Description

Macro Backdrop of Thesis

Even before present-day elevated inflation concerns and the Russia/Ukraine war, the nitrogen fertilizer market was starting to improve in 2H21. Overbuilding of nitrogen fertilizer production and heavy exporting from China led to soft nitrogen producer economics in the several years leading up to 2021. Then the market finally firmed as a result of subsiding supply side growth after 2018, persistent demand growth, and a confluence of weather events – Winter Storm Uri in the US and no wind in Europe (which was the big one) that drove up natural gas prices in the Fall of 2021 and curtailed European production in the process. Incremental events in late 2021 that tightened the nitrogen fertilizer market included China halting urea exports (typically 3-5m tons of a 50m ton market) and Russia shutting 1m tons (even before the war). Grain markets also tightened up last year with an “80 year” Brazil drought and China importing due to depleted state reserves. The summary of all of this was that we were exiting 2021 with tighter fertilizer supply / demand and tighter grain inventories than we’ve seen in the better part of a decade.  

Then the Russia/Ukraine war began in February 2022. Both countries are both very large fertilizer producers and very large grain exporters. Exiting 2021, industry experts thought 2023 would be the year that nitrogen fertilizer and grain markets were expected to normalize back to equilibrium. The Russia/Ukraine war has likely extended that to at least 2024.

Going forward, the supply side of the equation seems good for nitrogen fertilizer producers. There is no “next wave” of nitrogen fertilizer supply coming and it takes 4-5 years for capacity to be built. Per CF, only 4m additional tons are in the pipeline on a 185m ton market. This industry has a habit of developing assets over budget and much beyond scheduled timeframes.

From the demand side, nitrogen fertilizer application is not as voluntary as phosphate and potash – it must be applied. Corn stocks-to-use ratios, which tend to move inversely with crop prices, are at decade lows and are not expected to normalize for at least two more years and will require robust crop yields. Industrial usage of ammonia is sub-20% and would be more cyclical in the event of a material recession.

But Aren’t You Buying Peak? And Why OCI?

So things are great today, but aren’t fertilizer companies are overearning? The answer is unequivocally yes, but the most relevant question is for how long and what does the capital structure and normalized earnings profile look like when conditions go back to equilibrium? From a scan of the major producers, we believe OCI clearly looks the most attractive on this analysis.

It is also somewhat odd to us that Street median estimates are assuming that OCI earnings contract in 2023 at 2x the rate of CF (40% vs 20%), but this is a dynamic that we like. Recent product pricing has moderated back close to marginal production costs, which we think once again presents an opportunistic entry point on OCI in 2022.

We originally got involved in OCI earlier this year when we saw the stock underperforming its larger fertilizer peers and realized that Melinda Gates was aggressively selling down her 9% stake. But the more we learned, the more we liked OCI as a longer duration investment. OCI is led by a perennial winner in Nassef Sawiris, and his protege Ahmed El-Hoshy. Texas Industries and Signature Aviation are a couple of large companies that Sawiris was instrumental in getting sold at significant premiums in the last decade. Even with OCI itself, Sawiris was on the cusp of selling to CF in 2015 and the merger was approved before the deal was scuttled due to new tax inversion rules at the last minute. Sawiris and El-Hoshy are commercial, unemotional value creating machines and it would not surprise us to see them be opportunistic sellers. Lastly, OCI was historically the most levered of the larger fertilizer producers because of spending on large greenfield assets. That leverage issue is well in the rearview mirror. In fact, OCI has come so far that they were just upgraded to investment grade by all three rating agencies in April 2022.

If energy and food inflationary pressures in conjunction with a tight nitrogen supply market have duration beyond this year, OCI should work out quite well. If European energy futures are close to correct for the next couple years and if industry participants are also correct that crop yields will take a hit from lack of nutrient tons (driving up grain pricing) and grain tightness lasts into 2024, OCI should be a great investment. If Russia cuts off gas to Europe, OCI will likely be one of the best equity performers in the market.

Summary of Earnings Power and Implied Value

We assume that Europe (~10% of global production) is the marginal nitrogen fertilizer producer and we assume that product is priced such that European capacity is sold to zero margin at the level of current natural gas futures. For purposes of valuation to YE23, we then assume that profitability reverts to historical per ton profitability in normal times.

With the product prices above implied by European forward curves, cash production of OCI is phenomenal. OCI’s EV is shrinking extremely fast and Sawiris and El-Hoshy are also phenomenal capital allocators. Iowa production (20% of OCI’s fertilizer production) costs are tied to US natural gas prices, Fertiglobe (55% of OCI’s fertilizer production) gas contracts have somewhat of a profit sharing mechanism that results in a modest profit leakage in robust times like today but also a ~$3/mmbtu floor (this mechanism also minimizes political risk), and the Rotterdam port in the Netherlands allows OCI to produce solid downstream margins in Europe despite high Europe gas prices. OCI’s taxes are low due to exposure to tax-advantaged regions and tax-free zones. Recurring capex is low due to modern assets.

Despite a very robust 1Q FCF of $600m, FCF should improve markedly in 2Q as inventory was seasonally built in 1Q and volumes were opportunistically pushed to 2Q from 1Q. As we look out over the next 3 quarters of 2022 and 2023, we project that OCI’s share of FCF will be $4b+ or ~50% of current market cap (with current leverage <1x normalized EBITDA) and that YE23 EV will end the year at around $5.5b. We believe that based on the current asset base, OCI’s normalized proportionate EBITDA earnings power will cycle between $1.0b-$1.65b with an average of $1.4b (the same proportionate level of EBITDA as the 1Q-3Q 2021 run-rate before the market tightened up).

So at $5.5b of YE23 EV, OCI would be trading at 4x proportionate normalized EBITDA. OCI was historically a 7x forward EBITDA company when it had the highest leverage of the large fertilizer companies. CF, for comparison, has typically traded around 8x-9x. Let’s assume this 7x is fair and that at YE23, we magically go back to equilibrium. This would imply that OCI should trade at a $9.8b EV versus the $5.5b implied at YE23 with our FCF waterfall math. This results in an implied EUR 54/sh stock price. uFCF at $1.4b of EBITDA is ~$1b, so a ~$10b EV makes sense at a 10% yield.

Downside risk is that the Russia / Ukraine war is resolved and European natural gas prices collapse and a lot of the issues presented from the first paragraph immediately go away. This results in $1b of proportionate EBITDA (~30% below the 1Q-3Q21 run-rate). If we assume that this happens momentarily and that OCI only gets excess FCF in 2Q22 (could approach $1b), then at 7x, the $1b of EBITDA at 2Q22 quarter end cap structure results in a EUR 29/sh stock. At this level of EBITDA and a EUR 29/sh stock, it’s a roughly 10% unlevered FCF yield which makes sense.

So over the next ~18 months, we are getting roughly EUR 20/sh upside and 6/sh downside, or in excess of 3:1 upside:downside with 50%+ return potential. We are also getting protection from some of our longer duration investments should Russia cut off gas to Europe or some other incremental inflationary pressure present itself.

Quick Overview of Assets (And Implied Value Based on Public/Private Marks) and Capital Allocation

OCI generates the vast majority of earnings from nitrogen (~90% over next couple years most likely) and also has a sizeable methanol business. Nitrogen assets span from Iowa to Netherlands to Egypt, Algeria and UAE (these three geographies comprise Fertiglobe, of which OCI owns 50%). Fertiglobe is publicly traded and OCI’s share is currently worth $5.7b. OCI recently sold 15% of its methanol business at a $2.5b valuation, implying its remaining 85% share is worth $2.1b. OCI’s current EV is $9.3b, implying that on current EV, you’re getting Iowa and Europe for $1.5b. We believe that Iowa and Europe are run-rating in excess of $1b/yr of EBITDA and normalized close to $500m net of corporate expense.  

OCI’s recent results presentation and transcript does a pretty great job of walking through the industry dynamics, the company’s assets within the industry, and capital structure / allocation: https://www.oci.nl/media/2073/oci-nv-q1-2022-results-presentation_vf.pdf. CF’s recent quarterly results update and presentation are also a good read.

Basic parameters of OCI’s capital allocation are <2x net leverage through the cycle, $400m base annual dividend, and excess cash flow beyond business reinvestment going towards special distributions and/or share repurchase. Pretty much all excess Fertiglobe FCF will be upstreamed to OCI. OCI’s 2H21 distribution of EUR 1.45/sh is to be paid June 2022. 1H22 distribution is to be “significantly higher”. Annual fully consolidated maintenance capex amounts to $300m and we assume interest expense of $100m on an optimally levered business.

Catalyst

Duration of steep global cost curve, big 2Q22 EBITDA and FCF, June dividend payment and subsequent rising cash distributions, asset/company sale.