Description

UAN was previously written up by HoneyBadger in August 2018, and I encourage you to read that post in conjunction with this one. I echo the introductory comments on not being a commodity expert yet liking cheap options where cycle and capital structure are aligned to create a good chance for a double in the next few years.

A lot of ammonia capacity was added in 2016-2018, creating the trough period where UAN cut its dividend to zero and was treading water. The good news is that UAN was almost cash flow break even during this difficult time. 2019 and 2020 are years where we are just starting to recover from the trough and earnings remain well below prior cyclical average levels. Looking forward, there is little supply coming on-line over the next few years. Meanwhile, worldwide demand continues to grow at 2-3% per year based on more humans eating more food. Therefore, I think over the next few years, I believe the industry cycle and UAN’s earnings will continue to work their way towards “normalized” levels.

The chart below shows historical capacity additions along with forecasted additions. The blue bars in the forecasts are all known projects, many of those simply won’t be built. The smaller bars in the forecasts are from CF and Yara, the two largest nitrogen producers in the world.

It’s also worthwhile pointing out that North American nitrogen producers have a cost advantage vs. other global producers, especially delivering to US farmers (see cost curve chart below from CF’s Q3 19 presentation). UAN’s two plants in Kansas and Iowa are well-placed to serve American needs.

Much of what HoneyBadger wrote in August 2018 has since played out favorably, but the market doesn’t seem to care, which has led to the opportunity. Since the prior write-up, EBITDA has gone from $45m (LTM Q2 18) to $129m (LTM Q3 19). Trailing dividend per share has gone from 0c (LTM Q2 18) to 40c (LTM Q3 19). Despite the markedly improved financial performance the stock price has declined 25% from $3.75 to $2.85.

Why has the stock declined despite the better operating and financial performance? I think a large part of this is technical. MLPs have done very poorly in the last few months, and since UAN is a small-cap variable distribution MLP, it has likely been caught up in the selling pressure facing the whole industry.

Others may be concerned about leverage as UAN has $654m of debt ($570m net of cash) compared to a $319m market cap. There are no near-term liquidity or maturity issues as debt is almost entirely comprised of $645m of 9.25% debt due June 2023 which has no maintenance covenants. In fact, UAN is likely to call these in mid-2020 when the call price falls to 102.3% of par in order to reduce its interest expense burden. Note this slug of debt is currently trading at ~105% and S&P recently revised their outlook on UAN to stable.

Another potential explanation is that the market doesn’t believe that the current level of profitability is sustainable. I do think that UAN’s selling prices and earnings did benefit somewhat over the last season due to Midwestern flooding which made it harder to transport ammonia fertilizer. In addition, there are some concerns that Chinese exports have running a little higher than expected. However, I do not see 2020 earnings falling much from the levels we’ve seen over the past year. CF is the industry leader and they also foresee 2020 earnings similar to 2019.

Let’s look at a simple sensitivity analysis for near-term earnings and dividend. I think 2019 EBITDA will end up around $120m and subtracting out $59m of interest and $23m of capex leaves $38m of distributable cash flow (or 33c/share based on 113m shares). On today’s share price of $2.85, this is a 11.7% yield (which is very tax efficient for investors who can tolerate K-1s). I think 2020 earnings being flat is a reasonable “base case” but every $10m of EBITDA translates into ~9c/share of dividends. Thus, $110m of EBITDA translates into an 8.6% yield and $100m EBITDA results in a 5.5% yield.

“Normalized” earnings for cyclicals are hard to define and easy to debate. For my purposes, I look at cash margins per ton of nitrogen over time. Trough gross margins were $11/ton in 2017, peak gross margins were $180-190/ton in 2011-2012 and average over the last 10 years is $81/ton. Multiplying this by 1.54m tons of annual production, taking out $30m SG&A and adding back $80m of D&A results in trough/peak/average EBITDA of $67m/$335m/$175m. Looking at today’s TEV, UAN is trading at 5.1x normalized EBITDA and 2.7x peak EBITDA. Using an 8x EBITDA multiple on normalized EBITDA gets to a $7.30 target price.  

Taking a look at valuation on a dividend yield basis, I start with EBITDA and subtract interest expense of $59m, capex of $23m to get to trough/peak/average distributable cash flow of ($15m)/$253m/$92m. Dividing this by 113m shares results in trough/peak/average distributable cash flow per share of (14c)/$2.23/82c. Thus, if we get to “normalized” earnings UAN is trading at a 29% dividend yield. If UAN trades at a 10% dividend yield on normalized earnings, this results in a $8.20 target price.

It’s worth to look at that the stock could do under a peak EBITDA scenario, even though this clearly isn’t the central case. Using an 8x EBITDA multiple on peak EBITDA gets to a $18.60 target price.  Using a 10% yield on peak earnings results in a $22.30 target price.

Catalyst

UAN moves towards more normalized cycle earnings. I can’t predict exactly when this will happen, but I believe there is a good chance within the next 2-3 years. While I wait, I collect a nice tax-efficient dividend.