Description

YARA – YAR NO Equity

Thesis summary:

Yara looks very reasonably priced on a normalized basis. Earnings power finally looks to increase again for YAR both due to an improving supply-demand balance and consequently higher prices in its underlying fertilizer markets and several constructive internal business initiatives. Additionally, the recent entry of activist investor Magni Partners (Tor Olav Trøim) could act as a further catalyst for the stock price.

• YAR is a high quality cyclical company, but this is mostly a call on a tighter urea/fertilizer market in general. I am not the first to call this, but I’m probably not going to be the last, I think we’re just getting started. I have chosen YAR as the vehicle to express my views on fertilizer, partly for tax reasons (I pay double taxes on US or ex-EU stocks), partly because of Trøim’s recent entry, but I have no doubt that the entire sector will see better days ahead. There are probably many good ways to play this.
• I find that good investments are often found through a pattern recognition process. You recognize some characteristic of a successful investment in one industry (or in my case, one that you didn’t make the most of but watched run away from you on the sidelines after selling too soon) and apply what you learned somewhere else at a later time. The salmon market transition from 2011/12 came to mind when I revisited YAR this year, and I remembered Biffin’s thoughts on those stocks and even more vividly my own reluctance to acknowledge what was happening. So it was relatively unsurprising that I later found out that Biffins had written up OCI NV here on VIC (both Biffins’ write up on OCI and Blmsvalue’s on CF Industries are required reading if this write-up is at all interesting to you). The pattern that I think I recognize is this: the transition from a supply driven to a demand driven market can increase commodity prices faster and for a longer time than the market is willing to price in at first. And without taking the comparison between salmon years ago and urea today too far, it is interesting to note that just as we saw salmon spot prices rise throughout 2011 despite that being the year of peak new supply, average spot urea prices (black sea prill, GCFPURBS Index), increased in 2017, the year of peak new supply.
• The fact that Tor Olav Trøim has entered YAR is a promising sign in my opinion – he helped make Fredriksen billions in among other things Marine Harvest, Frontline (and yes, even Seadrill) over the years and probably has one of the best investment track records of anyone focused on cyclical industries. From the time he went to work for John Fredriksen in 1995 until he left in 2014, John Fredriksens fortune rose from somewhere between 5-10 Bn NOK to over 100 Bn NOK.
• The sell-side is increasingly focusing on this market balance transition recently, so the directional call in itself is admittedly on the way to becoming a consensus view. But I believe we have a long period of much stronger urea prices than they collectively expect ahead, and I doubt sustained 300 USD/t plus urea prices are in the models out there. Since fertilizer stocks tend to move in tandem with rising urea prices, it’s high time to buy in my opinion.

Brief company description

Yara (YAR NO Equity) is a Norwegian fertilizer company listed in Oslo but with an ADR trading on NYSE (ticker YARIY US). It was spun out of Norsk Hydro in 2004, of which it had been part since 1905. It is majority owned by the Norwegian government (36%). The current market cap is about 13 Bn USD. It has 3 divisions: Production of nitrogen-based products, Crop Nutrition which provides worldwide sales, marketing and distribution of a range of crop nutrition products and programs, and Industrial, which develops and markets environmental solutions and products for industrial applications. The 3 divisions account for 44%, 36% and 19% of EBITDA respectively.

Yara has a strong track record - avg annual shareholder returns have been >20% (company slide)

Average ROE last 15 years: 22%, but large variations through the cycle (source: BB)

The key to this thesis is the urea price – and that market is looking better

Nitrogen fertilizer producers first produce ammonia by reacting Nitrogen from air with hydrogen from natural gas (coal can also be used as feedstock) at high pressure and high temperatures. Urea is then made by reacting ammonia with CO2 at high pressure. Urea contains the highest percentage of nitrogen (46%) and constitutes about 50% of all nitrogen based agricultural application. It is in effect the price setter for all other nitrogen based fertilizers that can be made by further production steps. Yara uses urea as the basis for creating other nitrogen based fertilizers containing other nutrients as well (various nitrates, NPK, UAN etc). Different plants and soil types require different nutrients and so different fertilizers.

YAR is the world number one in nitrates and NPK (varies in exact composition but always contains nitrogen, potassium and phosphorus) and increasingly focuses on more complex or high-end fertilizer products. Nitrogen based fertilizer is a fragmented market, where the top 3 producers only account for 15% of world capacity. Phosphate and potash are much more concentrated, and the top 3 producers there account for 24% and 48% of capacity respectively. YAR is the European cost leader in its segments, but it does not have natural access to cheap natural gas like US, Middle Eastern and Russian producers. Cheap shale gas is an important advantage for the North-American producers, the gas cost for YAR's primarily Europe-based production will always be higher. YAR's primary competitive strenghts are its economies of scale, its significant sales/marketing infrastructure and to some extent its brand. I'm not going to claim that this is a company with significant economic moats though, it isn't. (As far as I'm concerned the only thing approaching a real moat in this business is permanent access to low cost natural gas). It's no wonder that YAR pursued a merger with CF a few years ago. Ultimately, the talks fell apart. https://www.reuters.com/article/us-cf-industries-yara-intl-m-a/cf-industries-yara-international-end-merger-talks-idUSKCN0I615820141017

Source: company

The market balance and product pricing for fertilizers and especially urea seems to be improving after mostly deteriorating since 2011/12. This is what will probably lift YAR’s earnings going forward.

Capacity utilization outside China is now close to 90% (i.e. as high as it gets) which means capacity in China would have to cover a supply shortfall ex-China. With utilization in China reportedly only at 50%, Chinese capacity could theoretically come to the rescue, but Chinese prices and cash costs are typically higher than elsewhere due to higher energy costs, which would pressure global urea prices upward, and YTD urea exports from China were down 74% in June on a yoy basis. According to CF industries, this is because environmental regulations in China continues to result in plant closures and higher cash costs, closures have been accelerating significantly throughout 2017 and 2018 and there will be more in 2019 according to CF. Anyway, if and when China steps up its exports again, it is unlikely that it would occur with prices below about 275 USD/ton (assumed China domestic urea price + any export tax, today prilled China urea spot is at 292 USD/t) which means downside from here in the urea price should be limited for some time.

New and unknown significant investments in capacity look fairly unlikely today. At recent urea (fob prilled bulk Yuzhny; source: Profercy) prices of 265, European producers on average just break even. Nitrate premiums are near all time lows. So investment in new capacity isn’t viable at these price levels, which should limit new capacity coming on stream. While a greenfield investment in China is cheaper than in the West, the urea price would have to go above at least 425 USD/ton to make this an interesting investment even in China, and above 540-600 to make this interesting in Europe, according to recent estimates by Blue Johnson and SB1 Markets*. North America would have a lower urea price requirement at 390-475 USD, they argue, (Source: SB1 Markets’ Lars Daniel Westby, August 28th 2018), but we are far away from those levels today.

* Westby’s assumed return requirement for new capacity investment is 8% after tax which might be on the high side for China in particular, but his point is still valid.

One important thing that should be noted and might be missing from that analysis is that Russian companies like Eurochem that have among the lower cash costs in the market, significantly lower than e.g. YAR (and way lower than the chinese) could conceivably start new projects at lower urea prices, but even they would probably want a sustained urea price above 325-350 USD/ton to do so, and though we can’t be 100% sure that they don’t have unknown projects in the works alreday, it typically takes 4-6 years for significant new greenfield investment to come to market. In Eurochem’s particular case they also have a large and well publicized capex program in place already so their ability to expand further might be limited.

Note also that there is the potential for sizable capacity increases in India, but also serious doubts about much of this reaching the market before 2020-2022 at the earliest or at all, and it’s notable that CRU are not including all this capacity in their forecasts. Also, India does not have acccess to cheap natural gas like e.g US and Russian producers, are thus well to the right on the urea cost curve and there are doubts about their ability to secure a stable flow of feedstock to support this capacity expansion. In the meantime they appear to rely on imports from Iran which could be compromised if sanction pressure increases.

The bottom line is that new supply will probably be constrained for years:

Urea demand keeps on growing at the same time as new supply at these price levels looks increasingly unlikely. Overall, CF estimates the net annual global urea supply growth will be «well below the historical demand growth rate of 2.3% (in 2019, 2020 and 2021)». Long term demand drivers continue to be increased grain and meat consumption in BRIC countries, and African demand is beginning to become a factor as well. Yara claims this demand growth is about 3% (10 year average) and also estimates demand will exceed new supply in the medium term though they are more cautious in the near term due to a large new addition in Nigeria in 2020 (however it is doubtful that this will come on line in 2020 after all according to CRU’s more recent updates). Furthermore, YAR notes that 2/3 of the world’s ammonia capacity is more than 30 years old, and in their view older capacity will struggle to maintain utilization rates at current levels so replacement of existing capacity will also be needed. Note that the World Bank differs from CF and YAR on the near term market balance, and expects fertilizer markets to be oversupplied in the near future, but write «prices are expected to strengthen moderately over the medium term due to anticipated growth in demand and higher energy costs, and to reach levels that will incentivize new capacity (Commodity Outlook, April 2018)». Given the new investment assumptions above, that would be a most welcome development for YAR shareholders.

Source charts: YAR CMD presentation 2018.

Finally, it’s possible that grain prices will increase again soon: 2016 and 2017 US and global agricultural harvests were among the best on record, apparently there has never been such perfect weather conditions. According to commodity specialists Goehring and Rosenzwajg’s Q2 commentary, «current supply/demand trends for all grains are dependent on on extremely high yield assumptions. For example, US corn yields have exceeded trend line growth four years in a row, something very seldom seen». So yields are at record levels, but at the same time, demand has increased. It stands to reason that any disappointing harvests in the coming years could quickly impact the global market balance and lead to increased grain prices, and that continued growth in stocks is unlikely. Which would be good for YAR as there is a very high correlation between agricultural commodity prices and fertilizer prices.

The United Nations Food and Agriculture Organization writes in its July Cereal Demand and Supply Brief:

«Latest indications continue to point to a reduction in cereal output in 2018 and negative prospects for the cereal supply outlook for the forthcoming 2018/19 marketing season. Based on the condition of crops already in the ground and assuming normal weather for the remainder of the 2018 cropping seasons, FAO's forecast for world cereal output this year is pegged at 2 586 million tonnes (including rice in milled terms), 64.5 million tonnes (2.4 percent) less than the record output in 2017 (…)

(..)The latest forecast for cereals is down nearly 24 million tonnes from June, mainly on lower than previously anticipated projections for wheat production in the EU as well as wheat, maize and barley production in the Russian Federation and Ukraine (…) utilization of all major cereals is likely to continue growing in 2018/19, keeping pace with rising food demand, while overall feed and industrial uses are also likely to expand further. If current production forecasts materialize, cereal output would not be sufficient to meet the expected total utilization requirements in 2018/19 and, as a result, global cereal stocks accumulated over the past five seasons would have to be drawn down to 749 million tonnes, over 7 percent down from their opening levels. At the current levels of utilization and stock forecasts, the stock-to-use ratio would drop from 30.6 percent in 2017/18 to 27.7 percent in 2018/19, its first decline in four years, while still well above the record low of 20.4 percent registered in 2007/08.»

Several internal intitiatives for increasing earnings and reducing costs are in the works and should help YAR support growth in earnings power going forward:

Cutting costs and increasing efficency:

• Successful cost improvement program (2015-2020) in place that according to the company could lift EBITDA by 350m USD by 2019e (3-4%), already almost 300m USD in EBITDA effect has supposedly been achieved by Q2 2018.

Increasing production capacity

• New brownfield and greenfield initiatives running from 2018 to 2021 that according to the company could lift EBITDA by another 150 mUSD.

Source: roadshow presentation Frankfurt March 2018

New growth areas in the industrial segment (AdBlue which reduces diesel pollution from trucks- urea and ammonia are used as reagents in NOx abatement), the scrubber technology area, Yara Digital) could also add to earnings power going forward, and Yara Digital especially could help lift sales of higher margins specialized fertilizers (helps farmers optimise fertilizer use through digital tools like satelite imagery and sensors).

• Alternatively, two of these could potentially be sold or spun off separately which could mean extraordinary dividends, see below section on possible activism by Trøim.

Valuation: Cyclical company, but probably past the trough in earnings. Cheap on a normalised basis.

YAR’s ROE has been falling since 2011 along with global fertilizer prices, as significant new capacity from the last big investment cycle has become operational and depressed prices. The company’s returns are unattractive looking at this year in isolation. However, the last few years have been characterized by significant nitrogen supply growth, and the company’s 15 year average ROE is actually 22%. I think 10-15% ROE levels are a realistic medium term goal with improving fertilizer markets, but it will probably take a couple of years to get there while fertilizer markets tighten.

There are too many moving parts in YAR for me to attempt to model earnings in detail. I feel I’m likely to get lost. Instead I’ll try a simple, common-sense approach: given my view on better fertilizer markets, what is likely price per YAR share by 2020?

• In 2014 and 2015, YAR realized ROEs of 13% and 11% respectively. The average urea prices in those years were 321 USD/t and 281 USD/t, respectively.

• I think it is more than likely that urea prices will move and stay above 300 USD/t going forward, given the supply-demand dynamics described earlier. The 15 year average urea price is 306 USD, to provide a longer term reference – i.e. I’m only assuming the long term avg urea price, anything else is gravy.

• Assuming for conservatism’s sake a 12.5% ROE on 2019 est. ending equity of roughly 9900 mUSD, a normalized EPS is then about 4.5 USD or 38 NOK. If YAR trades at 15x normalized EPS by 2020e, a fair price would be 564 NOK per share.

• 15x would be higher than Yara’s historical average multiple, but that’s not unreasonable in the tightening phase of the nitrogen/fertilizer cycle and would be in line with the current consensus 2020 multiple of 15x on Nutrien and well below CF’s 2020 consensus multiple at 20x.

• Should fertilizer markets tighten even more than I expect, we’d probably see further multiple expansion before reported results reflect that tightening and my target price will be way too low. For an example of the effect a truly tight fertilizer market can have on the YAR share price, look at 2006-2008 period – the stock went up 400%.

• Taking into account likely dividends of about 16 NOK per share in 2018 and 2019 combined, I get a total fair value of 580 NOK, or a projected CAGR of 17% by 2020e from the current price of 396. And that doesn’t assign any value to activist moves by Trøim in the interim.

Entry of Magni Partners (Tor Olav Trøim, Håkon Fure et al) could unlock further value for shareholders:

Magni has invested almost a billion NOK (120 mUSD) in YAR this summer. While I think the main reason for his entry is a perceived cyclical low point in the nitrogen cycle (and at peak-capex, just as FCF is about to increase big-time), pushing for sales or spin-offs of some of the areas within Industrial Solutions areas are a possibility. YAR is a company where NONE of the board members own a significant amount of stock. I can see why Trøim would want to pursue board representation and I expect him to push for higher leverage and increasing regular dividends or buybacks as earnings rise.

One other possibility, but that would perhaps require a repricing of YAR first, is a renewed effort to merge with CF Industries or buying other competitors. Pursuing further consolidation of the industry would be in line with the Trøim playbook and as the nitrogen industry is still so fragmented, it makes a lot of sense. At the current valuation that might be a dumb move for YAR shareholders, so that will have to come later, in my view.

Trøim’s actual agenda is unknown at this time, and the news of his investment in YAR broke this week in the Norwegian press. But I view it as a positive, his recent track record of activism is pretty good (STB NO e.g) and his track record in cyclical sectors is stellar overall.

So what structural moves could he be planning? As Bengt Jonassen of ABG Sundal Collier points out in a very interesting research note from November of last year («Undervalued Industrial Division (11.07.2017)», YAR has sold industrial divisions before: both the Scandinavian Industrial Gas division which they sold off through a JV with Praxair that they exited completely in 2011 (I don’t know at what price), and a sale of the CO2 division, also to Praxair, in 2016. The latter was sold at around 8x EBITDA, but that segment was hardly growing. There are still two sub-areas within the Industrials division with a weak strategic fit, according to Jonassen:

• AdBlue (aka Air1) produces urea-based NOx/SOx abatement solutions for diesel engines, both maritime and automotive. NOxCare offers solutions for abatement systems based on urea for poer plants and utilities. Raw materials for these areas are sourced at market prices from the upstream division. According to other sell-side analysts I’ve talked to, AdBlue has about 200m USD in run rate EBITDA contribution currently, which if sold at a 10-12x multiple (it’s growing at >12% p.a. so that seems reasonable enough to me) could mean a 60-70 NOK per share special dividend/ in spin-off value. With YAR trading at 8x EV/EBITDA for next year, this seems like a value creating move for shareholders.

• The Mining Applications division is another segment that could be sold, it makes products for the civil explosives industry (technical nitrates for mining and construction). Its main competitors are Orica and Incitec Pivot. With declining profitability in recent years and new capacity from competitors coming to market, this could also be sold off, though I have no clue what it might be worth.

Primary risk factors:

• Higher energy prices (natural gas primarily, YAR expects this cost to rise in the near term, at least)

• Surprising capacity additions from the Russian producers or irrational investment decisions from the chinese producers

• FX: A weak NOK is good for YAR, conversely a stronger NOK would hurt the bottom line.

• Continued perfect weather conditions globally keeping harvests and stocks strong and grain/fertilizer prices low

Link to YAR sensitivity estimates: https://www.yara.com/investor-relations/analyst-information/sensitivities/

Appendix:

Black Sea prilled urea – 15 years. Average: 306 USD/t

YAR vs urea prices 2004-2018

Global fertilizer prices 2010-2018 (source: World Bank)

YAR NO Equity, 15 years

YAR vs peers, 5 years

Capex + cash acquistions vs free cash flow (historical plus BB consensus):

Catalyst

Higher fertilizer prices

Selling off parts of the industrial business

Potential M&A