PotashCorp's Wide Moat Intact
The company will benefit as its expanded potash capacity is eventually filled.
We're holding steady on our U.S. dollar-denominated fair value estimate of $41 per share for Potash Corporation of Saskatchewan (POT) following the release of first-quarter results. Our Canadian dollar-denominated fair value estimate falls to CAD 50 per share from CAD 52 on movement in the Canadian/U.S. dollar exchange rate. Our wide economic moat rating based on cost advantage remains intact. We think the shares look undervalued.
Potash volume advanced marginally in the first quarter, up 1.6% from the first quarter of 2014. This was an encouraging result, given weakness in PotashCorp's important North American market caused by a late start to the spring planting season and above-normal offshore imports to the continent.
Over the long run, we expect PotashCorp's volume to increase significantly as the company fills capacity that it has built over the past few years. In the meantime, this extra capacity serves as deterrent to expansion projects from other potential players, most notably BHP Billiton (BHP).
Average realized potash prices were up 13.5% year over year and flat sequentially. We expect potash supply and demand to grow at similar rates over the next several years and we anticipate that potash prices will increase at an average annual rate of 2.25% from 2016 to 2019.
We think the market is missing PotashCorp's long-term production potential and its ability to increase free cash flow as it fills its already-completed expansions. The market seems concerned about the long-term supply/demand outlook for potash, competitive dynamics, and disappointing 2015 China contract prices.
Our long-term view of the potash market gives us confidence that near-term headwinds will fade and strong fundamentals will eventually take hold. Following a temporary step back in demand in 2014, we expect normal growth to return in years to come. Capacity is expected to grow at a faster clip, but we're not expecting much pressure on prices, as current producers add supply judiciously.
Potash Is the Crown Jewel
While PotashCorp has its hands in the production of all three primary crop nutrients, potash remains the jewel of the firm's operations. With a 20% share, PotashCorp is the world's largest producer of potash fertilizer by production capacity. The firm's Canadian mines sit at the low end of the cost curve and should generate profits even if prices drop to marginal costs of production. PotashCorp is wrapping up an $8 billion potash expansion, with operational capacity expected to reach roughly 17 million metric tons by 2018. With a handful of players controlling a large portion of global potash assets, the industry has recently functioned as an oligopoly, with big producers shuttering production temporarily in periods of low demand. The sustainability of pricing power in this oligopoly is somewhat in doubt after Uralkali's plans to produce near capacity and accept lower potash prices. That said, lower near-term prices are likely to lead to indefinite delays for large greenfield potash projects, which should eventually produce a tighter market.
In addition to potash, which accounted for nearly 60% of gross profit in 2014, the company produces nitrogen and phosphate fertilizers. These industries have lower barriers to entry than potash. From a competitive standpoint, we rate the firm's phosphate operations as more attractive than its nitrogen business. PotashCorp owns phosphate rock mines in the United States and benefits from not having to purchase expensive rock from third parties. Nonintegrated producers, which typically buy rock from Morocco, are commonly the marginal producers, and PotashCorp's access to cheaper rock currently places it below the marginal producer on the phosphate cost curve. Nitrogen fertilizer production is essentially natural gas upgrading, so the ability to produce is dictated by access to natural gas. PotashCorp uses long-term contracts to purchase the majority of its gas from Trinidad. With gas prices in North America subdued from the explosion in unconventional extraction techniques, the company's gas currently sits at a cost disadvantage to North American competitors.
Low-Cost Assets Widen the Moat
We think PotashCorp has a wide economic moat thanks to its low-cost potash assets and high barriers to entry created by staggering greenfield capital costs. PotashCorp is on the low end of the potash cost curve, allowing it to pump out profits even if potash prices should approach marginal costs of production in the future. Lower costs stem from the geology of the company's Canadian deposits and the scale of its mines.
Barriers to entry in the potash market are high, in our opinion. Economically viable deposits are found in only a handful of locations around the globe, with Canada, Russia, and Belarus as the main producing regions. PotashCorp's brownfield expansions come at lower capital costs per ton than proposed greenfield projects, most notably BHP Billiton's Jansen project. Additionally, greenfield projects can take more than seven years to complete and fully ramp, creating a barrier to entry for new participants.
PotashCorp will be able to produce potash for many years to come with reserve lives for its mines ranging from 65 to 85 years at current production levels. We expect returns on invested capital of roughly 20% in year five of our forecast, despite pressure on potash prices from growing supply and a potential end to the higher prices previously supported by a rational oligopoly. If we become more confident that the cartel-like nature of the potash oligopoly is truly dead and all competitors in the industry begin to produce at capacity without regard to price, we may reduce our wide moat rating for PotashCorp, as this could mean high-cost producers could be kicked off the cost curve, leading to lower marginal producers setting market-clearing prices. However, we view this scenario as unlikely.
Fertilizer Prices Depend on Crop Prices
Crop prices, which take their cues from demand and weather, can drive fluctuations in fertilizer pricing. Fertilizer prices have varied wildly in the past, and uncertainty of future supply makes it difficult to predict long-term prices. For example, BHP could theoretically break up the potash oligopoly by successfully developing the Jansen project. PotashCorp is exposed to underground mining risks associated with its potash assets in Canada. In addition to mining safety, underground water issues could drive up potash costs. The firm may be subject to lawsuits and regulations related to its phosphate mines. Further, the company has run into antitrust issues in the past, given its strong position in the potash industry, and these concerns could resurface.
Stewardship Is Exemplary
In our opinion, PotashCorp's management deserves credit for focusing on value creation. The company has a reputation for maintaining a disciplined approach to production through periods of low demand, choosing to support prices instead of chasing volume. In our opinion, it's easier for volume to recover than price. Further, we think the company has made smart capital-allocation decisions through the years, choosing to focus on expanding its potash business, which serves as the basis for its wide economic moat. We also applaud management for thus far not jumping on the current nitrogen expansion bandwagon in North America. In our view, North American nitrogen profits are near a cyclical peak, and this could be the wrong time to invest. Given the company's discipline in the past, we expect management will begin returning more cash to shareholders following the current round of potash expansion, instead of chasing growth projects in nitrogen or phosphate.
Jeffrey Stafford does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.