Markets & Finance

Focus Stock: Potash Corp.'s Growth Story


S&P likes the fertilizer giant's earnings outlook and the stock's "compelling" valuation, and ranks the shares strong buy

From Standard & Poor's Equity ResearchWe believe this week's S&P Focus Stock, Potash Corp. of Saskatchewan (POT; recent price, 180) has an extremely strong earnings per share (EPS) outlook combined with a compelling stock valuation. In 2009, we look for the sixth consecutive year of record EPS, driven by robust fertilizer markets and higher prices. The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy.

Potash is the world's largest integrated fertilizer company, including the largest global producer of potash with 22% of global capacity. Increased global fertilizer demand is being driven by population and economic growth in emerging economies such as China and India, which is resulting in improving standards of living and diet and boosting the need for food and animal feed. We believe crop plantings will rise in 2009, including an increase in U.S. corn acre plantings, as a result of near-record grain prices and historically low grain inventory-to-use ratios. This has given fertilizer producers extraordinary pricing power for the key nutrients—potash, phosphate, and nitrogen—required by farmers to boost crop yields.

The stock is quite volatile, with a rapid runup over the past four years, peaking in mid-June before a sharp pullback in recent weeks along with the energy, commodities, and grain prices. However, grain prices remain higher than a year earlier.

Company Profile and Outlook

As the world's largest integrated fertilizer company, Canada-based Potash Corp. produces all three of the key plant nutrients—potash, phosphates, and nitrogen. By our analysis, fertilizers accounted for about two-thirds of its sales in 2007, with industrial and animal feed products accounting for about one-third.

Potash

The company is the largest global producer of potash (34% of sales and 49% of gross profits in 2007). In 2007, it produced a record 9.2 million metric tons in Canada from six mines in Saskatchewan and one in New Brunswick, accounting for 17% of global production. It sold 9.4 million tons in 2007, with offshore (outside North America) markets accounting for 63% of shipments. We expect sales volume in 2008 to be a record 10.1 million tons, followed by about 11 million tons in 2009, driven by increasing export shipments. Both the potash industry and Potash Corp. have been operating essentially at capacity this year, and the company reports it has customers on supply allocation. North American potash industry inventories at the end of July 2008 were below the year-earlier level as well as 35% below the five-year average.

Robust markets and tight capacity have given fertilizer makers extraordinary ability to raise prices. The potash industry has announced a series of domestic price hikes totaling more than $600 a ton since early 2007, with the majority being effective this year, bringing the list price to $767 a ton beginning in September. The company's average realized North American price was $403 a ton in the second quarter, up from $182 in the 2007 period and $301 in the first quarter of 2008. Export price hikes have been just as large with prices in Latin America, Brazil, and Southeast Asia at $1,000 a ton for the fourth quarter. Prices at the beginning of 2008 were at $405 a ton for Brazil and $425 to Asian customers. In April, China, the largest foreign customer for Canadian producers, signed an annual contract for 2008 at $576 a ton (before shipping costs), up $400 from 2007. As a comparison, the company's offshore price in the second quarter averaged $417 a ton, up from $143 in the 2007 period.

We believe growth in global potash demand of about 4% annually will continue to exceed supply growth for the foreseeable future. In fact, due to its late signing this year of annual contracts, China, the second largest importer of potash behind the U.S. and the largest foreign customer for the three Canadian producers, will be able to buy only about two-thirds of the 9.3 million tons it purchased in 2007. As a result, China will likely nearly deplete its existing potash inventories and need to boost its purchases in 2009.

Since 2005, the company has announced a series of mine capacity expansions and new mine projects that in total will raise its operational capacity to 18 million tons by the end of 2012 at a total cost of nearly $7 billion.

Overall, we expect potash gross profits to be nearly $4 billion in 2008, up from $912 million in 2007, largely on fourfold increase in gross profit per ton sold, and to be nearly $6 billion in 2009, helped by greater volumes.

A wild card is that on Aug. 7, 2008, unionized workers at three Saskatchewan operations went on strike. The three facilities account for 30% of output in 2007, with the largest of the three alone accounting for 19%. Previous union contracts expired Apr. 30. The largest mine was scheduled to resume operation on Aug. 10 from normal maintenance downtime, while the smallest mine does not produce during the summer months. We believe if the strikes were to extend, financial results would be disrupted. On Aug. 19, a company spokesman said the strike could affect shipments to industrial (non-agricultural) customers, which account for about 5% of Potash Corp.'s potash sales, but it was too early to tell how the strike would affect its fertilizer business.

Phosphates

The company's phosphate business (31% of sales and 23% of profits in 2007) is the second largest U.S. maker of phosphate fertilizer such as diammonium phosphate, as well as the largest producer of animal feed ingredients and industrial-grade purified phosphoric acid. It is also the second largest global seller of phosphoric acid, the intermediate product for phosphate fertilizers. The company mines phosphate rock at two of its three facilities, giving it a cost advantage over non-integrated producers that need to buy rock, in our view. The normally higher-margin and less-cyclical animal feed supplements and industrial products accounted for 37% of phosphate sales in 2007, but only 29% of gross profits as a result of improved fertilizer results.

We believe the high quality of the company's phosphate rock gives it the ability to produce the most profitable combination of fertilizer, feed, and industrial products. In 2007, for example, Potash Corp. adjusted its product mix to capitalize on the turnaround in the fertilizer market, which turned profitable on double-digit percentage price increases. This led to a total phosphate gross margin of $433 million, the highest in the company's history.

U.S. phosphate shipments will likely rise in 2008, by our analysis, with a further increase expected for 2009 led by exports. Strong global phosphate fertilizer demand has led to tight supplies of phosphate rock and significant increases in world rock prices since early 2007.

Contract prices for phosphoric acid in the third quarter of 2008 were recently reported by trade publications to have been settled between Morocco, the largest rock exporter, and Indian buyers at $2,310 per metric ton on a cost and freight basis. This price is up $325 from $1,985 a tonne that Potash Corp. also had with the Indian buyers for the second quarter of 2008, and up from the price of $566 for the company's annual contract that expired at the end of March 2008.

North American prices for phosphoric acid will begin to reflect these higher prices as such sales are contracted on a fertilizer year basis beginning in July. Higher phosphate prices have also driven prices for other derivative products higher. The company implemented a $250 a ton price increase for feed ingredients in both April and May, while the industrial products business has several longer-term contracts with pricing terms that will be reset in early 2009 at substantial increases, which should also help profits in 2009.

We expect considerable improvement in phosphate gross profits in 2008 to about $1.4 billion driven by the surge in fertilizer prices, with greater contributions from the industrial phosphate and feed supplement businesses.

Nitrogen

Potash Corp. is the second largest global nitrogen producer (35% of sales in 2007 and 28% of gross profits) and the largest in the western hemisphere when measured by ammonia capacity. Two-thirds of ammonia capacity is in Trinidad and benefits from favorable gas contracts and proximity to the U.S. Natural gas accounts for the bulk of the manufacturing costs to make ammonia. Natural gas costs in Trinidad are indexed to ammonia prices in Tampa, and provide the company with a valuable competitive advantage, in our view.

Increasing demand combined with higher natural gas prices has driven increased nitrogen prices. In 2007, a strong Trinidad performance, plus improved contributions from U.S. plants, drove the nitrogen gross margin to a record $536 million.

China, which was the world's largest urea exporter in 2007, imposed an export tax on nitrogen fertilizer in April 2008, which drove world prices higher. Based on higher fertilizer prices supported by high world energy prices, we expect nitrogen gross profits to nearly double in 2008 from 2007.

Financial Outlook

We forecast EPS of $12.50 in 2008, up from $3.40 for 2007. We expect EPS of $17.85 in 2009, the sixth consecutive year of record profits, driven by higher selling prices. Our financial assumptions include that provincial mining and other taxes will be 16.5% of total potash gross profits, up from 14.8% in 2007, reflecting expected increased profit per ton of potash. The Saskatchewan production tax is comprised of a base tax per ton sold and an additional progressive tax based on mine profits on the first 5.7 million tons sold. We also expect the overall consolidated income tax rate to be 29%, up from 27.4% in 2007. We forecast equity and dividend income from foreign investments to total $165 million in 2008, up from $117.4 million in 2007.

We believe Potash Corp.'s financial profile is relatively healthy. Its total debt-to-capital ratio was 25.6% as of June 30, 2008, up from 19% at the end of 2007. The company had repurchased 10.9 million common shares in the first half of 2008 for $2 billion as part of a plan to repurchase up to 15.8 million (5% of outstanding) shares announced in January 2008. We expect capital spending to be about $1.4 billion in 2008, up from $607 million in 2007, and then to average about $2 billion annually over 2009 and 2010 as a result of capacity expansions at the company's potash mines.

Valuation

The stock is off about 25% from its all-time high set on June 19, along with energy, commodities, and grain prices, and the overall agricultural chemicals sector, but less than its closest competitor Mosaic (MOS). The shares are trading at about 14.4 times our 2008 EPS estimate of $12.50 and 10.1 times our estimate for 2009, close to the low end of its historical annual range for the past four years. We believe crop plantings will remain high in 2009, resulting in continued strong demand for fertilizers. Our target price of $280 is based on a price-earnings ratio of 15.8 times our 2009 estimate, still below the mid-point of the stock's range for the past several years, reflecting the continued strong earnings prospects we foresee. As industry fundamentals continue to play out favorably, we think the multiple will expand.

Corporate Governance

We have a favorable view of Potash Corp.'s corporate governance. Positive factors, in our view, include that the positions of chairman and CEO are separated; only one insider director (the CEO) serves on the board (out of 12 directors); the audit, compensation, and nominating committees are comprised solely of outside directors; the CEO serves on two or less boards; the company has only one class of common stock; and the company does not have a poison pill.

Negative factors, in our view, include that the company is incorporated in a country with antitakeover provisions; a supermajority vote of shareholders is required to amend certain provisions of the charter or bylaws; and shareholders do not have cumulative voting rights.

Investment Risks

Risks to our recommendation and target price include lower-than-expected domestic and/or foreign demand for fertilizer, higher-than-expected production and/or transportation costs, unplanned mining or production outages, and volatile currency exchange rates. A sharp drop in natural gas prices would likely reduce the competitive advantage of the company's Trinidad facilities.


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