February 27, 2016 - 6:53am EST by
2016 2017
Price: 35.00 EPS 0 0
Shares Out. (in M): 234 P/E 0 0
Market Cap (in $M): 8,183 P/FCF 0 0
Net Debt (in $M): 5,307 EBIT 0 0
TEV (in $M): 13,490 TEV/EBIT 0 0

Sign up for free guest access to view investment idea with a 45 days delay.

  • Tax Inversion


CF Industries is the largest nitrogen fertiliser producer in the US and one of the leading players globally. Just as other commodity companies CF’s share price also got hammered in 2015 (-26%) and into 2016 (-15% YTD). Additionally, the story around the company is somewhat complex given a flurry of recent corporate activity, which hasn’t been digested or alternatively completely ignored in the commodity downturn.
The title of my CF write ups has changed dramatically over the past couple of months. It went to from “CF stands for cash flow in CF Industries”, then “CF Industries, putting the puzzle together”, finally now to something that borders along the lines of “CF Industries, is it safe to come out of the foxhole yet?”. I’m not quite sure of the answer save for a few spots in the sector 2016 is going to be a tough year for anything agriculture related but judging where sentiment is, taking a look at CF is probably timely.
I don’t think that there is any rush with this stock, given where the short term fertiliser outlook is not sure how much interest there is in these names. There was a recent uptick in N fertiliser prices following the anticipation of the spring rally, indeed prices went from low $200/st on low volumes in the US to $260/st recently, however futures for April are already pointing to lower levels. The stock has also been owned by the who’s who of hedge funds and there has been rotating out recently as the share price collapsed so there is also a question of when these holders would eventually throw in the towel given the bleak near term outlook.
I think the attraction in the stock is management’s plan (whom are also shareholder friendly) in putting a company together in the downturn that could enjoy significant increase in earnings as the cycle normalises over time. If all goes well, by 2016/2017 CF will have increased its own production capacity by 24% via brownfield expansions, secured a long-term off-take agreement with a long-time client and an investment at a very attractive valuation, further increased its capacity by nearly 40% via M&A, potentially re-domiciled to Holland and began to return nearly a substantial amount of its current market cap via buybacks.
There is definitely execution risk, which makes the story complicated thus the stock will likely trade on sentiment for the next few quarters as all the pieces fall in their place. However, I’d argue that even in the base case there is upside to CF (though modest) on through earnings. If the transactions close (and the sell side gets more clarity) and management delivers on their capital return plan the story could be very interesting for a large and mature business like CF.
Brief primer on nitrogen fertiliser
Nitrogen is an essential fertiliser along with phosphate and potash and is the N in the NPK love triangle. The key difference compared to P and K is that N has to be applied every year to enable a certain crop quality as well as yield thus demand is rather inelastic. Without going too much into agronomics, N fertiliser will give farmers a certain improvement on yield (vs not applying anything), while P and K improve crop quality and yield even further. However, normally due to affordability EM farmers often skip applying them in a given year (most EM farming is very inefficient and happens on a small scale thus long term agricultural development is usually sacrificed for saving money). I’d also add that the supply/demand balance, while not perfect for N either, is much more challenged for potash and phosphate. While nitrogen is a “sticky” product it is a commodity - US urea is very much the same as Chinese urea, thus the cost curve is key.
Nitrogen fertiliser can be produced from a source of hydrogen (natural gas or for instance coal in China) into the first building block, which is ammonia - the base product for all further nitrogen production whether it’s for fertiliser or industrial uses. Normally natural gas constitutes over 80% of total production costs. Urea is the most commonly used and globally traded nitrogen fertiliser and consists of ammonia and CO2. Lastly, ammonium nitrate (mix of ammonia and nitric acid) is often mixed with urea to form UAN (a liquid fertiliser). Ammonia, urea and UAN are the three most often used N fertilisers.
Global ammonia capacity is about 240mtpa (actual production/demand is somewhere in the region of 180mtpa) and over 75% is used in the production of some form of fertiliser. As ammonia is essentially a gas it is expensive to transport globally (needs specialised tankers) thus most of the production goes into downstream production on site. Approximately half of global ammonia production is used to make urea. Global nameplate urea capacity is about 270mtpa and 2015 demand is around 180mt. Historically demand has grown 2% p.a. and expected to continue on the same trajectory over the long term. As it is the most commonly used nitrogen fertiliser globally the urea cost curve is closely watched. On the low end are the producers in the Middle East, US (such as CF), Russia to name a few while on the high end are producers in Ukraine and China. Demand requires these countries to price product essentially at the marginal cost, enabling the low-cost producers to take advantage of the spread.
China is very important regarding global urea production. As it is common in other commodities businesses China has built out substantial domestic capacity and it has been a net exporter of urea to the detriment of global prices. To make life even more complicated there used to be a domestic export policy in place, which balanced the domestic prices by encouraging producers to sell in-country or export according to the agricultural season (planting or off-season). Coupled with global capacity expansions and low crop prices the downward impact has been significantly felt on global nitrogen fertiliser prices during 2015 for instance. Not all is lost though. The Chinese government started a wave of rationalisation in the industry such as closing down high cost capacity, lowerinoperating rates, introducing VAT, limiting the growth in N fertiliser application, which over time should work their way through the system.
In commodities there are two ways to make money sustainably a company either has logistic advantages (i.e. sell to a customer 10 miles away) or production cost advantages (i.e. the bottom left of the cost curve). If a company happens to have both logistics and production cost advantages that is a rather fortunate situation.
While the urea market is global the US is somewhat of a special situation. As things stand the country doesn’t have sufficient capacity to meet domestic demand thus it relies on imports and marginal cost producers (e.g. Chinese coal based producers). This has to be imported to a port in the US (+$20-30/t seaborne shipping costs) then from the port to the actual users of the fertiliser in the middle of the country via river barges (additional $20-30/t for shipping) where again there isn’t sufficient production thus a price premium exists. Historically, this averaged over $60/t for urea (normally there is additional premium on top of the transportation costs due to scarcity of production). The below table shows the production costs in key nitrogen production regions as well as the logistics costs of importing into the US.
Current Urea Production Cost Image Link:
To have sustainable premium prices it is essential that the US continues to import fertiliser, requiring production from the marginal cost players. During the 1990s and early 2000s companies in the US were actually disassembling plants and taking them offshore given the high input costs (natural gas). Then the shale revolution happened, which was a game changer. During 2007 and 2012 no new projects were announced given difficulties around regulations (at the end of the day you are dealing with natural gas) and locking up long-term gas supply contracts. However, since 2012 projects with 17mstpa cumulative nameplate capacity (14mstpa on a nutrient/ammonia basis; 82% x 17mstpa) were announced in the US. Of this 7 projects with approx. 5mstpa capacity are actually proceeding of which 2 are CF’s (potentially one more if the OCI transaction closes). CF estimates that the US will import approx. 14mst of nitrogen fertiliser products in 2015. As new capacity comes online management expects this to drop to 9mst by 2017. The reliance on imports will shrink but the US is expected maintain its premium market status. In a worst case scenario, if all projects come online the US could lose premium prices however the key here again will be CF. Their own capacity expansion (Donaldsonville, see more below) is expected to act as the balancer in the market i.e. they’ll use this plant for exports should the market become overwhelmed.
One of the reasons for the project cancellations is capex. It takes about 3-5 year to construct a large scale, greenfield 1mtpa ammonia plant and well over $2bn (some recently cancelled capacity was more like $3bn). CF’s own capacity expansion of approx. 2mtpa ammonia is expected to cost $4.6bn (up from the original $3.8bn) or about $2.3bn/mtpa. At current fertiliser prices and capex estimates it is unlikely that new projects will be sanctioned by boards or be able to raise financing, in fact we’ve actually seen projects being cancelled in the US due to rising costs.
What is CF Industries?
Founded in 1946, CF (stands for Central Farmers) started out life as a cooperative engaged in fertiliser brokerage. During the 1960s it started an expansion into fertiliser production as well as distribution. During the 1970s and 1990s it spent about $1bn on further expansion in each of the decades. In 2002 the company began a transition away from being a cooperative (i.e. reliable supply of fertiliser to its members) to a company focused on financial performance. This effort culminated in CF’s IPO in August 2005. At current share count CF went public at around $3/sh vs the current $35/sh, which is a remarkable increase considering the nature of the business and actually one of the best in the S&P in that time frame.
In 2010, following a three-way battle it acquired Terra Industries, one of its competitors in the US, for $4.7bn in cash and a rather ill-timed share issuance in 2009. With this acquisition CF got five nitrogen plants, 75% stake in a listed nitrogen MLP (Terra Nitrogen Partners), trading and JV interests. CF also had a small-scale phosphate operation in Florida, which it sold to Mosaic in 2013 for $1.4bn in cash and agreed a long-term ammonia supply agreement. It’s worth noting that in 2013 Dan Loeb had an activist involvement in CF (exited in early 2014). His efforts led to a 2.5x increase in dividend, sale of the above mentioned phosphate business as well as a change in CEO. Tony Will took over in 2014 and has been at the helm of the company very ably since (previously SVP of manufacturing and distribution).
But the new CF is nothing like the old CF
CF closed 2015 with revenues and EBITDA of $4.3bn and $1.7bn, however in the grand scheme of things this is completely irrelevant as during 2015 the company announced a few significant changes.
Let’s evaluate these:
  • As noted above, CF is finalising a $4.6bn capacity expansion programme it started in 2012 that will see its capacity increase from the 15.2mstpa (as of 2014) to 18.9mstpa (+24% in capacity). After some delay it should be ramping up through 2016
  • It acquired 50% of GrowHow (UK fertiliser business) it didn’t own for $580m. This was a JV with Yara (Norwegian N fertiliser producer) and has capacity to produce approximately 0.9mst gross ammonia, 1.2mst AN and 0.4mst NPK annually
  • Announced the acquisition of OCI’s (Amsterdam listed nitrogen fertiliser business) European and US production assets and Dubai based trading business for $8.2bn (EV) at the time. It is a rather complicated deal (spiced with an inversion) and expected to close in the middle of 2016
  • Announced a deal, whereby CHS (US based agriculture co-operative and long-time CF customer) will invest $2.8bn (tax free) into a CF subsidiary in exchange for roughly 9% capacity share and secure up to 1.7mst fertiliser product on an annual basis. This deal is not contingent upon the OCI deal and closed already this February
Standalone CF
In 2012, CF announced a $4.6bn capacity expansion of its Port Neal and Donaldsonville facilities. Expansion at these two facilities will add 2.1mstpa of gross ammonia capacity and approx. 3.7mstpa nameplate nitrogen fertiliser capacity. After an increase in the capex budget (from $3.8bn originally – relatively common in capex intensive projects) as well as a delay in the timeline, these facilities are expected to ramp up by 2016. Combined the expansions will take CF’s total nameplate fertiliser production capacity to 18.9mstpa and make it the largest nitrogen fertiliser producer in the world with 10.4mstpa gross ammonia capacity. Following the capacity ramp-up CF will be producing roughly 30% of North American nitrogen fertilisers and consuming 1-1.5% of all US natural gas.
Production cost and location advantages (as noted above) enabled CF to earn 40% EBIT and 50% EBITDA margins over the last five years on average. With the increase in capacity as well as additional consolidated capacity, CF could be on track to sell an additional 4mst product by 2018 for a total of around 18mst. Assuming flat fertiliser prices for the next few years (at Q4’15 economics) and natural gas prices rising to $3.25/mmbtu, CF could add approximately $550m to EBIT and $650m to EBITDA vs the 2015. This translates to a total $4/sh in EPS and $4.2/sh in FCFPS (run-rate). Assuming a 10x P/E and 10x P/FCF (below the historicals following the re-rating in 2013) CF is worth somewhere in the region of $40/sh in the base case (assuming no buyback).
GrowHow acquisition
This acquisition is not a big deal in and of itself and doesn’t give CF much ($580m investment at an OK-to-high multiple of 8x trailing EBITDA; fully consolidate 1.9mst fertiliser capacity in the UK), rather it was key for a previous iteration of the OCI transaction. This acquisition closed in July 2015 and is already baked into the numbers.
OCI transaction
There have been all sorts of rumours about a combination of OCI and CF in some way for a while. OCI (previously Orascom) has a rather interesting history and a few years ago it was a combination of an engineering/construction and nitrogen fertiliser business, controlled by the Sawiris family. In 2015 a separation of the two businesses was concluded and the fertiliser/chemicals assets were listed in Holland.
In July 2015 CF bid for OCI’s production facility in Geleen (Holland), nitrogen MLP (OCI Partners, listed in the US), two in-construction plants in the US - Iowa Fertiliser Co (CF calls it Wever) and Natgasoline (methanol production facility) and a trading company based in Dubai. Under the terms, CF is buying the assets for $8.2bn EV, $6.1bn for the businesses and assuming $2bn worth of debt from OCI. The $8.2bn will be financed by $5.4bn worth of shares and $2.8bn in cash. Note the $5.4bn is as of the summer, when CF’s share price was at $60/sh (now it’s $35/sh). As part of the deal, CF will also acquire a 45% interest in Natgasoline, a 1.9mstpa (100% basis) methanol production facility in the US for approx. $520m with the option to purchase the rest for roughly $700m in 2017. Note, mgmt said on a recent call that there are some difficulties in raising the project financing for this project thus it could be excluded from the deal. For now I’m assuming that it is not removed and they consolidate the whole thing.
CF gets the following with this transaction (note that these are very initial estimates based on Q4’15 plant economics - as some of the plants are not even up and running yet): roughly low $200m EBITDA from the legacy OCI assets, additional c. $220m from the Wever facility once it’s up and running by 2017 and c. $200m from Natgasoline (on a 100% basis) by 2018. So by 2018, when everything is fully functioning additional run-rate EBITDA could be around $600-700m based on through earnings. Further the company guides $500m post-tax synergies on a run-rate basis (by 2018), though most will be from a planned tax inversion. An additional benefit of the OCI transaction would be CF’s taking control over OCI’s Wever facility, which would help further increase their share and reach over the US nitrogen fertiliser production capacity.
What’s key here is the tax rate. CF is a US company and OCI is a Dutch company and the plans call for an inversion to Holland to pay around a 25% tax rate (vs the 35% currently). This is a rather complicated process and open to many roadblocks, such as the US Treasury’s review of inversions, which sent CF’s share price down over 10% in two days when announced in late 2015. Both CF and OCI reiterate their support for the transaction (and have done so on a recent investor call). I’ve previously assumed that the original plan (to redomicile to the UK) would be unsuccessful (apparently “country shopping” as defined by the Treasury is not an acceptable practice) and that new CF would pay a 25% tax rate (mgmt guides low 20%s effective). Assuming the inversion is not successful (i.e. the tax rate stays 35%) the deal could lose its attractiveness financially and the operational synergies alone likely wouldn’t justify it, unless CF can reduce the purchase price of the OCI assets. However, everything at this stage is speculation.
Assuming it all goes well, CF sees the deal being closed by the middle of next year. Anti-trust wasn’t expected to be a bottleneck given the fragmented nature of the global nitrogen fertiliser market. A combined CF/OCI would have only approx. 5% of the global urea market. Accordingly, both the US and European anti-trust hurdles have been cleared.
As part of the deal CF will issue approximately 100m new shares on top of its existing 233m shares and receive the above mentioned $600-700m in EBITDA. Assuming the tax inversion (to 25%) is successful the incremental impact on net income and free cash flow would be in the range of $350-450m by 2018, respectively ($150-250m if the 35% tax rate remains). I’m assuming additional $150m synergies by 2018 (vs the $600m pre-tax guidance, of which actually a large chunk is from the inversion). Below is management’s thesis as to why they view the OCI transaction as key:
“So, the way Bert [Frost, SVP sales, distribution and market development] is going to manage, kind of, product flows around the globe, is that we’re going to look at, what is the netback we get, not just from a pricing perspective but from a net cash position; and then manage where we send the product. Whether you send it up into the Corn Belt, or whether we send it to Latin America or Europe. And it’s strictly going to be based on, whatever generates more net cash at the end of the day per ton that’s where the product is going to go. The benefit we have is, we can become hyper-efficient now, serving the rest of the global marketplace out of Donaldsonville.
CHS transaction
This move scores high on the creativity scale. In essence, CHS (US agriculture co- op) will purchase stake in one of CF’s subsidiaries and roughly 9% production capacity share in four plants: Donaldsonville, Port Neal, Yazoo City and Woodward. CHS will have the right to purchase up to 1.7mst of nitrogen fertiliser product and receive an annual distribution of $200-220m (assuming same pricing as above). The total consideration to CF is $2.8bn (tax free) and will ensure continued reliable off-take from a long-time customer. Additionally, this will take out CHS’s planned c. 1mtpa, $3bn ammonia capacity expansion in the US, thereby ensuring balance in the market and reducing the possibility of premium fertiliser prices disappearing faster than anticipated. The deal is not contingent on the OCI transaction and has closed earlier in February. As an aside, CF has done a similar deal in the past when it sold its phosphate business to Mosaic and secured a long-term ammonia supply contract, leading to Mosaic cancelling the construction of their own ammonia production facility.
The rough math is as follows. CHS is paying 10-11x EBITDA (vs 7x historical average for CF) and buys 1.675mstpa capacity for $2.8bn ($1,672/st). Assuming one applies this to the fully ramped-up, pre-OCI capacity of 18.9mst, the EV is $32bn vs $13bn current (or $115/sh on an equity basis vs $35/sh current). Now I wouldn’t expect CF to trade anywhere that region (it is more or less the replacement value) but it is certainly a nice marker.
After the close of the CHS and OCI transactions management estimated to have $10-11bn unallocated capital available for some form of return to shareholders, likely buybacks judging by historical patterns (note this was last the summer so most likely they’ve tempered their estimates since the fertiliser price collapse)From 2011 to date, CF bought back $5.4bn worth of shares. Now management’s number could be ambitious (essentially subject to fertiliser prices in the future) and ultimately one has to see how these moves play out but you have to give it to management, they are certainly thinking creatively. It is positive to see that they are trying to optimise the cash flow of the business.
Something else along these lines caught my eye during a recent conference call: “[…] we’re not really thinking about it [selling products] from a net-back margin perspective anymore. We are thinking about it from a netback after-tax cash flow perspective. And what we are going to be maximizing is a little bit of a different calculus that what we've done in the past, which was focus on EBITDA and margin. We're going to look at what's the best possible after-tax cash position. And that might on the margin lead us to tapping into international opportunities if they look attractive. But it's really going to be an at-the-moment decision based on the different global market conditions and where we can maximize our cash returns.
Valuation scenarios
Perhaps it is easier to summarise all of the above options in one table. Below are the different scenarios and their respective financial outcomes in 2018 (basically run-rate), which are hopefully self-explanatory. The first table uses avg. prices below Q4’15 economics ($255/st for the entire model period) while the second avg. prices just under Q4’15 economics ($275/st) to illustrate earnings power in a minor recovery situation. I’m not terribly a big fan of running commodity company valuation models with increasing/decreasing price assumptions (it’s hard to time the cycles and volatile at best) but more interested in what cash flows the company can generate under various assumptions to triangulate some sort of earnings power.
Key assumptions are as follows:
  • Base case: price assumptions as above, increasing natural gas costs, additional capacity ramp-up and sales volume to 18.1mst by 2018, no buybacks, no change to the current $1.2/sh annual dividend payout (3.5% yield as of today)
  • CHS: $2.8bn (tax free) cash inflow in Q1’16, 1.7mstpa volume sold to CHS and $220m annual distribution, buybacks to maintain at or below 2.5x net debt/EBITDA guidance (total buybacks of approx. $2.5bn and $3.5bn in the two cases spread out over 2016-19 reflecting respective annual valuations), no change to the dividend payout
  • OCI: transaction close in early Q3’16, sources, uses and OCI asset financials as above, 25% tax rate going forward, buybacks to maintain at or below 2.5x net leverage guidance starting in late 2016 after the transaction close (approx. $2.7bn and $4.5bn in the two cases spread out over 2016-19 reflecting respective annual valuations), assume $150m run-rate synergies from 2018 (there is potential for further upside as the company guides for more from 2018, however most is from the tax rate change), no change to the dividend payout
Three points to take away from here:
  • Even in the base case CF is probably fairly valued
  • Assuming only the CHS transaction closes there could still be a 25% upside mostly coming from the capital returned to shareholders
  • If all of the above closes CF’s intrinsic value could theoretically increase by 50%. A large part of the increase in the per share value comes from management carrying out their capital return plan to which history gives comfort. Now the upside quantum is not like a 5x, however considering that it is a relatively stable and mature business, it is commensurate with the risk one is taking on 
Some sensitivities based on 2018 financials (pro forma for transactions, buybacks etc):
  • Change in prices: +/- 5% change in average prices (roughly $15/st) impacts EBITDA by $260m, net income and FCF by $130m ($0.5/sh)
  • Change in volume: +/- 5% change in volumes sold (0.9mst) impacts EBITDA by $90, net income and FCF by $50m ($0.2/sh)
  • Change in gas prices: +/- 5% change in the cost of natural gas ($15c/mmbtu) impacts EBITDA by $60m, net income and FCF by $30m ($0.1/sh)
  • Change in tax rate: +/- 5% change in the tax rate impacts net income and FCF by $100m ($0.4/sh)


  • Gas prices: Current prices are around $1.7/mmbtu in the US and the futures are pointing to a $2-2.5/mmbtu for the coming 2 years. As natural gas is the key input cost to production any changes to the US shale thesis would impact the valuation significantly. Prices are very volatile but given where we are in the cycle and the outlook for supply it is unlikely to increase substantially in the near to mid term. I’m using $3.25/mmbtu gas costs and have included sensitivies to see what a price movement up/down means
  • Fertiliser prices: CF operates in the most-well supplied part of the global fertiliser business with a couple of irrational players. The US is somewhat sheltered from the global market, however even that couldn’t stop prices eroding in 2015 as China exported heavily and new capacity came on line. Looking at the global urea S/D, prices are not expected to increase dramatically in the near term but with perhaps more (state-required) discipline from Chinese producers the pressure should ease. The nitrogen cost curve is functioning reasonably well and that could ensure that prices don’t fall below current levels for sustained periods. However, should the Yuan devalue further that would reduce production costs for Chinese producers essentially moving the cost curve to the left. In terms of the US, the premium prices vs the rest of the world should remain given the supply/demand imbalance at least in the near to mid term. While nitrogen fertiliser application is a must every year crop prices can influence fertiliser prices as we’ve seen in 2015
  • Transactions: The deal with CHS is relatively straightforward, however OCI poses potential for hiccups with the key being the threat to inversion. The anti-trust issues have been cleared and if the tax inversion is not allowed the deal could lose financial attraction and might not close at all. However, even without the OCI transaction CF presents an interesting situation. Note, CF is not able to buy back shares unless the OCI transaction is closed or abandoned so there could be pressure on the share price until then
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


Further clarity on pro forma numbers and tax issue, buyback plans and close of the OCI transaction

Improvement of fertiliser prices from current levels

    show   sort by    
      Back to top