Market Takes a Bite Out of CF for Weak Results

The market punished  CF Industries (CF) for falling short of second-quarter consensus estimates, but we had already expected weak results in 2016. If anything, CF mildly outperformed our already low expectations for the quarter. With our forecast largely intact, we’re maintaining our $28 fair value estimate, no-moat rating, and very high uncertainty rating.

Management signaled that low nitrogen prices are here to stay for the medium term, matching our prior expectations. The nitrogen market is currently plagued by lower coal input costs for marginal producers in China, increased global supply from completed projects, and elevated Chinese exports--all contributing to weaker prices. Higher-cost production is being curtailed in China, but more closures will need to happen for price pressure to abate. We don’t expect much of a price recovery in the medium term, as we expect the marginal cost of production to remain at lower levels as capacity expansions persist through 2017.

Financial results for this nitrogen pure play reflected the difficult market conditions. Adjusted EBITDA was more than cut in half, to $342 million from $708 million in the second quarter of 2015. Results would have been somewhat better if not for a $61 million realized loss on natural gas hedges that pegged the company’s gas costs at $2.85 per million Btu for the quarter versus an average Henry Hub price of only $2.10. Given the company’s current hedge book and our outlook for natural gas pricing, we expect CF’s gas costs will stay near $3.00 through the end of the decade.

Although we don’t expect marked improvement in nitrogen pricing, CF should see its sales rise from the current run rate as production is set to increase roughly 25% in the coming months with expansions completed. Even during a period of lower prices, CF expects to run these new assets near full capacity. With its position on the low end of the global nitrogen cost curve intact, the company is able to pursue such a strategy and hopes to displace imports into North America. Cash margins for North American nitrogen plants are still quite high.

The company announced it would suspend share buybacks during this period of slumping prices to maintain its investment-grade credit rating and have the flexibility to retire maturing debt in 2018.

Substantial Scale in Nitrogen Fertilizers
CF Industries is the largest nitrogen fertilizer producer in North America, with complexes in the United States and Canada. CF’s plants, which benefit from low-cost North American natural gas, are connected to its main customers in the U.S. Corn Belt by an extensive distribution network of rail, barge, and pipelines, giving the company an advantage over foreign competition. Leveraging its scale, CF’s nitrogen sales and profits have benefited immensely from recent high U.S. corn planted acreage. Nitrogen fertilizers are key to achieving higher yields in corn, as the crop, unlike soybeans, does not produce its own nitrogen.

Natural gas is the main feedstock used in nitrogen fertilizer production, with roughly 50% of CF’s cost of sales in its nitrogen business coming from natural gas. Declines in North American gas costs over the past several years have made CF and other North American producers more competitive compared with overseas rivals. Urea prices generally fall in line with marginal cost producers in China using coal as feedstock. Urea imports from China pose a constant threat to prices, and North American supply is set to grow markedly over the next several years with the announcement of multiple nitrogen expansion projects. Both factors are likely to cap price gains. Our long-term price forecast for natural gas is $3 per thousand cubic feet (Henry Hub).

Subject to Price Volatility
We don’t think CF Industries has an economic moat. The company possesses substantial scale in nitrogen fertilizers, but the major factor that determines relative cost advantage in the nitrogen industry is the price a firm pays for natural gas (or coal in many China plants) to produce ammonia and urea. CF and other North American nitrogen producers currently sit toward the low end of the global ammonia cost curve, but we’re not confident that position is sustainable over the next decade. We expect natural gas prices in North America will rise substantially over the next several years and other regions could develop shale gas deposits over the long run, lowering global natural gas prices. Further, a plethora of announced nitrogen projects in North America has the potential to shift the high end of the ammonia cost curve to a lower point. We don’t have enough confidence that CF’s return on invested capital consistently will outpace the firm’s cost of capital over the long run.

CF’s cash flows are based largely on the price of nitrogen fertilizers and the price of natural gas, both of which are subject to volatility. Factors affecting the price of fertilizers include weather and the planting decisions of farmers. Further, CF’s health is linked to the price of corn. Many of the company’s customers in the Midwestern U.S. rotate between corn and soybeans, based on net return, among other factors. Higher soybean prices relative to corn can hurt CF’s cash flows, as soybeans do not require nitrogen fertilizer.