Iron Ore vs. Potash, and the Winner is...

By Peter Epstein - August 22, 2012 | Tickers: BHP, VALE, POT, RIO | 0 Comments

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Potash is a key ingredient used to make fertilizer. Iron ore is a key ingredient used to make steel. Which is more important for the emergence of middle class populations around the world? 

Fertilizer is increasingly important as a means to keep crop yields high. Fertilizer is like a drug -- once the soil gets a taste, it can't live without it. On the other hand, steel is the #1 standardized construction material in the world. The bridges, buildings and transportation systems of modern cities can't be built without it.

Both potash and iron ore are extremely important. Neither has a ready substitute. PotashCorp (NYSE: POT) is the bellwether potash company serving the fertilizer industry. Vale (NYSE: VALE) and Rio Tinto (NYSE: RIO) are the Big 2 iron ore-focused heavyweights supplying the steel industry. BHP Billiton (NYSE: BHP) is a top-3 producer, but the company is so large that iron ore is just one of four major segments including base metals, coal and petroleum. I'm on record as liking these mega-iron ore producers for their strong margins and market dominance. However, is iron ore any match for the very compelling economics of potash? 

PotashCorp is the clear winner when it comes to margins. Analysts peg PotashCorp's EBITDA margin going forward at about 50%, and Rio and Vale in the 40%-45% range. Demand for potash is less cyclical than that of iron ore. A prerequisite for climbing the economic ladder to middle class and beyond is access to higher quality and a greater variety of foods and being able to afford them. Of course the very next step on the ladder is appliances, cars and cities to drive in.

On other financial metrics PotashCorp and the iron ore companies have similarly strong attributes. Both generate prodigious cash flows and maintain healthy balance sheets. However, PotashCorp is the winner with regard to country risk with all of its operations in Canada. While Rio and Vale get their production from relatively low-risk Australia and Brazil, new projects are in less hospitable places. For example, both Rio and Vale have green field projects in Guinea, Africa. 

I'm willing to concede that producing and selling potash might be superior to iron ore. It has more stable demand, higher margins, and is produced in safer jurisdictions. However for PotashCorp, the best company is not necessarily the best investment. By no means am I saying that POT is overvalued, I don't know. But, Rio and Vale look foolishly cheap by comparison. Let me explain.

Vale and Rio are trading at roughly a 4x multiple of Enterprise Value (EV) to 2013 estimated EBITDA. PotashCorp is trading at closer to an 8x multiple. With regard to next year's P/E, Vale and Rio are at 5.5x-6.0x and POT is at 11.3x. Given that potash and iron ore are both incredibly important to economic growth, I think the valuation gap is too wide. If Vale and Rio return to historical multiples, a 1-year forward EV/EBITDA multiple of 6x would imply 50% upside.  

I think a 50% return is perfectly reasonable. Rio has one of the best iron ore franchises in the world and gets 70% of its EBITDA from that commodity. As the single largest iron ore producer, Vale gets about 85% of its EBITDA from iron ore. These are the two dominant players with sustainable industry-low costs.   

All else equal, the same 50% upside in PotashCorp implies that its 1-year forward EV/EBITDA multiple would have to expand to 12x. While certainly possible, I think it more likely that the valuation gap between potash and iron ore will compress. The best way to play this theme is through Vale, with a yield of almost 6.5% compared to 1.3% for PotashCorp.

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