Tilling for Returns in Potash Corporation (POT)

Monday, November 08, 2010

Potash Corporation of Saskatchewan (POT) hit headlines in mid-August when BHP Billiton (BHP) bid $39 billion for the company (~$130 per share). PotashCorp immediately rejected the bid calling it "wholly inadequate", "highly opportunistic" and an "ill-disguised attempt to exploit an anomaly in the equity market valuation". Last week Canadian authorities also rebuffed the bid believing it is "not likely to be of net benefit to Canada". With the bid out of the way and shares trading up 30% year-to-date versus the S&P's 9% gain, investors must value the enterprise's futures prospects.

The secular fertilizer story

PotashCorp is a distinct beneficiary of a major secular global trend: rising populations and rising affluence. These two trends make for significant annual increases on the demand side yet are met on the supply side with limited arable land space, particularly in the largest and fastest emerging economies of China and India. We will add 80 million people to the planet this year and many millions will achieve higher standards of living. As populations progress economically, diets typically change to ones with higher meat content over grains. Meat requires a much greater intake of grains by animals than humans themselves need with grains alone to meet the same level of satiation.

The supply side sees farmers around the world developing new lands and attempting to garner greater yields from their fields already in use. Arable land around the world is relatively fixed and massive mountain ranges and deserts in China and India limit possible future enlargement of farmland. America has some of the most fertile soil in the world endowed with 589 hectacres of land per 1000 people. This is contrasted with China and India which only have 80 and 146 hectacres, respectively. These countries will likely become major importers of grains in the future to meet their growing and advancing societies.

Both sides of the supply/demand equation create the increased need for fertilizer over time. As farmers grow more food to feed the world, they must reuse their fields year after year depleting the soil of key nutrients and minerals required. Add in major technological advancements to increase yields and fields are depleted faster than ever before. Fertilizer companies are well-positioned in a secular global trend.

Where does PotashCorp fit in?

PotashCorp is the world's largest fertilizer company and in particular controls 20% of the world's potash production capacity. It is estimated that Canada holds over 60% of the world's potash reserves putting the big three producers in a prime spot for growth: PotashCorp, along with The Mosaic Company (MOS) and Agrium Inc. (AGU). The three key ingredients to replenish in soils through fertilizers are potassium, nitrogen and phosphate, thus the three primary lines of production at PotashCorp. Potash itself is the best and purest way to restock potassium in fields placing it in high demand with an estimated 93% of potash used exclusively for fertilizers.

PotashCorp is located in the middle of a major rebound wave in agriculture production and economic growth. After the devastating destruction in soft commodity prices following the oil bubble in 2008, farmers and dealers stepped back, demand for fertilizer fell off and potash prices collapsed. Now the recovery in prices has been well underway throughout 2010. This summer's large advances in prices of soft commodities should allow for a much clearer demand picture as wheat, corn, soybeans, oats are all up anywhere between 40-100% just since June of this year.

Importantly the valuation is still attractive

PotashCorp management is known for being conservative and oriented to generating sustainable long-term results for shareholders. CEO William Doyle has been with the company for over two decades slowly but surely acquiring and expanding operations to forge a dominant fertilizer company. With the BHP bid out of the way, third quarter earnings provide a very exciting narrative for investors to consider.

In the Q3 earnings release the company stated their forward-looking expectations:
We expect 2010 net income to be in the range of $5.75-$6.00 per share.

In this tightening environment, we anticipate that restocking of the distribution chain will begin in 2011 and, accordingly, have raised our global potash demand forecast to between 55 million tonnes and 60 million tonnes in the next calendar year. Given our expectation that current conditions represent the front end of an escalation in demand and pricing for our products, we are providing 2011 earnings guidance in the range of $8.00-$8.75 per share. [emphasis mine]
In valuing shares using the bottom end of management estimates, POT is selling at 24.5x 2010 EPS and 17.6x 2011. The lower end of guidance of $8.00 per share translates to 39% EPS growth should full year EPS come in at the lower end $5.75. Closing out the year with EPS of $5.75 should not be tough to achieve given the $4.34 already booked this year.

Notably within the report was a look at the pricing trends seen for the quarter. PotashCorp's third quarter earnings grew 61% year-over-year yet average potash prices were lower than last year. The gains were made in the tripling in sales of potash. The report states that "pricing trends improved significantly with September and October announcements of higher spot-market prices, although third-quarter realized prices did not yet reflect the shipment of tonnes booked at these higher levels." When the prices are reflected in Q4 earnings, the company should be able to handily meet the $5.75 guidance.

PotashCorp's business lines have significant momentum behind them with pricing hitting the "inflection point" management has been predicting for several quarters. Current valuation on shares is 30x trailing EPS which simply applied to year-end 2011 makes for a price target of $240 (a 70% gain from current prices). It is not unreasonable to apply at 30x P/E when EPS growth as foreseen by management is 39%. This would result is a PEG of 0.77. With a 5-year EPS growth rate of 28% based on year end guidance above average growth in this economic rebound is to be expected and could possibly be maintained for an extended period of time.

Risks to PotashCorp

Shares of PotashCorp are particularly sensitive to movements in grain prices and the prices of its outputs, potash, nitrogen and phosphate. A slowdown in the economic turnaround may negatively affect these prices and, in turn, hurt PotashCorp. Given the dominance of the big three Canadian producers, the company has been investigated by US authorities for monopolistic pricing tactics. Any restrictive measures imposed could adversely affect the company.

In the conclusion of the earnings report from CEO William Doyle he bluntly offers his compelling case for owning shares of PotashCorp:
Our strategies are designed to maximize earnings in the strong market conditions we see unfolding today," said Doyle. "As we have demonstrated in the past, we have an unmatched ability to move quickly to capture value when demand and prices are on the upswing. Looking ahead, we believe market conditions will provide an extended opportunity to show the full strength of our operations in all three nutrients — particularly potash — and to deliver substantially greater value to our shareholders. This is our time to demonstrate how our patient, long-term approach delivers returns for all stakeholders.

Brandon R. Rowley
"Chance favors the prepared mind."

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