One Agriculture Stock to Buy, One to Avoid

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Agriculture is one of the toughest markets to invest in. Profit margins are razor thin (ADM's was 1.1% in 2012) and the industry largely depends on subsidies. Several feed and fertilizer producers, however, are also diversified in chemicals, which are highly volatile. Below, I review a few stocks related to these industries and explain the upside and downside factors.

Reasons to Buy Mosaic (NYSE: MOS)

Mosaic is a producer of chemicals and agricultural material, such as phosphate, potash, and animal feed ingredients. It trades at a respective 13.1x and 10.9x past and forward earnings, which is below the historical 19.3x 5-year average. Free cash flow started to take off around the late-2009 trough and has since plateaued at nearly $800 million, which amounts to a yield of less than 3.4%, quite poor. The balance sheet is strong with little debt and a cash-to-capitalization ratio of 15.2%. In mid-November, Standpoint Research upgraded the stock from "hold" to "buy."

The company's current hurdle, contracts with emerging markets China and India, may soon turn into a positive catalyst. They are expected to be restarted in a few months, yet the stock has been largely hovering around its current price. Downside has already been factored in with management cutting volume guidance amidst inventory reductions. Shipments have become weaker in the export markets, which is likely the result of price uncertainty.

It should not be surprising then that Barron's is forecasting a long-term growth in demand for potash and phosphate with the contract renewals. Bank of America puts the company among its Top 10 favorite stocks of next year. Further, advantageous crop prices create a favorable environment for fertilizers. Companies with high sensitivity to corn prices have outperformed the S&P 500 by an average of 2,500 bps the year following a spike in prices due to consolidation activity. But Potash has only outperformed the S&P 500 by around 300 bps since record levels were reached. The goal in investing is to buy low and sell high, and that means getting into Mosaic now and waiting for multiples to expand to around 16x, a reasonable average.

Why You Should Avoid Potash (NYSE: POT)

Industry leader Potash has been in the news lately with its round of output reductions. It has cut prices for domestic customers after announcing shutdowns of several potash mines over 36 weeks through February 2013. Shut-ins have accounted for around ~1.6 million tonnes, or 13% of Potash's capacity. Yet the company is basically telling the market to buy now when it states that global potash shipments will rebound to around 57.5 million metric tons in 2013, around a 12.7% increase from expected shipments this year, through increased demand from China and India. Potash currently trades at 15x past earnings.

One major catalyst that the company has going for it is a potential takeover of the ~$16 billion Israel Chemicals. The market seems to be fully discounting that the deal will close, because the stock is about twice as close to the 52-week low than the 52-week high. And the market has good reason to be skeptical: Management has come out and expressed that there are a lot of hurdles to closing a deal, and Israel's Ministry of Finance has had reservations against a transaction.

I do not recommend making an investment investment in Potash right now. It is only forecasted for 4.5% annual EPS growth over the next five years, which, combined with the 2.1% dividend yield, is not worthy of an active investment right now at the premium to Mosaic. It is, however, even worse than an investment in Archer Daniels Midland, which trades at 19.4x past earnings and is rated closer to a "sell" than a "buy" on the Street. ADM is at least forecasted for 10% annual EPS growth over the next five years, and it has also hit a "double bottom" at around $24.60, which provides price support against a fall of 10% in value. I thus recommend avoiding Potash for now.


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