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More Commentary on Commodities, Part 4

Below is a great analysis of one of the Premier commodity names that we have owned for a few years, Potash Corp. More evidence that the selling is overdone and that these companies are extremely cheap now based upon earnings.

Potash Corp: Dynamics of Supply and Demand Drive Earnings Growth

by: Sofie July posted on: August 05, 2008 |

The stock of Potash Corp. (POT) has experienced a huge sell-off lately due to decline of agriculture commodities prices, profit taking, concerns on the possible change of policy on ethanol after the election, etc.

Yet I think many investors overreacted to the situation. Please see my analysis below.

With the largest fertilizers manufacturing capacity, Potash Corp. provides farmers around the world with the three primary plant nutrients – potash, nitrogen and phosphate, enabling the farmers to enrich the soil and improve yields. It is the largest potash producer, the second largest producer of nitrogen and the third largest producer of phosphate in the world. We expect Potash Corp. to continue to deliver quality earnings in the coming years.

“Skewed” Supply-Demand Dynamics

The demand for potash has been very strong worldwide.

In China, due to the massive industrialization and urbanization, especially, the rapid development in its agriculture, the demand for potash has increased from 2 million ton to 10 million ton per annum over the last decade. China has been one of the largest importers of potash from the consortium lately, buying almost one third of the output from Potash Corp.. Among the major three elements of fertilizer, nitrogen, phosphate and potash, China is self-sufficient with the former two, and in 2007 China turned itself from a phosphate importer to a phosphate exporter.

Potash is the only element that China has to heavily rely on imports, since the potassium resource is severely scarce in China. Every year, China has to import about 70% of potassium fertilizer products and 2007 alone purchased 9.414 million ton from abroad, an increase of 33.5% compared to the amount of import of potassium products in 2006.

At the Conference of the International Fertilizer Industry Association [IFA] held in May this year in Vienna, Chinese representatives expressed interest in expanding cooperation with the major potash exporters. Note that this took place after the stunning increase in potash import price for China in April 2008. Challenged by the strong demand of potash, China has no choice but accepts the skyrocketing prices for imported potash.

Thailand, a major agriculture economy in Asia, heavily relies on chemical fertilizers to improve productivity. Yet nearly all chemical fertilizers and raw materials for fertilizer mixing must be imported since necessary raw materials for manufacturing chemical fertilizers can not be found on domestic land. Although lack of raw materials for chemical fertilizer subjects the country to the world market price fluctuation, the government of Thailand controls the prices of chemical fertilizer sold to its farmers, and has to provide subsidy if necessary.

Brazil is the third largest importer of potash, consuming about 15% of the global potash market and growing at 11% per year. (China and US are the largest market for potash, consuming 21% and 18% respectively.) As the largest ethanol producer in the world and with a major agriculture economy, Brazil has an insatiable demand for fertilizers to grow corn, soybeans, sugarcane and other agriculture commodities. The trend seems showing little change. It is reported that the demand for potash fertilizer has been unusually strong in the first quarter of this year, and expected to have its highest agricultural income ever in 2008, reaching $84.2 billion, an increase of 14% over 2007 according to the Brazilian Ministry of Agriculture, Livestock and Supply.

India, another major agriculture economy with the largest number of farmers in the world, consumes more than 4.5 million tons of potash per year with a growth rate of 9%. It is another country whose demand for potash fertilizer can not be satisfied by domestic supply, and has to rely heavily on imports. Most farmers are of disadvantage economically and have to resort to government subsidy for fertilizer products. It is estimated that India is likely to spend about $30 billion on fertilizer subsidy in 2008.

While demand of potash fertilizers comes from all over the world, the supply of potash is extremely concentrated. Potassium, the major chemical element of potash, is the seventh most abundant chemical element in the world, yet the minable potash deposit is rare to find. Minable potash deposit is only found in 20 regions of the world and only 12 countries produce potash to provide fertilizers for over 150 countries. Blessed by the geographic location, Canada has the world’s largest and best potash reserves and about 95% of its reserves are found in the province of Saskatchewan, where Potash Corp. is located.

Over 50% of the world’s potash reserve is found in Saskatchewan, and over 65% of the global potash capacity is located in two regions – Saskatchewan (37%) and FSU (30%). Saskatchewan is the best place to mine potash as its deposits are flat-lying evaporated sea beds that are relatively easy to mine. Other countries with significant potash deposit include Russia, Belarus, Germany, etc. With 13.2 million KCI tones, Potash Corp. is the number 1 potash manufacture with 22% of world potash capacity.

Since 2000, demand growth in potash more than double new capacity growth. In its 2nd quarter earnings release, Potash Corp. claimed that

…as demand continued to exceed available supply in the quarter, Potash Corp. and Canpotex,…… shipped volumes to customers in North America and offshore, respectively, on an allocation basis.

To put it explicitly, demand from some importing countries could not get the volume they want. China, for example, only received poultry portion (18%) of its total potash imported in 2007 from Potash Corp. because of the delay in its price negotiation with Canpotex and supply constraint from Potash Corp..

Will this disequilibrium situation be improved going forward? In the short term, unfortunately, significant increase in potash supply to match the demand is mostly unlikely due to inventory decline and production capacity constraints. At the end of 2nd quarter 2008, Potash Corp.’s inventory was at record low of 315,000 tones, representing 58% below the inventory level at the same time last year and 53% below March 31, 2008 levels. Aggregate potash supply in the marketplace in 2008 is 41% below the previous 5-year average.

Contrarily, the demand of the major fertilizers remains robust and shows no sign of waning. From Potash Corp.’s 2nd quarter earnings release:

“Second quarter potash sales volumes of 2.7 million tones were the 2nd highest in history”, trailing only to the 2nd quarter last year “because offshore volumes were 7% below the same period last year due to lack of available product”.

Demand from North America customers increased 3% despite a weather delayed spring season; and offshore demand increased substantially.

“Compared to the same period in 2007, second-quarter volumes to Brazil increased by 36% to 670,000 tones, to Southeast Asia by 49% to 825,000 tones and to India by 28% to 310,000 tones.”

With regard to the aggregate amount of potash imports from developing countries, the most stunning growth reward goes to India – in the first half of 2008, India’s potash import grew over 90% compa
red to the same period in 2007.

Solid Support for Pricing Power

The imbalance in the dynamics of supply and demand of potash underpins the upward trend in potash pricing. Potash Corp.’s 2nd quarter earnings release discloses that:

The per-tonne North American realized price of $403 was up 122% quarter over quarter, as we realized five price increases in that time totaling more than $330 per tonne. ……

The offshore realized price of $417 was up 192% from last year’s second quarter as, since that time, Canpotex realized 10 price increases totaling approximately $520 per tonne to Brazil and eight increases totaling $465 per ton to Southeast Asia. It also began to realize the $355-per-tonne increase built into India’s new contract in March, while the $400-per-tonne increase in China’s contract signed in April did not appear until late in the quarter because of limited available supply.

As the imbalance in potash supply and demand intensifies, price might go even higher. As a matter of fact, Potash Corp. just released a new domestic potash price list on July 8th, 2008, raising $250 per short ton of product shipped into the US market, effective September 1 through November 30, 2008.

The shortage in potash supply has propelled the price to $1000 per ton. It is reported that SE Asia countries and Brazil have started to accept contracts featuring a price tag of about $1,000/ton, deliverable in August 2008. In its news announcement, Canpotex

confirms that it has now concluded significant volumes for shipment to Asian spot markets in the fourth quarter at a price level of USD 1000 for standard grade material ($1025 for granular grade). As a result, Canpotex is advising it’s customers that all new sales for shipment through the balance of 2008 will be priced at these new and higher levels. The new pricing will also apply to all new sales to customers in Brazil and Latin America”.

Given that $100/st increase in potash price and in N, P, K fertilizers prices only incurs $0.03/bu and $0.14/bu to corn cost, respectively, and the relatively high incremental returns farmers can harvest, the high prices for fertilizers paid by farmers around the world seem to be sustainable and still have room to go.

Apparently in many major agriculture developing economies, potash is significantly under-applied according to the scientific recommendation levels for the major fertilizer elements – Nitrogen, Phosphate, and Potash. Lack of application of potash depletes the potassium nutrient content in the soils, resulting poor crop yields even though enough Nitrogen and Phosphate fertilizer are applied. For instance, corn yields in China and other developing countries are only 50% of those in the US. As the arable farmland per capita continues to decrease yet the food demand continues to rise, the best possible solution for China, India, Brazil and other agricultural countries to provide sustainable food supply to their citizens and curb rising food price is to empower the farmers to apply more potash to utilize other elements of fertilizer and retain nutrient content in the soils, ultimately improve yields.

Scientific formula to maximize the utilization of Nitrogen and Phosphate calls for significant increase in the amount of Potash for countries such as China, India and Thailand.

Quality Earnings Growth

Potash Corp. most likely will continue to deliver superior earnings growth as it increases its capacity to meet the robust global demand. In the coming two years, Potash could complete the Lenigan and Patience Lake Projects and increase production capacity by over 20%. In the long term, however, Potash could increase its potash production capacity considerably. When completed, Potash Corp.’s expanded projects, including Cory Project, New Brunswich project, Rocanville and Allan Project, will bring total potash production capacity to 15.7 million tones by end of 2012 and up to 17.2 million tones by 2015.

In addition, Potash Corp.’s earnings will benefit from the upward trend for the spot price of potash. The tight supply and increasingly strong demand most likely will continue to grant pricing power to Potash Corp. and its peers. According to Fertecon Ltd, a fertilizer economic and market consultancy firm, “the outlook for potash price is extremely firm with new record price levels achieved for July”.

Fertecon estimates that the spot potash price will continue to rise from $625/ton in 2008 up to $1350/ton by 2011. Thereafter the spot potash price will fall back temporarily to about $1000/ton in 2014 and rise again to $1500/ton by 2020. From 2009 to 2020, the average price for potash is expected to be $1150/ton.

As demand for fertilizers increases, Potash Corp.’s market share will continue to expand. It is well known by now that population growth (the world adds over 70 million people a year) and economic growth exert significant demand in food, especially food with richer nutrition, such as livestock, in the coming years and decades; And the industrial consumptions of crops, mainly from ethanol production, only steepen the demand curve for grains.

It is estimated that demand growth for potash worldwide could reach 3% to 4% per year, which is equivalent to growth of more than 2 million ton per year. Demand from certain regions, such as emerging economies, will outgrow others. China, India and other developing countries have long under-applied fertilizers, resulting in poor soil quality hence low crop yields. Should China, India and Brazil make efforts to approach the scientific recommendation of fertilizer usage to maximize the efficiency of applied fertilizers in order to improve crop yields, the demand of Potash from these three countries could double, from 21 million ton to 50 million ton in the next 15 to 20 years.

Impact of Increase in Natural Gas Prices

As natural gas prices increase, the “cost of goods sold” for nitrogen fertilizer manufacturers increases too as natural gas constitutes significant part of the costs to produce nitrogen.

Yet the price for nitrogen fertilizer has been rising almost in tandem with that of ammonia.

According to Amber Waves – the economics of Food, Farming, Natural Resource, and Rural America,

the composite fertilizer price increased 113% from 2000 to 2007, led by gains in nitrogen prices. During the same period, the price of ammonia, the main source of nitrogen in fertilizer production, increased 130% from $227 to $523 per ton. The price of urea, the primary solid nitrogen fertilizer used in the US, rose 127% from $200 to $453 per ton.

In May 2008, while the price of ammonia are ranging between $425 to $555 per ton, the price of urea rose to between $605 – $680 per ton with a much larger rate of increase which allows the fertilizer producer to offset the rising costs in raw materials.

Although a further sharp rise in natural gas prices would impose great pressure on the margins of nitrogen fertilizer manufacturers, Potash Corp. will be the least affected since it possesses low-cost natural gas contracts in Trinidad.

These long term contracts shield Potash Corp. from the major fluctuations in the natural gas costs, and allow it benefit from the rising nitrogen fertilizer prices to the greatest extent.

Now that we see the natural gas price declining, the resultant lower materials costs for the major fertilizers would be positive for Potash Corp.’s profit margins.

Impact of Agriculture Commodity Prices

One of the risk factors on Potash Corp.’s margins is the agricultural commodities prices. Declining agriculture commodity prices could potentially force farmers to scale back on crops production and fertilizers applications.

Yet as long as grain prices stay above certain level where marginal output exceeds marginal cost, farmers have the incentive to maximize production and impr
ove crop yield by utilizing balanced fertilizer application. And if corn price and other agrimodities (agriculture commodity) prices stay high enough, farmers even have the incentive to take more fragile land out of the federal Conservation Reserve Program to increase operation scale and improve production. While some grains, such as wheat, are seeing increasing stocks and their prices show signs of softening lately, the largest potash consuming category, corn which consumes more than nine times as much potash as wheat, may see its price remaining high over time.

Like other agrimodities, corn price is experiencing a correction as well, yet to a certain extent, it is a price adjustment from the price deviation due to the abnormal weather in North America in June this year. The continuing decline in corn stocks and strong demand suggest a high price for corn.

According to Allendale, USDA official March 31st release was 3.419 billion bushels use, an increase of 39% over the usage of a year ago for the 3rd quarter (2.535 billion bushels) and representing more than 35% over the average usage for 3rd quarter. The three year average third quarter use has been 2.525 billion bushels and five year average 2.409 billion bushels. In addition, USDA’s acreage and quarterly stocks for corn suggest a fall in end stocks from 1.433 billion bushels for the 2007/08 market year to an estimated 568 million bushels for the 2008/09 market year.

Many experts from international government agencies predict that food price will rise about 5% this year and remain high at least in the near future. In the long term, the upward trend in agricultural commodity price as a result of strong demand for food, livestock, and biofuel remain intact and is irreversible. Rising agrimodity prices over time are likely to continue to provide farmers incentives to expand operation and increase production, and sustain the strong demand for potash and other fertilizers.

Impact of Oil Prices

A decline in oil prices would also decrease the transportation/shipping costs for fertilizers producers and reduce input costs for farmers around the world, which should be a positive for both fertilizer providers and farmers.

Valuation

In most of the 2005 and 2006, Potash Corp. has been traded with a P/E ratio of about 20x, and started in early 2007 to experience a steady P/E expansion. For most of the year 2008, Potash Corp. has been traded with a P/E [TTM] premium higher than 50x before it drops to 30x.

Currently Potash Corp. is traded at about 28 times of trailing-twelve-month earnings and at about 15 times of 2008 estimated earnings, yet the forward P/E for 2009 is just about 8.68x. If we assume conservatively that, at the end of 2009, Potash Corp. would be traded at the valuation of its pre-food-crisis level, which is about 20x, the price of POT would be between $15.5 x 20.8 = 322.4 and $22.35 x 20.8 = 464.88, with the average of price of $19.57 x 20.8 = $407.06. (15.5, 22.35 and 19.57 are the low estimate, high estimate and average estimate of earnings for 2009 by analysts, respectively).

In the world of commodities, no other commodity is so unevenly “allocated” by nature as potash, with Canada, Russia, and Belarus being home to 85% of the known world reserves; and no other commodity is so tightly controlled by a cartel as potash, of which supply could almost be legally “monopolized”.

And to add some urgency to the situation, there is no substitute for potash. High product pricing power and sales volume power result in lucrative free cash flows from its operations. In the 2nd quarter 2008, Potash Corp. generated $894.6 million of operating cash flow and $1055.4 million total cash flow, an increase of 70% and 122.8% over the same time period last year, respectively. With great foresight, the management of Potash Corp. has made the wise move to invest its rich cash flows in building its production capacity to meet the future increasing demand for its products.

In a capital and labor intensive industry, fertilizer companies have been seeing very impressive profit margins comparable with traditionally high margin business due to the tremendous pricing power of its products. For the trailing twelve months, Potash Corp.’s operating margin is 41.29% and profit margin is 31.05%. As prices of fertilizers continue to rise, Potash Corp.’s profit margin will continue to improve, providing a great degree of margin of safety in the current tough macroeconomic environment.

The pricing power of fertilizers, along with the strong demand, has made fertilizer business one of the most profitable businesses in the current investment environment. In the last twelve months Potash Corp. achieved a return on equity of 37.07%, exceeding its cost of capital with a great margin. Potash Corp. has a debt-to-capital ratio of 25.6%. The relative high ROE demonstrated that the management of Potash has the acumen and the ability to effectively use leverage to capture business opportunity and monetize it successfully.

Endowed by nature and blessed by great timing, Potash Corp. is immersed with rare opportunities, once every many decades for agricultural companies to catch up with the unprecedented growth of emerging economies. With the least government control and enormous barrier of entry to the fertilizer business and its economies of scale, Potash Corp. is in a unique position to benefit tremendously from the escalation of food prices, increasing meat consumptions, the long term population growth, and the economic growth of the emerging markets.