Investment Activity Review-October 2015-Part 1


I’ve decided to break down the monthly activity review post into several posts for October as there were two new positions I took during the month. If you have been following this series, for new positions that I take , I try to follow my template involving answering the 8 questions you need to ask when evaluating a stock and I thought each of these types of decisions deserved a post for itself. In part 1, I look at fertilizer.

Opened position in Potash Corporation of Saskatchewan (Ticker: POT)

Q1: What do they sell?

Potash Corporation of Saskatchewan Inc is a fertilizer company. The Company operates in three business segments: potash, nitrogen and phosphate. The Company owns and operates five potash operations in Saskatchewan and one in New Brunswick. Its nitrogen operations involve the production of nitrogen fertilizers and nitrogen feed and industrial products, including ammonia, urea, nitrogen solutions, ammonium nitrate and nitric acid. It has nitrogen facilities in Georgia, Louisiana, Ohio and Trinidad. The Company’s phosphate operations include the manufacture and sale of solid and liquid phosphate fertilizers, phosphate feed and industrial acid, which is used in food products and industrial processes. It has phosphate mines and mineral processing plant complexes in Florida and North Carolina. The Company also has four phosphate feed plants in the United States and produce phosphoric acid at its Geismar, Louisiana facility.

Q2: Who do they compete with?

Potash competes with other agricultural companies that sell potash, nitrogen, and phosphate products. These range from pure play potash companies like CF Industries and Urukali to broad conglomerates such as Agrium and Rio Tinto.

Q3: Who buys their products and services?

The end user are farmers who use it extensively to fertilize  the food supply. Ninety-five percent of the world's potash is used on farms to fertilize the food supply. It's a critical ingredient that helps to improve crop yields, increase resistance to plant diseases and heighten water retention. It also has a positive effect on food color, taste and texture. Potash is a component of feed supplements used to grow livestock and enhance milk production. It still has several industrial applications that trace their roots back to the colonial days, including glass, soap and ceramic production.

With the world's population projected to grow by 75 million in the next year, the demand for potash is expected to grow along with it. The sources for potash are finite and they are concentrated in Canada, Russia and Belarus. Several years ago speculators drove the price from $200 to $900 per metric ton. The bubble subsequently burst and currently potash has reverted back historical prices ranges of $200-250 per metric ton.

Q4: Will they buy their product over and over again?

Given farming is an everlasting function and the importance of potash in the food production cycle, ongoing demand for the material is expected. The volume of potash sold is a product of the supply various agricultural commodities. If there is too much wheat in the market, chances are farmers will grow less of it in the short term and hence require less fertilizer products. Overall there appears to always be an underlying demand for their products. Life can't survive without food and water, and potash is a vital part of the formula for expanding the efficient expansion of the world's food supply. There are no known substitutes for potash. A company fits the profile nicely as one of the Core Pillars (LINK)

Q5: Do they make money?

Source: Valuentum Securities

Source: Valuentum Securities

PotashCorp is the largest fertilizer company in the world. With a presence in seven countries, it accounts for 20% of global production. In 2009, potash accounted for one-third of the company's revenues, totaling $1.2B in net sales. More impressive was that the gross margin from potash sales was 71% of the total, ample evidence of the profitability of this business segment.

The pullback in global potash prices due to the combination of weaker demand by large countries like China and India along with changes in the industry has had a negative impact on Potash’s earnings, however it is still creating tangible wealth.  The company continues to generate meaningful Return’s on Invested Capital that are greater than its Cost of Capital. Recent reports showed that it earned US$282 million in the third quarter, or 34 cents a share, down from 38 cents in the same quarter last year. Profit was 37 cents a share after stripping out one-time items, which was in line with consensus analyst estimates.

Q6: What do they own and who do they owe money to?

POT has a very clean balance sheet with little to no Goodwill or Intangible assets. Most of its assets are tied up in fixed assets. In terms of its capital structure, the company has a very manageable level of debt (Debt/Equity ratio approx. 0.33). The company has been able to grow its capital base organically rather than rely on buying other businesses to gain scale.

Q7: How risky is their business?

The company is at the mercy of agriculture and commodity prices for Potash. Commodity prices can be very volatile and hence the company operates within a commodity cycle that is very pronounced. When prices move, they move very well and when prices tank it goes down hard. In addition, the potash industry is undergoing a structural change. The potash industry has been run in a cartel format with several companies including Potash essentially controlling supply and setting prices often higher than what they should be. Recently one of the main members of the cartel, Urukali, announced they would be leaving the cartel and will be pushing to increase market share by lowering prices. Many indicate that the cartel would disintegrate and heaven forbid companies would have to compete in an open market. While this will not cause Potash to go out of business, the logic is that more competition for market share will lead to lower prices and lower profits for Potash.

Q8: Is the stock cheap?

On a relative basis, Potash stock is cheaper than its competitors trading at about 11 times earnings versus other companies that are trading around 14 times earnings . On a discounted cashflow basis, the stock is valued in the high $30’s to low $40’s range. From these perspectives the stock is trading at a discount and the market appears to be pricing the stock based on potash prices remaining low. The reality is that potash prices are trading around historical norms but the market was spoiled by the caffeinated go-go days of $900 potash. The company like other commodity companies are very out of favour as the surging US dollar has dampened commodity prices across the board.

Source: Valuentum Securities

Source: Valuentum Securities

The mantra of great investing is to identify for great well managed companies that own dominant positions in their sector, have clean balance sheets, and create tangible wealth. When you find them, you buy them when they are cheap. Potash appears to meet those qualities. Often a stock is cheap when the company is in a down phase of the business cycle but as humans we’re wired to think that because the stock has been falling, that something is wrong with the company. I’m also always looking for companies that can still create tangible profits in a depressed market because at some point demand will rebound and profits along with it, which is ultimately good for stock prices. Potash the material is finite and hard to substitute and is a critical material used in our production of our food supply. There will always be a demand for it. Add to this more and more people around the world are making more money and looking to eat better. This will create more demand for higher quality food products which should fuel more demand for fertilizer products. Potash is a best of breed company and I’m thinking the company is in the low end of its demand cycle. At some point market forces will go the other way and demand will return. I have no idea when. It could be years, but I’m OK to buy the stock these prices and wait it out (oh yes I forgot to mention the dividend is yielding a very chunky 7 percent which wouldn’t surprise me if it gets cut).  The stock could easily go lower especially if the stock market as a whole pulls back, so I bought a small position and will slowly build it up over time.