Description
Investment Overview
Terra Industries (TRA) presents an interesting value investment opportunity. Hurricanes Katrina and Rita has resulted in significantly higher prices and volatility in natural gas which is a primary feedstock for TRA. TRA stock has traded down from $8.00 before Hurricane Katrina to $5.83. Higher natural gas have impacted TRA in the short term (4Q. 2005 and 1Q. 2006) but the long term story for TRA is still positive. TRA is a strong free cash flow generating company that is de-levering its balance sheet and has valuable assets located in strategic geographic markets.
Terra Industries Company Background
TRA is primarily a North American nitrogen fertilizer manufacture with plants in North America, Trinidad and the United Kingdom. TRA has the capacity to produce over 8 mil. tons of nitrogen fertilizer and its primary products are upgraded nitrogen fertilizer – UAN and Ammonia Nitrate. Majority of TRA’s North American fertilizer plants are located in the interior mid-continent region (Oklahoma & Iowa).
TRA capital structure is composed of $333 mil. in corporate debt ($200 mil. 12.875% of 2008, $133mil. 11.500% of 2010), $125 mil. preferreds (4.25% 2049), $98mil. minority interest in TNH, $132 mil. cash on balance sheet (net of customer pre-payments) and 95.172 mil. common shares current trading at $5.83. The enterprise value is approximately $972 mil. TRA’s LTM pro-forma revenue is $1.9 bil. and EBITDA $317 mil.
The primary feedstock for the manufacture of nitrogen fertilizer is natural gas. Hurricanes Katrina & Rita haven taken a significantly toll on TRA’s stock as the price and volatility in natural gas markets has increased significantly.
Nitrogen Fertilizer Market Dynamics
Nitrogen fertilizers are a key input for agriculture that has to be applied prior to each planting in order to achieve optimal yields. Nitrogen fertilizer is not replaceable; the only substitute for nitrogen fertilizer is animal manure.
The demand for nitrogen fertilizer is relatively stable and grows at 3-3.5% a year. World demand for nitrogen tends to grow at the rate of population growth. Other factors increasing demand for nitrogen fertilizer are increase in grain consumption, increased meat/protein consumption and declining global grain inventories.
Nitrogen fertilizers are a global commodity. Marginal nitrogen fertilizer prices are determined by the production costs of US Gulf of Mexico producers.
Currently global nitrogen supply is tight. New nitrogen fertilizer plants are under construction in the middle-east (primarily to supply Asia) and in Trinidad. Industry sources state that construction costs for new greenfield nitrogen fertilizer plants have increased significantly in recent years as input costs (specialized steel ect.) have increased. There is a long term global trend to move production to captive natural gas locations.
North America
TRA’s North American fertilizer sales are primarily to farmers in the mid-west. The primary crop for which TRA’s fertilizers are used is corn. US Department of Agricultures projects over 81 mil. acres of corn to be planted in 2005.
Domestic US nitrogen fertilizer is a consolidating industry as marginal gulf coast nitrogen fertilizer plants have either shutdown or been acquired. The main remaining domestic nitrogen players are TRA, CF, Agrium, and Koch Industries.
US nitrogen fertilizer products and application process tends to be more specialized than global fertilizer products and applications. US corn farmers use ammonia and UAN as their primary source of nitrogen and have specialized farming equipment for the application of nitrogen fertilizer. Majority of the world uses granular urea as their primary source of nitrogen fertilizer.
For US nitrogen fertilizer producers’ geographic location is very important. Locations closer to end users (mid-west farmers) have transportation, storage and distribution advantages. Currently US nitrogen fertilizer inventories and supplies are tight. US fertilizer transportation and distribution infrastructure (terminals, barges) is limited and in the short term cannot handle significant imports.
Significant structural changes have taken place in the US fertilizer market in the last 5 years. Marginal gulf coast plants have been shut down and significant capacity has been permanently taken off. Cooperative like Farmland have gone out of business and their assets liquidated. CF Industries has gone for a cooperative to a for profit public corporation. The irrational pricing (selling below cash production costs), and cooperative non profit production decisions are no longer central business tenets of the US nitrogen fertilizer industry.
There is not enough global capacity to replace US nitrogen production in the near or medium term – 3-5 years. For UAN, US producers account for over 60% of global capacity. Profitability for US fertilizer producers is primarily driven by capacity and supply environment. TRA nearly went bankrupt in 2002-03 when natural gas was $2BTU and made record profits and cash flows when natural gas was over $7BTU. TRA margin is primarily a function of capacity/supply.
Nitrogen Fertilizer Costs & Agricultural Costs
There has been significant news and market speculation on the impact of record high fertilizer prices on US fertilizer demand. Higher fertilizer prices will result in some demand reduction. Census data from 2001 shows that when fertilizer prices increased significantly due to natural gas spikes there was a less than 10 percent reduction in demand. US Nitrogen manufactures expect less than 10 reduction in fertilizer demand.
Nitrogen fertilizer is an essential component for growing corn. One simply cannot grow corn without nitrogen fertilizer. There has been some speculation of farmers planting soybean instead of corp. There might be some rotation between corn and soybean but farmers don’t like to change from their historic crop rotations just to economize on fertilizer cost which is just one component of the farmers cost function. It is also important to note that corn is a highly subsidized product. The farmers’ decision to plant corn is not just a function of current and futures prices but also government subsidies.
In 2005 fertilizer costs accounted for around 32 cents per bushel of corn. Total cash cost of producing a bushel of corn is $.88. Each $100 per ton increase in Ammonia prices only increases corn production costs by $.05 cents per bushel according to Agrium. Even with higher fuel costs and fertilizer costs, growing corn at $2 per bushel is a profitable endeavor. The farmer’s decision choice is between current cash cost of fertilizer versus future yield and future selling price. Fall 2006 corn futures are at $2.40.
Terra & Hurricanes/Natural Gas Volatility
Katrina and Rita have had a negative impact on Terra Industries. TRA’s feedstock costs significantly increased overnight, the demand and distribution of its product came to a standstill and its natural gas hedges partially failed. TRA entered into collar transactions on its natural gas hedges by selling calls and buying puts around its fixed price gas swap. After entering into forward sales TRA did not buy back its calls, this was a failure of its risk management/hedging. TRA has repurchased the calls and the losses associated with the collar transaction (max. $38 mil.) will be reflected in 4Q. 2005 results.
So How Does Terra Operate In High Natural Gas Price Environment?
The current natural gas market has resulted in significant price differences between regional markets and geographic spot prices on different regional gas pipelines. TRA has been buying spot natural gas at a significant discount to Henry Hub. Vergidis, Woodward and Port Neal plants buy natural gas on the Mid-Continent natural gas pipelines. There has been a basis spread widening between spot prices on Henry Hub/Gulf Coast and Mid-Continent pipelines.
TRA has shut down in Woodward, OK plant and its operations in UK due to high natural gas prices. Woodward, OK plant was primarily making merchant ammonia. Under current market conditions it does not make economic sense for TRA to make merchant ammonia – cheaper to buy imported ammonia. TRA is manufacturing upgraded ammonia products – UAN and Ammonium Nitrate.
TRA Valuation
Natural gas prices, imperfect hedging and standstill in fertilizer orders has resulted in TRA declining from $8 to $5.83. TRA at current prices is an orphaned equity and presents an excellent medium to long term value investment.
Historical financial statement analysis does not provide much guidance to TRA’s short term financial performance. Volatility of US natural gas prices and the correlation of fertilizer prices to natural gas makes TRA near term financial performance very parameter sensitive.
High US natural gas prices raises global fertilizer prices as global marginal prices are determined by US Gulf coast producers. TRA diverse geographic production footprint should allow TRA to generate EBITDA and FCF in 2006 even with $15BTU gas during the first 3 months of 2006.
TRA is a 50% partner in joint venture with Koch Industries to produce 720,000 tons of ammonia in Trinidad. The JV has long term contract with the Trinidad government for natural gas at captive gas rates. At $350 per ton ammonia, Trinidad generates $75-$80 mil. in EBITDA for TRA assuming 360,000 tons with natural gas feedstock cost at $2.50 BTU. The Trinidad JV is TRA’s crown jewel – its produces a constant stream of cash flows with its long term low cost natural gas contract and it serves as a hedge when US margins are impacted by high natural gas prices.
TRA does not break out separately the EBITDA generated from its UK operations. TRA’s UK operations have a capacity of 1.5 mil. tons of nitrogen fertilizer. Natural gas prices in the UK have spiked as they have in the US.
At its Donaldsonville, LA, TRA operates a terminal facility with 700K ton capacity. Assuming TRA generates $15 per ton, the terminals should generate $10 mil. in EBITDA independent of fertilizer prices.
In 2006, I expect TRA to generate $1.8 bil. in revenue and operate with 10% EBITDA margin. TRA should generate $180 mil. in EBITDA and between $80-100 mil. in free cash flow.
I value TRA stock at $7.50 by the end of 2006 - 28% upside from current price of $5.83. TEV with $7.50 stock price is approximately $1063 mil. with cash at the end of 2006 projected at $200 mil. Assuming $7.50 price, TRA at the end of 2006 should have FCF yield of over 15% and an EV/EBITDA multiple of around 5. Even with unprecedented high feedstock costs I expect TRA to generate significant free cash flow in 2006.
TRA best comp is CF Industries (CF). CF trades at cheaper multiple than TRA on current LTM basis. TRA has better assets and geographic footprint than CF, TRA also has significant NOLs and will be de-levering their capital structure over the next two years. CF stock has significantly improved for its October lows of $11.30 to $15.30. I like CF stock – please see an excellent write up by ruby831 posted on Value Investors Club on September 19, 2005. At current prices I think TRA offers better domestic operations, international diversification and more stable cash flows.
Catalysts
Improved Fertilizer Pricing – currently the domestic nitrogen fertilizer sector is in standstill mode. My channel checks from distributors and agricultural purchasing cooperatives is that purchasers are basically waiting to see if there is a pull back in natural gas prices. This is also reflected in CF Industries forward purchasing program. Historically distributors and cooperatives were willing to take the risk that fertilizer prices would appreciate between purchasing in the fall and winter and the spring application. With current natural gas and fertilizer price volatility no one in the distribution or application chain is willing to take any risk. However, waiting can only go on for limited time. There is not a lot of excess inventory in the distribution channel and farmers will have to order fertilizers if they want to plant in the spring. I expect orders and pre-payments to pick up around mid-December. Overall fertilizer demand will be lower than spring 2005 planting but it is not going to be a fraction of last years demand. CF has already stated that its will shut down production before selling on a cash negative basis. I expect TRA to be disciplined in pricing and not take orders to produce at negative cash basis. Since current prices do not support US domestic nitrogen fertilizer production costs, either prices increase, more production shuts down or both.
TRA takes advantages of its geographic footprint and UAN production focus versus other domestic manufactures. TRA ability to purchase natural gas cheaper than gulf coast producers at its mid-continent plants gives TRA a competitive advantage in the current high price natural gas. TRA focus on UAN and the high transportation costs and limited global UAN production capacity should allow TRA to operate most of its domestic manufacturing facilities even with high natural gas prices.
TRA purchases monthly and spot natural gas at a significant discount on mid-continent pipelines. TRA can turn the pipeline basis differential into a cost advantage over gulf coast domestic manufactures. For its mid-continent plants (Verdigirs, Woodward and Port Neal), TRA purchases natural gas on Panhandle Eastern, Northern Natural Demarc and Northern Natural Ventura. The daily spot market prices on these pipelines is available on Bloomberg. Spot gas on these pipelines is trading at a sizeable discount to Henry Hub spot.
Stock buyback – I expect TRA management to be under significant shareholder pressure to buyback stock in 2006.
TRA is a de-levering story with $333 mil. in debt that comes due or is callable between now and 2008. I believe TRA management would prefer to de-lever the firm than buy back stock. TRA management has stated that they are comfortable operating with current financial leverage but would like to lower the financing costs. I expect TRA to call its 11.500% 2010 bonds in 2007 using either cash on balance sheet or a new debt issuance. Lowering interest cost would increase future free cash flow. TRA also has significant NOL tax losses ($212 mil.) that will allow it to increase its cash build.
Merger/Buyout – With its current low enterprise value and its operational footprint, TRA is an interesting acquisition target. TRA would be perfect candidate for Yara to acquire. TRA would allow Yara to expand its global geographic and product footprint by gaining access to US UAN producer.
New UAN JV in Trinidad with CF Industries.
Risk Factors
The main risk in TRA is natural gas price spiking and going higher that the already record high current futures prices.
Irrational pricing by fertilizer manufactures such as selling below cash costs. This happened in 2001 but is unlikely to happen this time around as fertilizer inventories are tight, weak marginal players along the Gulf Coast have permanently shut down plants and current manufactures have the liquidity to shut down production for an extended period of time.
Catalyst
Improved Fertilizer Pricing, Geographic Differential in US Natural Gas markets