Description

Rookie964 provided a great short recommendation on Potash Corp. in 2013 but substantial time has passed and I believe a short position in Potash Corp continues to be an attractive opportunity.  I won’t rewrite the market history and context that Rookie previously provided.

The global potash market has poor long term fundamentals and I see multiple headwinds for potash pricing over the coming year that should negatively impact producers. Potash Corp represents the best short vehicle for this trade due to its potash exposure (59% of gross profit), strong liquidity and low short interest.  

Negative Long Term Potash Outlook

• Market is oversupplied and is expected to add 15mt more capacity than forecast demand through 2020

• 2015 name plate capacity of 72mtpa vs ~58mt sold (i.e. significant oversupply at present)

• Marginal cost curve moving down as new production comes on line

• 10mt of Russian brownfield supply going online at ~$60/t by 2020

• 2.9mt K+S legacy mine coming online in 2016 with $90-100/t costs

• Mosaic's K3 expansion due in 2017 built to reduce costs rather than increase supply

• Industry margins fallings as the industry becomes more commoditized and price transparency increases

• Following breakup of the BPC cartel in 2013, competitive forces have continued to increase

• Market pricing is still above the marginal cost curve indicating there is further the price can fall

• Expect price to continue to erode due to competition over time

Negative Near Term Potash Price Drivers

• Market is currently oversupplied and facing increased competition

• Global inventories are very high which should lead to weaker short term demand

• China (+58% y/y); India closing stock +79% y/y; North American stocks +51% y/y; and Brazil inventory +56% y/y

• Global FX declines versus US$ has made potash more expensive in local currencies for key markets (China, Brazil) despite potash spot prices falling as much as 30% in 2015

• Brazil local MOP prices (+~23%); Malaysia (+~11%); India (+~7%);

• Reduced farmer income will be negative for demand:

• Key crop prices dropped 15-30% during 2015, reducing farmers’ income

• Key importers facing challenging economic circumstances

• Brazil Poor availability of credit for Brazilian farmers due to ongoing economic and political challenges

• Chinese lending and economic stimulus likely to be reduced going forward; implementation of 13% Chinese VAT on potash began in 2015 increasing local price

• Lack of clarity surrounding contract prices and volumes – typical annual contract with China and India is significantly delayed and likely to be at very low price levels

• India recently announced a contract with Belarus for $227/t, down from last year’s price of $332/t (also at lower volumes than the 2015 contract)

• India contract of $227/t implies a Chinese contract pricing of $210/t based on historical price differentials

Potash Corp. Trade

PotashCorp is one of the world’s largest potash producers, and a significant producer of ammonia and phosphates. The company is finishing brownfield expansion plans to increase potash capacity significantly. PotashCorp is the largest member of Canpotex (sales and marketing agent for North American potash producers), which sells potash to key offshore markets such as China, Brazil, S.E. Asia, and India. Potash sales represent the largest share of Potash Corp’s earnings at approximately 59% of gross profit.  

• Key reasons for the short now:

• Valuation: POT currently trades at approximately 19x forward earnings, which is at or near its peak for the past 5 years; EV/EBITDA at approximately 10x which is more in line with historical levels but still above the average on expensive for a low/zero growth business

• Earnings are also likely to be weaker than forecasted as potash prices remain under pressure

• Competitor K+S recently released a Q2 profit warning, generating EBIT of EUR10m vs 2015 Q2 at EUR179m and broker estimates at EUR107m (the miss was attributed to both lower potash prices and production volumes)

• Dividend cut: POT currently pays a dividend of US$1.00 per year (6.3% yield) but has guided toward US$0.60 - US$0.80/sh in earnings for 2016 – this is clearly unsustainable (even if earnings meet guidance) and a dividend cut is likely in the near future

• Investor positioning: Investors seem to maintain interest in POT due to the belief that we are at the bottom of the mining cycle.  While this may be true in some commodities, potash is oversupplied at present and will be further oversupplies as additional production comes on in the near term

Key Risks

• Reunion of BPC cartel: there have been recent rumors that key competitors in Belarus and Russia may be considering reforming the cartel that was broken up in 2013 – if this was acted upon it would challenge the investment thesis due to a potential reduction in supply

• We believe that a reformation of BPC cartel is very unlikely due to both political and economic factors

• Positive Chinese contract: if China were to sign a contract above the market’s expectations of $220 - $230/t, Potash Corp may be able to meet/exceed earning and maintain its dividend; longer term, this does not materially impact the issue of oversupply however

Catalyst

• Dividend cut
• Reduction in production volumes
• Reduced 2016 earnings
• China contract pricing/volumes lower than expectations or cancelled altogether