Description

Agrium is one of the world's largest nitrogen (N) fertilizer manufacturers with a capacity of 7MM tpa, or 3MM tpa measured by end nutrient-content, representing 3% of worldwide capacity (excluding China and Former Soviet Union, or FSU). Agrium also produces phosphate (P) and potash (K), the other two major fertilizer. Additionally Agrium is a major retail supplier of fertilizer and agri-chemical in both NA and Argentina.

Agrium's earnings are highly leveraged to nitrogen pricing. Consequently peak earnings from nitrogen business alone can be used as a good proxy of peak earnings estimate for the whole firm. Given the tight worldwide supply of nitrogen (primarily ammonia and urea), nitrogen pricing is expected to rise dramatically even if demand only grows moderately (+2-3%). In a setting that peak arrives in '04/'05, Agrium could realize a peak cash margin of $120 per ton or higher and earn close to $4 per share. If that occurs, at a peak earnings multiple of 9-11x, the stock can sell at price of $35-40 by '04 or '05, or 1x its replacement cost (net of debt). At the current stock price of just above $9, you can quadruple your money in three to four years - great reward for patience, with little downside risk protected by the hard book value of $6-7/shr and a dividend yielding 1.2%.

From portfolio construction perspective, Agrium stocks offer a neutral to slightly positive beta, carrying the characteristics of both defensive and offensive. Agri demand, which represents 85% of nitrogen usage, is largely independent of overall economy. The rest 15% exposure that is related to the industrial sectors, given the expectation of an inventory replenishment, should add more upward pressure on nitrogen pricing at the margin, thus making a recovery in nitrogen pricing stronger. Also, Agrium is an indirect play into the structural change of NA natural gas industry given its secured supply of low price natural gas in Argentina and Alaska as well as favorable pricing differentials enjoyed in Western Canada. In a world that the economy recovery might be modest in light of the consumer lag and dollar weakening, Agrium is a good addition into the portfolio to enhance long term performance with reduced risk.

For people uncertain about the timing of the peak but willing to wait(instead of simply categorizing it as another "value trap"), it is important to highlight that Agrium owns a well-structured balance sheet and generates solid free cash flow even in a downturn. Little debt is required to be repaid until 2004. This should enable Agrium to weather a prolonged cycle before the next peak arrives.

Industry fundamental

Nitrogen is kind of must-have item on the spending list of farmers seeking higher yields (typically 3:1, or $3 pay-off for $1 purchase). The agri-related nitrogen demand growth is a function of a variety of factors, as shown below in the order of importance:
1) Planting acreage, particularly for wheat and corn since they consume nitrogen most;
2) Grain pricing, particularly wheat and corn;
3) Weather, most important metric being moisture (warm and dry weather in the spring planting season could be a big problem);
4) Natural gas pricing, a key feedstock to produce nitrogen and major cost item (representing 75-85% of total cash cost)
5) Stock-to-use ratio in the international grain market;

Obviously, these factors have high correlation to each other, therefore causing great complexity and difficulty for investors to forecast precisely the magnitude of demand growth. While futures traders might feel good about their model's accuracy of predicting corn and wheat pricing based on inventory information, they have no easy way to translate that view into nitrogen pricing. One frustration shared by Agrium stock investors is probably the weather factor. At the beginning of 2001, the management turned quite bullish about the cycle and started to talk about '03/'04 peaking scenario. However, in the spring, the bad weather that hit both domestic and international markets, a rare thing indeed in the history, turned 2001 into a disastrous year when the agri-demand in North America and in the rest of the world was down by 5% and 3%, respectively. To add salt on the wound, demand for industrial use nitrogen (15% of total nitrogen demand) also dropped by 5% due to the recession. All together, demand for nitrogen was estimated to have declined by 5+ MM tons, representing roughly 4% of total effective capacity. In the end, such giant demand loss effectively delayed an otherwise recovery of nitrogen market by at least 6 months.

Nevertheless, the above factor model does give the directional prediction for demand growth. To save the burden of details, based on the best intelligence from the agricultural and meteorological sources, every factor simply shows improvement or no further deterioration: corn planting acreage is projected to rise by 2%, corn and wheat prices are estimated by USDA to rise by 5-10%, moisture condition is improved as Western Canada got the first spring rain last week, NA natural gas price is well under $3/MMBtu, worldwide grain stock-to-use ratio continues to fall to the lowest level since 95/96, etc.. The management is currently projecting agri-demand for nitrogen to grow by 2-3% in '02, with the strongest growth in South America, South East Asia and Australia. China recently reported significant volume of imports, a reversal from its traditional position as a net exporter. With its WTO entry, China is expected to increase imports in nitrogen, which could drive up pricing for nitrogen globally. And with the global economy recovering, industrial demand could become a positive surprise, adding upward pressure on the nitrogen pricing at the margin. It is noted that Agrium has close to 30% ammonia capacity targeting industrial market from its Kenai facility in Alaska, mainly supplying Far East market, esp. Korea.

Supply is much easier a story to tell and quite a favorable one. The worldwide capacity is standing at 160MM tpa, measured by end nutrient-content. For two reasons supply will be constrained:

1) Of 160MM tpa, 60MM is located in China and FSU. A large portion of these capacities were built in 1950s and 1960s and are in poor maintenance. Some Chinese facilities still use coal as feedstock. As a result, operating rates are as low as below 70%. Therefore, the average utilization of worldwide capacity is at maximum of 85%, giving rise to an effective capacity of only 135-140 MM tpa.
2) There will be very few new capacity additions before '05. It is noted that it takes three to four years to build a greenfield plant.

A tight worldwide supply, coupled with a normal demand growth, will eventually lead to a strong cycle for nitrogen. Though timing is uncertain given the complexities of predicting when peak will come along, the trend is surely there. Plus, China’s WTO entry could remove the inefficient producers there, which according to the management’s estimate, might start from ’02 at a minimum of 1 MM tons each year. If the Middle East turmoil gets worse, supply disruption there would amount to as many as 8-9 MM tons, representing another 6-7% of global capacity. It is estimated that, at a normal growth rate of 2-3% for global demand, by '04, the average utilization of worldwide nitrogen capacity will have to be kept well above 80% throughout the year without any scrapping or disruption to avoid shortage. This is a tall order, if not a mission impossible.

Quality assets

Nitrogen is a commodity so competition is based upon cost. Agrium owns the industry's lowest-cost facilities in Argentina and Alaska, where Agrium buys natural gas at price below $1.5/MMBtu. In addition, over 50% of its capacity is located in West Canada, where natural gas cost is 50 to 80 cents/MMBtu lower than NYMEX prices (called "Alberta Advantage"). Most of Agrium's capacities are highly efficient, meaning consuming less natural gas to produce nitrogen, therefore reducing unit cost further.

In a downturn, nitrogen is sold in the U.S. at a floor price set by marginal producers whose production costs are the highest in NA. For instance, in late January 2001, ammonia price peaked at $342 per ton in New Orleans, Louisiana (NOLA) market when natural gas price was $10. Lured by high prices in NA, in 2001 foreign imports poured in at 2 x historical average when nitrogen demand stayed weak. However, over the long term, the imports can not bring in enough supply to replace high-cost North American producers since that would require diverting 80% of global nitrogen trade to NA and/or building 40 new plants outside NA, both of which are highly unlikely. It is reasonable to conclude that the price of nitrogen, in a downturn, is largely a function of natural gas prices that set floor pricing, like what we've seen during the past 12 months; and in a upturn, is purely determined by inventory balance and/or supply shortfall. Demand would not matter too much if natural gas price were extremely high, say above $5, but that doesn't appear likely to incur on a sustained basis. Nevertheless, low cost of natural gas supply is instrumental to Agrium and the key reason to get this commodity business increasingly attractive. Today, when natural gas is between $2.50-2.80/MMBtu, the equilibrium pricing of nitrogen in NA is $110-120/ton, exactly where nitrogen is currently trading.

Financials

Earnings basically breakeven in a depressed year of 2001 (excluding the non-cash charges taken to reflect the re-evaluation of assets in Argentina after the peso devaluation). The firm guided the street '02 EPS at 30-60 cents per share. Each $10/ton increase in nitrogen prices would impact earnings 30 cents per share. So the firm is assuming nitrogen pricing to rebound by only $10-20/ton, a very conservative assumption. Again, natural gas is a wild card that could create positive surprises for nitrogen pricing. On the cost side, Agrium has a lot of room to reduce the gas cost even lower. One option is to reprice some hedging contracts that are currently losing money; the other is to renegotiate gas contracts in Argentina after the currency devaluation, which could likely lower natural gas purchase price from $1.50 to $1.20-1.25. Each $0.10 per MMBtu reduction in the average gas purchase price would improve net earnings by 10 cents per share.

With majority of capacity expansion behind them, Agrium expects capex for '02 and thereafter to be $80MM. D&A is running at $135MM. Working capital should be source of funds given the reduced working capital needs which ran abnormally high last year with the new start of its Argentine operation, high natural gas costs in the first half o 2001, and high inventory hoarding. Deferred tax added, free cash flow is estimated to be $100MM in 2002, of which majority is to be generated after 2Q02, reflecting the seasonally strong 2Q and 4Q.

Balance sheet is in good shape, too. Majority of its $750MM LT debt will not be required to repay until 2004. Last week's $110MM equity offering came as a surprise to everybody, but the net impact is positive since after the issuance, short term debt is cut to $110MM from $220MM before. After the conversation with the management, I believe this forced equity offering simply reflected today's tightened credit environment and lenders' sometimes over-caution. Dilution effect is quite insignificant if compared with the earnings leverage to nitrogen pricing.


Valuation

The stock is trading at 6x EBITDA estimated for '02 and free cash flow yield of 15%.

The retail business is worth $500MM (10 x recurring EBIT), or $4 per share. Potash is also relatively stable business, and generates $30-40MM EBIT, which can be valued at another $2-3/shr. Debt is $8 on per share basis and by the end of 2002 should be down to $7 per share. So the market values Agrium’s cyclical business (mostly nitrogen, also including phosphate) at $9 per share, net of debt, or 2.3 x peak earnings.

While not surprisingly cheap numbers for a commodity business in a depressed environment, the current market price hardly reflects the industry fundamental that is getting stronger by the month and the quality of these assets.

Catalyst

1. A strong start of spring planting season in late March and early to mid April.
2. Favorable weather condition.
3. Stronger corn and wheat future pricing
4. Higher natural gas pricing
5. China imports surprise
6. Middle East crisis out of control