Anyone that has looked over stocks trading near 52-week lows in the US will know that fertiliser companies are very out of favour at the moment. A major Russian producer has recently turned its back on a cartel which fixed prices and is now going alone. The stocks of fertiliser companies have quite rightly been thrashed as a result of the impending price declines that will occur as a result. This means that value investors and contrarians’ will be looking for any mis-pricing that could present a good buying opportunity among the wreckage. That’s why I decided to do this article on the industry and how to look at companies within it. Unlike my previous ‘How to value series’ this will be in one part, but I will follow up with an industry comparison and specific example.
What is fertiliser?
Any natural or manufactured material that contains at least 5% of one or more of the three primary nutrients – nitrogen (N), phosphorous (P), or potassium (K) – can be considered a fertilizer. Industrially manufactured fertilizers are sometimes referred to as “mineral” fertilizers [source: http://www.fertilizer.org/]
Large amounts of energy are required to convert this nitrogen to a form that can be used by plants. The production of ammonia from atmospheric nitrogen was made possible in the first part of the 20th century by the development of the Haber-Bosch process. The most important nitrogen-based fertilizers are urea and ammonium nitrate. The cost of natural gas (for energy) makes up about 90% of the cost of producing ammonia.
Phosphorus, in the form of phosphate (a salt of phosphoric acid) is mined from naturally occurring mineral deposits (phosphate rock) that were once sediments at the bottom of ancient seas. Rock phosphate is the raw material used in the manufacture of most commercial phosphate fertilizers. Ground rock phosphate was once applied directly to acid soils. However, due to low availability of phosphorous, high transport costs, and low crop responses, very little rock phosphate is currently used in agriculture. Phosphate rock processing consists in the separation of phosphate from the mix of sand, clay and phosphate that makes up the matrix layer.
The potassium used in fertilizers is found in a salt form called potash. Potash deposits are derived from evaporated sea water. They occur in beds of sediment at only a few places in the world. The largest deposit, in Saskatchewan, Canada is 2.7 to 23.5 metres (9 to 77.6 feet) thick and found at depths of 1000 to 10, 000 metres (3,200 to 10,000 feet). Solution mining methods are used to extract potash at greater depths. Conventional underground dry-shaft mining methods are used in mines as great as 1100 metres (3500 feet.). The ore is extracted from potash deposits by electrically operated mining machines and conveyed to the surface, where it is crushed. Using a flotation process, salt and clay particles are removed, the brine solution is dried, and the potash is sized by screening. The resultant coarse grade product is then ready for distribution. Fine particles remaining from the screening process are compacted into sheets that are crushed and screened to particle sizes suitable for blending.
Most of the sulphur used by the fertilizer industry is a by-product of other industrial processes. Sulphur is used to create coated fertilisers which release nutrients more slowly into the soil.
There are some differences between the three. Nitrogen fertilisers do not ‘bank’ in the soil and need to be replaced every year. Potassium and Phosphorus is banked, hence farmers can actually decide to reduce their P and K fertilisation for certain years if they wish. This actually happened in India recently.
The fertiliser industry
Fertiliser can be thought of like any other commodity. There are low barriers to entry in this industry and the price of fertiliser depends entirely on supply and demand. Demand is widely thought to be increasing on a long term basis, caused by population growth and an ever increasing need to grow more food on less ground. A must read to understand the current and long term outlook are the free reports here. They also give information on a single nutrient basis, N, P and K, which is important because different companies will be reliant on different nutrients and will not just follow the overall fertiliser market’s demand. This point is very important and why two fertiliser companies can have wildly different values.
The market is international, with countries like China exporting to the rest of the world. The US is one of the largest producers of fertiliser, part of which feeds its huge corn industry which receives heavy subsidies from the government. This has been amplified in recent years with government backing of ethanol programs for biofuel.
It is important to understand this when investing in companies. A US company can sell to US customers more cheaply than a Chinese company due the latter needing to ship the material. But there are scenarios where it is cheaper to import so be aware of that. For example Russia fixes natural gas prices very low so it is much cheaper for companies to make nitrogen based fertilisers there. But the US prevents mass Russian imports be levying duties.
Another important thing to note is that different plants need different types of fertiliser. For example corn needs a lot of nitrogen, so a company located in the US making primarily nitrogen fertilisers will have its fortunes very closely tied to corn prices. It isn’t possible to suddenly switch to a different form of fertiliser if it is cheaper but farmers may grow different crops if they are more economically attractive, which may require a different fertiliser mix.
But there is a balance between normal fertilisers and slow release versions. Depending on when farmers plan to fertilise and plant crops, they may opt for more slow release products and less instant release, or vice versa.
How to value a fertiliser company
So now that we have a basic understanding of the industry and the products we can move onto actual companies. Despite it appearing to be a relatively simple industry it is rather complex with a lot of moving factors.
The first thing an investor should do, as I highlighted before, is to learn what specific products a company produces and then read the latest market outlooks for that product, which give forecasts for supply and demand.
Then it is important to look at the input costs and forecasts going forward. In the previous section I highlighted the key inputs (e.g. natural gas), they are also commodities so open to fluctuation in price.
The next thing to look at are the primary customers and competitive landscape. How susceptible is the company to cheaper imports? Are its customers reliant on government subsidy e.g. corn?
Depreciation vs capital spending
This industry usually has high capital spending, but a lot of that is to fuel growth. If you look at Potash Corp’s annual report, page 97, they give a breakdown of ‘sustaining’ capital spending as well as growth capital spending. From it we can see that in recent years the amount charged to the income statement for depreciation is a good proxy for ‘sustaining’ capital spending, hence net income is a good proxy for so called ‘owners earnings’ and can be used to value the business.
The final part is looking at net income and then valuing the company with a Discounted Cash Flow model, being mindful where the company and industry is based on the previous investigations.
It is hard to give more precise details on valuing a company as they are all so different. So in a follow up article I am going to look at the key players in the industry and compare them. After that I will choose one and go through an example valuation based on the methods I described here. I find an example is the best way to really show the valuation process.