Description

I recommend a long TRA position on 12/12/2005 when the stock traded at $5.83.  Today at $51.40, TRA presents a great short opportunity for an investor willing to tolerate some volatility as this primarily domestic US nitrogen fertilizer producer has become a “bubble stock” – something I would never have imagined in my lifetime.

Please see my earlier write for background on nitrogen fertilizer and TRA.  

Short Thesis

Ethanol production and global grain demand has created the strongest demand for nitrogen fertilizer in recent years.  The strong demand and tight supplies have resulted in nitrogen fertilizers margins going from $30 to over $200 per short ton on UAN and ammonia cornbelt premium going from $75 to over $225.  

In 2007 and 2008 TRA should be a cash generator as a once in a lifetime pricing and margin are realized.  The short thesis for TRA is that these margins and cash flows have been priced into the stock and the current stock price also assumes that the margins and cash flows will continue into the foreseeable future.  

Nitrogen fertilizer has historically been and will be going forward a very cyclical industry with cyclicality driven by supply additions in natural gas stranded regions.  TRA stock price today assumes that there is no cyclicality in nitrogen fertilizers and that the margins which are significantly higher than anything historically observed will continue into the future.  Nitrogen fertilizer is a commodity business that is not based on any extraction of natural resources and in the long run abnormally high margins cannot be sustained.  The primary feedstock for nitrogen fertilizer is natural gas and none of the US fertilizer manufactures other than CVI (CVI has a pet coke based ammonia facility tied to a refinery) are vertically integrated into their feedstock. The market and sell side analysts seem to be confusing nitrogen with potassium and phosphates which are fertilizers whose manufacture to varying degrees is based on extraction and mining.  

TRA equity today values its assets at or above replacement cost.  This makes no logical sense as its assets other than the Trinidad JV are not located in natural gas stranded areas.  The equity market is valuing TRA assets at or above replacement costs when they don’t have any feedstock advantage by being located in the US.  Over time the margins will attract entrants to build new capacity in natural gas stranded geographies like Egypt, Australia, and Qatar.  The terminal value of the business in sell side analysts’ models is not achievable.  The current extrapolation of cash flows and margins into the future cannot be achieved as long as there is stranded natural gas and implied assets value is significantly above replacement costs.  None of the bulls on the sell side has provided a rational reason for why long term margins and cash flows are sustainable – “why this time it’s different.”  Nitrogen margins in 1992-1994 attracted significant new capacity as will current nitrogen margins.  

There has been a transition is shareholders of TRA as value investors have sold their positions to momentum investors who in my opinion do not understand the cyclicality in the business.  The current momentum crowd in TRA is basically playing a nitrogen fertilizer company as a substitute for corn.  The market is also using spot prices to imputed actually contracted prices for TRA.  TRA sells a majority of its production on pre-payment and forward customer contracts.  Current spot prices and spot implied margins have been increasing significantly driven by tight supplies.  But I doubt TRA in its pre-payment and forward customer sales have locked in the spot implied margins.  Reporting in 2008 is going to show significant margins and cash flows but it is very likely they are below implied spot margins and this may disappoint the momentum crowd.  

Nitrogen historically had been treated as a highly cyclical commodity and did not warrant a multiple above 5 times.  Nitrogen assets were considered second class to other fertilizer assets and fertilizer firms have tired to strategically position themselves as having minimal US nitrogen production exposure to minimize any negative valuation multiple contraction.  Today the market is giving TRA a higher valuation multiple on historically high EBITDA - completely opposite of how cyclical industries are normally valued.  Firms like Agrium with domestic North American nitrogen manufacturing are using the current cash flows to position themselves with overseas (stranded gas) production and diversifying into agricultural retail.  Even TRA is not looking to build any domestic production because TRA management knows this is a very cyclical industry and preferring to building in Peru or other natural gas stranded areas outside the US.  But the equity market is today valuing TRA at or above the replacement costs of its assets.  If TRA put itself for sale there would be no buyers – strategic or private equity willing to pay anywhere near $50.  

Fertilizer prices today are driven by strong market demand for agricultural commodities.  But global nitrogen utilization rates are around 85%.  Global prices will drive global producers like Yara, Qatar Basic Industries, Petro China ect. to build new manufacturing plants.  Even US nitrogen manufactures (TRA, CF and AGU) are looking to build new plants – just not in the US.  Another important reason for US farm belt fertilizer prices being historically high is infrastructure to transport, store and deliver fertilizer.   Over time the increased demand and current high prices will result in farm cooperatives and retailers/distributors investing in infrastructure to arbitrage price discrepancies between us farm belt and us gulf coast.  The current price discrepancy and additional new demand is large enough to warrant investment in infrastructure.  In the long run the farm belt margins will contract and TRA’s geographic advantage will dissipate.  I expect TRA to be a long term US producer – just don’t expect it to make margins are significantly higher than the cost to replace their assets.  The market currently is forgetting that TRA and all US nitrogen fertilizer manufactures are short natural gas and the more importantly the volatility in natural gas. 

Risk

Irrational pricing continues – IBD technical traders confuse nitrogen a natural gas feedstock product with potassium and phosphates which are mining extraction based.  

TRA uses its cash flow generation in 2007 and 2008 to repurchase shares.  I don’t expect TRA management to aggressively deploy the cash build to buy back shares beyond the buybacks announced as the equity implies US assets trading at or above replacement costs.  

TRA adds assets into TNH its MLP.  TNH is even more overvalued than TRA but is tougher to borrow to short.  

Catalyst