Description

Unlike most commodity oriented businesses, an investment in CF Industries is not a bet on emerging market demand.  It is not a bet on product pricing improvements driven by tight utilization or supply discipline.  Generally speaking, I am not a big fan of those kind of investments as they require assumptions on drivers that I do not fully understand (Chinese GDP, etc).  Instead, CF's investment merits are based entirely on the cost curve (CF's favorable cost position v high cost producers). Based on the assumption that pricing is set by the marginal cost producer, I believe CF can generate $10/share in earnings thereby placing fair value at roughly $120/share. 

While I am sure there are other industries with similar characteristics, I cannot think of one where the cost curve is as steep as in nitrogen fertilizer.  If one evaluated iron ore, met coal, potash, or copper by same methodology (P = Marginal Cost), most of these companies would be close to insolvency with earnings power non-existent.  I am not insinuating that other commodity oriented equities are poor investments, but rather point out that those investments rely on rising demand or restrictive supply to lead to higher pricing well above the marginal cost of the industry.  

Valuation:

Nitrogen Fertilizer:

Of the three basic fertilizers (nitrogen, phosphate, and potash), nitrogen is the only one that is not mined out of the ground and therefore not limited by geology.  Nitrogen is more similar to the chemical industry in that the product is created through the capital intensive conversion of natural gas into nitrogen.  While a plant can be built anywhere, the fact that 85% of the cost to manufacturer nitrogen comes from natural gas implies returns are very much tied to the regional cost of gas v the rest of the world.  Given the nutrient is fully depleted from the soil every harvest its demand is highly inelastic and not subject to the same pricing sensitivity as other fertilizers.  Nitrogen can also be applied to the crop in a gas, liquid or solid form and therefore sold as such (Ammonia, Urea, or UAN).  There is also a "feed the world" thesis on fertilizer - long term secular shift of consumption habits from grain to chicken/beef/pork which require 2-3x the amount of grains to produce.

 The key to US profitability is not necessarily low gas prices in the US, but rather lower gas prices v the rest of the world.  Given the Ukraine and much of Europe buys its gas via oil based contracts ($7-$10 gas) and a large portion of capacity in China is paying an mmbtu equivalent of roughly $8 gas, the US industry is structurally advantaged.  The thesis for CF is quite simple; Demand globally requires high cost producers to price at marginal cost, thereby allowing all others to generate the difference in the cost curve.  For CF, this can be broken down mathematically into a few buckets.  1) Gas costs difference of CF v high cost producer, 2) efficiency difference of CF plants v high cost producer and 3) logistic costs for high cost producer to ship nitrogen to the US. 

Gas Cost Advantage - Ukrainian producers which represent the largest swing producers on the export market (10% of export mkt) have contracted to pay an average all in price of $7-$8/mmbtu.  Assuming US gas remains roughly $2/mmbtu lower than that of the Ukraine ($5.50 v $7.50) then the average US producer should be able to produce ammonia at $66/ton discount to the Ukraine.  Given CF's capacity of 6.7mm ammonia equivalent tons, the gas cost alone should provide a $440mm EBIT advantage or $4/share in earnings.  In addition, many of CF's plants realize gas pricing well below that of Henry Hub.  Its plants in Canada & the corn belt (Mid-con) generally pay a $.10-$.75/mmbtu discount to Henry Hub and the company's Trinidad operations benefits from one of the lowest gas costs in the world ($2.50-$3.00). 

Efficiency -  In addition to the gas advantage, CF's plants are more energy efficient in producing nitrogen fertilizer than the high cost producers.  While CF can create a ton of ammonia with 33 mmbtus of gas, Ukrainian producers are 5%-10% less efficient in mmbtus/ton.  Assuming the lower end of these estimates, CF's assets would realize a $15/ton cost advantage from efficiency or roughly $100mm of EBIT annually.

Transportation - Once the Ukrainian producer manufactures the nitrogen fertilizer, it must transport the product from the plant to the port and then from the port to the US.  I have assumed this cost to be roughly $55/ton, $15 to port and $40 from the port to the US Gulf (worth noting that CF believes the ocean freight alone to be $50/ton).  The key point here from a logistics standpoint is that the US is not self sufficient in nitrogen. In fact, over 40% of the nitrogen consumed in the US must be imported from the overseas market leaving those that do produce on domestic soil to be significantly advantaged.  For CF's assets, this transportation advantage translates to roughly $370mm in EBIT annually.   

In the past few years, returns for nitrogen producers in the US have structurally changed as natural gas prices in the US have fallen substantially relative to the rest of the world.  The above mentioned items currently provide CF with roughly a $135/ton advantage in the ammonia market or around $900mm in EBIT on an annualized basis just for the nitrogen business.  This structural change in the global cost curve helps explain why CF can be so profitable during difficult economic times (2009) while only marginal profitable during a healthy economy (2005).  Despite management's best efforts & further evidence from the significant M&A interest in the space, the street has yet to fully understand the earnings power from these fundamental drivers. 

It is worth addressing some of risks associated with the thesis:

• 1. US Gas - While gas prices in the US are volatile, I am of the view that we are in a relatively low gas environment for the next several years. The magnitude of reserves associated with shale gas coupled with very favorable economics & the industry's endless need to grow has led to a collapse in gas pricing (2012 strip at $5.50). Gas production in the US started to accelerate prior the downturn in 2008 and remains at near record levels. Recent monthly production data has shown signs of continued growth in the production and with shale regions such as the Marcellus just starting to ramp up in the next year, I am not terribly concerned about spiking prices. Additionally, the US market has sustained peak production with 35% fewer rigs due to efficiency/geology and with recent spikes in the rig count, production growth acceleration should shortly follow.
• 2. Ukrainian Gas - The Ukrainian government just finalized the pricing via an oil linked contract which is unlikely to change anytime soon. Pricing was favorable to the Ukraine as compared to the previous contract, so it is unlikely the government will try toreadjust it downward.
• 3. Import Parity/Demand - The import needs for the US market are likely to increase in the coming years as ethanol drives greater demand for corn acres (corn requires multiple times the amount of application of fertilizer than soybeans). The current ethanol mandate requires a 25% increase in corn based ethanol through 2015 and with a possible E-15 decision coming at the end of the summer (allowing for 15% blend of ethanol in gas tanks v 10% today) the required demand could be much higher. As noted above, the demand for nitrogen is highly inelastic thereby suggesting that high cost producers will be required even if recent economic improvement stalls or declines.
• 4. Capacity - On a global basis, limited new production capacity is set to come online (unlike potash and phosphate) such that demand and supply should remain in healthy balance.

While we have yet to take into account the phosphate operations, logistic assets or the synergies associated with Terra merger, the structural cost advantages noted above translate to over $7 in eps.

Logistic Assets:

Synergies w/TRA Merger:

CF has highlighted synergies of $105-$135mm associated with the acquisition of Terra Industries.  While the deal only recently closed, public commentary from management suggest that they are likely to come in at the high end or above publicly guided numbers.  Conversations with management have strengthened my view that these estimates are likely conservative, especially when considering the specifics of some of the Terra's assets.  For example, Terra's Woodward, Oklahoma plant sells 50% of its ammonia to industrial customers at gulf based pricing and even incurs rail expenses to ship the product to the gulf (sometimes as much as $80/ton) when there is ample demand in the corn belt at significantly higher pricing. While it may take some time, I believe CF can realize greater pricing in some of Terra's legacy plants and save on the transportation costs by supplying customers' product from other plants.  There are numerous examples like this that go well beyond simple SG&A redundancies associated with the Terra merger.  The low end of management's synergy estimates translates to roughly $1.00/share in eps. 

Additionally, the merger with Terra does present the opportunity for a step change increase in corn belt ammonia pricing.  While I certainly would not bet on it, it is something to consider.  Each type of nitrogen fertilizer has a specified nitrogen content such that there is some level of substitution between them.  Ammonia, in terms of price per embedded ton of nitrogen usually trades at a 30%-40% discount to urea because it requires specific equipment to inject the gas into the soil.  The farmer that has already made the capital investment for this equipment would theoretically be willing to pay significantly more for ammonia given the substantial discount to substitutes.  Following the acquisition of Terra, CF now has a 52% share of the ammonia sold in the corn belt and given the logistical difficulties to get the product into the region, it is possible CF will be able to close the parity gap.  While this is something that management has not addressed, I believe it to be an interesting call option to earnings improvement.

Phosphate:

I am not a bull on the phosphate market and certainly not willing to underwrite any return to the profitability of a few years back, but do believe the segment is currently overlooked by the market.  I believe CF can generate around $200mm/year in EBIT assuming current pricing on phosphate rock & no incremental profitability on the processing side.   While there appears to be some significant capacity coming online in late 2011/early 2012, I believe the industry will continue to require non-integrated processing capacity thereby allowing for healthy margins for integrated players.  Additionally, investors do not appear to be appropriately valuing CF's phosphate assets given recent transactions in the space (most notably VALE/BG).  Such a transaction would likely  be done at a relatively high multiple (8x+ EBITDA) and would be immediately accretive.

Summary:

Overall, CF can generate close to $1.4B in EBIT per annum assuming strategic merits of the investment hold, thereby putting the stock at just under 5x EBIT.  While I believe there to be strong support for all of the above earnings drivers, there is also considerable volatility associated with each of these inputs.  Management has put forth pro-forma guidance EBITDA of $1.5B ($1.3B EBIT) assuming the synergies are fully realized or about $10.50-$11.00/share assuming year end net debt of $1.7B.  I generally think of this as a 2012 eps number given the time it takes to realize synergies, but will note that management as recently as two weeks ago commented that they feel more comfortable with this number today v when the deal closed.  If you look at the past 12 months, the earnings sustainability in CF has actually been stress tested. Despite a collapse in the economy and significant decline in fertilizer prices, CF managed to do close to $8 in eps in 2009 (now, the assets are double the size and the capital structure is more efficient). 

New Build Economics:

Generally speaking, it is difficult to structure a low cost gas contract for new builds in the Mid-east.  Governments have changed the way they view the cost of natural gas and look to take a larger piece of the pie for new builds.   That said, if one is able to secure a low gas contract (lets assume $3/mmbtu), it  would not make economic sense to build a new plant in the Middle east today.  A large scale urea plant with $3 gas could produce at around $110/ton and break even selling product into the US gulf at $150/ton.  Assuming a new plant costs $1,200/ton to build and requires a 15% rate of return, product pricing would have to be closer to $330/ton in the US (assuming this is a destination plant) to justify new economics.  At this level of pricing, CF would post record earnings.  Put it another way, the transport cost advantage erases +$1.50/mmbtu of the lower gas costs of a mid-east producer.  For additional data, take a look at the Yara's presentation when they signed the definitive merger agreement with Terra Industries ( http://www.yara.com/doc/2010_02_15%20Terra%20acquisition%20Web.pdf ).  Management highlighted that it was actually cheaper to buy Terra rather than build brand new mid-east capacity when factoring in lower gas costs, transportation, and discount to reinvestment costs.

 Additional Datapoints:

• - AGU's attempted hostile acquisition of CF implies $98/share based on today's AGU price (Bid was at 1 AGU share + $45/share). Additionally, AGU suggested that there was room to increase the bid further if CF agreed to enter into friendly discussions.
• - CF trades at roughly 50% of its replacement costs. Usually this is a bit of an irrelevant datapoint as assets that usually fall into this category do not generate their cost of capital, but relevant here given the cost structure of US producers. This discount to replacement economics is why you have seen the large fertilizer manufacturer try to acquire additional capacity rather than build (AGU for CF, YAR for TRA, CF for TRA).
• - There has a fair amount of insider purchases in the past month from numerous directors.
• - I expect the company to post strong Q2 numbers due to a considerable improvement in volumes (ammonia volumes in April were up over 100% over last years' level), low gas prices, and solid corn belt pricing.

Catalyst