Skip to Content
Stock Strategist Industry Reports

Potash Corp.'s Shareholder Returns Should Thrive

We expect potash prices will contract over the long term, but this producer looks undervalued nonetheless.

Mentioned: , ,

We believe potash prices will contract over time as supply grows faster than demand. However, we still think Potash Corporation of Saskatchewan (POT) is an undervalued fertilizer producer, as its low-cost position and resulting wide economic moat should allow it to generate solid shareholder returns over the long run. Potash Corp. currently trades at about a 30% discount to our fair value estimate of $56 per share.

We expect 3% annual growth in potash demand over the long run. However, we think demand year to year will be uneven, affected by inventory levels (at both producers and dealers), crop prices, potash prices, and government subsidies, among other factors. The current environment illustrates the inherent choppiness in the potash market. With high crop prices generating excellent farmer economics, demand at the grower level has been relatively strong for spring planting in North America. However, sales volume at the producer level has been weaker than expected, partly because inventories at the dealer level have swelled in recent months. With dealers striving to avoid price risk and end the spring season with minimal inventories, purchasing at the producer level has slowed. This is just one example of short-term volatility that tends to smooth out over the long term. In the long run, we continue to believe that population growth, declining arable land per person, and rising application rates in developing markets will fuel demand growth.

We expect the strongest demand growth to come from developing regions. Potash Corp. management highlights India as an important growth market, pointing out that the country accounts for more than 20% of the world's projected population growth through 2020. We agree that India is an interesting market, as population growth will put further pressure on the nation's food supply and food prices, which have almost doubled over the past six years. Further, grain, oilseed, and meat consumption per capita in India trails China by a wide margin, leading to a potential increase in food intake as incomes rise. Recently, India has scaled back its potash purchases and the government has adopted a subsidy policy that favors nitrogen over potash. This is not surprising, since India imports the vast majority of its potash but produces more than half of its nitrogen fertilizer needs domestically. From 2010 to 2011, the ratio of nitrogen/potash applied in India rose to about 6/1 from about 4.5/1 (compared with a recent rate in the United States of less than 3/1). Pressure on food prices in India is likely to lead to growth in potash purchases, but the subsidy scheme in India is an important driver of potash demand, and political wrangling increases uncertainty. Further, the Indian government does not have unlimited funds to spend on fertilizer subsidies, and with fiscal problems mounting, government officials will have to make tough decisions about how to allocate revenue. In the end, we think food security (increasing crop yields) will win out over political pressure to prop up the nitrogen industry, but the story could take years to play out.

China is another important growth market for the potash industry. We expect a boost in potash application rates in China to fuel growth, as the country still trails the U.S. by a wide margin in terms of scientifically recommended potash application rates. Similar to India's situation, China's food prices have exploded over the past decade, and with the government facing pressure to feed the growing population, we think potash purchases will increase. We also expect incremental gains in caloric intake to fuel demand for more food (and thus more fertilizer). As the population mix shifts from rural to urban and per capita income rises, we think China will consume more meats, vegetables, and fruits per capita. However, we think the growth rate in calories consumed from protein (for example, meat, eggs, and fish) will slow over the coming years, as the daily caloric intake from protein has grown so fast over the past decade that it now approaches that of Japan and is not far off from that of the U.S. Protein consumption per capita is important because of the multiplier effect of meat production on grain production. For example, it takes 7 kilograms of grain to produce 1 kilogram of beef. For pork and poultry, the multipliers are 4 and 2, respectively.

For the developed and mature U.S. market, Potash Corp. has some interesting data on potash soil levels and crop yields in the major corn- and soybean-producing states. According to the company, which used data from the Department of Agriculture and the International Plant Nutrition Institute, North American potash levels were down about 5 parts per million from 2005 to 2010, with declines of greater than 10 PPM in Iowa, Indiana, and Ohio. We think the bulk of this decline is most likely related to the period around 2009, when many farmers chose to skip potash application in the face of sky-high potash prices. Management implies that the decline in potash levels has led to a decline in corn yields over the past few seasons. In our opinion, weather has probably been much more of a factor in declining U.S. corn yields. However, we agree that farmers have been "mining" the soil more than normal over the past several years, and we could see an uptick in North American demand above the historical trend line. As a result, we may slightly bump up our expectations for North American potash demand growth over the next several years. However, we may have been a bit bullish on China's demand prospects, given limited potential gains in caloric intake, and we may temper our expectations slightly. All together, we expect to keep our annual long-term potash demand growth forecast right around 3%. We think supply growth will outpace demand growth, leading to an easing in potash prices over the coming years.

A Wide-Moat Fertilizer Producer at a Fairly Attractive Price
Potash Corp.'s competitive advantage is driven by an unparalleled portfolio of low-cost, long-life potash mines. We think the firm benefits from operating in a rational oligopoly, where a few large industry players adjust supply to match demand to maintain pricing. Potash Corp.'s margins were generally stable in its potash segment before the boom of 2006. Remarkably, the firm was able to post gross margins above 50% in 2009 even when it was running at half of its capacity. In fiscal 2011, potash gross margins approached 70%. We think the combination of low-cost production and the potash oligopoly (which should keep prices above marginal costs of production) makes for an attractive business model.

Further, large capital expenditures are largely behind Potash Corp., which reduces potential risks associated with these capacity expansion projects. The company embarked on a $7 billion capacity expansion plan in 2009, targeting a 55% increase in production capacity across its potash portfolio. We expect the capital expenditures related to these projects will wind down in 2012, and most of the risks associated with these projects--such as project delays, underground flooding and other geological headaches, cost overruns, and labor and contractor issues--to dissipate. Further, without the $1.5 billion-$2 billion annual cash outflow, we expect the company to have ample liquidity to support dividends and sizable stock repurchases, boosting the appeal of its stock.

The world potash market is operating under a rational oligopoly, which protects all players from disruptive pricing competition. Canpotex--the potash exporter association from Canada--is jointly owned by Potash Corp., Mosaic (MOS), and Agrium (AGU) and headed by Potash Corp. chairman and CEO Bill Doyle. Canpotex negotiates prices with international governments or wholesale buyers, builds and operates rail transportation and port terminals, and sets sales quotas for its three members according to their stated production capacities. We think Potash Corp.'s active role in Canpotex supports its value-before-volume strategy, which in turn reduces the downside risk of the company. However, we caution that new entrants in the market, particularly BHP Billiton BHP, may disrupt this harmony. Nevertheless, BHP's Jansen project will not become fully commissioned for at least another five to seven years, which curbs any material impact on Potash Corp. in the intermediate term.

Our biggest open question at this point of the company's cycle is what Potash Corp. will choose to do with all its cash as its capital expansion program comes to a close. Our 2012 projection for earnings before interest, taxes, depreciation, and amortization of about $5 billion dwarfs the combination of our estimated maintenance capital expenditures (roughly $800 million), dividends (about $250 million-$300 million), and potential share repurchases (another $250 million-$300 million). We expect the gap to widen between cash flow from operations versus uses of cash, but we have yet to hear a concrete plan for reinvestment, significant transformational transactions, or sizable stock repurchase. We note that Potash Corp. has already accumulated 14% ownership of Israel Chemicals, 32% ownership of Sociedad Quimica y Minera de Chile, 26% of Arab Potash, and 22% of Sinofert. These investments carry a book value of less than $2 billion and a market value of 8-10 times book value. The biggest cash outflow, in our opinion, would be if Potash Corp. elects to increase its ownership of some of these minority investments, which would make the producers' ranks even more concentrated.

Morningstar Analysts does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.