Los Angeles, CA-based Rentech Inc. (RTK) and Rentech Nitrogen Partners, L.P. (RNF) are two companies that are inextricably joined at the hip (see mack885’s 7/16/13 write-up on RTK for some historical details on this relationship).  While RTK is an inexpensive stock with a fair amount of upside, the higher value is in shares of RNF at current levels.  RNF stock offers very considerably upside with limited downside at current levels.

For many years, RTK was unsuccessfully and unprofitably trying to develop a series of clean fuel technologies.  In 2006, RTK accidentally made the prescient decision of buying a nitrogen fertilizer plant in East Dubuque, IL from Royster-Clark for only $70 million when high natural gas prices and relatively low corn prices were causing that plant to be merely scraping by.  Five years later, the price of natural gas and the price of corn had reversed earlier trends, significantly boosting profitability.  As a result of this secular shift, RTK spun off 40% of its ownership in the nitrogen business in 2011 in the form of a master limited partnership (MLP); the new publicly-traded nitrogen fertilizer company was named Rentech Nitrogen Partners, L.P. (RNF).  Subsequent to the IPO, RTK has not sold any of its shares in RNF and retains a controlling interest; the management team of both companies are one and the same, and RTK is the general partner of the RNF MLP.

Today, RTK is using the cash flow that it is receiving from RNF to continue investment in its nascent wood pellet businesses.  RTK plans on acquiring enough wood pellet businesses to launch another MLP in the wood pellet area sometime in 2015.  Although management runs both businesses, they cannot take capital from RNF other than through distributions and give it to RTK.  Long-term, RTK (and Blackstone, a big investor/board member of RTK) wants to first and foremost accelerate the growth in wood pellets.  To RTK, RNF seems to be an asset to be used and/or sold off if necessary, particularly so if RTK finds a way to use up its considerable tax loss carryforwards in a potential sale.

Some background in fertilizer is necessary here.  The agricultural fertilizer industry is immense in size and increasingly dominated regionally by an increasingly smaller number of participants.  Generally, the fertilizer industry revolves around three major inputs:  nitrogen, phosphorus, and potassium.  Nitrogen is essential to the formation of proteins, which help to improve plant strength and nutrition.  Most crops need heavy applications of nitrogen, excepting legumes like soy and alfalfa that symbiotically create their own nitrogen from the atmosphere.  Nitrogen fertilizer is essentially produced by combining nitrogen with hydrogen with a hydrocarbon like natural gas as the primary feedstock.  Unlike phosphorus and potassium, nitrogen must be applied annually and thus has limited risk of demand destruction.

Investing in nitrogen fertilizer is akin to drinking a cocktail of corn, oil, GDP growth, and natural gas.  In a perfect world for RNF investors, the mixture of this cocktail would be the following:

• Corn prices would be increasing because of demand, providing farmers with more income to reinvest into fertilizer purchases.
• U.S. natural gas prices would be decreasing, reducing the cost of sales for U.S. nitrogen products.
• As the wealth of nations and their people grow as demonstrated through global GDP growth, the demand for crops grows as the population upgrades its dietary habits and governments direct investment dollars to the agricultural sector to support growing demand.  In the long-term, the global nitrogen fertilizer industry should grow at a low single-digit pace.
• Oil prices would be rising, increasing the breakeven cost of nitrogen fertilizer production in Europe – the high-cost fertilizer supplier to the United States and therefore the floor price for nitrogen in the United States. 

As the simplest form of nitrogen fertilizer, ammonia is the best proxy for nitrogen fertilizer products of all variants.  In North America, Tampa Index pricing is the cheapest ammonia pricing available.  Tampa ammonia pricing increased from $273/ ton in 2009 and peaked in Q1 2013 at $643/ton, and has subsequently dropped back down as corn prices fell and less nitrogen was applied in the U.S. Cornbelt.  It should be noted that nitrogen prices in the U.S. Cornbelt have a ~$160/ton transportation premium vs. Tampa pricing for ammonia and ~$60/ton for UAN.  Ammonia prices realized in the U.S. Cornbelt in the beginning of 2013 broke through $700/ton. 

Nitrogen pricing remains strong currently due to a variety of factors including: Tight global supplies, a continued wide spread between Brent oil and U.S. natural gas, geopolitical issues in big nitrogen exporters like Russia/Ukraine, and others. While nitrogen prices remain elevated, weakening corn prices may be a concerning leading indicator for falling nitrogen prices, thus causing many investors consternation.  However, each growing season is a new enterprise for the Company; with a normalized weather pattern, corn prices may back off the bottom and give RNF some much needed relief.

RNF represents just 0.2% of the global supply of nitrogen fertilizer and only 3.9% of the domestic supply.  RNF has a mix of five different products, but sales of anhydrous ammonia (commonly known as just ammonia) and urea ammonium nitrate solution (UAN) make up 80% or more of the revenues generated at its primary facility in East Dubuque.  The primary feedstock for these products is natural gas, which soaks up roughly 50% of cost of sales. 

The East Dubuque facility has several key value propositions in the nitrogen fertilizer industry.  First of all, only about 10% of annual East Dubuque production is shipped by barge or pipeline.  Rather, almost all of RNF’s production at the East Dubuque facility is picked up at the plant by its customers, eliminating the costly transportation expenses that most competitors have.  Many competitors have to transport production 400-1,000 miles, at incremental costs that can run from $50 -$150/ton, depending on the mode of transport and location of the producer.  East Dubuque has the advantaged location in that most of its customers are located within a 200 mile radius of East Dubuque.  The closest competitive nitrogen facilities to East Dubuque are located in Fort Dodge, IA (190 miles), Creston, IA (275 miles), and Port Neal, IA (300 miles).

The reason why RNF does not have to incur shipping charges is that the East Dubuque facility is located at the epicenter of the world’s corn production, straddling northern Iowa (the #1 corn producing state – 16-17% of U.S. corn production occurs in Iowa) and NW Illinois (the #2 corn producing state), and is less than 100 miles from Minnesota (#4 corn producing state) and Wisconsin.  The East Dubuque facility is the northernmost nitrogen plant in the United States, and, for now, there is only one other local nitrogen fertilizer facility (Fort Dodge) in this market, allowing for low levels of competition and high customer demand.  The amount of ammonia consumed in Illinois, Iowa, and Wisconsin was approximately four times the amount produced for sale in those states, and the amount of UAN consumed was 1.4x the amount produced for sale locally.  Thus, this market must import nitrogen fertilizer from other parts of the United States or from foreign countries.  That also means that they should have waiting customers ready to purchase for the incremental product made from the expansion project.

Second, while nitrogen fertilizer variants are commodities, the United States is a net importer of nitrogen fertilizer with roughly 40% of overall nitrogen needs imported.  Thus, the pricing for these products is based on the marginal cost of the highest cost producer that imports into the market; in this case, it is the European nitrogen producers.  To RNF’s benefit, there currently is a massive spread in natural gas prices between the United States ($3.94/Mmbtu) and Europe ($9.14 Mmbtu).  European natural gas prices are priced based on the cost of Brent oil in Europe.  Thus, the nitrogen products being imported into the United States sets the price for nitrogen with a very high cost of production compared to that generated by East Dubuque.  Thus, margin strength should remain in place for East Dubuque as long as this spread remains more or less intact.  It should be noted that for every $1 increase in natural gas prices domestically, RNF EBITDA would be negatively impacted by $10 million.

Should U.S. natural gas rise above $5/Mmbtu without a corresponding rise in European natural gas prices, the Company would likely see margin contraction.  However, there is an abundance of natural gas supply domestically that can economically come online in the near term at levels between $3.50/Mmbtu and $4.50/Mmbtu, such as the Barnett, Haynesville, and Fayetteville shale plays.  Given the glut of natural gas in the United States and the high cost of extracting oil, this spread should remain in place for the intermediate period ahead.  Thus, the likelihood of natural gas prices above $5/Mmbtu should be limited in the medium term, thus providing a certain level of downside protection on margins at East Dubuque.

Of course, one of the larger risks here is that new greenfield nitrogen plants could come on line in East Dubuque’s neighborhood.  However, nitrogen fertilizer start-up costs are high ($1.5-$2.0 billion per 1 million tons of ammonia).  Economies of scale for a greenfield facility are required; projected investment returns on a 1 million ton/year facility is in the low-teens area.  Thus, there needs to be a massive capital investment to build a new greenfield facility.  Furthermore, the environmental permit process for a greenfield facility seems onerous and possibly punitive.  Plus, the uncertain legislative environment surrounding carbon footprints may also play a role.  For those reasons, the market has heard noise about foreign producers setting up shop in the American Midwest but have not taken any action yet with one exception.  Hence, despite very favorable nitrogen economics since 2008, no greenfield nitrogen projects have been constructed.  That being said, Orascom Construction Industries (Cairo:  OCIC) has been working on a greenfield project in Iowa that is projected to start-up in 2016.

On November 1, 2012, RNF announced the acquisition of a second fertilizer plant.  RNF acquired a large plant for synthetic granulated ammonium sulfate in Pasadena, TX.  At the time of acquisition, management communicated that the EBITDA anticipated from this acquisition is expected to be $25 million in 2013.  Unfortunately, due to ammonia pricing changes, U.S. dollar strength, and operational difficulties experienced in its 2013 expansion projects, Pasadena has proved to be an unmitigated disaster.  In 2014, Pasadena is now projected to generate negative EBITDA of -$10 million.  RNF has already wrote down 100% of the goodwill associated with this facility, and they are trying to find ways to either sell Pasadena or make a little money on operations.  My guess is that Pasadena is worth $25 to $75 million, unfavorably compared to the acquisition price of $128 million.

When RTK originally spun off RNF, it made the decision to set it up as an MLP.  The variable distribution rate is somewhat rare in the MLP world.  The variable distribution rate accurately reflects the cyclical nature of RNF’s underlying cash flow, and it provides investors with direct exposure to changes in underlying nitrogen fertilizer fundamentals.  RNF has the proven capacity to generate gobs of cash flow like it did in 2012, but it has limited opportunities to reinvest the cash organically.  The MLP model promotes transparency and theoretically requires that management display prudent capital discipline.  RNF is therefore required to distribute all the cash it generates each year, thus providing investors with direct participation in the underlying business profitability in a tax-efficient manner. 

With its recent operational difficulties and commodities headwinds, quarterly distributions from RNF fell from a peak of $1.17/share in Q2 2012 to $0.05/share in Q4 2013.  With higher working capital requirements due to the expansion programs and lower net income, RNF has paid out far less in distributions than net income in the last quarter.  RNF has little sell-side coverage, and even less buy-side support.  Many institutional investors are not interested in RNF due to the MLP structure, and yet, the equity income investors who would be interested at most times are out of the stock until the distribution starts to become more reasonable.  At the same time, retail yield hogs that bought the stock at $50 with a projected 8% yield sold all their holdings awhile ago because they want to see a far higher distribution than is currently available.  Thus, it seems that the stock is unlikely to trade up significantly until the quarterly distribution is up to $0.40 or $0.50.  In my view (and consensus sell-side as well), this level of distribution could occur as early as Q4 2014.

From a valuation perspective, it is difficult to determine a single point estimate of valuation for RNF.  Hence, I have created a bear case valuation scenario and a bull case valuation scenario, and a reasonably conservative valuation is somewhere between these two valuations.

                                                                                Bear Case                             Bull Case

E. Dubuque EBITDA                                                   $82                                         $158

Partnership Expenses                                              -$10                                        -$10

Interest Expenses                                                    -$21                                        -$21

Depreciation Expenses                                             -$18                                        -$18

Net Income                                                                $33                                         $119

Shares Outstanding                                                   38.9                                        38.9

E. Dubuque EPU                                                       $0.86                                      $3.07

Historically, variable dividend fertilizer MLPs typically trade at a distribution yield of roughly 8%.  If you apply that distribution yield to the above listed EPU, that would reflect that E. Dubuque alone is worth $10.76 to $38.36.  Adding another $25 - $75 million in value for Pasadena would result in a per share valuation range of $11.41 to $40.29.  With agriculture in a horrible bear market already, that says to me that the worst case scenario is already built into the stock at current levels.  In my view, a stock price in the mid-to-high $20s sometime over the next 2 years is not an unreasonable nor aggressive expectation.

Risks:

• Corn prices remain weak for a prolonged period of time.
• OCI’s new facility in 2016 becomes irrational from a price perspective.
• Another value-destroying fertilizer acquisition occurs.
• RNF is a price taker.

• RNF starts to post a more reasonable quarterly distribution rate
• 2015 crops do not have another record year in terms of yield.
• RNF sells Pasadena or just stops losing money at this plant.
• The board of directors forces a CEO changeover.
• RTK sells its RNF ownership to CF Industries, Yara, Agrium, or another producer in order to further pursue its wood pellet strategies.