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A Weak Price Environment Causes Fear Even in Companies with Courage
Posted by: Victor Selva (IP Logged)
Date: November 7, 2013 05:23PM

The U.S. chemical sector is one of the largest manufacturing industries, with around 10.000 companies, annual revenue of $760 billion (in 2011) and more than 800,000 employees. The industry is characterized by a great concentration in a few large manufacturers (that hold significant market share) and capital-intensiveness –the industry spends around $50 billion per year in R&D. Moreover, as it is highly affected by oil and gas prices, this is a considerably cyclical industry.

New Market Conditions

Potash Corporation of Saskatchewan Inc. (POT) is the world's largest integrated fertilizer and related industrial and feed products company by capacity. The company aims to be the leader supplier of potash, nitrogen and phosphate products. The products are:

a) Potash (accounted for 42% of sales and 58% of gross profits in 2012): a crop nutrient used for fertilizer which is limited in supply

b) Nitrogen (30% of sales, 29% of gross profit): a naturally occurring gas that is necessary for cell maturation, plastics, resins, and is a key component of proteins and enzymes

c) Phosphate (accounted for 42% of sales and 58% of gross profits in 2012): nutrient used in increase crop yields, in soft drinks, and other food products

Potash is the primary segment because there are no known substitutes for this mineral.

An $8 Billion Expansion

Potash’s expansion projects expected to raise its total annual potash capacity to 17.1 million tonnes by 2015. The significantly higher potash demand in the future is a key driver to stable and sustainable earnings potential for the company. Also, natural gas which is a primary cost for the nitrogen segment is having a price decrease compared to historical averages, so this key cost driver will impact the bottom line.

Fear of a Price War

In July, the largest Russian producer of potash, Uralkali Group, announced plans to begin selling its own potash through its Switzerland-based trade arm Uralkali Trading, rather than using the potash cartel, the Belarus Potash Company. This cartel as any other makes independent decisions on quantity and price. Each firm would sell at the same price and would set its individual production volume such that every firm operates at the same marginal cost. Now, the company will focus on volume over price, using its position as low-cost producer to gain markets share, and this could affect in a considerable negative way the industry.

In terms of valuation, the stock sells at a trailing P/E of 14x, trading at a discount compared to the industry average of 15.3x. Analysts’ expectations imply a forward P/E of 15.58. To use another metric, its price-to-book ratio of 2.8 indicates a premium versus the industry average of 1.34 and the price-to-sales ratio of 3.82 is above the industry average of 1.17.

The Largest U.S. Phosphate Fertilizer Producer

The Mosaic Company (MOS) is one of the world's largest producers and marketers of concentrated phosphate and potash crop nutrients for the global agriculture industry. The company is characterized for a vertical integration model which generates synergies that reduce costs among competitors.

Potash Segment

The company intends to grow by continuing investing in brownfield expansions, program which started in 2006 and is planned two more phased expansion between 2013 and 2016. This will increase Mosaic´s capacity nearly 50% more. Not all are good news, there are price-risk concerning the Uralkali Group announcement analyze before.

Phosphates Segment

Mosaic is focusing on diversifying its phosphate rock sources, expanding the value of the business and maintaining its position as one of the lowest cost phosphate producers in the world. The firm enters into an agreement with Vale S.A. and Mitsui & Co., Ltd. related to a proposed joint venture that will own the Bayovar phosphate rock mine being constructed by Vale in Peru. The deal will give Mosaic the right to purchase 35% of the phosphate rock produced from the Bayovar mine, so this gives the company an access to additional phosphate rock.

Its P/E multiple on a trailing-12 month basis is 19.8 and the forward P/E multiple is 17.97. The current dividend yield is 2.16%, which is quite good to protect the purchasing power.

Finally, I always like to see the evolution of one of the most important financial ratios applying to stockholders, the best measure of performance for a firm's management: the return on equity.

Company ROE Compared to Industry Mean (=6.5)
Potash Corp. 21 Above
Mosaic 14.1 Above

Looking at the table we can see both ratios above the industry average.

Final Comment

Shale gas has become an increasingly important source of natural gas in the U.S., making the interest of companies in moving production to the U.S grow. The increase in the supply of natural gas has led to a reduction in prices relative to global crude oil prices. As a matter of fact, I think the chemical industry will expand this year because this industry is expected to see a strong boost as energy prices drop due to the rapid growth of shale gas production. I expect the chemical industry to recover along with the overall economic condition. Looking forward, as the population increases the demand for food will obviously grow, so population growth and dietary trends will increase demand for fertilizers.

In my point of view, having control on a phosphate rock mine make Mosaic the most attractive choice. Also, Zacks downgrade the recommendation on Potash Corporation to Underperform.

Hedge fund gurus Ray Dalio, Steven Cohen Paul Tudor Jones and Mason Hawkins added Mosaic to their portfolios, and I would advise fundamental investors should consider adding this stock to their portfolios as it seems to be an attractive option for long-term investors.

Disclosure: Victor Selva holds no position in any stocks mentioned.

Guru Discussed: Mason Hawkins: Current Portfolio, Stock Picks
Paul Tudor Jones: Current Portfolio, Stock Picks
Stocks Discussed: MOS, POT,
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