Why CF Industries Is Likely To Underperform Despite Low Valuation

By Ashish Sharma - June 1, 2012 | Tickers: CF, POT, MOS | 0 Comments

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I discussed my bullish thesis on Mosaic (NYSE: MOS) in a previous article. The key arguments were low valuations, better geographic exposure and a lot of company specific catalyst. In this article, I would be focusing on another fertilizer stock CF Industries (NYSE: CF). Although, CF is trading at lowest relative valuations on PE & EV/EBITDA basis among the North American fertilizer companies, I believe it is likely to underperform going forward.

CF Industries is the largest producer of nitrogen fertilizer products in North America and the second largest nitrogen producer in the world after its acquisition of Terra Industries in 2010. It is also the third largest producer of phosphates in North America. CF has 38% North American market share in Ammonia and 30% in UAN.                               

Product exposure (in sales) for CF

Recent stock correction

Any investor who is looking at numbers and estimates will be perplexed on why this stock has corrected so sharply from $197.5 closing on May 3^rd (a day before CF declared 1Q results) to $172 currently despite posting a blowout quarter, street estimates only going up (2012 EPSe standing at $24.80/sh, up full $2/sh than what they were 90 days ago), cheap valuations, higher grain prices (in last three weeks wheat is 15% and corn is up 2%).

Looking into the past to predict the future

In order to predict the future stock performance, looking at the recent past to understand what drove the stock down will be helpful.

On May 4^th CF posted a blowout Q1 report with 70c EPS beat (including 60c losses booked on Natural Gas hedging) on better Ammonia results (on shipments and realizations, both being 20% better than expectations) and higher phosphate shipments (at 516k tons and roughly ~25% better than expectations).

What disappointed the market?

a) Bulk of the upside due to pull-forward from 2Q12 due to an early application season. On the conference call management acknowledged that unusual strength in Ammonia volumes will not be repeated and Ammonia volumes could be down y/y in 2Q (due to very strong 2Q11 and also pull forward demand in 1Q12)

b) Higher than expected Nitrogen COGS/ton, which were $35/ton higher than expected.

c) Most importantly, disappointment from capital management: CF did not execute remaining $500mn of its $1.5bn buyback authorization which was announced in 2Q11. A fresh new buyback authorization was also absent. This was despite the fact that CF generated $550mn in cash during the quarter and now holds $100mn net cash position. I believe it suggests that management is taking a cautious stance on the near to medium term outlook and doesn't find the current stock price attractive enough for buy backs.

Industry newsflow and datapoints are also bearish

In addition to company specific factors, broader macros are also not encouraging.

a) Disappointment from India’s Urea tender: India allowed Iran to participate in its 1.2MT urea tender on May 8th. This caused Indian tender to settle at the rather muted level of $535-540/T cfr. Additionally, India’s DoF also only approved 690kT in volumes as against original plan of 1.2MT, as India adopted cautious stand on demand after its Finance Ministry proposed a 10% increase in urea farmer prices.

b) Reversal in key input prices: Natural Gas prices (US Henry Hub) has gone up by greater than 35% in the last one month to $2.6/mmbtu from the lows of $2, causing unwinding of Long Natural Gas theme trades. It is estimated that $0.10 change in natural gas prices impact ~20c/share in EPS.

Inevitable correction in Urea prices

a) Urea prices had nearly doubled (to touch $700/st) in North America over the last one year, whereas phosphate prices were flattish and Potash prices were up nearly thirty percent. Most of pricing jump in Urea was due to demand pull forward in Q1 due to favorable weather and supply issues for ammonia (exported to US) in Trinidad. So, there is a good chance that they will correct going forward.

b) Increased Urea capacity will also lead to cooling off of the prices. Global capacity increase of ~13% in 2012 /13 (bulk of it coming in China) as against ~2% annual increase in demand will ease the effective capacity utilization of ~90% in 2011.

What will the stock go from here?

While market is capturing some of the negative newsflow in the Urea pricing and consensus estimates for CF call for 9% y/y decline in Sales in 2013, further negative revisions cannot be ruled out. Moreover, should spot Natural Gas prices follow/move up along with the pricing prices in Futures (contango in US Natural gas prices), CF is more likely to witness selling pressure.

Henry Hub Natural Gas futures prices on CME (in contango)

It is estimated that $0.10 change in natural gas prices impacts ~20c/sh in EPS for CF.

CONCLUSION

Although the stock looks cheap at 6.96x 2012 EPS estimates, it is fairly valued at 8.3x 2013 estimates. Near to medium term outlook for CF is bearish as its margins are likely to compress due to both lower Urea pricing and higher Natural Gas pricing. Barring an aggressive share buyback, I don’t see any potential positive for the stock in the near term and believe it will likely underperform going forward. I prefer both major potash producers- Potash Corp. (NYSE: POT) and Mosaic over CF Industries. Mosaic is my favorite pick given its better geographic exposure than Potash Corp and several company specific catalysts.

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