Description
CF Industries (“CF”) offers an opportunity to invest at 2.6x TTM EBITDA or 5.0x TTM FCF, and below recent management purchases and stock options. We believe cash-flow will continue to be robust, and the company may take shareholder friendly actions. The recent spike in natural gas has created this opportunity, as the market is concerned about the company’s ability to push increased costs through.
Shrs: 55MM
Mkt cap: $836MM
Net cash: $107MM
Overview:
CF is a leading manufacturer and distributor of nitrogen and phosphate based fertilizer products in North America. The company was founded as a cooperative in 1948 – and owned by its customers (agricultural cooperatives). The company was IPO’d at $16/share on August 11th, with the sale of 47.4 million shares. All proceeds went to selling shareholders, and most selling shareholders sold 100% of their stake. We believe there were a number of interesting dynamics in play, which caused the IPO to be priced at a discount to fair value:
• The selling shareholders, agricultural cooperatives, are not private equity investors, and to a certain degree this was “found money” for them
• Management, which did not previously have significant ownership, was granted 2.7 million shares struck at the IPO price. Therefore, the lower the IPO price, the better for management.
• To the extent the company was trying to maximize the price they could get, it would seem strange to do such a large deal in a boring business in mid-August
• To the extent the sellers were savvy, it seems like they would not have sold 100% of their holdings in most cases – but instead, would have helped the supply/demand dynamic by selling some at the IPO price and some at (presumably) a higher price some time from now
• While the company has almost $2/share of net cash, management indicated that they planned to look at doing a bond offering subsequent to the deal as they believe this business should carry some debt. Again, to the extent the sellers were trying to maximize their value, why didn’t they simply dividend themselves cash and put $200 million of debt on the business before IPOing it rather than letting it happen post-deal
• This also raises an interesting question of what will the company do with all of this cash, especially since it generates significant free cash flow and there are limited acquisition opportunities. We believe management may do a stock buyback to realize value for shareholders
The fertilizer industry is cyclical, with low (but generally steady) demand growth and lumpy supply growth – especially with nitrogen, where large-scale facilities are required and the global industry is fragmented. There was a major dislocation in demand for five years after the fall of the Soviet Union, but in general the market cyclicality is supply driven.
Natural gas is the principal raw material used to produce nitrogen fertilizers, and constitutes a substantial majority of the cash costs. High natural gas costs over the last few years have led to a significant decline in North American capacity, which has been displaced by imports from low natural gas cost parts of the world. On the phosphate side of the business, North America has significant reserves and is a net exporter. Declining phosphate buying from China – which has become more self-sufficient – has largely been offset by increased buying from South America.
The company’s primary nitrogen fertilizer products are ammonia, urea and UAN. It operates North America’s largest nitrogen fertilizer production facilities in Donaldsonville, Louisiana and North America’s third largest in Medicine Hat, Alberta, Canada. The company’s main phosphate fertilizer products are DAP and MAP. Its phosphate fertilizer manufacturing operations are located in central Florida and consist of a phosphate fertilizer chemical complex in Plant City and a phosphate rock mine, beneficiation plant and phosphate rock reserves in Hardee County.
Importantly, the company also owns and operates one of the most extensive distribution systems for nitrogen and phosphate fertilizers in North America. These facilities are located principally in the grain-producing regions of the Midwest, and give the company a competitive barrier vs. imports. This has insulated the company somewhat from lower-cost natural gas nitrogen imports, and in some cases the company can even make build/buy decisions to import ammonia and use its own distribution system.
CF was historically run for the benefit of its owners, and not with a profit motive. In late 2002, after suffering significant losses, the company started to adjust the way it ran its business and conduct itself on an arms-length basis and with a profit motive.
• Customer rationalization. Owner-customers accounted for 88% of sales in 2002, but just under 60% in 2004. Previously, geographic and strategic realities were ignored for the purpose of over serving an owner (in a remote geography) or being prohibited from serving a non-owner who might be adjacently located
• Irrational pricing programs have been eliminated. Previously, owners could lock-in the price of nitrogen fertilizer for months ahead based on the prevailing natural gas prices. If natural gas went up, CF was held to the contract. If natural gas went down, the owner could re-cut at lower prices.
• Risk management programs have been introduced. The company introduced forward pricing programs to reduce its exposure – and the exposure of its customers – to natural gas volatility.
• Natural gas dependency management. The company is looking at a JV in Trinidad/Tobago, which would be a world-scale facility with cheap natural gas. Secondly, the company is looking at using alternative feedstocks (i.e. petroleum coke or coal).
Earnings model & valuation:
2002 2003 2004 LTM(6/30) 2005
Revenue 1,014 1,370 1,651 1,891 1,980
Multiple 0.72 0.53 0.44 0.39 0.37
EBITDA 85 95 234 277 285
Multiple 8.6 7.7 3.1 2.6 2.6
Margin 8.4% 7.0% 14.1% 14.7% 14.4%
Capex 26 29 34 54 70
EBITDA-Capex 59 67 200 223 215
Multiple 12.4 11.0 3.6 3.3 3.4
FCF/s (txd/norm w/c) 0.69 0.79 2.36 2.64 2.54
Mult (ex-net cash) 19.1 16.8 5.6 5.0 5.2
3Q performance should be fine, and not particularly impacted by the recent natural gas spikes – although it is seasonally a slower quarter. 4Q05 and 1Q06 are the bigger question marks and so far it is too early to tell whether fertilizer producers will be able to fully offset natural gas increases. However, industry management teams we have spoken with seem reasonably comfortable – although it is difficult for them to know (or say) much yet. To be clear, fertilizer prices have been moving up – the question is not can they raise prices, but can they raise them fast enough and high enough. Over a longer time horizon, we believe the company will do $160-180 million of mid-cycle EBITDA. With $50 million of mid-cycle capex, and giving EBITDA-capex an 8-10 multiple, we would have a stock in the low $20s. Given that the company is currently generating significant free cash flow above this, there should be room for this value to grow toward the mid-$20s over the next 12 months.
Terra Industries (“TRA”) and Agrium (“AGU”) are probably the best U.S. comps. TRA, probably the closer comp since it is entirely nitrogen fertilizer, trades at 4.4x TTM EBITDA. AGU is more diversified and probably a better business, with modest South American exposure as well as a potash and retail business, and trades at 4.5x TTM EBITDA. At 4.4x TTM EBITDA, CF would be a $24 stock. This would equate to 8.5x TTM FCF (ex-net cash) on a fully-taxed basis. Capital intensity is comparable at TRA, and has been higher at AGU, so EBITDA is not a comparison that unfairly favors CF. For example, FCF comparisons are slightly more favorable to CF.
Catalysts:
• Company reports 3Q results and gets a couple of quarters under its belt as a public company
• Natural gas spike receeds somewhat, and/or fertilizer companies are able to withstand
• Morgan Stanley and JP Morgan initiate coverage
• Company potentially announces a stock buyback
Risks:
• North American nitrogen fertilizer producers are not able to pass through explosive natural gas prices either due to customer rejection or displacement from foreign sources
• Global/North American economy slows down, negatively impacting farmer demand (although demand has been less cyclical than supply historically).
• Management uses excess cash-flow and debt proceeds for poor-return capital projects or overpriced M&A
Catalyst
• Company reports 3Q results and gets a couple of quarters under its belt as a public company
• Natural gas spike receeds somewhat, and/or fertilizer companies are able to withstand
• Morgan Stanley and JP Morgan initiate coverage
• Company potentially announces a stock buyback