The end of July will mark a bitter anniversary for investors. As the scars of most fertilizer stock charts still clearly show, it will soon be five years since the Belarusian Potash Company abruptly dissolved into a shell of its former self. It was responsible for nearly 70% of global potash sales, which gave it incredible pricing power over the market. Its collapse gave buyers the upper hand in setting potash prices -- and they were quick to exact revenge.
Prices today are almost half of what they were in 2013. The end of the Belarusian Potash Company as the market knew it hasn't been the only factor contributing to sour market conditions, but it served as a crucial tipping point. It exposed a huge oversupply of potash from years of unchecked mining investments, while manufacturers of the other two leading agricultural nutrients (nitrogen and phosphate) were engaged in the same tactics. Throw in the rise of China's domestic producers and the slowdown of global agricultural markets, and it's no wonder fertilizer stocks have incinerated shareholder value in recent years.
But there are signs fertilizer markets are finally inching toward balance. Nutrien (NYSE: NTR) and Mosaic (NYSE: MOS) both raised their full-year 2018 adjusted EPS guidance after announcing first-quarter operating results. Meanwhile, CF Industries' (NYSE: CF) gross profit increased 77% in the first quarter of 2018 from the prior-year period despite an 8% drop in revenue. Should investors begin looking around the industry for investment opportunities, or is more pain on the way?
Image source: Getty Images.
Returning to growth?
As alluded to above, a complex mix of factors affect fertilizer prices. Energy prices, trade flows, and the size of agricultural harvests on multiple continents all play a role. However, they can all be put into the same black box labelled "supply and demand". In the simplest terms, a more balanced market will give suppliers more power in setting prices than they've had in recent years. Achieving balance depends primarily on demand growth, and some companies are choosing to read the tea leaves in their favor.
Nutrien sees delayed planting in North America caused by a lingering winter as a potential boon for crop prices. That, combined with smaller harvests in North and South America, could lift farmer incomes and support higher fertilizer selling prices, especially if markets plan ahead for healthier harvests next year to make up for shortages in 2018.
The Canadian fertilizer giant sees healthy fundamentals for potash through the remainder of 2018 thanks to strong demand in key markets (China, India, and Brazil) and slowing supply growth. That's good news considering potash sales provided 33% of Nutrien's adjusted EBITDA in 2017. The bad news: The outlook for nitrogen is a little hazier, with general expectations of continued sideways movements in prices. Nitrogen accounted for 25% of adjusted EBITDA last year.
Nonetheless, Nutrien's strong start post-merger and increased focus on its retail segment, which provided 35% of adjusted EBITDA in 2017, allowed it to increase full-year 2018 financial guidance. Peer Mosaic, which is the other member of the Canadian fertilizer cartel Canpotex, followed suit by lifting the lower end of adjusted EPS expectations 20%.
New Full-Year 2018 Guidance, Adjusted EPS
Prior Full-Year 2018 Guidance, Adjusted EPS
$2.20 to $2.60
$2.10 to $2.60
$1.20 to $1.60
$1.00 to $1.50
Data source: First-quarter 2018 press releases.
CF Industries hasn't provided guidance for 2018, but expects to exit the year on solid footing. The $10.5 billion fertilizer supplier turned in a great first-quarter of 2018 as selling prices were up for two of its three nitrogen products compared to the year-ago period, aided further by lower natural gas costs. It generated $101 million in cash from operations during the period despite delayed planting in North America. Plus, it acquired all outstanding units of Terra Nitrogen that it didn't own, cementing its fertilizer prowess and adding an immediate boost to earnings.
On one hand, these are relatively bullish outlooks, both for the broader market and the individual businesses. That provides room for an argument that fertilizer stocks could be poised for a long-awaited rebound -- and a possible return to leading dividend stocks.
On the other hand, fertilizer selling prices are increasing at a snail's pace, and achieving a sustainable market balance is far from certain. That's especially true considering farmer incomes in the United States are expected to be 35% lower in 2018 than in 2013. That will severely limit upward momentum in fertilizer prices for at least one more harvest.
That's enough for investors to tread carefully with fertilizer stocks, but there's another important consideration: debt.
Image source: Getty Images.
Work left to do
Nutrien, Mosaic, and CF Industries all have plans to keep reducing debt, but some efforts are more serious than others -- and the success of all three hinges on higher selling prices.
Consider that all three major producers have historically high leverage ratios (debt to EBITDA). While some of that is due to a lingering bear market for fertilizer selling prices (resulting in lower EBITDA), the businesses aren't well-positioned to endure sour market conditions for much longer, as creditors and credit rating agencies want to see leverage ratios that are less than half of current levels.
Nutrien expects to sell all of its equity stake in Sociedad Quimica y Minera de Chile (SQM) for net proceeds of $4 billion to $5 billion. That will take a serious bite out of the balance sheet's $8 billion in long-term debt, making the company's 3% dividend yield more sustainable and better positioning Nutrien to capitalize on an improving market.
For its part, Mosaic plans to reduce its long-term debt by $500 million this year, and it has already made $300 million in payments. However, it had $5.1 billion in debt at the end of the first quarter. Seeing as it already pays one of the weakest dividends in the industry, with a yield of just 0.3%, investors shouldn't expect it to catch up to peers any time soon.
CF Industries has about as much long-term debt ($4.6 billion) as Mosaic, and its dividend is about the same (yielding 2.6%) as Nutrien's. What should investors make of that? Well, it reduced its long-term debt by over $1 billion in 2017 compared to the prior year, and the all-cash acquisition of Terra Nitrogen will provide an extra $40 million in annual net income, good for an 11% boost. But that may only be enough to maintain the balance sheet's status quo in the near term.
Image source: Getty Images.
Investors should be picky if they move in the industry
Fertilizer stocks have headed higher in 2018 on the belief that the market is improving. While that's a generally accurate view, investors who dig into the details will see that the improvements are relatively small. Then again, given nearly five years of misery, even a small sign of life is welcome news.
That said, it still might be a little too early for investors to jump into the fertilizer industry without being selective. Aside from Nutrien's ability to sell its stake in SQM, major fertilizer producers have limited options at their disposal to improve their balance sheets outside of significantly higher selling prices. That could limit the ability of Mosaic and CF Industries to increase their dividends for the foreseeable future, especially considering they'll need to prioritize cleaning up their balance sheets.
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