Continued from Part 5
Buybacks aren’t always desirable
Does it make sense for companies to initiate buybacks when the company’s share price is expensive? Not really. Suppose a company’s price-to-earnings ratio were 20 times and it had a cash balance that was 30% of market cap. After adjusting for price-to-earnings multiple with the excess cash, we arrive at an adjusted multiple of 14 times. At that rate, any stock investment in the company’s core business would only generate 7.14%—lower than the historic average return of stocks of ~10%. The management would be unlikely to get involved in this practice and would prefer to distribute the excess amount of cash as dividends.
But no buybacks aren’t bad
In some cases, the price-to-earnings ratio is high because investors demand just a low return from the company due to its low risk profile. Potash Corp. (POT), with its high A grade credit rating, is one example. With a current price-to-earnings ratio of 11.9, the return that investors can expect—if earnings stay constant forever—is 8.58%. But this was after Uralkali, a major producer of potash in the world market, announced its decision to end its partnership with Belaruskali in selling potash in the global market, and potash shares fell 20% after. So before the crash, Potash Corp. had a price-to-earnings ratio of ~14.9x—equivalent to an annual return of ~7%.
But a high price-to-earnings ratio isn’t bad as long as the company can maintain its low risk profile. If the incremental return the company can make by deploying additional capital is high, earnings growth will drive share prices higher. This is the case for Potash Corp. (POT), which has preferred expansions, given its low cost mines, rather than purchasing its shares in the market. Its current brownfield projects’ return are expected to be above 20% when potash price is above $300 per metric tonne, largely because several fixed costs such as overheads are already being paid for. Indeed, we see a smaller incentive for Mosaic Co. (MOS) to expand its potash mines immediately given the weak market.
CF Industries also pushing ahead
You can make the same case for CF Industries Holdings Inc. (CF), which boasts a solid 34.79% return on equity (excluding the effect of cash). Late last year, the company announced $3.8 billion dollars worth of expansion plans, which will drive sales volume. Managers also understand not to overextend, or the industry may end up with excess capacity and intensified competition.
As management believes the market is inadequately reflecting the true value of the company, it also announced a $3 billion share buyback program (expiring in 2016). Of the total amount, it has used $1.1 billion up to the first half of this year. With current market cap sitting around $11.1 billion, this means it could repurchase an additional ~17% of existing shares in the stock market, which could increase earnings per share by another 20% until 2016 just because of fewer shares.
Drivers of share prices
While industry fundamentals will likely have a larger impact on share prices at the moment, ongoing delays in new capacity additions and share buyback programs bode positive for the future earnings of fertilizer companies such as Mosaic Co. (MOS) and CF Industries Holdings Inc. (CF). For Potash Corp. (POT) and Agrium Inc. (AGU), the key driver will continue to be industry fundamentals, given the relatively smaller size of their buyback programs. The Market Vectors Agribusiness ETF (MOO), which invests in all four companies mentioned, will reflect these developments.
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