This article is part of our Rising Star Portfolios series.
Welcome to 2012 and the first purchase this year of my Messed-Up Expectations portfolio. My aim is to find companies that are doing well or are improving their situations, but are being undervalued by the market thanks to sentiment, fear, or other mistakes in expectations. Today, I believe I've found another such company.
CF Industries (NYSE: CF ) is a major supplier of fertilizer, selling nitrogen and phosphate to farmers primarily in the United States and Canada. Those are two of the three primary fertilizer nutrients (the third is potassium in the form of potash). It is the largest producer of nitrogen fertilizer in North America. As you can see from this table, nitrogen is by far the primary source of revenue for CF Industries, unlike its competitors.
|PotashCorp (NYSE: POT )||27%||27%||46%|
|Mosaic (NYSE: MOS )||0%||70%||30%|
|Agrium (NYSE: AGU ) *||35%||15%||16%|
Source: S&P Capital IQ and company filings. *Figures are for wholesale segment revenue only. The retail segment also sells nutrients, but the company does not break out by nutrient type. Wholesale revenue was 33% of total revenue.
Nitrogen fertilizer is made from nitrogen (condensed from the air) and natural gas, and is sold primarily as ammonia, urea, and urea ammonium nitrate solutions, or UAN. Both phosphate and potash are mined. Nitrogen is sold to customers from the company's seven manufacturing plants or numerous storage plants. As farmers plant more crops -- especially corn, cotton, and wheat -- demand for fertilizer increases. This coming year, expectations are that farmers will plant more than 90 million acres of corn, just about a record amount.
The biggest input cost for CF Industries is natural gas, which is used both as a raw material and as an energy source. Right now, natural gas prices have been very low thanks to the increase in supply from shale sources and new drilling techniques. On the flip side, fertilizer prices are relatively high. This combination has led to record earnings and cash flow for the company, prompting management to recently quadruple the dividend to $1.60 per share per year, buy back nearly 6 million shares, and start investing in capital projects designed to improve efficiency and throughput at its facilities.
Yet many in the market believe that 2012 will see reduced demand for fertilizers, at least in the early part of the year. As recently reported by ICIS, economic uncertainty, fears of a repeat of the market crashes of 2008, and hesitant buyers are putting downward pressure on fertilizer prices. According to the USDA, however, while potash and phosphate demand has remained pretty flat over the past 20 years -- affecting PotashCorp, Mosaic, and Agrium more than CF Industries -- demand for nitrogen is still rising, as seen in the following graph. This should help CF Industries more than the others going forward.
Source: USDA data, through 2009. Shows thousands of tons of nutrients used in U.S. for each year ending June 30.
The near-term uncertainty is what I believe is holding the share price of CF Industries down right now. Using last night's closing price of $153.81, current expectations are for declines in free cash flow of nearly 9% annually for the next five years, more than 4% annually for the following five, and then no growth after that, forever. Yet the above chart indicates that demand for nitrogen will remain high and even increase over the next several years, which bodes well for the company. If I model unchanging FCF going forward, the shares are valued at more than $230 (at a 15% discount rate).
The most obvious potential problem is a pullback in the amount of corn being planted, as corn is a big user of nitrogen fertilizer. If corn prices drop -- as might be the case now that the ethanol-for-fuel subsidy has expired -- corn planting would follow, leading to lower fertilizer demand and prices. Yet corn remains a big export crop to places such as China, which needs it to feed its growing and more prosperous population. Prices might drop, but demand for corn should remain high, both here and abroad.
Another potential problem is an increase in natural gas use as a transportation fuel. This would hit both corn production (as use of ethanol-gasoline blends would probably decline) and natural gas supplies (leading to increased prices) -- both negatives for CF Industries. However, this would not happen overnight, so farmers should have time to find new buyers of their corn. Also, CF Industries has been concentrating on making sales that have high margins for them, so I'd expect it to work hard to pass on a significant portion of any increase in natural gas prices.
One last point. The U.S. is a net importer of nitrogen. If it increases production, which it is planning to do, CF Industries has a significant opportunity to capture more of the domestic market. It has facilities scattered all over the country and an excellent distribution system via pipes, trucks, and barges, which gives it an advantage for supplying this critical component of agriculture to just about anywhere it's needed.
Tomorrow, my Messed-Up Expectation portfolio will open an initial position in CF Industries.
If natural gas prices rise, CF Industries could be hurt. But your portfolio doesn't have to be. Click here to find out the name of the one company that will take off if the Natural Gas Act of 2011 becomes law.