MFI STOCK REVIEW: CF INDUSTRIES HOLDINGS INC (CF)
CF is mostly in the nitrogen business. Nitrogen-based products are created by combining the extracted hydrogen from natural gas with the nitrogen in the atmosphere. Obviously, both input components are readily available. This makes the production of nitrogen fertilizers a business with low barriers to entry, creating lots of competition (especially internationally) and severe pricing swings. For example, in the last reported quarter, prices plummeted over 50% from 2008 for both nitrate and phosphate applications! There are no switching costs, unique assets, or regulatory barriers - this is a true commodity market.
The only way to have a lasting competitive advantage in a commodity market is to be the low-cost producer. After the recent merger with Terra Industries, CF will control over 50% of the North American nitrate fertilizer market, a dominant scale and an important competitive advantage. The company will have a particular advantage inside North America, where cheaper transportation costs and excise taxes on imports give it price advantages. Also, foreign competition has killed off a lot of domestic players over the past decade or so. This will be offset somewhat by usually higher natural gas costs in North America than in other parts of the world. Natural gas is the major input component to producing nitrates, accounting for 60% or more of cash costs.
All-in-all, the near-term future looks pretty good for this company. Corn prices and acreage, a major demand component, continue to trend well above historical rates, owed partly to the demand for ethanol. At the same time, natural gas prices have been low and could continue to be low given the abundant new sources being found in North America.
Valuing CF is tricky. To start with, levels of revenue and gross profits vary wildly due to the factors outlined above. Gross margin has varied between 7.2% and 32.2% over the past 5 years alone. Revenues grew 42% in 2008, then fell 34% in 2009. Predictability is unpredictable!
Also, more importantly, is the $4.7 billion merger with Terra Industries. Although CF reports today, I'm not positive they will be consolidating Terra's results. But we need to combine the two companies and account for the deal financing on the financial statements. Doing this, I get a company with about $4.2 billion in trailing 12-month revenues, $1.1 billion in operating profits, and 70 million shares outstanding, about a $5.2 billion dollar market cap at the current price of $74. All of this assumes the company meets their projected "synergy" cost savings target of about $135 million a year.
The balance sheet looks like it could be ugly. The deal was financed with $3.7 billion in cash and fractional shares (already accounted for). To raise this cash, CF added $1.6 billion in new debt and also did a secondary share offering of 11.2 million shares, raising another billion dollars. In addition, there was a $123 million breakup fee with Yara, who had an agreement to buy Terra before CF sweetened their own bid.
By my calculations, considering the balance sheets of CF and Terra prior, this leaves CF with about $150 million in cash vs. $2.2 billion in total debt, before any cash flow from Q1 is applied. The Magic Formula statistics still look pretty good: 15.4% trailing earnings yield and 78% MFI-adjusted return on capital.
So, what's the verdict? Well, many readers know that one of MagicDiligence's least favorite things is to see a heavy cyclical with a lot of debt, and that's what CF is going to be. However, I am actually putting a positive rating on this company. The debt is funded at reasonable rates around 7%, and is not due until 2018-2020. Even with the new interest burden, interest payments would have been covered 8 times over by operating earnings, a decent level. Cash levels should rise very quickly, as both CF and Terra were generating copious amounts of cash that should continue for the near future. The competitive advantages of scale and location in a commodity market are strong ones. Finally, all indications are that crop volumes will remain high and natural gas prices low in the short-term.
I'll stop short of recommending CF as a Top Buy pick, mainly because this is such an unpredictable business with a large interest charge burden. However, Magic Formula investors should do pretty well from the current price over the next year. After all, competitor Agrium (AGU) was bidding $112 for this company just a few months ago!
Date: May 7, 2010
Competitive Moat: C+
Financial Health: C-
Opinion: Strong advantages in nitrate fertilizer. OK buy.
Steve owns no position in any stocks discussed in this article.