Description

Recommendation: Short IGL

In my opinion, IMC Global had been heading towards eventual insolvency. On March 31, 2004, the company’s net debt equaled $2,100 million vs. hard shareholders’ equity of only $235 million. During most of the past several years, operating earnings have been insufficient to offset interest expense, with the result that the company has lost money and has faced the prospect of ever increasing debt and diminishing shareholders’ equity. If it had not been for asset sales, there is a good chance that the company would not have been able to avoid a default on its debt.

Soon, IMC will merge with Cargill’s fertilizer business in an exchange of shares. The combined company will have a new name: Mosaic. While IMC is much larger than Cargill’s fertilizer operations (IMC’s plant and investments total $2,350 million vs. Cargill’s $1,151 million), IMC’s shareholders will own only 1/3 of Mosaic. It appears to us that the merger is the equivalent of a reorganization out of bankruptcy. IMC shareholders will avoid the prospect of financial problems, but will only own 1/3 of the new company.

What will Mosaic be worth? The recently issued Form S-4 helps value the new company. The merger is being treated as an acquisition of IMC by Cargill’s fertilizer business. Purchase accounting is being used, so IMC’s assets are being marked up to “market”. According to the S-4, Mosaic will have a hard book value of $1,822, or $4.29 per share on about 425 million shares that will be outstanding. The $4.29 per share values IMC’s asets at market, but Cargill’s at historical cost. Cargill mainly is a “put together” company that entered the fertilizer business in the mid-1980s when it acquired Gardinier and that then expanded through acquisitions during the 1990s. In our opinion, the understatement in Cargill’s book value is limited by the fact that most of the company’s assets were acquired fairly recently at what, one can assume, was their fair value at the time. If the value of these assets has appreciated by 100% vs. their current book value, one could add $1,151 million (or $2.71 per share) to the pro-forma value of Mosaic – and conclude that Mosaic will be worth roughly $7.00 per pro forma share – or less that half of the current market price of IMC Global. (Note – during the past six years, Cargill’s operating earnings have averaged roughly $100 million (pre-tax) and never exceeded $200 million in a single year, so a $2,300 million valuation of the company’s assets appears liberal.)

Another approach to valuing Mosaic is to project pro-forma mid-cycle earnings. During the five-year period that ended in 2003, IMC’s operating earnings averaged about $195 million. These earnings included both good and bad market conditions. We will assume that the company’s “mid-cycle earnings power” has grown some in recent years – and currently is about $225 million. During the same five-year period, the operating earnings of Cargill’s fertilizer business averaged just under $100 million. We will assume that Cargill’s earnings power subsequently has increased to about $125 million. An additional consideration is the savings that should result from the merger of the two companies, which management estimates will be $145 million. While we generally are skeptical of the magnitude of “synergistic” savings, if the savings do turn out to be $145 million, we estimate that Mosaic’s pro forma mid-cycle earnings power will be $495 million. Then, to calculate our estimate of mid-cycle net earnings, one has to subtract $160 million of pro forma interest expense and income taxes at a 36% effective rate. The result of this calculation is $215 million, or $.50 per pro forma share. At 15X mid-cycle earnings, Mosaic would be worth $7.50 per share.

Thus, based on both an appraisal of assets and on a reasonable multiple of mid-cycle earnings power, we conclude that IMC Global’s shares currently are substantially over-valued. One suggestion is a paired trade – with investors shorting shares of IMC Global and purchasing shares of Yara International, a competitor of IMC Global that was written-up recently in a Value Investors Club recommendation. We believe that Yara is selling at less than 7X its mid-cycle earnings power.

Catalyst