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Why CF Industries is overvalued and won’t be a great investment

Xun Yao Chen

Why I am negative about nitrogenous fertilizers (Part 10 of 11)

(Continued from Part 9)

Enterprise-based valuations above historic average

Based on the next 12 months of EBITDA (earnings before interest, taxes, depreciation, and amortization) estimates and current enterprise value, however, current valuation remains above the five-year historic average of 3.90 for EV (enterprise value)-to-EBITDA and 1.67 for EV-to-sales for CF Industries Holdings Inc. (CF). On September 18, the two valuation multiples stood at 5.37 for EV-to-EBITDA (38% higher than the historic average) and 2.59 for EV-to-sales (55% more than the historic average).

The enterprise-based method: Adjusting for cash

Analysts often use the enterprise method of valuation because it’s a quick method that adjusts the company for debt levels and cash that isn’t used as part of the primary business. It’s based on the assumption that the amount of cash sitting on the companies’ books isn’t used in the business at all. So managers could use it to buy back shares or distribute them as dividends. You can think of this as “free cash.” So what might look like an expensive investment from a price-to-earnings standpoint may not actually be.

The enterprise-based method: Adjusting for debt

The enterprise value ratio also adjusts for the differences in the amount of debt the company is using to run its business. So investors can compare companies in the same industry or similar industries—but with different ratios of debt (borrowed money) and equity (shareholders’ money). Of course, the shares of these companies may not trade based on enterprise value and instead rely on a price-to-earnings multiple due to fundamental reasons that allow the company to hold much more debt or excess cash sitting on the companies’ books. So the cash may not be unlocked—like with several tech companies.

The difference between EV-to-sales and EV-to-EBITDA

While EV-to-sales is currently much higher as a percentage of its average than EV-to-EBITDA is to its average, the difference is driven by a decrease in input cost for CF Industries Holdings Inc. (CF). So although investors may be paying higher for a piece of the company’s revenue, each revenue is generating higher revenue due to falling natural gas costs over the past four years. So you can see that EV-to-sales valuation has been rising over the past few years, whereas EV-to-EBITDA has traded relatively flat.

Possible explanations for why valuation is above its historic average

There are several other reasons why the enterprise value is rising above the historic average. These include a fundamental shift in the company’s business that makes them a much safer investment (a safety premium), possible distribution of dividends or share buybacks (if the company hasn’t been doing that in the past), expansion plans that will generate higher returns for the company, and investors just willing to pay more for the company’s prospects. The first factor is out because the industry hasn’t really changed. In fact, it may be even more risky given low coal prices. The second and third factors are possible explanations.

The current $3.0 billion repurchase program is the largest CF Industries has ever released, but it has repurchased $1.5 billion worth of shares throughout 2011 and 2012. While expansion plans are underway and the company has recently taken on more debt (which doesn’t  reflect in the valuation shown here), new capacity will only come online in 2016—quite far away. So even if coal prices rise, CF Industries Holdings Inc. (CF), like Agrium Inc. (AGU), is likely overvalued and will move sideways inside of 20% higher.

How about Terra Nitrogen Company LP (TNH)?

Continue to Part 11

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