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When RBC Capital Markets initiated coverage on CF Industries Holdings (NYSE: CF ) with a "sector perform" rating last Wednesday morning, it surely wouldn't have expected the stock to hit its target of $135 within hours of trade. The 10% pop left investors scratching their heads -- can a neutral rating trigger such frantic buying activity? After all, RBC Capital had also initiated coverage on PotashCorp (NYSE: POT ) shares that morning with a price target of $35, but the stock fell short of 2% gains.
The secret was out soon enough: CF Industries revealed a surprise plan at the Citi Basic Materials Symposium Conference that same day which actually sent the markets into a tizzy.
CF Industries wants to raise $1.5 billion in long-term debt early next year to fund its expansion programs. One would generally expect the company to go for a bond offering or project financing from financial institutions. Interestingly, the fertilizer giant is considering the unconventional master limited partnership, or MLP option.
An MLP enjoys two advantages that allow it to raise capital at low cost -- it can build a strong initial capital base by accessing equity markets, and it can avoid corporate taxes by paying out nearly all of its profits to investors, just like a partnership firm would do. That explains why a much smaller nitrogen company like CVR Partners (NYSE: UAN ) sports a handsome dividend yield of 13.3% at current prices. Comparatively, CF stock yields only 1.9% currently.
While an MLP structure can be complex, CF Industries already has hands-on experience as the general partner and owner of 75% interest in Terra Nitrogen. The general partner manages the MLP's day-to-day operations. CF Industries has appointed two investment banks for advice on using MLP as a financing vehicle.
If CF Industries opts for an MLP, it will likely spin off some assets into the partnership structure and raise funds through it. That will also allow it to pay greater attention to those assets, thereby boosting returns from them. For investors, that will mean hefty dividends.
But investors should remember that a decision on MLP is still pending, and CF Industries hasn't ruled out other alternatives for funding. Of these, a bond scores the highest, thanks to attractive interest rates and stable ratings. CF Industries enjoys a better credit rating than PotashCorp. While CF Industries boasts investment grade ratings (i.e., low default risk) from both Moody's and S&P, PotashCorp recently uffered a ratings cut to negative from S&P after the Uralkali- Belaruskali potash cartel collapsed. Another cut will push PotashCorp's bonds into the speculative grade.
Investment-grade ratings improve CF Industries' ability to offer bonds at very low rates, making it a viable option. Moreover, since the company already raised $1.5 billion through senior notes with 20- to 30-year maturity periods in May this year, it is well conversed with the nitty-gritty of the bond market.
I think an MLP and an investment-grade bond have equal chances of getting picked up by CF Industries. While investors will prefer an MLP in pursuit of greater dividends, a bond doesn't rule out the possibility of dividend increases either.
That's because CF Industries is financially strong, with $2.3 billion in cash and equivalents as of September 30, 2013, and free cash flow generation of nearly $1 billion over the past twelve months. Count in the $1.5 billion to be raised from debt, and the $1 billion that is expected to flow in from the sale of CF Industries' phosphate business to Mosaic, and you can safely expect to see a cash-rich CF Industries in 2014. Looking even further, the company expects to generate nearly $4.5 to $5 billion in operating cash flow through 2016. That's certainly inspiring.
Of course, only a portion of these cash flows will go into the shareholders' pockets, and it's important to estimate how much that would be after CF Industries' tentative capital and other essential spending.
The good news
Aside from its $3.1 billion nitrogen capacity expansion project spread over the next three years, there is no big spending on the horizon. So CF Industries has ample scope to look for potential growth opportunities through mergers or acquisitions. Considering that it currently sports a comfortable total-debt-to-equity ratio of 61%, and maintains solid interest coverage of 17 times, debt repayment isn't a concern.
CF Industries expects to pump roughly $2 billion into additive growth programs over the next three years. But if it doesn't find suitable opportunities, and assuming that its operating cash grows as expected, that portion set aside for growth initiatives will likely be returned to shareholders. That will be a huge bonus.
That CF Industries can generate up to $5 billion operating cash flow by 2016 is a pretty safe assumption, since the company deals in nitrogen, a nutrient that's most widely applied and essential to corn crops. Being the largest nitrogen producer in North America is a big advantage. While 2013 turned out to be a mediocre year because of soft nutrient prices, CF Industries generated more than $2 billion worth of cash from operations in both 2011 and 2012. That gives a fair idea of what the company can achieve if market conditions are conducive.
The Foolish bottom line
MLP or not, investors can expect a lot from CF Industries going forward.
It has a $2 billion share repurchase pending to be executed, and management expects "to have significant cash flows available for additional distribution to shareholders." CF Industries wants you to get rich, so why not pay heed?
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