122 S. Phillips Ave Suite 201 Tel: (605) 367-3336 / 1-888-828-3339 Sioux Falls, SD 57104 Fax: (605) 367-1118 PotashCorp (NYSE:POT) By Adam D. Schwab, CFA, CPA Investment Thesis PotashCorp is the world s largest fertilizer company and produces three primary crop nutrients: potash (K), nitrogen (N), and phosphate (P). 1 PotashCorp is headquartered in Canada, with most of its assets concentrated in North America. PotashCorp s nutrients play a critical role in agriculture and crop production. As demand for food rises across the globe these nutrients will become a bigger part of the solution to support growing populations. There are no easy alternatives for these nutrients, giving the company long-term protection against substitutes. As food demand grows, many emerging market farmers will increase their use of fertilizer to achieve required yields. Fertilizer is responsible for 40% of the world s total crop yield. 4 Given the high cost to commence a mining operation, PotashCorp is protected from intense competition and new entry. To illustrate, competitor BHP Billiton is struggling with their multi-decade Jansen project, which will likely cost between $15-18 Billion to bring online and will only be profitable if prices rise above $450/ton. 5 There are significant doubts whether BHP will continue to develop the Jansen project. PotashCorp s potash assets sit on the low end of the cost curve, allowing the company to remain profitable when prices cycle down and capitalize on fertilizer market fluctuations. Although PotashCorp s nitrogen and phosphate assets are valuable, they do not enjoy the returns or profitability to the potash assets. Although PotashCorp is susceptible to end market demand swings and commodity prices, they are protected by a solid balance sheet, low-cost assets, barriers to entry, and favorable long-term demographic and agricultural growth. Advantages Low-cost and geographically-advantaged potash assets 6.8% Dividend Yield Secure balance sheet. Debt/Equity: 40%, Interest Coverage: 12x Free Cash Flow ramping up as major capex is completed $2B in projected Free Cash Flow; >10% FCF Yield Great long-term end-market growth Risks Potash price under pressure from supply increases and soft end-market demand Rely on Canpotex to ensure price stability Mining is a notoriously difficult and cyclical industry Application rates in emerging markets may never reach developed world rates New CEO may lead to unexpected strategy shifts 1 P a g e
Segments and Operations Potash operates in three segments: Potash (KCL), Nitrogen (NH 3), and Phosphate (P 2O 5). All three are components of fertilizer, but each segment has a different competitive profile and contribution to PotashCorp. *potashcorp.com Potash - #1 worldwide market share 40% of Revenues The company s potash assets are the major driver of the moat behind the business. PotashCorp s low cost assets and the immense costs to bring new potash supply to market give the company an exceptional competitive advantage, especially given volatile and depressed end markets. The cash cost of the potash assets will likely be sub-$100 per ton in 2015, compared other North American producers at $120-150 per ton. Although the two major Russian producers, Uralkali and Belaruskali, produce at a cash cost between $58-77 3, they have significant transportation costs that PotashCorp avoids. Uralkali has estimated transportation costs of $75 per ton, giving PotashCorp a lower overall all-in cash cost. There is significant potential for potash demand growth. Many developing countries, including China, India, and Brazil, apply fertilizer at a rate well below recommended levels. Although these levels will not be achieved overnight, higher farm income and wealth will allow more emerging market farmers to increase applications of fertilizer. Effort is directed at educating farmers and governments on the appropriate and beneficial use of fertilizer. Of the 60 million tons of global potash demand, China accounts for 14 million tons of consumption, followed by Europe/Former Soviet Union at 10.3 million tons and the U.S. at 9.8 million tons. 2 P a g e
Potash Pricing Potash prices have fallen due to an increasing imbalance between supply and demand. Historic prices have averaged between $450-500 per ton. Recent shipments have sold around $315-400 per ton. Capacity additions, including at PotashCorp, led to an increase in supply while end-market demand softened as global agriculture markets weakened. Although an imbalance may persist for some time, eventually the market will clear and force the high cost producers to cut production. Given PotashCorp s low cost and geographical advantage in North America, the company will emerge as a beneficiary of supply and demand rebalancing. Since higher yields are necessary to feed the world, PotashCorp will be a beneficiary of long-term global growth. Elgethun assumes long-term sustainable pricing of $375/ton based on the marginal cost profile of potash producers. Given the inherent volatility of the industry, we use $300/ton and $450/ton as our long-term worst and best case scenario prices. Even if the worst case scenario plays out, PotashCorp remains profitable and will benefit from the ensuing industry consolidation. The chart to the right shows 10 year potash pricing. Nitrogen - #6 worldwide market share 34% of Revenues PotashCorp holds 2% of the global market share for Nitrogen. 1 Over 80% of PotashCorp s nitrogen sales are to North America. Half of nitrogen sales are sold as ammonia and the other half as urea and other solutions. Nitrogen is the most widely used fertilizer, accounting for half of all fertilizer consumption. Phosphate and potash each account for approximately 25%. Nitrogen is applied at a great rate per acre (150lbs) vs. phosphate and potash (50lbs each). Unlike potash, farmers cannot skip applications of nitrogen. Nitrogen must be replaced annually or crop yields will quickly suffer. PotashCorp s nitrogen assets are more susceptible to commodity price swings given their low market share and location of their assets. Managed properly, nitrogen will still benefit the company but not to the degree like potash. The gross margin for nitrogen has averaged 34% over the last 10 years, compared to 63% for potash. This gap illustrates the relative attractiveness of the potash vs. nitrogen assets. Phosphate - #4 worldwide market share 8% of Revenues Phosphate is critical to proper plant development by strengthening root development and enhancing the resistance to drought. Because phosphate cannot be directly applied to crops, phosphate rock is converted into phosphoric acid and then combined with ammonia. 88% of phosphate is used for fertilizer, the remaining 12% used in food, metal treatment, and cleanings agents. 1 While Morocco holds 75% of the world s phosphate reserves, China is the largest producer of phosphate annually. Phosphate production is not concentrated and few companies enjoy exceptional returns on assets. Like nitrogen, PotashCorp s phosphate assets are valuable but are susceptible to tighter profitability margins and fewer barriers to entry. The gross margins for the phosphate assets have averaged 20% the last 10 years, the least profitable segment. 3 P a g e
Canpotex Canpotex is a consortium of the three largest North American potash producers: PotashCorp, Mosaic, and Agrium. It is responsible for selling potash outside North America and 17% of PotashCorp s 2014 sales were through/to Canpotex. Canpotex markets, transports, and distributes production from Canada to the rest of the world. Canpotex allows the companies to achieve better price negotiation and better control of capacity. Uralkali/Belaruskali (BPC) Up until 2013, two major European potash producers (Uralkali & Belaruskali), called Belarus Potash Company BPC, had an agreement to limit supply and support higher selling prices for potash. The partnership allowed the companies to set higher prices and regulate supply to the market. Canpotex and BPC controlled the majority of the world potash sales, creating a cartel-like scenario. These actions clearly boosted profitability of all participating firms. However, in 2013, Uralkali quit the BPC and announced its intention to ramp up sales volume and cut prices. This caused a serious market share war between the two European companies and pushed potash prices well below historic norms. While disagreement has pushed prices lower, ultimately the companies do not want to destroy long-term profitability and we believe a longterm strategy will be reached that balances price and supply. The industry does not need potash prices near $500/ton to be profitable, but investors are still unsure where the price floor will be set. Management PotashCorp was previously led by Bill Doyle, who had an excellent reputation in the fertilizer industry. He served as CEO for 15 years after taking the position in 1999. Bill led Potash from a $625 million market cap to over a $30 billion market cap upon retiring. 4 Potash is currently led by Jochen Tilk, who took over as CEO on July 1, 2014. Jochen served as the CEO of Inmet Mining from 2009 to 2013 and has 30 years of experience in the mining industry 1. Jochen brings an outside perspective as PotashCorp faces volatile end-market prices and continued pressure on global supply. Although the company has a respected and long-tenured management team, the real moat of the company rests in the low cost asset base, barriers to entry, and a conservative balance sheet. Management s most important job is capital allocation and we expect the team to continue to reinforce the asset base quality without venturing into unrelated businesses. Wayne Brownlee has been CFO since 2006 and has worked at Potash since 1989. He helped lead the privatization of PotashCorp from a provincial Crown Corporation to a publically-traded entity 2. David Delaney has served as COO since 2010. He joined the company in 1998. Valuation Summary Using our base case scenario, PotashCorp is worth $32.55. The major driver in the valuation is the price of potash, which is assumed at a long-term sustainable price of $375/ton. The worst and best case scenarios reflect possibilities given the inherent volatility of the mining business and the cyclical conditions of the market. Even in a worst case scenario, the sustainable earnings power of PotashCorp should not drop below $1.50/share. With cost-advantaged assets and a powerful balance sheet, the company can emerge from any downturn. Many competitors are in tough situations, and PotashCorp may use any market weakness to buy assets at a discount. We use a DCF approach (not shown) to reflect the changing capex and free cash flow profile of the company. The multiples used below reflect those changes and the future cash flows and earnings of the company. With a 25% downside case more than offset by a near 100% upside case, we believe PotashCorp is an attractive investment for long-term investors. 4 P a g e
Conclusion The opportunity in PotashCorp is reflective of the depressed price of potash due to a current imbalance between supply and demand. Compounding the price drop has been the dissolution of BPC. Although both European producers are intent on chasing market share today, Elgethun assumes rational minds will prevail, even if the BPC never formally reunites. PotashCorp has several attractive elements of a long-term investment and the current volatility is providing an opportunity to own shares at an extremely discounted valuation. We first purchased shares in 2013 and have been adding in 2015. 1 potashcorp.com 2 http://www.potashcorp.com/about/overview/#why 3 Uralkali Company Presentation 4 https://issaasad.org/top-ceos-of-the-world-number-10-william-doyle-of-potashcorp/ 5 http://www.fool.com/investing/general/2014/07/24/why-potash-corp-and-mosaic-have-nothing-to-fear-fr.aspx About, Inc. is a fee-based, fiduciary Registered Investment Advisory (RIA) firm established in 2003. We are registered with the Securities & Exchange Commission (SEC) and subject to their audit reviews. We are independently owned and operated. As of September 30, 2015, we had approximately $280 million dollars under management/advisement. Our clients are high-net-worth individuals and institutional investors. Our investments include individual stocks, bonds, and stock/bond mutual funds. Disclaimer The discussion of portfolio investments represents the views of the investment manager. These views are current as of the date of this commentary but are subject to change without notice. As of the date of this publication, has a position in the security mentioned herein and may purchase or sell shares at any time without notice. All information provided is for informational purposes only and should not be considered investment advice or a recommendation to purchase or sell any specific security. Security examples featured are samples for presentation purposes and are intended to illustrate our investment philosophy and its application. While the information presented herein is believed to be reliable, no representations or warranty is made concerning the accuracy of any data presented. Portfolio composition will change due to ongoing management of the portfolios. References to individual securities are for informational purposes only and should not be construed as recommendations by or its members. 5 P a g e