Description

Investment Idea

Idea: Short K+S (Ticker: SDF GR)

Thesis:

K+S is a potash producer who is facing numerous challenges to its businesses. Not only is the potash market facing structural challenges and potash prices are under duress, K+S also faces seasonal challenges to its US salt business, increased competition in the Sulphate of Potash market, and teething issues at its upcoming major investment in a new mine.

Business description:

K+S is one of the world's largest salt and fertiliser suppliers. Its primary activity is the production and distribution of potash fertilisers. It has an ageing mine life which has led to one of the highest cost of production across all producers. This has led management to invest in a new mine called “Legacy Project” due to come online shortly. K+S is also one of the world's largest salt producers, with leading positions in Europe and the Americas, the latter through the acquisition of Morton Salt.

Industry Outlook:

Potash is used as one of the main three fertilizers for the crops industry. The other two are nitrogen (in the form of urea or ammonia) and phosphates.

The Potash market operated as an oligopoly for years with two big cartels cooperating to keep prices elevated well above the global cost curve. The cartels included Canpotex and BPC. Canpotex comprised of Potash Corp of Saskatchwan, Mosaic and Agrium in North America. BPC comprised of Uralkali and Belaruskali from Russia and Belarus. K+S managed to operate outside of these much larger companies and producers and hence managed to benefit from the oligopoly by benefitting from much higher potash prices without having to withhold production capacity and operate at lower utilization level like the bigger producers in the two cartels. K+S has the highest costs of all significant producers.  Note below the major potash producers and the current cost curve.

From 2000-2007 potash pricing averaged approximately $165/mt before exploding upwards as the agriculture bull cycle took off and the oligopolistic effects enhanced the up-cycle. These historical datapoints emphasize that this has not always been a high priced commodity. See below for historical prices.

Potash prices stayed elevated from 2007-2013 due to the agricultural bull cycle where prices of all major agricultural commodities spiked higher and production increased. The agricultural bull cycle was linked to the oil price bull cycle due to bio-fuels. The demand for crops used in biofuel production increased dramatically from 2000 to 2014, especially between 2005 and 2010. For example, in 2000, 0.8% of the world’s oils, 2.5% of the maize, and 11% of sugar cane went for biofuels. In 2014, the shares increased to 17% for oils, 15% for maize and 23% for cane. As a result, vegetable oils and maize prices have become much more closely linked to crude oil as 15% of the world's biggest crops go into biofuels. The use of crops for biofuels production has created a link since 2007 between crude oil and crop prices. However, biofuel demand is slowing as governments are recognizing the unintended impact on food prices.

Note in the charts below the increase in the percentage of the agricultural commodity going into biofuels as well as the linkage of these biofuels with Brent crude.

So as Brent declines, the prices of biofuels are collapsing and these are causing the prices for the underlying agricultural commodities to collapse with them. Note I list wheat here as well because even though it’s not directly linked to biofuel, but the competition for farmland caused by biofuels led to a shortage of farmland and an increase in farmland prices and hence even wheat prices.

After the recent Brent collapse, the entire agriculture complex is under tremendous pressure. Everything from agricultural commodities, fertilizers, agricultural equipment, and farmland prices are being affected. There are a couple of other very interesting shorts besides this write-up. Within fertilizers both CF Industries and Potash Corp have fallen about 55% in last 6 months and I recently closed some short positions and feel the risk reward for further downside is better in K+S. Deere is another outstanding short I still have active.

Meanwhile the pain for potash prices started even earlier than the Brent price falling. During the period of high potash prices, a number of major new players announced intentions to enter the industry including BHP Billiton and Rio Tinto and they announced major new projects. In addition smaller players who were not part of the cartel and maximizing production anyway (like K+S) announced new projects which were higher cost than the existing capacity many cartel participants were withholding. In addition a number of cartel participants were cheating on their quotes. This led Uralkali, the largest potash producer globally, to abandon the cartel in summer 2013 and announce intention to maximize production and potash prices collapsed and have stayed low since then. Potash prices were threatening to fall even further and would have if not for a flooding incident at one of Uralkali’s mines in summer 2014 which took about 3% of global capacity offline. The recent agricultural downturn has now exacerbated the situation and the commodity is set to bleed downwards as current prices remain elevated well above cost curve and a lot of new supply is set to come online in the next few years, even as demand is likely to be weak.

Supply and Demand:

Just like many other commodities (met coal, iron ore, copper, oil etc.), the boom period of 2007-2012 (barring the 2009 blip)  led to capital deployment decisions that are impacting the market today and over the next several years. A potash mine takes about 8-9 years from investment decision to bring into full production. K+S itself gave the greenlight for its Legacy project in 2011 and it will only reach full production in 2019.

From an industry standpoint, demand has actually been flattish for a long time and very slowly moving up. Demand was 57mm mt in 2007 and 2013 it was actually lower at 53.5mm mt and 58mt now in 2015. There are various reasons for weak flattish demand.  Potash was historically over-applied in the Soviet era and even in 1990s in Russia as Uralkali sells it to the local market cheap and there was no effort to make efficient use. As these practices have reduced, demand in Ukraine and Russia has decreased. Also some recent studies have even questioned the long-term benefits of potash and farmers have generally responded by reducing its use. As farmers cash flows come under duress with the collapse in agricultural commodities, I expect to see more thrifting in potash use. In 2009, during the financial crisis, potash demand almost halved temporarily as farmers cash flows dried up, albeit under extraordinary circumstances. Still I expect demand to be weak as commodity prices weaken.

Meanwhile supply is set to increase materially over the next several years as a large number of projects were approved 4-6 years ago when Potash prices were materially higher than today. As a result, the already low utilization rates of ~79% today are going to decline to 70% or lower when assuming demand growth of 2-3% which seems optimistc.  Given the fact that most of the capacity projects are brownfields and likely to come online, it would appear difficult to see pricing long term above the marginal cost.  Ironically, both nitrogen and phosphate fertilizer are currently being set by the marginal cost and potash has survived despite the breakdown in the cartel due to the Uralkali accident in 2014. Prices do remain weak though and are heading downward.

Part of the reason demand is so weak in potash that unlike other commodities, Chinese demand for potash imports hasn’t budged significantly for a decade.

 As Uralkali continues to increase production and a number of these projects come online over next few years (including the K+S’ Legacy Project), even as demand remains weak, potash prices should decline significantly as the cost curve shifts to the right, and as the most expensive potash producer K+S will feel the brunt.

K+S company specific

K+S has an potash mining business in Europe. In this potash mining business, it sells half the potash as the standard MOP (muriate of potash) and half as SOP (sulphate of potash). All the prices and analysis you have seen above in industry outlook are for MOP. SOP is basically another form of potash with some sulphate minerals blended in that are used by farmers mostly in Europe who lack another source of sulphur for their land. In other countries sulphur is applied by other techniques and methods. Recently SOP prices locally in Europe had trended up in Euros as the Euro depreciated, benefitting K+S. But its major competitor in SOP, Tessenderlo of Belgium, announced a major expansion project last year to debottleneck its existing capacity and that capacity addition of SOP will hit the market in Q3 16, which will likely erode away the historically high SOP premium K+S is experiencing right now.

The other major business K+S is its Morten Salt business in the Americas. While this business has some stable components like table salt and industrial salts, the major component for this is de-icing salt which experiences seasonal swings. Unfortunately for Morton Salt, the current winter is one of the weakest in recent memory and the lack of snow is likely to lead to a huge drop in demand for de-icing salt. A similarly warm winter in 2012 in the US led to EBITDA for Morton Salt to collapse from $325m to $180m, and a similar effect is likely to take place now for the business’ 2016 EBITDA. Compass Minerals, a US listed salt business, with whom I have had conversations, has already given warnings and is experiencing the downturn. It’s also unclear how long this El-Nino will last and 2016 winter might be warm too. Long-term warming trends are not conducive either, with now 2 severely warm winters in last 4 years (2012 and 2015).

The business in Germany has been run at full utilization and has been experiencing labour inflation in light of Germany’s tight labour market. Once potash prices started to trend down, K+S management put into action a cost tightening program 2 years ago to curtail its costs because it sat very high on the cost curve and the commodity price was falling. This was someone fruitful initially but as the minor gains were achieved, the costs have started to rise again coming back in par with a few years ago as seen below.

The last remaining bit of the business is the new major expansion the company greenlighted in 2011 called the Legacy Project. This project requires about $400-450 potash price to break-even. Potash prices are $300 currently and on my forecast will head down to $260 or lower in next 3-4 years. Hence the NPV of the Legacy Project is coming out closer to Euro -10. These mines are complicated and take a long time to ramp up and already K+S is facing delays and higher than expected costs. The market is also too optimistic on the ramp-up expectations based on my experience with other similar projects.

K+S also has a small minor segment called Complementary Business Segments which is a hodge podge of small businesses with negligible contribution.

Because of the drop in the salt business, my EBITDA is well below consensus of Euro 950m already in 2016. Also I expect the SOP premium to start getting eroded in 2H 16 as Tessenderlo ramps up SOP production. The salt business will bounce back after this year if weather normalizes and that’s what I have assumed. But my potash forecasts of potash trending down from $300 to $260 by 2019 differentiate me from consensus which has potash prices trending up to $350. Consensus also is too bullish on K+S ramp-up and its cost structure when ramped up. Consensus EBITDA for 2018 is current Euro 1.1b and for 2019 with K+S fully ramped up at Euro 1.3b. Hence my view is extremely differentiated.

This is perhaps why the market is relatively sanguine about the large debt K+S has piled up as it spent $4.5b on this Legacy Project which will be a big money loser. Infact not only has this company not generated any FCFs in the good years for potash prices, as it ploughed all the cash into the doomed Legacy Project, it won’t generate any FCFs in future either as the market turns sour and it has the highest costs in the industry. On that analysis, the Debt/EBITDA for the company balloons out to 7.0x by 2019 making the company’s capital structure unsustainable and potential distressed situation. Infact I feel I have been rather conservative assuming Potash prices only drop to $260 by 2019. I think there's a real risk they will go below $200 as Canpotex fails to curtail supply enough by itself to keep supporting prices in the face of falling demand and collapsing cost curve. Keep in mind that Uralkali and Belaruskali cost curves linked to Rubles have been falling, as have Canadian production in CAD, all of these FX are linked to Brent. Hence the global cost curve continues to collapse and I expect prices to fall substantially, but K+S is expensive even with my moderate price drop assumption.

The management may have realized this and recently announced a few days ago that it may IPO or sell Morton Salt. Morton Salt’s last 5 year average EBITDA is $240m. A 8.0x multiple (same as Compass Minerals) would value it at $2.0b. Using that valuation for Morton Salt would put the remaining potash business at an absurd valuation north of 20x+ EV/EBITDA as potash prices fail to bounce back and slip a little. Also Debt/EBITDA of the remaining business is still unsustainable.

Once the salt business is IPO’ed or sold, an appropriate valuation for K+S’s potash business would be closer to 7.0x for 2018 EBITDA (Potash Corp’s current multiple). At that valuation the target share price comes out to Euro 7.1 versus Euros 21 currently. K+S is a good short.

One last point on M&A speculation. After potash prices remained weak, Potash Corp’s financials were deteriorating and it made an absurd bid for K+S in July for Euros 41. The rationale behind this from Potash Corp’s perspective was to effectively use its own absurdly strong share price to buyout K+S who was adding additional capacity to the market in the form of the Legacy Project and then shutdown the mine to try impose some oligopolistic control again on the market. I was short Potash Corp then and since then Potash Corp’s own share price has collapsed, and it withdrew the bid in Oct 2015 and is not coming back as its own shares continue to bleed and are down almost 60% since the announcement of the bid. This is part of the reason K+S is holding up so well, hoping for another bid to come to the table and I am certain it won’t happen as Potash Corp faces severe challenges of its own.

Catalyst

Collapsing Potash Price. SOP premium starts declining from late 2016. Salt business turbulence from weather. Stretched balance sheet from Legacy Project ramp-up. Potential delays in Legacy Project. Potential EUR appreciation versus USD.