This 4.6% Yielder Could See Cash Flow Surge

The global population continues to expand at a steady pace, and agronomists believe that crop yields will need to double by 2050 to meet rising food demand. That should be leading to rising demand for fertilizer producers, but these firms haven’t seen much benefit from the trend in recent years.  

Blame goes to a weakening Chinese economy and lower commodity prices, which reduce farm incomes.  The knockout punch came in July 2013 when Russian potash miner Uralkali decided to abandon cartel-like pricing policies and favor sales volumes over pricing. Potash is one of the three key compounds, along with nitrogen and phosphate, in organic fertilizers.

#-ad_banner-#Until that seismic event, global potash prices had been set by two trading companies: the Belarusian Potash Company and Canpotex. The former is a joint venture between Uralkali and Belaruskali. The latter is controlled by Potash Corp. of Saskatchewan, Inc. (NYSE: POT), Agrium, Inc. (NYSE: AGU) and The Mosaic Co. (NYSE: MOS). By limiting potash production, the group kept prices higher than natural supply and demand would allow.

When Uralkali decided to produce at full capacity in 2013, the publicly-traded companies saw 30% of their market capitalization erased in a single day, as analysts forecasted potash prices might drop by 25% to $300 per ton.

Are Potash Prices About To Raise?
The global price is set by negotiations between producers and China, which accounts for 22% of global demand. At the current price, potash production is only economically viable in a few regions including Canada, Russia and Belarus.

A complete breakdown in potash pricing, as some had feared in 2013, never materialized. Belarus, for example, recently signed a deal to sell potash to China for $315 per ton, 3.2% higher than the $305 per ton price in 2014. The fact that Belarus didn’t concede to a lower price with China is a good sign that there are limits to how low major producers will go.

Another plus for industry supply/demand factors is the industry’s high price of entry. It costs upward of $8.2 billion to build a new potash operation and five-to-seven years to get the product to market, which limits new competition.  

Last year, an Uralkali mine in Siberia flooded, which instantly removed 3% of the world’s potash supply. This event revived speculation that BHP Billliton Ltd (NYSE: BHP) will develop its own mine in Saskatchewan, plans for which were scrapped in June 2014 on market conditions. BHP hasn’t provided an update on development, but production is estimated to be at least four years out.

The threat of future production may be enough to keep potash prices from surging. But the industry’s market leader, which is cutting costs and could increase its cash returned to investors, doesn’t seem to care.

Market Leader Is Increasing Cash Flow
Potash Corp. of Saskatchewan, Inc. (NYSE: POT)
is the world’s largest potash producer with 20% of the market. Size and asset locations make it one of the lowest cost producers at a cash cost of $90 per ton. The company managed to lower costs by $13 a ton over the last two years and is expecting further reductions as new projects come online and capital spending decreases.

By 2017, the company will complete $6.6 billion in expansions, which will increase potential capacity to 17.2 million tons from 10.9 million tons this year. Capital expenditures are forecast to drop more than $300 million by 2017, as production increases by nearly 58% — a recipe for soaring cash flow growth.

Potash Corp. returned $2.17 billion to investors in 2014, with more than $1 billion of that sum used in a stock repurchase program. Free cash flow was $1.16 billion last year and should increase significantly over the next several years.

Just 32% of the capital structure ($3.2 billion) is tied to debt and the company is able to issue 10-year bonds at 2.93%. So its cost of capital is low.

This year, earnings are expected to rise for the first time in three years to around $2 per share. That would represent an 18% gain on 2014 levels.

Shares have traded at an average of 19.8 times trailing earnings over the last five years. Even on a relatively conservative 18 times projected earnings multiple, my price target of $36.72 is 13% higher than the current price. Not to mention, the firm’s attractive 4.6% dividend yield.

Despite tough industry conditions, Potash Corp. is set to see cash flow jump over the next several years. This will support a strong cash return to investors as global demand catches up with supply, which should boost potash prices.

There is little incentive for the major producers to concede to larger price discounts and barriers to entry keep new players out. Eventually, Uralkali may decide it is not worth competing on price and the oligopoly pricing control mechanisms could return and send prices back up quickly.

Risks To Consider: There is still a chance that other companies choose a volume-over-price strategy and potash prices could fall further. Potash Corp. would still do well over the longer-term, but it could be several years before weaker players get shaken out.

Action To Take –> Potash Corp. pays the highest dividend yield in the industry and strong cash flow should support the cash return until longer-term demand picks up and drives price appreciation.

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