze. Agrium's (NYSE: AGU ) and Terra Industries' (NYSE: TRA ) nitrogen-derived products are largely driven by energy prices, and I'm not going down that road today.
As with grains, inventory tightness is the key support for today's elevated potash prices. And unlike crop supply response, which can occur in the course of a superheroic planting season, the lead time on a capacity expansion, or especially a brand new mine, stretches out for years.
A recent report from the Fertilizer Institute states that North American potash producer inventories have dropped to the lowest on record. (Data isn't available prior to 1989.) PotashCorp is one of very few global companies with any meaningful excess capacity, and it's expanding at a very disciplined pace. I simply do not see a pending potash pileup.
The potash players actually got hit with a pair of lawsuits recently, alleging global price-fixing. I don't know where pricing discipline ends and conspiracy begins, but these companies are clearly in the catbird seat. There are massive barriers to entry in this business, both geographically and economically. Combined with the demand picture outlined above, a near-to-medium term price drop seems downright improbable.
The Foolish bottom line
Obviously, not all fertilizer companies are created equal, so this macro-level look at the sector is no substitute for bottom-up stock picking. It's merely a starting point that indicates -- to this Fool, anyway -- that further research into individual fertilizer names is well worth your time.
Further fertile Foolishness: