The highly profitable fertilizer business continues to remain under pressure as the thesis is that the supply/demand equation remains challenged. To address its substantially lower earnings during the first quarter, Mosaic (NYSE:MOS) rehashed its intent to eliminate 500 positions as part of a long-term plan to cut costs by $500 million.
This follows the recently implemented plan by Potash Corp (NYSE:POT) to reduce costs following the crash in potash prices after the Belarusian marketing arrangement between Belarus and Russia broke up. With margins still relatively high in the potash market and the prime additional customers in the emerging markets of China and India unable to afford high prices, one has to wonder if the fundamental growth prospects aren't flawed.
High potash margins
Despite huge cuts to potash prices and margins, the gross margins generated by Mosaic and PotashCorp remain much higher than those of other fertilizers. Investors have to decide if a structural shift has taken place in potash pricing or if it is realistic to expect a rebound to the nearly 50% margins previously generated by Mosaic.
Common sense dictates that the recent expansion plans in the Middle East, where Mosaic is participating in a Saudi Arabian joint venture, and the decision by BHP Billiton (NYSE:BHP) to advance the spending of $2.6 billion to complete construction of the massive Jansen Project in Canada will pressure potash pricing. In fact, BHP Billiton listed potash as a pillar commodity of the future, and this suggests that it is likely to squeeze margins in the near-term rather than help expand them back to previous norms.
On the earnings call, Mosaic management was very frank that potash will be in an oversupplied situation for the next couple of years, yet the company is spending a total of $1.3 billion on capital projects to expand production.
Mosaic plans to cut at least $200 million from each fertilizer segment with an additional $50 million coming from corporate. The company suggests that these cuts will allow the phosphate segment to remain at the low end of the cost curve while the potash-segment reductions will help bring costs in line with the competition. At least for potash, these cuts only further highlight the rather high margins in the business. If a company can cut over $50 million from costs after previously producing a 48% net margin, this suggests excessive pricing in the past. These cost cuts, along with the previous ones implemented by PotashCorp, only enhance the likelihood that prices will remain low and possibly fall further.
To recall, PotashCorp cut its workforce by 18% with a goal of reducing the cash costs per tonne for potash by $15 to $20 based on 2013 levels. It has a long-term target of reducing the 2016 cost by $20 to $30 per ton.
With an elevated gross margin on potash and an oversupplied market, the price cuts appear more like a race to the bottom than a way to improve profits. Mosaic even admitted that it needed to improve its cost position in the fertilizer, yet it generated substantially higher margins in that product than it did for phosphates.
It is entirely possible that the perceived long-term demand for fertilizers, especially potash considering the elevated margins present in the past, only occurs with lower market prices. The Chinese government and Indian farmers don't appear likely to fork over absorbent prices for a commodity apparently in abundant supply.
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Mark Holder has no position in any stocks mentioned. The Motley Fool owns shares of PotashCorp. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.