3 Reasons to Believe PotashCorp Will Be a Great Long-Term Holding

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PotashCorp (NYSE: POT) shares currently pose an interesting situation. The stock has dropped by almost half in the past 12 months, giving PotashCorp a current valuation of roughly 17 times 2016 estimated earnings. That figure compares with the S&P 500's forward P/E of 17.5 and Mosaic Co.'s (NYSE: MOS) estimated 2016 P/E multiple of 15.7.

Although PotashCorp's valuation is in line with the market and at a slight premium to Mosaic's, its shares will nevertheless prove cheap if potash prices rebound.  So let's examine why PotashCorp shares fell and analyze three conditions that make this a good long-term holding. 

Why PotashCorp shares fell
PotashCorp shares have fallen because potash prices have cratered, from $400 per metric ton in early 2013 to $238 for the fourth quarter of 2015. Potash prices have declined because of oversupply and, more importantly, weaker macroeconomic conditions that have negatively affected potash affordability for emerging-market farmers. As Mosaic CEO Joc O'Rourke put it in a recent conference call:

We believe recent price declines in potash and phosphates have been driven more by macroeconomic trend than by the current supply and demand balance. Weak currency valuations against the U.S. dollar are low in production costs for exporting nations and raising prices for importing nations. Normal seasonal pressures are exacerbating the fertilizer price trends.

The weaker prices have proved to be a big negative for PotashCorp's overall results. In 2015, its potash segment made up 58% of total gross margin, while nitrogen made up 31% and phosphate made up 11%.  Given the lower potash cash flow, PotashCorp was forced to cut its dividend for the first time since its IPO. The dividend cut of almost 35% drove many dividend investors away from the stock and sent shares falling. 

Although potash prices look bad, there are several reasons to believe a rebounding scenario will occur in the long term.

1. PotashCorp has a low cost of production and macroeconomic conditions in emerging markets will improve 
Given the cyclical nature of the business cycle, macroeconomic conditions in emerging markets will eventually improve, supply can be cut relative to demand, and potash prices can rise more effectively. Given that production in the industry is very concentrated, with PotashCorp retaining about 20% of the global nameplate capacity alone, the process of cutting production or 'freezing' supply growth for potash to optimize for profit is easier than cutting production for other less consolidated sectors. 

PotashCorp also has an advantage in that it has a low cost of production. The company's cost of goods sold for potash averaged $111 per metric ton for 2015, versus Mosaic's cost of goods of around $130 per metric ton for the same time period.  PotashCorp's costs could decline in 2016. Earlier this year, the company suspended operations in Picadilly mine and accelerated the closure for its Penobsquis mine. Management expects the moves to save the company $40 million to $50 million a year in terms of cost of goods sold, and $185 million in capital expenditures over the next 24 months. PotashCorp's low cost of production ensures that it will stay in business long enough to capture the benefits of the potash up-cycle. 

2. Demand is inelastic and growing at a steady rate
Because it's an essential fertilizer, potash finds its demand pretty inelastic. Total demand for potash averaged 60 million metric tons in 2015 and is expected to remain steady at around 59 million to 62 million metric tons for 2016.Because of population growth, demand for potash is expected to rise 2.5%-3% a year. If the potash producers can reach an agreement in terms of successfully controlling supply (which the major potash producers have done before), demand will grow to bridge some of the oversupply gap. Because of its inelastic nature, the price of potash can also move up quickly if enough supply is removed.

3. The company's nitrogen and phosphate segments offer diversification

Although weak global macro-economic factors have negatively affected PotashCorp's nitrogen and phosphate divisions, the two segments offer valuable diversification. PotashCorp's nitrogen and phosphate divisions made up 42% of total gross margin in 2015, and could make up more gross margin for 2016. The company forecasts, for example, a combined nitrogen and phosphate gross margin of $0.7-$0.9 billion in 2016, versus a gross margin of $0.8-$1.1 billion for potash for the same year. That equates to 52% of total gross margin on the higher end because PotashCorp's nitrogen and phosphate divisions are less affected by sector oversupply than the company's potash segment. 

What the future holds for PotashCorp

PotashCorp is currently in a difficult situation. Because of the low potash prices, analysts are expecting PotashCorp's free cash flow to be $822 million over the next year, versus its annual dividend cost of $837 million. The company also estimates that it will earn $0.90 to $1.20 per share for 2016, versus its annual dividend cost of $1 per share. That gives PotashCorp a potential payout ratio of 111% in the worst-case scenario. Given the high payout ratio and lack of cash flow coverage, PotashCorp's dividend isn't sustainable if potash prices remain weak. PotashCorp could cut its dividend again and its stock could fall further in the short term. 

In the long term, PotashCorp is nevertheless a great value holding, given population growth and the essential nature of potash, nitrogen, and phosphate. PotashCorp's low cost of production ensures that it will be able to take advantage of the upcycle when macroeconomic conditions improve.