Learning from hedge funds: CF Industries' 70% outperformance (Part 7 of 7)
Asset expansions would increase the amount of products that CF could sell to its customers, which would translate to higher revenue and earnings. If the market hasn’t priced in the impact of expected share repurchases or asset expansions, investors could still benefit.
In 2012, CF Industries announced a plan to increase its capacity at Donaldsonville, Lousiana, and Port Neal, Iowa. These two projects combined are expected to add a total of ~2.1 million tons of ammonia capacity, ~1.8 million tons of UAN, and ~2.6 million tons of urea by 2016. CF Industries had recently said in its earnings call that these projects are expected to increase the company’s production capacity by 25%. Note that the actual amount of increase of ammonia available for sale would be less than the gross ammonia capacity because some of it will be used to produce urea and UAN.
Based on analysts’ consensus, CF Industries’ adjusted net income is expected to increase 18.6% between 2015 and 2016, perhaps already reflecting the expected completion of capital expansion. Ongoing share repurchases are expected to take the share count to 48 million for 2016. Given CF Industries’ free cash flow of above 1 billion, the company could potentially buyback ~3 million shares every year at stock price of ~$300 a share.
Enough cash to spend
Does CF Industries have that much cash to spend? At the end of 2013, the company had made $0.7 billion of capital expenditures related to its $3.8 billion capacity expansion projects. In 2014, it’s expected to spend ~$2.0 billion on these projects. At the end of December 31, 2013, CF Industries had $1.7 billion in cash. If all of that were used to repurchase shares, the company would have to find ~$2.0 billion. With low leverage ratio, CF Industries expects itself to raise a debt worth $1.5 billion this year. With free cash flow of $1.0 billion plus coming in every year, it shouldn’t have a problem funding these capacity expansions and repurchases.
A growth stock
CF Industries is fairly priced at the moment. But based on estimated earnings of $27.04 a share in 2016, and forward PE of 13x, CF could trade at $350 by the end of 2015, representing a compounded annual return of 17.3% over the next two years. Throughout 2014, shares might only increase 10% based on estimated earnings of $21.50 a share in 2015, but if the market is much more forward looking, CF could hit $350 earlier. Investors should know there are risks. If earnings consensus is too optimistic when 2014 to 2015 comes around, or industry fundamentals deteriorate significantly from 2013, CF’s return to risk profile wouldn’t be as attractive (see Investors’ guide to nitrogen fertilizer companies in 2014).
Stocks that are undervalued can be great value opportunities, but do keep industry fundamentals in mind. CF Industries’ 2013 returns would have been greater if the sector hadn’t perform poorly last year, sending Terra Nitrogen Company, L.P. and CVR Partners, LP down. If CF Industries wasn’t that undervalued, the sector’s negatives could have outweighed the company’s valuation positives. Hedge fund holdings are a great starting point for screening investments, but investors should scrutinize them properly.
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