POT: Under the Hood
Over the past twelve months, a historic shift in fundamentals has occurred in the Agricultural industry, specifically with fertilizer producers. Fertilizer pricing has traditionally been driven by excess supply, with demand increasing at a marginal rate annually from world population growth. This allowed for little pricing leverage for producers of potash, phosphate, and nitrogen based fertilizers. However, times have changed due to the development of substantial new crop demand resulting from an increased focus on renewable fuels in developed countries, coupled with booming emerging market economies.
One of the companies benefiting from the shift in industry fundamentals is the Potash Corporation of Saskatchewan, Canada (ticker: POT). Potash Corp. operates three business segments: potash, phosphate, and nitrogen; however, their strategic focus is potash. The following report will outline the highlights and risks of each business segment.Potash Production
Potash Corp. is the largest producer of potash in the world. Potash is a nutrient that strengthens root systems and increases crop yield when used as a fertilizer. It is the strategic focus nutrient produced by Potash Corp. and carried a 51% gross margin for the first half of 2007, versus 40.4% for the same period in 2006. Margin expansion year over year was due primarily to a decrease in potash conversion costs of 10%, stemming from higher productivity and fewer shutdown weeks.Compared to the first two quarters of 2006, sales of potash increased 71% during that same period in 2007. This increase was due to an upsurge in sales volume in both North America and overseas markets. Realized price per ton increased by 7% in North America. One item of note related to the increase in 2007 sales, is that sales to China and India were zero over the same period in 2006 due to extended contract negotiation.
One of the historic risks for the fertilizer industry has been the cyclical nature of the crop growth cycle. As many countries grow in population and per capita income, the ever-growing demand for food and Bio-fuels have pushed the price of Wheat, Soybeans, and Corn to near historic highs. As a result, farmers within the United States have increased their rate of planting to the greatest it has been since 1944. As planting has accelerated, the supply/demand surplus ratio of potash has decreased to 20%. Additional planting in the future may result in increased pricing power, which will support higher potash margins.As we approach the peak of the crop cycle, the risk of crop yield exceeding crop demand growth becomes increasingly probable.
The macroeconomic bull market in oil should partially mitigate the risk of excess crop yield, as it continues to trend upward making higher highs and higher lows. In-turn, this should cement a longer-term growing demand for Bio-fuels.Growth in potash demand in larger emerging markets is difficult to determine given the contract dispute in India and China in early 2006. However, it can be illustrated by an increase in shipments to Brazil of .49 million tons, up from .21 million tons in the first half of 2006. One opportunity to expand margins among overseas markets is the increase in demand for higher quality potash products. The average price realized per ton in North America was $177 versus $139 offshore during the first two quarters of 2007. As emerging market economies grow, the demand for more expensive, higher quality potash products should replace demand for the lower quality product most commonly demanded overseas to date. In addition, emerging market crops have been historically under fertilized. As crop prices soar near historic highs, the cost of under fertilization has never been greater.
Yet another sign of accelerating worldwide fertilizer demand can be evidenced by Potash Corp.’s expansion plans. Expansion projects in development include the following: 1.5m tons at their Lanigan, Saskatchewan mine to be completed in Q2 2008; 360,000 tons at Patience Lake, Saskatchewan to be completed in early 2009; de-bottlenecking and excess capacity at Cory, Saskatchewan of 1.2m tons to be completed by mid 2010; and new mine development of 2m tons in New Brunswick by 2011. These projects are expected to be funded by free cash flow and will increase annual production to an estimated 14.9m tons.
Nitrogen
Potash Corp. is the 4th largest nitrogen producer in the world. Nitrogen is used to speed crop growth, increase yield, and enhance quality. Sales for the first half of 2007 exceeded $481m, while gross margin increased 3.2% over the same period in 2006 due to an increase in realized price for Urea products. Gross margin for nitrogen products is expected to remain strong going forward as Natural Gas prices continue to decline near $6 per MMBTU. Natural Gas is one of the primary Cost of Sales components in Nitrogen fertilizer production.
Phosphate
Potash Corp. is the 3rd largest phosphate producer in the world. Phosphate is essential for crop growth and maturation. Gross margin attributable to their phosphate segment increased to 26.8% from 10% in 2006, due to an increase in price of solid and liquid fertilizers, an increase in sales volume as a result of new business in Latin America, and increased demand in North America.Future prospects in the phosphate division exist not only for fertilizer, but also for solar panel manufacturing. Silicon tetrafluoride, a byproduct of phosphate production, is used as a purification agent in the manufacturing of solar wafers. Potash Corp. has recently completed production on a 7500 short ton per year factory for recovering Silicon tetrafluoride for sale to the solar industry. During the second quarter of 2007, Potash Corp. entered into a contract to build three additional factories of similar size.
Entity
Recent changes in the Canadian corporate tax structure should prove to be a boon for Potash Corp. The Canadian national tax rate is scheduled to decline from 23% to 18% by 2011, with the corporate surtax phasing out from 1.12% to zero by 2008. Saskatchewan provincial corporate income tax is scheduled to decline from 17% to 12% by 2009. These tax changes should result in significant additional future earnings and cash flow for Potash Corp.Another strength of Potash Corp. is its extensive potash reserve. The estimated life of each mine exceeds 30 years, with the exception of Esterhazy, which carries an estimated life of 7 years. However, production from currently planned expansion will more than account for the loss in production from Esterhazy in 2014. Potash Corp. leases 66% of mineable acreage, with the option to renew at the company’s discretion. Leasing these properties significantly decreases the cash outlay requirements to secure rights to the property. Furthermore, Potash Corp. holds long-term leases on railcars, port facilities, and ocean transport vessels, with the earliest expiration occurring in 2016.There are two additional risks to Potash Corp. that may affect their earnings going forward. The first risk is the expiration of collective bargaining agreements with their workers. Collective bargaining agreements with their employees at the Allen, Cory, and Patience Lake sites expire April 30, 2008. Based on 2006 output, these three sites constitute 28% of Potash Corp.’s production; any work stoppage may significantly impact 2008 operating figures.The second is foreign currency exchange risk. Potash Corp. records sales in US Dollars; however, expenses are incurred primarily in CN Dollars. As the US dollar declines against the CN dollar, Potash Corp. incurs foreign currency losses. Given the current state of the US economy, this trend is likely to continue. In the short run, the US dollar should decline against the CN dollar as the US credit and housing markets deteriorate. Provided the Fed lowers interest rates, this trend will most likely reverse in the long term, as the US economy recovers resulting in a stronger US dollar.
In summary, Potash Corp. of Saskatchewan’s growth prospects significantly outweigh its risks. Earnings growth and margin expansion should continue amidst growing world demand for both food and Bio-fuels. There is also potential for potash demand to outstrip supply, which will add to the pricing power of potash in future contract negotiations. In addition, the average development time of a new potash mine is 5-7 years, adding to constricting demand and significant time barriers to entry. Nitrogen margins should remain sustainable in the near-to-medium term as Natural Gas reserves near all time highs, pushing the price below 6$ per MMBTU. Phosphate margins continue to expand as new markets for production by-products emerge, such as solar demand for silicon tetrafluoride. Finally, corporate friendly tax changes in Canada will magnify growth in all three of Potash Corp.’s business units resulting in historic earnings in future quarters.
(POT: 202.27 +8.27 +4.26%, cap: 63.204B)
