Investors in fertilizer stocks face a long winter

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Earlier this year, investors saw the four major North American fertilizer producers as being all but assured of long-term success, based on the growing global need for food. The sluggish demand for crop nutrients and the lack of pricing power that fertilizer companies were then experiencing was supposed to be just a near-term weakness.

As 2013 nears its close, it seems the near-term weakness is going to last a lot longer than first thought.

The bleak outlook was underscored this week as Potash Corp. of Saskatchewan Inc. reported a sharp drop in profits and a reduction in its 2013 earnings guidance. All the other major fertilizer firms had already issued warnings, and Potash Corp. had previously reduced its third-quarter guidance, but the new full-year outlook was below analysts' already underwhelming expectations.

Shares of the producers immediately fell. Many in the analyst community, failing to find signs the stocks can gain meaningfully in the next 12 months, have rated the shares "hold" – or even "sell."

That means investors interested in using the fertilizer stocks to play the global agriculture boom may have a long, hard slog ahead of them.

"If I have my fundamentals hat on, it's brutal, and will be for a couple of quarters," says analyst Spencer Churchill of Paradigm Capital, referring to Potash Corp., on which he has a "buy" recommendation and target price of $38 (U.S.) "But if I've got my sentiment, stock-price hat, if you're more of a longer-term investor, you're not going to get hurt buying this in the low $30s. I think the lows for all the stocks were put in in early August. The only question is how long it's going to take for us to recover."

Among the various crop nutrients, it's potash – and its primary producers, Potash Corp. and Mosaic Co. – that have suffered most. The deceleration of the Chinese economy, a driving force behind potash demand, had already helped cut potash prices by a third or more by early this year. This was a trough, many felt.

Then Russia-based OAO Uralkali said it would pull out of one of the world's two major marketing co-operatives that had helped control the supply – and prices – of the mineral. The situation quickly became, in the words of Mr. Churchill, a "soap opera," with the Uralkali CEO detained in Belarus and charged with abuse of office.

While some think the matter will be settled and the world's duopoly will return, many are now assuming potash prices closer to $300 per ton, versus the $400 to $500 levels of 2012. And those folks disagree with Mr. Churchill's view that investors won't get hurt buying Potash Corp. shares in the low $30s.

Analyst Peter Prattas of Cantor Fitzgerald downgraded Potash Corp. stock in September when the shares topped $33, a gain of more than 16 per cent from the early August lows on the Uralkali news. He predicted potash prices would continue to "spiral downward," and only raised his recommendation to "hold" this week when the shares fell below $31, his target price.

Some market math suggests the stock may have further to slide, despite its lush 4.5 per cent yield. Robert Winslow of National Bank Financial notes that Potash Corp. traded as low as 9.1 times its forward earnings estimates in late 2011. While he maintains a target price of $32.50, he observes that applying a multiple of 10 to the company's projected 2014 earnings would yield a share price of just $24.

Sentiment is slightly more favourable toward Mosaic, created nearly a decade ago in part from the fertilizer business of agriculture giant Cargill. That's not because of the company's performance outlook, however; a Cargill family trust that maintains significant Mosaic ownership has so far blocked the company from doing significant share repurchases. That restriction ends Nov. 26.

Analyst Joel Jackson of BMO Nesbitt Burns, who has a "neutral" rating and target price of $42, below current levels near $46, believes the company will buy back $3.2-billion of stock between December and the end of 2014 with $1.5-billion of that in December.

Unlike its peers, CF Industries Holdings Inc. has emerged as a surprise winner. It specializes in nitrogen fertilizer, for which natural gas is a key element of production. Not so long ago, the conventional wisdom was that the ultra-low natural gas prices that fattened nitrogen profit margins to all-time highs couldn't last.

The spike in gas prices, much like the spike in interest rates many expected, has not arrived. So the company posted a gross profit margin of nearly 50 per cent in the last 12 months, according to Standard & Poor's Capital IQ, and the shares are actually up since Aug. 1, unlike the other three players.

Still, the pessimism continues: The weakness in nitrogen pricing, coupled with the belief that gas prices can still rise, makes CF Industries one of the cheapest stocks in the Standard & Poor's 500.

It is Agrium Inc. that is in the most interesting position. A year ago, the company was at the height of its battle with an activist investor, Jana Partners, that insisted the company should split its wholesale fertilizer business from its chain of retail stores that serve farmers, given the different valuations investors place on the two businesses.

Jana has since retreated, and the market action in the last six months can be used to argue either side of its position: Agrium shares haven't fallen as much as Potash Corp.'s or Mosaic's, but they've fallen further than if the company simply had a retail division with no wholesale business.

That retail chain, now the largest agricultural retailer in North America after the acquisition of the stores once operated by Saskatchewan's Viterra Inc., is what prompts more positive sentiment from analysts than for any other name in the fertilizer space.

"In our view the current share price reflects a lack of confidence in Agrium's ability to achieve its longer term targets, particularly in the retail segment," says Credit Suisse analyst Christopher Parkinson, who has a $110 target price, above recent trades in the mid-$80s. "The Agrium thesis has certainly become a 'show me' story, but we also believe that these opportunities in the retail segment remain significantly underappreciated. We concede the retail thesis will likely take time to be fully visible, but is worth the wait."

"Worth the wait." It's a phrase growing familiar to investors in any of the fertilizer companies.

Disclosure: The author owns shares in Mosaic and Potash Corp.