Potash (POT): Fertilizer Companies Have Pricing Power ~ market folly

Saturday, April 19, 2008

Potash (POT): Fertilizer Companies Have Pricing Power

Buy: POT, Target Price: $250, Time Frame: 6 months

It's pretty obvious that agriculture has been one of the hottest sectors over the past 6 months. Having ripped through all my previous price targets, the fertilizer names continue to trend higher and it's time to re-evaluate them. Just like my previous analysis of the sector, this analysis is a three part agriculture series in which I'll be covering Agrium (AGU), Potash (POT), and Mosaic (MOS). These three companies specialize in fertilizer (potash, nitrogens, & phosphates) and currently there is a shortage in supply of fertilizer and thus these companies are ripe for success. All three of these companies are compelling because they are in the agriculture sector, and more importantly, the fertilizer sub-sector. But, they are all appealing investments for different reasons: valuation, growth, and market share, respectively. Instead of just picking one of these names to own, pick all three and spread the money you would have spent on one stock across all three names. That way, you diversify yourself away from company specific risk while still gaining exposure to the sub-sector secular growth. Fertilizer is in the midst of a secular bull market due to the pricing power that these companies have.

Commodity prices are sky high and this only benefits the fertilizer producers. This is mainly due to an issue I've touched on previously: there is simply not enough crop supply to meet crop demand. There are not enough farmers, there is not enough farmland, and there's simply too much demand. When a scenario like this plays out, the suppliers of such a product cannot lose. The makers of fertilizers and seeds are seeing huge demand from farmers who are struggling to meet the robust crop demand. So, the producers of these products, who are facing this robust demand, then see a shortage of their supply of fertilizer and the like. And, that's exactly what we're seeing right now. POT, AGU, and MOS all have pricing power because there is insane demand for their product and their product is in very short supply. This issue will not be solved for some time either because demand for crops (especially corn) is not going anywhere and thus the producers have to find a way to step up their supply of fertilizer. But, any outcome is a victory for companies like Potash, Agrium, and Mosaic simply because they're raking in cash. This analysis focuses on Potash (POT) but I will be doing a series of 3 analyses on the 3 main fertilizer companies: Potash, Agrium, and Mosaic. POT is my favorite of the bunch simply because they have a dominant market share of around 75% of the potash sold.

Potash is a Canadian company who produces integrated fertilizer and various other feed products. A year ago, they represented 55% of global potash excess capacity. And, nowadays, with the supply issues at hand, you can bet that Potash (POT) is raking in the cash on their reserves.

POT's strong suit is not its valuation. And, this is because it trades at a premium to other fertilizer names due to its 'best of breed' status. AGU is the cheapest on valuation, while MOS is second. With a trailing PE of 56 and a forward PE of 17, POT is richer than both AGU and MOS. Note, though, that POT's forward PE has been declining substantially on a quarterly basis, based on future earnings forecasts. And, I strongly believe that analysts are underestimating the earnings potential POT has with their strong market share and pricing power due to the inability by all parties to bring new Potash to market until year 2012 and beyond. (It takes years to bring a potash mine online). So, I believe you will see the real numbers continue to blow away estimates (as they report earnings here soon) and then eventually you will find that POT is actually trading at a lower multiple than everyone thinks. The fundamental story here is very real and people aren't grasping that these suppliers just can't "grow" or "discover" more potash all of a sudden. It takes years to bring more potash to market. Thus, the prices of the limited capacity will skyrocket and their earnings potential will continue to grow. Estimates will be continually smashed until the analysts realize what is happening and adjust their estimates accordingly. But, when it comes down to it, POT is not your value play in the fertilizer sub-sector of agriculture. AGU would be your value play (check that analysis to see why). Potash (POT) is actually my pick for the dominant company of a sector, i.e. best of breed. In any sector, there is usually a growth story, a value story, and a best of breed story. And, within fertilizer, POT is best of breed and here's why. POT's operating margins and return on equity absolutely crush their competitors. And, these are the real bread and butter numbers of any business. Firstly, looking at operating margins, we see that AGU is slightly weak in this area with margins of only 11% (due to their smaller company size). Mosaic (MOS), a larger company, has margins of 24%. POT's operating margins dwarf that of both these companies. POT's margins come in at 32%, tripling that of AGU. So, this is one of the main reasons POT is best of breed: their ability to crank up huge margins in their business. Additionally, POT has returns on equity higher than AGU as well. AGU has returns of 20%, which is respectable. POT trumps them with a return on equity of nearly 25%. So, you want best of breed? You got it. POT dominates the industry with their huge margins and solid return on equity. Like I said earlier, there are typically 3 types of names within any industry: a growth name, a value name, and a dominant name. POT is the dominant name in the fertilizer sub-sector of the agricultural industry.

As if you needed another good reason to own POT, they are also seeing very strong quarterly revenue growth of 42%. And, that number is accelerating on a quarterly basis. Additionally, they're seeing strong quarterly earnings growth of 102%, a number which is also accelerating. Also, POT was rumored to be a possible takeover target or merger participant back in early December. Although these rumors have died down, you never know. POT could still see an additional boost from any mergers and acquisitions activity that might pop up. Analysts covering the situation cited that POT might either be taken out by a company or merge with a peer where the newly created entity would then use leverage. So, this is something else to watch out for as time goes by.

AGU, POT, and MOS are the 3 main players within the fertilizer space and each is compelling as a buy for a different reason. POT, for instance, has superior operating margins and returns on equity when directly compared to its competitors and is thus the 'best of breed' play of the group. Additionally, they have the largest market share in terms of potash, the fertilizer nutrient in the shortest supply and highest demand. Play the increasing demand for crops, play the increasing demand for fertilizer, and play the pricing power fertilizer producers have gained by playing AGU, POT, or MOS. In this case, play POT because it is performing extremely well in terms of the 'bread and butter' aspects of the business.

One last thing I wanted to point out is to wait for a slight pullback because the stock is overextended and due for consolidation before the next leg higher. After they all report earnings, look for continued strength in the names and get in on any weakness that you can. I'm simply writing this analysis before any pullback occurs because I wanted to get the information out there beforehand. Watch the chart and the moving averages that act as support lines to help guide you with an entry point. Buy on any weakness and continue to watch the fertilizer story play out. This is pricing power at its finest. POT keeps raising prices (as they just did again this week) and they simply continue to dominate.

Buy: POT, Target Price: $250, Time Frame: 6 months