Potash (POT) Poised to Benefit Should Hedge Fund Worries Subside ~ market folly

Monday, September 22, 2008

Potash (POT) Poised to Benefit Should Hedge Fund Worries Subside

If you want to understand why Potash (POT) has been such a solid performer over the past year or so, all you have to do is look at simple supply and demand. And, Potash (POT) has done just that in their Market Analysis Report released on August 29th, 2008. They've assembled a slideshow of charts that illustrate the very pricing power they are seeing in their industry. Demand is rising and supply is falling. This industry is easily one of the strongest groups fundamentally right now because of secular trends. But, due to hedge fund redemptions/liquidations and the commodity sell-off, this name has been inexplicably sold off along with any and all energy or commodity related names. In a market where logic and fundamentals have been thrown out the window, it may be best to stand aside and let the chaos pass. But, when/if/should normalcy return to the financial markets, POT is poised to benefit simply because they actually have a strong fundamental story behind them.

Such strong fundamentals have been illustrated with charts extracted from Potash's latest Market Analysis Report:

Firstly, we see Global Grain production and fertilizer use increasing.

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Secondly, we see worldwide fertilizer demand growth: "Recognizing that without sufficient potash they cannot raise their yields – no matter how much N and P they apply – farmers have raised their potash consumption an average 5.6% per year for the past five years. This compares to 2.7% for N fertilizer and 3.8% for P. Over the past five-year period cumulative world fertilizer growth has been greater than adding a market the size of the US or India, the second and third largest fertilizer markets."

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Thirdly, we see that potash ending inventory has decreased each year for the past 3 years.

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Additionally, commentary from their Market Report reads,

"Potash is used on a diverse group of agricultural commodities. Wheat, rice, corn, soybeans and sugar cane consume roughly 50% of the world’s potash. This diversity means that global potash demand is not highly dependent on the market fundamentals for any single crop or growing region. US use of corn for ethanol has grown in recent years but this segment of market accounts for only 2% of world potash consumption. The global potash industry is operating at historically high rates to meet the significant growth in potash demand. With the industry running at or near full capability, world production in 2008 is expected to be limited to an increase of only 2.0-2.5%. This (production) is well below the 5.6% demand growth rate of the past 5 years."

So, simply put, fertilizer demand is outpacing supply.

In addition to the supply/demand equation tilting in Potash's favor, they are also seeing more favorable input costs. Natural Gas is one of the main agricultural input costs. And, as you've witnessed this summer, prices of natural gas have fallen hard 40%. So, this can only further POT's bottom line. And, if for some reason you still need further reassurance that the agriculture boom is still in play, just turn to analyst comments from Morgan Stanley. They say that the selloff in these names is "unfounded" and that they expect peak earnings around 2011. They rate Potash (POT) "Overweight" with a $297 price target (POT is trading around $180 now).

Additionally, as NotableCalls mentions (re: Morgan Stanley analyst comments),

"Fertilizer prices will stay higher for longer: i) A global economic slowdown is unlikely to affect fertilizer demand; ii) US farmers are still earning a ~60% ROIC on fertilizer purchases and are thus unlikely to reduce fertilizer application; iii) Emerging market farmers are very low on the yield response curve (i.e., increased application pays for itself); iv) NPK prices have yet to catch up to commodity prices (i.e., record US farmer profits despite higher NPK prices); and v) They believe capacity increases will simply meet underlying demand rather than flood the market and force lower prices. Valuation extremely compelling: 2009e EV/EBITDA of 2-5x; FCF yields of 10% to 20%. Minimal balance sheet leverage (in some cases none) should allow for substantial share repurchases and dividend payments. POT has the most leverage to potash, the nutrient with the greatest pricing power and barriers to entry."

So, the real dilemma here is trying to decide whether to enter POT at these levels given the market uncertainty. Hedge funds closing their doors like the Ospraie Fund are forced to sell their positions. And, if they are heavily invested in fertilizer/energy/commodity names (as many of them are), you can guess what that means for the stocks. Given the fact that we have seen numerous commodities and macro hedge funds negatively affected by the commodities sell-off, one would have to think that further hedge fund redemptions or liquidations are in store, as I wrote about here. Additionally, Nouriel Roubini seems to think the next step of the crisis will be the de-leveraging of hedge funds. But, it would still be hard to envision a commodities selloff as great in magnitude as the one we recently saw, given the already vast depreciation in equity prices.

Trading at just an 8.37 forward PE, POT is very compelling here. The bulk of the gains come from solid operating margins of 41.29% and return on equity of 37%. They are seeing year over year quarterly revenue growth of 102.30% and year over year quarterly earnings growth of 216.80%, both massive figures to say the least. The only major negatives would be their $2.27 billion in debt, compared to $269 million in cash. But, one could easily argue that since POT is essentially printing cash with their business, that their debt is not worrisome at all. In the end, their debt/equity ratio comes in at around 0.34. Lastly, we see that around 77% of shares are held by institutions. And, among those institutions are numerous hedge funds we track here at Market Folly. Firstly, $10 billion global macro hedge fund Moore Capital Management (ran by Louis Bacon) owns POT, as we noted in our recent hedge fund tracking piece. Additionally, POT is owned by $10 billion Maverick Capital (ran by Lee Ainslie), whose portfolio holdings we analyzed here. And, last, but not least, we also noted that George Soros had been purchasing Potash (POT). Now, I don't believe these funds are in jeopardy of massive hedge fund redemptions/liquidations as I referenced earlier. But, at the same time, anything can happen these days and there are undoubtedly numerous highly leveraged funds out there waiting to explode/de-leverage.

So, we really are at a crossroads here. On one hand, the fundamentals are screaming "buy," as the supply and demand picture only gets further squeezed, since new potash cannot be brought online for years. But, at the same time, you run the inherent risk of POT being sold off ridiculously hard again should a bunch of hedge funds face redemptions or liquidations as many are forecasting. So, the inherent risk here is not company specific, nor sector specific, but rather financial market specific. The fundamentals are in-tact and that's all that matters. But, with some hedge funds teetering on edge, things can swing either way. Value investors and deep fundamentalists will tell you that even if you have to go down through a valley before getting to the mountain top, it's still worth going through for the opportunity. But, given the recent market volatility and unpredictability, exercising some caution can never be a bad thing. If the saying holds true that fundamentals trump all, then buying POT now could payoff large come 2010 and 2011. This must be what it feels like to be a value investor, huh?

Sources: NotableCalls & Potash Market Analysis Report

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