Uralkali and the Potash Industry

The Canadian government scotched BHP Billiton's proposed takeover of Potash Corp in 2010, largely due to the mining giant's plans to withdraw from Canpotex, the marketing arm through which Canada's producers sell and distribute their products.  The Saskatchewan government feared that a weakened Canpotex would mean a weakened price for potash, reducing royalties and income taxes for the province.  Today, the potash world saw that those fears were indeed valid.

Potash producers in Russia and Belarus have sold over 40% of the world's capacity via BPC, an institution similar to Canpotex, until Uralkali, a large Russian producer, abruptly announced that it will withdraw from the marketing body.  Instead, the company plans to market its own products, with an emphasis on maximizing volume, rather than withholding supply for a better price.  The company itself acknowledges that this move could reduce potash prices by 25%, to around $300 a tonne, at least in the short-term.  The share prices of all publically traded potash producers instantly fell by 15-25%. 

In the long-term, the supply-demand equation is likely to remain favorable to producers: in fact, $300 a tonne pricing will render any greenfield capacity uneconomic, and will reduce the number of proposed brownfield expansions that go forward, as well.  Interestingly, Uralkali itself has confirmed that it will put one of its own expansions on hold because of the move.  At the same time, lower prices will increase volumes, eventually raising the price of potash.  In addition, an industry where only three sellers - Canpotex, a smaller BPC and a stand-alone Uralkali - account for 70% of capacity remains a heavily consolidated industry (there's additional, though less visible, consolidation, as well, since Potash Corp holds significant sway with the company’s that it holds minority interests in, all of which operate outside of the main two marketing bodies).  

Still, the industry's future doesn't appear as bright today as it did yesterday.  If the marketing arrangement is permanently weakened, the average price of potash is likely to be lower than it otherwise would've been, and will crash harder in down markets than it has in the past, a dismal fact of life for producers of most other commodities.  Not only will producers be less profitable, it will force them to hold more cash - or take on less debt - than they would have under the status quo, which will increase a range of opportunity costs.

 

There are still many unanswered questions.  For one: Why?  It's possible that Uralkali is merely maneuvering against its Belarusian partner, due to reports that one or both parties have sold product outside of the arrangement.  Indeed, Uralkali appears no better off in this brave new world of its own making.  Its stock, too, fell by about 20%, and even selling at all-out capacity, the company predicts flat earnings, suspended its stock buyback, and, as mentioned, put at least one planned expansion on hold.   

Economists often use the classic "prisoner's dilemma" as a model to help explain - and predict - how players in this sort of situation will behave.  Uralkali is behaving in a way undreamed of in this formulation: it "squealed" on the others, but did so with no benefit to itself.  The prisoner’s dilemma assumes rational people making informed, disinterested decisions, however.  In this case, Uralkali may be attempting to correct a perceived lack of fairness (experiments show that people sometimes act counter to their own interests in the name of fairness) or it could simply be behaving foolishly.  Or the company may in fact be acting rationally, after all, with the explanation to be found not in an economics textbook, but at the poker table: this could be a bluff.

In any case, the industry appears less attractive than it once was – although it’s also more appealingly priced.  

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New Supply in the Potash Industry - The First Greenfield Mine In Four Decades

As discussed earlier, the most significant threat to incumbent potash producers is the potential of major new supplies of potash coming online, which would put downward pressure on both prices and profits.  However, the barriers to entry are very high: a capital cost of $4-5.5 billion, and many years before a greenfield mine reaches full production.

This week, German-based K+S AG broke ground on the first new potash mine in more than four decades (there have been expansions of existing mines, however).  The company, as a long-time producer of potash, has credibility that some other would-be producers lack.  For instance, K+S projects that it will take more than a decade to reach full production of 2.86 million tonnes/year, a much more realistic timeframe than is often cited.

However, the company announced a rather optimistic 2015 as their target date to begin producing at 1 million tonnes/year, and a capital expenditure of just $3.25 billion, significantly lower than most other estimates of the cost of bringing on new production.  Time may show that both of these estimates are too low.

The company also suggested that once in production, it's unlikely to sell its potash through the Canpotex marketing body, citing European anti-trust issues.  However, it reiterated its long-held philosophy of maximizing price, rather than the volume of tonnes sold, even if it requires restricting supply.

Overall, this new development should not cause investors in Potash Corp, Mosaic and Agrium to tremble.  The new capacity will be a long time coming.  And it's moderate in size, especially in the early years, which shouldn't cause significant pricing pressure.  Moreover, any pricing weakness will be counteracted by withholding supply.  However, the added production figures to be sizable enough to increase risks for other aspiring newcomers.  BHP's large Jansen project remains the wild card in the potash industry, but recent signs suggest the company will at least postpone a decision on the project.  If K+S's move was enough to give BHP pause, this week's announcement may actually turn out to be positive news for potash investors.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Potash Corporation of Saskatchewan - Investment Analysis

Potash Corp is one of the world's leading producers of fertilizer.  Sales of potash account for 64% of gross margins, with the remainder split between phosphate and nitrogen-based fertilizers (since the company's future rests largely on its potash operations, this analysis will focus there).  Five of the company's six potash mines are located in Saskatchewan, the sixth in New Brunswick.  Potash Corp directly supplies the North American market, and sells into the offshore market via Canpotex, a marketing arm operated jointly with Mosaic and Agrium.

Demand

Every year, the world's population grows by around 75 million people, relentlessly increasing food demand.  Indeed, now over 7 billion, global population is expected to reach 9 billion by 2050.  Equally important, as poor people in the developing world grow richer – from, say, $1000 US/year in annual income to $2000 – a large proportion of incremental income is used to purchase more nutritious food, namely protein-filled meat.  However, between two and seven pounds of feed (depending on the animal) are required to produce one pound of meat, putting major pressure on the world's crops.

However, little arable land remains available for development.  To produce more yields per acre, therefore, increased fertilizer use is inescapable.  In fact, despite genetic modifications to crops, more efficient irrigation, and other productivity enhancing measures, fertilizer is responsible for about half the world's crop yield.  For most of the past decade, humanity has consumed more food than has been produced, with the difference being drawn from stockpiles.  This will ensure high prices for most crops for years to come, giving farmers an incentive to invest more in fertilizer.  Since the 1960s, potash demand has grown on average by 3% per year, an upward trend likely to continue indefinitely.

Supply

However voracious the demand for a product, if new supply is very easy to produce, prices - and profits - will remain low.  Happily, Potash Corp occupies a supply-side "sweet spot": it owns many years worth of reserves, allowing for not just steady but growing production; however, there isn't an over-abundance of supply in the industry overall, which would hold down prices.

Company Reserves

One major challenge that most mining companies face is the "hole-in-the-ground" conundrum: each ounce, pound or tonne sold puts them one unit closer to being out of business.  Potash Corp, however, has 100 years of reserves just at existing shafts, and several centuries' worth of additional supply available, so even investors named Methuselah needn't worry about exhausting reserves.

Barriers to Entry

Building a new potash mine – or expanding an existing one – is a very difficult technical challenge, and even if all hurdles can be cleared, the economics are imposing: a two million tonne/year greenfield (new) potash mine in Saskatchewan costs between $4.0-5.5 billion (including infrastructure), and takes at least seven years to produce at full capacity.  Few investors are interested in an investment of such size when the payback period is so far in the future.  After all, a lot can happen over a seven year period (or longer), including rising costs, falling fertilizer prices, royalty changes, credit crunches, and many other unwelcome developments. 

According to Potash Corp, a netback of at least $600 is required to justify such an endeavor, even assuming a very affordable expansion and settling for a very average 10% internal rate of return.  More expensive investments, and a more ambitious 15% return would demand a netback at or above $1000 per tonne.  Currently, netbacks are under $500 per tonne.  These formidable barriers to entry serve to insulate existing producers from new competition, however. 

Eventually, high prices will ensure new greenfield supply, which will push down prices, and make the industry less attractive.  However, new supply can't sneak up and surprise the industry, and it's virtually assured that potash sales will provide investors with attractive returns for many years.  In fact, past projections of future supply have turned out to be much higher than what was actually achieved.

Two added factors make Potash Corp's supply situation yet more attractive:

OPEC-like Economics

Potash Corp is one of three North American producers that sell into the offshore market via Canpotex, which operates a shared infrastructure, reducing costs.  But the marketing body's most important function is to restrict supply when demand is soft, thus propping up prices, similar to how OPEC operates in the global oil markets.  A similar arrangement between several large Russian and Belarusian producers operates in Europe, and the two marketers combined supply over 60% of the world's potash.

Low Cost Producer

Potash Corp is among the world's lowest cost producers.  In a commodity industry, the surest, and often only, way to gain a competitive advantage is to be the low-cost provider.  Just as drivers don't care whether they fill their tanks with Shell's gas or Exxon's, farmers aren't loyal to one supplier's potash over another's; the only thing that will attract a farmer's hard-earned dollars is a more affordable price.  Though Potash Corp is willing to accept reduced volumes in return for higher prices, if it was unable to do so, it could remain profitable even at lower prices.  In fact, it has done exactly that: due to the recession, the company operated at a mere 30% of capacity in 2009, but nonetheless logged the third best results in its history to that point, in part due to its low-cost economics.

Management

Potash Corp has a first-rate management team.  CEO Bill Doyle is competent, honest, an independent thinker, and a patient, long-term planner.  There’s a solid bench of talent behind him, which isn't always the case among senior management in the mining industry.  The company manages its operations reliably and safely, and maintains good relations with its largely unionized workforce.  In addition, it has an unusually transparent board, and superb relations with investors.  One could argue, however, that the board has lavished the CEO with compensation beyond what's necessary to motivate and retain him, though the stock has performed exceptionally well during his reign.

Shareholders will only enjoy excellent returns if earnings are reinvested wisely.  Over the past decade, Potash Corp's management has done an excellent job allocating capital.  The company has reinvested much of its income internally – it'll amount to nearly $8 billion by the time expansions are complete – at high returns on capital: from 2004-11, ROE ranged from 13%-76%, and averaged 29%.  $6.3 billion has been spent repurchasing shares during that period, shrinking the share base by more than 20%.  Most importantly, buybacks have been pursued only when shares were cheap or reasonably priced.  $2 billion was spent over the same time frame on equity investments, which have ranged in price from between $8-10 billion in recent years.  Finally, the company pays a modest, but quickly growing, dividend.  Shareholders can rest assured that management will use earnings to add value in the future.

Valuation

Given the company's cost structure and the complex formula that determines its mining taxes, it's difficult to project Potash Corp's future earnings.  Helpfully, the company has published broad guidelines for its earnings potential over the next few years.  The most aggressive scenario they contemplate is actually quite realistic, and would see the company earning around $6.0 billion by 2015 or 2016.  However, free cash flow would be approaching $6.4 billion, as the company's ongoing capex will have fallen significantly below its depreciation and amortization expense.  Assuming a multiple of 15 times FCF, Potash Corp's market cap would be $96 billion.  Assuming earnings of $23.7 between 2012 and 2016, D & A of $4.2, and capex of $5.5 billion, cumulative FCF through 2016 would amount to $22.4 billion.  Assuming the company's common stock investments appreciate by 50%, to around $12 billion, and subtracting current net debt of around $4.3 billion, the total return for shareholders could plausibly amount to about $126 billion, or $148 per share.  Even if shareholders assumed a more cautious total return of $125, from the current $40 or so price, the return would be well over 25% per year through 2016.

Risks

Any mining project carries with it significant technical risks.  However, Potash Corp operates six mines, and a problem at any specific mine - water inflow, challenges with expansions etc. - won't affect production elsewhere.  The company has decades of experience, and formidable resources, so any problems that arise are likely to be dealt with effectively.

The company's most serious risk is the threat of substantial new supply pushing down prices.  Though the barriers to entry into the potash market are high, they're not infinite, and at some point high potash prices will prompt new supply.  There have been long stretches in the past when profitability in the industry has been ruined by excess supply, and it could happen again in the future. 

While there are over 50 potential potash projects worldwide, only a handful of those stand much chance of being developed.   The most talked-about potential new entrant into the potash industry is BHP Billiton, which may develop its large Jansen project.  However, the company has yet to decide when – or even whether – to go ahead with its project, and recent reports suggest the company may postpone a decision for up to two years.  Overall, it seems unlikely that there will be any new greenfield supply in the industry for a decade or so.

Conclusion 

Potash Corp is a superb company.  It has a valuable economic and strategic resource.  For all the uncertainty that investors face - economic, political, technological - peoples' appetites won't disappear any time soon.  Increasing demand for food, combined with an enviable supply-side equation for the company, means Potash Corp stands to reap huge and growing profits, and high returns on capital, for at least a decade to come.  An experienced, high-quality management team will navigate the company through any challenges, and will continue to create shareholder value.

Sources:

2011 AR, 2012 Q1, a Globe and Mail article on BHP Billiton, and several recent company presentations and transcripts:

http://www.potashcorp.com/media/POT_2012_BMO_Conference.pdf

http://www.potashcorp.com/media/POT_2012_BMO_Transcript.pdf

http://www.potashcorp.com/media/Doyle_Presentation.pdf

http://www.potashcorp.com/media/Brownlee_Presentation.pdf

http://www.potashcorp.com/media/Delaney_Presentation.pdf

http://www.potashcorp.com/media/Moore_Presentation.pdf

http://www.potashcorp.com/media/POT_2012_Analyst_Meeting_Transcript.pdf

There's ongoing commentary on Potash Corp: an update on the first greenfield mine in the potash industry for over four decades; a 2012 second quarter update; a 2012 third quarter update

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.