CF Industries (CF): A Fertilizer “Stock To Watch”

CF Industries is the largest and the most flexible producer of nitrogen fertilizers in North America. Nitrogen is the most important nutrient in support of crop yields, and CF’s main market, the United States, remains structurally short. As a result, the domestic prices of nitrogen remain high and the country also continues to attract a large amount of imports.

Corn, the world’s largest cash crop, has significant fertilizer requirements with a particular reliance on nitrogen. Although the crops prices have rebounded from last year’s drought and have come down notably since then, economics still favor crop planting and it is believed that the upcoming spring season should see a steady demand.

Low-Cost Producer

As a North American producer CF has another advantage, the company benefits from a long-term trend of low North American energy costs. Natural gas is the main raw material in nitrogen production and there is an ample supply of it in North America. The low energy costs benefit CF as a low-cost producer in a price-advantaged market. This advantaged situation results in highly attractive margins for the company. Moreover, the margins have remained robust even in a down cycle.

Capital Return and Expansion Plans

Going forward, the company’s ability to conduct substantial capital returns and execute on its expansion plans should also attract investors’ attention. CF has continued its buyback program in the 4Q13 and has bought back 665,000 shares for $114.2 million so far. The company is still left with $1.7 billion in its current buyback program. CF anticipates that it could finish its $3.0 billion buyback program by early 2015, which is earlier than market expectations. At the same time the company is also executing on its capacity expansion plans. After the company executes on both the buyback program and volumes expansion, its free cash flow profile should improve substantially.

CF’s expansion projects are moving forward on schedule and on budget. In the longer-term, the company through its $3.8 billion nitrogen capacity expansion should be able to further leverage its cost advantage. It is important to note here that other producers have also sought to build new facilities but are faced with cost and permitting challenges. However, the Deerfield, Illinois based company remains committed to complete these projects, which has helped to crowd out other producers. The more important thing to note here is that even after funding its expansion projects and completing the current share repurchase program, the company believes it is likely to have the financial flexibility to return even more capital to shareholders.

Optimizing Capital Structure

CF disclosed in a recently filed 8-K document that it may return more cash to shareholders and is examining a more lightly taxed financial structure. The company is planning to issue $1.5 billion in new long-term debt next year. Moreover, in comparison to the previous target of 1.0-1.5 times, the company is now targeting 2.0-2.5 times debt-to-EBITDA leverage ratio as an optimal balance over the cycle. Along with other financing options, CF is also in discussions to evaluate MLP and MLP-like structures.

CF’s move to more transparently optimize its capital structure is positive and should be received favorably by the market. Following the new activist investor Dan Loeb’s Third Point LLC hedge fund investment, the company has taken a number of investor friendly decisions. It recently increased its dividend by 150% and optimized its portfolio by selling its phosphate business to Mosaic (MOS). CF also witnessed a change at the top management recently and there is a visible change in the company’s communication with investors, implying greater flexibility on methods of capital returns. The market next expects the company to deliver on its intentions to create value for shareholders via greater repurchase, higher dividends, and/or creation of an MLP and CF promises to deliver on all fronts.

CF is also trading at very attractive valuations and at a discount compared to its industry peers. It has a price/earnings ratio of 8.8, lower than the industry average of 14.1 and CF’s own 5 year average of 11.1. The company has a forward P/E of 8.3. CF has a price/book ratio of 2.6 vs. the industry average of 2.9. It has a price/sales ratio of 2.5, slightly above the industry average of 2.4.

Going forward, I expect as CF demonstrates earnings stability through the cycle, investors will be willing to support a valuation for the stock more in line with the rest of the industry.

Conclusion

I think CF is a stock to watch for in the agriculture sector and will likely outperform in 2014. The company is an advantaged nitrogen producer. It not only benefits from strong fertilizer demand in the domestic market but is also a beneficiary of a long-term trend for low North American energy costs. CF’s recent capital allocation actions, including its sale of phosphate business to MOS, are evidence that the company is positioning itself as a pure play nitrogen producer, which should help the company attract more of a traditional long-term shareholder base.

CF’s capital structure transformation is also taking shape. Although the MLP process is still in the early stages and the company has given no timeline as to when and which assets would be part of an MLP, the important thing is the company no longer regards these actions as too complex or difficult to execute as has been the case in the past.

The company continues to actively engage shareholders and explore all options of value creation and its commitment to more transparently optimize its capital structure should reduce its historical share price volatility and improve its valuation. Potential MLP and/or other alternative financing structures introduce further upside potential. CF’s increased capital allocation visibility, more simplistic business model, and improved yield should also attract incremental shareholders over time.

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