Post on 08-May-2015
description
Prepared By Matthew W. Scullen
11
Terra Nitrogen
Company, L.P. Analysis of Business, Competition, Demand,
Supply, Cost, Risk and Stock Valuation
CONTENTS
Terra Nitrogen Company, LP TNH [NYSE] ..................................................................................................................... 3
Summary Recommendation: .................................................................................................................................................... 3
Business Description: .................................................................................................................................................................. 3
Thesis Summary ............................................................................................................................................................................. 4
Competition: .................................................................................................................................................................................... 5
Industry Demand: ....................................................................................................................................................................... 10
Industry Supply: ........................................................................................................................................................................... 15
Costs: ................................................................................................................................................................................................. 17
Principal Risks: ............................................................................................................................................................................. 19
Pro-Forma Cash Flows: ............................................................................................................................................................. 23
Valuation ......................................................................................................................................................................................... 24
Risk Adjusted Margin of Safety.............................................................................................................................................. 24
Conclusion ...................................................................................................................................................................................... 25
References ...................................................................................................................................................................................... 26
TERRA NITROGEN COMPANY, LP TNH [NYSE]
SUMMARY RECOMMENDATION:
Through at least 2014, the agriculture chemicals industry outlook is very
attractive due to a number of factors discussed below in the thesis
summary. Despite the positive outlook for the industry and Terra Nitrogen,
the stock is currently overvalued as compared to the estimated fair value.
Regardless of the lofty valuation, the outlook through the 2011 third
quarter is positive due to aggressive targets for corn production. I
recommend holding Terra Nitrogen at least through the third quarter.
Investors holding the stock are expected to be well compensated through
an approximate 8% dividend yield. Terra Nitrogen's MLP status means they
have a residual payout policy with a rich history of paying dividends.
BUSINESS DESCRIPTION i:
Terra Nitrogen Company, LP produces and distributes nitrogen (N) fertilizer products essential for
boosting key crop yields. The primary products are anhydrous ammonia (ammonia) and urea
ammonium nitrate solutions (UAN). Ammonia, UAN and other N fertilizers are mostly applied to
corn, wheat, cotton, rice and sugar cane in the North American region. Corn is the main crop focus of
Terra Nitrogen. Growth is therefore dependent on global demand for these crops. Due to N
absorption by crops and nitrogen evaporating or leaching, it must be reapplied every year to keep
crop yield and quality high. This typically results in steady demand for nitrogen fertilizer on a year-
to-year basis. The application is seasonal, where spring and fall traditionally have higher demand
because of planting and harvesting. Weather patterns can alter this trend if farmers decide to delay
planting or harvesting in anticipation of better conditions.
The company is a wholly owned subsidiary of Terra Industries, Inc., which is a wholly owned
subsidiary of CF Industries, Inc.
The manufacturing facility is located in Verdigris, Oklahoma where it is the second largest UAN
production facility in North America. It has two ammonia plants, two nitric acid plants, two UAN
plants, all owned by the partnership and a leased port terminal. The facility is designed to operate
continuously. The location is strategically located to serve the Corn Belt region. Capacity at the plants
is reflected below in Table 1:
Price data as of:
7/6/11
Prepared by:
Matthew Scullen
Analyst does not own a
position in TNH while
initiating coverage
Style: Small Cap Market Cap: $2.01B Buy Price: $65.48 Industry: Agricultural Chemicals Last Price: $139.66 Recommendation: Hold Type: Cyclical Fair Value: $95.59 short-term
Table 1
Product Annual Capacity (tons) % of Total N. American Capacity
Ammonia 1,100,000 7%
UAN (32% N Content) 2,000,000 14%
Approximately 70% of the ammonia produced is used for upgrading to UAN.
Products are sold to dealers, national farm retail chains, distributors and other fertilizer producers
and users. Sales our exclusively wholesale, but ultimately the end-users are farmers. 26% of sales in
2010 were concentrated with 5 customers and 1 customer accounted for 9% of total sales. CF
Industries, effective 1/1/2011, is now the only customer of Terra Nitrogen Company.
Natural gas is the raw material used to produce N fertilizers. In 2010 it accounted for 50% of the
companies’ cost of goods sold. Natural gas prices therefore have a significant effect on gross margins.
The facility is served by the OneOK gas pipeline, which Terra Nitrogen states gives a basis advantage
as compared to Henry Hub.
Recent Developments
CF Industries acquired Terra Industries during the first quarter of 2010. Previously, Terra Nitrogen
Company was an indirect wholly owned subsidiary of Terra Industries. Subsequent to the
acquisition, CF Industries through their holding company took all of the rights and obligations from
Terra Industries to conduct the operations of the limited partnership for Terra Nitrogen. As a result,
Terra Nitrogen’s product is now sold exclusively to CF Industries.
Another consequence of the acquisition was its affect on Terra Nitrogen’s credit facilities. The event
triggered a “technical default” and terminated the $50 million credit facility in place. Fortunately,
Terra Nitrogen has adequate cash flows and cash deposits and had no outstanding credit used from
the facility; the “default” was non-material to the operations of the company.
THESIS SUMMARY
The growing global middle class is
experiencing diet shifts to meats,
fruits and vegetables. Feeding
livestock requires abundant sources
of feed, which require more fertilizer.
Consumption is outpacing production
and historically low stock to use
ratios are sending agriculture prices
higher
Fertilizers are the most efficient way
to boost crop yields
N fertilizer application is essential to
high crop yields
Domestically, anti-dumping policy,
lower natural gas prices and a lower
trending dollar protects against low
cost importers
The global financial crisis reduced
global production and curtailed
expansion plans, but not population
growth
Ethanol mandates require large corn
acreage devotion, which requires
nitrogen fertilizer
COMPETITION:
The competitive landscape for N fertilizer products is based from “price, supply, delivery time and
quality of service”ii. Competition comes from both domestic and foreign N producers. Competition is
subsequently analyzed from the perspective of Porter’s Five Forces:
Threat of entry
The fertilizer industry is fairly mature with many large established firms. Many of these
producers already have large capital investments in PP&E, long established relationships
with buyers and suppliers, in some instances well-known brand names and strategic
locations centralized in the Great Plains region. Facilities located in the corn-belt region
where known supply chains lead to production efficiencies and centralized product
distribution advantages to customers create barriers to new entrants. Extrapolating from
Terra Nitrogen's 2010 PP&E and inventory balance along with total North American
Capacity, an estimate can be made for the cost of start up, excluding labor costs. Table 2
represents a hypothetical entrant firm, Firm ABC, which represents a 1.5% market share.
Table 2iii
The considerable start up cost and time to bring a new facility on line suggest new
entrants are unlikely. Persistently high ammonia, urea and UAN prices could theoretically
lead to new entrants as profits are typically higher than normal, especially in conjunction
with low natural gas prices as is the state currently.
Most likely, additional capacity would come from existing competition expanding their
production capabilities. The cost represents little extra above existing capex.
Competition from foreign exporters can be a significant source of new competitors. Many
of these foreign exporters have subsidized natural gas costs, which can make them more
competitive in price. This is especially true when the dollar has been strengthening and
imports of fertilizer become relatively more attractive. A weaker dollar leads to the
opposite conclusion, where imports become relatively less attractive. Foreign exporters
also gain advantage when domestic prices of natural gas become relatively high due to
their gas subsidy advantages.
TNH Firm ABC*
Gross PPE (in 000's) 273,600 4,350
Inventory, net (in 000's) 27,600 431
Total Investment 4,782
Domestic Firm ABC*
Total Capacity (000 metric tonnes) 13,396 209
*Firm ABC represents 1.5% domestic market share
Power of suppliers
Specifically for Terra Nitrogen, they receive natural gas materials through the OneOK
pipeline. While this pipeline is strategically located for abundant access, any disruptions or
disagreements with suppliers could adversely affect production at the Vertigris facility.
That being said, natural gas is a widely used, exchange-traded commodity. Its pricing is not
controlled by suppliers in a material way. Terra Nitrogen does not rely on any single
natural gas supplier and therefore the power of suppliers is not a significant factor.
Power of buyers
Farmers’ ultimately account for the majority of end users in N fertilizers. Due to the
intensive needs of crops like corn and wheat, N fertilizer application is required annually
from crops draining the soil of its natural N content. Therefore, buyers are limited in their
power in that they must apply N to their soil at least annually and only have control over
the timing of the application. In the case of Terra Nitrogen, a single customer accounted
for 9% of their sales with 26% concentrated in the hands of 5 customers during 2010.
Having a concentration of buyers in theory could limit the ability of Terra Nitrogen to pass
along increasing costs and allow buyers to control terms by threatening to switch business
to other suppliers. In reality, ammonia, UAN and urea are all commodity products with
widely quoted prices. As a result, switching would most likely be triggered by untimely
delivery and poor service.
Threat of substitutesiv
There are several types of nitrogen fertilizers with distinct properties, advantages and
disadvantages available. Soil type, product price, application process, safety, storage,
transportation ease/cost and weather conditions all impact the source of nitrogen farmers
decide to use. There is not significant differentiation among crop yields between nitrogen
sources if applied correctly. Depending on the relevancy of these factors, buyers can easily
substitute products. The most widely used types are described below.
Anhydrous Ammonia AA (82% N): Must be injected into the soil. Of all of the forms
of nitrogen fertilizer, AA has the slowest nitrate conversion rate. Most AA is
upgraded to urea or solutions.
Benefits: No loss due to surface volatilization, low chance of leaching or
denitrification. (defined below)
Disadvantage: It is hazardous to handle, must be injected into the soil and
erosion can occur on steep slopes.
Urea (45-46% N): Has a relatively quick nitrate conversion, usually in less than two-
weeks. It is available in prills or a granulated form. Best applied in spring when
temperatures are cool.
Benefits: Effective when applied correctly, is not hazardous, can be safely
stored and cheaply transported.
Disadvantages: Denitrification on wet or compacted soil, leaching in coarse
soils, volatilization risk if surface applied.
Urea Ammonium Nitrate Solutions UAN (28-32% N): a water solution of both
urea and AN.
Benefits: Ease of application, handling and storage. Can be applied through
sprinkler irrigation systems. Has both a fast acting component and slow
acting component of N. Not hazardous.
Disadvantages: Subject to the same N losses as urea (application through
dribbling can make volatilization risk minimal), is more costly to transport
than urea.
Ammonium Sulfate AS (21% N): All of the N is in ammonia form.
Benefits: Suited best for high PH soils and where low sulfur content is
suspected. Generally not subject to high volatilization loss.
Disadvantages: Most acidic of nitrogen fertilizers, requiring more limestone
to neutralize it. Higher cost.
Ammonium Nitrate AN (34% N): 50% ammonium, 50% nitrate. The ammonium
quickly converts to nitrate when added to the soil.
Benefits: Has no urea, therefore ideal for conditions where volatilization is
expected.
Disadvantages: It is potentially hazardous and is subject to leaching and
dentrification immediately.
Definitions:
Denitrification: results in nitrogen escaping the soil as N gas due to a deficit of
oxygen in the soil. Wet soils, compact soils and warm temperatures promote this
condition.
Leaching: when more water (rain) enters the soil than it can hold and the N moves
through the soil with it. Coarse soils (sands) pose the most risk. This risk can be
minimized by limiting the time N is in the soil before plant uptake.
Surface Volatilization: occurs in urea forms of N where it breaks down into ammonia
gas and escapes the soil because there is not enough water to absorb it. This most
often occurs when the urea is spread so there is no direct contact with the soil or
when spread on corn residue. Volatilization loss results from warm temperatures,
high moisture content, and high surface ph of the soil.
Rivalry among existing firmsv
North American production of N fertilizer is dominated by a few firms. AA was chosen as
the product to analyze from because it is generally widely produced and upgraded and
therefore more comparable. To properly analyze the competition, two separate landscapes
of domestic producers are presented; one with Terra Nitrogen as a separate distinct firm
(Table 3) and one as a consolidated subsidiary of CF Industries (Table 4). The reason is
that technically Terra Nitrogen and CF Industries are competitors. Since the acquisition of
Terra Industries, CF industries has control over the operations of Terra Nitrogen and is
now the sole customer. This relationship more closely resembles co-opetition in which
firms work together and share market.
Table 3
Table 4
The glaring reality from observing these charts is that CF Industries is a clear market
leader in AA production and a dominant leader in UAN production. In either case, the
Herfindahl-Hirschman Index (HH Index) indicates competition that more resembles a
monopoly than perfect competition. What isn't perfectly known is how many other firms
represent the "Other" portion of gross capacity. If more than 14 firms are represented than
more competition will be present. Of course, imports represent a significant portion of
competition and the market structure cannot be analyzed without it. Table 5 shows the
trend in imports of Nitrogen fertilizer. Canada is excluded because it is already reflected in
Tables 3 & 4.
2010 N. American Annual Capacity
Company Capacity
% Share
of Total HH Index
# of Firms
w/ Even % UAN** UAN % HH Index
# of Firms
w/ Even %
CF Industries 5,461 41% 1,662 2 4,520 33% 1,101 3
Koch 2,076 15% 240 6 1,700 12% 156 8
Agrium 2,403 18% 322 6 1,200 9% 78 11
Terra Nitrogen 980 7% 54 14 1,965 14% 208 7
Potash Corp 1,067 8% 63 13 2,000 15% 216 7
CVR Partners (est.) 447 3% 11 30 739 5% 29 18
Other (est.) 962 7% 52 14 1,500 11% 121 9
Total Production* 13,396 2,403 85 13,624 1,908 64
*Data from Agrium 2010-2011 Agrium Fact Book
**Data from CF Industries Scotia Capital Global Fertil izer Conference 2011
(000's short tons)(‘000 metric nutrient tons per year)
Anhydrous Ammonia, Gross UAN Nitrogen Solutions
2010 N. American Annual Capacity
Company Capacity
% Share
of Total HH Index
# of Firms
w/ Even % UAN** UAN % HH Index
# of Firms
w/ Even %
CF Industries 6,441 48% 2,312 2 6,485 48% 2,266 2
Koch 2,076 15% 240 6 1,700 12% 156 8
Agrium 2,403 18% 322 6 1,200 9% 78 11
Potash Corp 1,067 8% 63 13 2,000 15% 216 7
CVR Partners (est.) 447 3% 11 30 739 5% 29 18
Other (est.) 962 7% 52 14 1,500 11% 121 9
Total Production* 13,396 3,000 71 13,624 2,865 56
*Data from Agrium 2010-2011 Agrium Fact Book
**Data from CF Industries Scotia Capital Global Fertil izer Conference 2011
(‘000 metric nutrient tons per year) (000's short tons)
Anhydrous Ammonia, Gross UAN Nitrogen Solutions
Table 5vi
There is a trend of decreasing imports, except during 2009 when the global financial crisis
dislocated markets. This is most likely due to a weak trending dollar and domestic capacity
beginning to expand as well as foreign natural gas costs exceeding domestic. Table 6 adds
imports to the North American Capacity picture.
Table 6
Market share among the domestic producers is noticeably reduced where imports are
added to the picture. Unfortunately, the HH Index for this table provides very little
information because there is no indication as to the number of importers, but a realistic
assumption is that the number is not concentrated. Still, CF Industries (including Terra
Nitrogen) has a dominant market share for N Solutions products.
Imports (Metric Tonnes), excl. Canada 2010 2009 2008 2007
Anhydrous Ammonia 5,730 4,683 6,409 7,019
Urea 4,640 3,067 3,976 4,843
UAN 2,069 779 1,954 2,415
Source: USDA/ERS, see website www.ers.usda.gov/data/fertil izertrade/ for more information.
2010 N. American Annual Capacity
Company Capacity
% Share
of Total HH Index
# of Firms
w/ Even % UAN** UAN % HH Index
# of Firms
w/ Even %
CF Industries 6,441 34% 1,134 3 6,485 41% 1,662 2
Koch 2,076 11% 118 9 1,700 11% 114 9
Agrium 2,403 13% 158 8 1,200 8% 57 13
Potash Corp 1,067 6% 31 18 2,000 13% 158 8
CVR Partners (est.) 447 2% 5 43 739 5% 22 22
Other (est.) 962 5% 25 20 1,500 9% 89 11
U.S. Imports*** 5,730 30% 898 3 2,281 14% 206 7
Total Production* 19,126 2,369 104 15,905 2,308 72
*Data from Agrium 2010-2011 Agrium Fact Book
**Data from CF Industries Scotia Capital Global Fertil izer Conference 2011
***Source: USDA/ERS, see website www.ers.usda.gov/data/fertil izertrade/ for more information.
Anhydrous Ammonia, Gross UAN Nitrogen Solutions
(‘000 metric nutrient tons per year) (000's short tons)
INDUSTRY DEMAND:
Terra Nitrogen identifies several factors that contribute to global demand for fertilizers.
Long-term drivers
population growth
rising use of bio-fuels
increases in disposable income
improvements in diet
Short-term drivers
world growth rates
weather patterns
stocks to use ratios
agriculture commodity prices
energy prices
crop mix
fertilizer application rates
farm income
trade policy
Demand for N is expected to grow modestly through 2014 at a CAGR of 1.01% in North America.
Figure 1vii
Positive outlook for bio-fuels and corn acreage
Corn represents approximately 46% of fertilizer demand in North Americaviii. A newer
source of demand for corn through the emergence of ethanol as an alternative energy is
driving marginal demand for fertilizer through increased acreage of corn.
The Energy Independence and Security Act (EISA) of 2007 includes provisions for a
Renewable Fuel Standard (RFS) to increase the supply of alternative fuel sources by
requiring fuel producers to use at least 36 billion gallons of biofuel by 2022. The RFS
provision establishes a level of 15 billion gallons of conventional ethanol by 2015 and at
least 21 billion gallons of cellulosic (noncornstarch) ethanol and advanced biofuels
(including ethanol from sugarcane and biodiesel) by 2022ix.
Figures 2 and 3x show that acreage outlooks for corn remain positive through the next 4
years. A low corn stocks to use ratio and low natural gas prices combine to represent a
favorable demand scenario and abnormal margins for nitrogen fertilizer for years to come
and especially for 2011.
Figure 2
Figure 3
Improving diets
As developing countries grow and technology and disposable incomes increase, diets
switch from rice based to meat, dairy, fruit and vegetable based. IMF research predicts
emerging and developing economies will grow at over 6% through 2016 while advanced
economies will only grow at slightly over 2% during the same time framexi. This requires
more use of fertilizers to boost crop yields. According to The Fertilizer Institute,
“Production of a pound of beef requires 7 pounds of feed and every pound of pork
produced requires 4 pounds of feed.” “With the increased world population, the United
Nations Food and Agriculture Organization (FAO) estimates that the total world demand
for agricultural products will be 60 percent higher in 2030 than it is today. FAO projects
that more than 85 percent of this additional demand will come from developing
countries.”xii
We’re already witnessing signs of this as evidenced by world consumption of grains
outpacing growth in production. Figure 4 displays four charts showing world consumption
patterns and their respective affect on fertilizer prices. Potash predicts “fertilizer as a
percentage of farm revenue remains below historical average levels. We believe this is a
much more sustainable situation and provides greater opportunity for improved pricing
levels in the coming months and years.”xiii
Figure 4xiv
Farm income
The 2011 forecast from the ERS for farm income is broadly positive as shown in Figure 5.
Figure 5xv
Trade policy
China is the world's largest producer of nitrogen fertilizers. Due to local conditions, the
Chinese government has raised existing export tariffs to promote higher domestic use of
fertilizers. Given that from 2007 to 2008 the United States imported nearly 1 million tons
of urea from China, this trade policy could promote more production and capacity
expansion domestically in North Americaxvi.
Russia and Ukraine are the largest urea exporters, but due to subsidized natural gas costs
they are able to sell product at below market prices. Anti-dumping orders have been in
place since 1987, as a result very little urea has been imported as compared to their
production capacity. A review by the International Trade Commission is set to complete in
late 2011 to determine if the anti-dumping orders should remain in place.
Anti-dumping orders are also in place for Russian and Ukrainian fertilizer grade
ammonium nitrate where for Russia prices are set to market and volumes are capped at
150,000 metric tons. Ukrainian imports are subject to a 156% duty. These agreements are
under review and a decision will be reached by 2012.xvii
These anti-dumping policies serve to protect North American fertilizer producers from
unfair trade practices. If the orders are removed in the future, added competition will
bring price pressures on fertilizer prices and suppress production leading to a period of
low margins and depressed earnings.
Current conditions
Figure 6 provides a global breakdown of the current crop conditions. If conditions improve
through the summer and into fall crop yields could be expected to improve. However, if
conditions remain unaccommodating to crop growth fertilizer demand will be pushed
forward.
Figure 6xviii
INDUSTRY SUPPLY:
From 1999 to 2008, rising natural gas costs and a long period of capacity additions from the 90's led
to a period of plant closures and low production volumes. Figure 7 illustrates this history.
Figure 7xix
During this time period imports rose to meet the demand no longer being served domestically,
displayed in Figure 8. Below is a copy of previously referenced Table 5, which shows the trend in
imports since 2007. Production has recently stabilized with imports falling.
Table 5
Figure 8xx
Imports (Metric Tonnes), excl. Canada 2010 2009 2008 2007
Anhydrous Ammonia 5,730 4,683 6,409 7,019
Urea 4,640 3,067 3,976 4,843
UAN 2,069 779 1,954 2,415
Source: USDA/ERS, see website www.ers.usda.gov/data/fertil izertrade/ for more information.
The distinction should be made, that the discrepancy in N imports from Figure 8 vs. Table 5 is due to
N sources. Table 5 tabulates specific N sources where Figure 8 aggregates all sources.
Operating rates
Table 7xxi
Company 2010 Ammonia Capacity
Utilization
2010 UAN Capacity
Utilization
2010 N Segment Capacity
Utilization
CF Industries 83% 60%
Agrium 76%
Terra
Nitrogen 104% 98%
Potash 100%
CVR
Partners* 94% 92%
*Represents annualized data
Table 8 visualizes the utilization rates among the top domestic producers for N fertilizers.
CF Industries represents a large share of the market and has considerable room to expand
operations, as does Agrium.
COSTS:
Natural gas is the primary raw material for producing nitrogen fertilizers. The process for producing
anhydrous ammonia, the basic building block for upgrade products, is summarized in figure 9 in a 5-
step process. For Terra Nitrogen, natural gas represented 50% of overall costs in 2010 due to low
natural gas prices. Higher prices lead to lower gross margins as overall costs rise.
Figure 9xxii
Globally, natural gas costs can vary significantly. Figure 10 is a chart that shows production costs
among the largest producing regions globally. Currently, the US has a significant cost advantage over
the majority of other producers.
Figure 10xxiii
Figure 11 breaks down N importers by country during 2007/08. Surely this profile has changed due
to the dramatic decrease in US natural gas prices, giving US producers a cost advantage over major
exporting countries.
Figure 11xxiv
PRINCIPAL RISKSxxv:
Business risks
Reliance on the Verdigris facility as the sole operations center is subject to the risk of plant
disruptions caused by accidents, natural disasters or severe weather. If any disruptions were
to occur, sales could be materially affected. For the most part, disruptions of this nature are
largely unpredictable.
Natural gas costs are highly volatile and difficult to forecast. Because natural gas prices
account for the majority of production costs, any unexpected rise in price that is not hedged
will have an adverse impact on margins.
The fertilizer industry is cyclical in nature, subject to periods of optimism where oversupply
lowers profitability and may lead to losses. 1999 through 2003 represents such a period.
Fertilizer products including N are commodity products with very little differentiation and
are traded globally. Foreign competitors may have lower material costs and more abundant
access to resources like in the Middle East. Other foreign competitors have subsidized
natural gas costs, which can result in their fertilizers having a cost advantage.
Agricultural demand for fertilizers is dependent on ideal weather conditions, inventory
stocks, government policies, trade policies, price volatility and population growth to name
some factors. Any adverse change in any of these factors can result in lower demand for
fertilizers.
Terra Nitrogen, through its operating agreement, relies on CF Industries and third parties to
operate. If CF Industries were to experience hardship, Terra Nitrogen may be impacted
adversely as a result. Third parties provide services such as deliveries and transportation
subject to similar risks as the Vertigris facility. Any disruptions in the operations of third
party servicers could materially impact Terra Nitrogen.
Health, safety and environmental laws are numerous in the US. These include the Clean Air
Act, the Clean Water Act, the Comprehensive Environmental Response, Compensation and
Liability Act, or CERCLA, the Toxic Substances Control Act and various other federal, state,
provincial, local and international statutes. Accidents are an ongoing part of operations and
therefore any major accident could result in major disruptions or litigation, which could
have a material impact on results.
Derivatives hedging is used to manage price risk in natural gas costs. Ineffective hedging
could result in reduced cash flows and profitability.
Any demand forecast error could result excess inventories or too few inventories to meet
demand.
Terra Nitrogen relies exclusively on operating cash flow to carry business and fuel growth.
In the event cash flows are insufficient, additional equity and/or credit would be necessary
which may not be accessible if market conditions are depressed during the time of need.
A weak global economy could result in insufficient demand for agriculture and fertilizer
products.
Dividends are paid on a residual basis after other working capital and investment needs
have been met. If there is insufficient cash on hand or to meet these needs, a dividend may
not be paid. Dividends may be in jeopardy during periods of oversupply when profitability is
suppressed.
Financial risk
In aggregate, Terra Nitrogen's financial position in terms of solvency, liquidity, accounting
quality, efficiency and profitability is conservative and does not pose serious risks. The
following tables illustrate the analysis.
The DuPont analysis reveals that Terra Nitrogen is well balanced in terms of profitability
and not reliant on leverage to produce a profit. Their position is highly solvent and liquid
with no debt. Operating leases are present, but would not be material if present values
were included in the balance sheet.
Margins are volatile, mainly due to volatility in natural gas prices and UAN/ammonia
prices. This makes quarterly predictions in earnings subject to a high degree of
uncertainty.
Terra Nitrogen is a Master Limited Partnership, which requires that it pays all available
cash to its partners (shareholders). The policy is a residual dividend policy, dependent on
plans for capex, cash on hand and operating cash flows. The company has a history of
paying quarterly dividends dating back to 1994. The year 1999 represents the only year it
did not pay at least one quarterly dividend.
DuPont Analysis
2010 ROE =
Profit
Margin x
Asset
Turnover x
Financial
Leverage
96.79% 0.36 1.90 1.41
2010 ROA =
Profit
Margin x
Asset
Turnover
68.51% 0.36 1.90
Solvency Ratios
Debt / Equity -
EBIT / Interest 504.75
Current Ratio 2.24
Cash Ratio 1.52
Margins 2010 2009 2008 2007 2006
Gross
Margin 39% 32% 48% 35% 12%
Profit
Margin 36% 28% 47% 32% 11%
Free Cash Flow
Margin 41% 26% 32% 52% 21%
Payout Ratio 2010 2009 2008 2007 2006
Payout Ratio 64% 183% 89% 70% 79%
Accruals have no apparent trend and have averaged only 0.12 since 2006, suggesting no
suspicious accounting gimmicks.
PP&E investments are fairly aged, but Terra Nitrogen consistently replaces investments at
a stable enough rate that no major capex should be expected to reduce cash flows in a way
that would significantly reduce cash available to partners.
Inventory and sales are generally sold and collected within 30 days. Sales collection times
have trended favorably, while inventory holding times have been stretched. Payables
appear to have been managed more efficiently, signaling confidence by creditors. Since
2006, with the exception of 2009 and the global financial crisis, Terra Nitrogen has
effectively improved its cash conversion cycle.
Inventories are accounted for using FIFO. Because natural gas prices are so volatile, a FIFO
policy for inventory accounting is not necessarily aggressive.
Accrual Ratio 2010 2009 2008 2007 2006
Accrual Ratio (0.35) 0.43 6.65 (5.88) (0.23)
Fixed Assets 2010 2009 2008 2007 2006
Average Age 11.13 11.03 7.94 9.38 10.89
Total Life 16.00 15.86 11.11 13.42 16.04
Remaining Life 4.87 4.84 3.17 4.03 5.15
Efficiency 2010 2009 2008 2007 2006
Receivables
Turnover 19.71 16.40 20.60 14.58 12.19
Inventory
Turnover 12.15 8.00 12.30 19.72 15.05
Payables
Turnover 14.55 14.37 17.50 14.63 19.57
Days of Sales
Outstanding 18.51 22.26 17.72 25.04 29.95
Days of Inventory
on Hand 30.03 45.63 29.67 18.51 24.26
Days of Payables
Outstanding 25.09 25.39 20.86 24.95 18.65
Cash Conversion
Cycle 23.46 42.50 26.54 18.60 35.56
Valuation risk
The forecast of fair value for Terra Nitrogen is based upon past growth and margin
observations, historical demand growth for N fertilizers and expected demand growth for
N fertilizers. The probabilities of these growth scenarios are unknown due to cost and
product price volatility and the fair value calculation was equal weighted. The actual
revenue growth and free cash flow margin outcomes may differ significantly from what was
forecast.
The range of prices in the forecast scenarios is $38.21. The standard deviation of the
forecasted values (aka the growth sensitivity factor) is 14.55. In the analysts view, the
wider the forecast range and larger the standard deviation relative to fair value, the more
uncertainty is present in the forecast of fair value, and therefore more risk. The ratio of
standard deviation to fair value is 0.15. The conclusion then is that the forecast itself is not
based on wildly different assumptions and contains a normal amount of uncertainty.
The cost of equity capital is not calculated by use of CAPM, GGM, ABT or other widely
accepted models. Instead it is the percentage of capex to equity, averaged over 5 years. The
theory to using this method is that the cost of equity capital is the amount of investment
needed to maintain and grow the business. There is no empirical research to suggest using
capex as a % of equity is a superior method.
PRO-FORMA CASH FLOWS:
Free cash flow has been projected for Terra Nitrogen though 2014 based on scenarios of revenue
growth estimates and free cash-flow margins. Margins are estimated using historically observed
margins.
*Terminal cash flow estimated using the Gordon Growth Model. cost of equity capital 12%. The cost of equity capital was calculated by using average capex as a % of equity over the past 5 years.
(in thousands) Terminal* 2014 E 2013 E 2012 E 2011 E 2010 A
Total revenues (4% Growth) 686,922 660,502 635,098 610,671 587,184 564,600
Revenue CAGR 3% 3% 111.20%
FCFE Margin (Average 30%) 41%
Free Cash Flow to Equity 2,575,958 198,151 190,529 183,201 176,155 230,300
Scenario 1 - Historical Revenue Growth
Total revenues (2% Growth) 623,364 611,141 599,158 587,410 575,892 564,600
FCFE Margin (Average 30%) 41%
Free Cash Flow to Equity 1,870,092 183,342 179,747 176,223 172,768 230,300
Scenario 2 - Historical Nitrogen Demand
Total revenues (1% Growth) 593,400 587,525 581,708 575,948 570,246 564,600
FCFE Margin 30% 30% 30% 40% 50% 41%
Free Cash Flow to Equity 1,780,201 176,258 174,512 230,379 285,123 230,300
Scenario 3 - Expected Nitrogen Demand w/ Abnormal Profits
Total revenues (1% Growth) 593,400 587,525 581,708 575,948 570,246 564,600
FCFE Margin 30% 30% 20% 7% 50% 41%
Free Cash Flow to Equity 1,780,201 176,258 116,342 40,316 285,123 230,300
Scenario 4 - Expected Nitrogen Demand w/ Abnormal Profit, Overcapacity & Return to Normal Profits
Total revenues (1% Growth) 593,400 587,525 581,708 575,948 570,246 564,600
FCFE Margin 30% 30% 30% 20% 7% 41%
Free Cash Flow to Equity 1,780,201 176,258 174,512 115,190 39,917 230,300
Scenario 5 - Expected Nitrogen Demand w/ Overcapacity then Return to Normal Profits
VALUATION
Terra Nitrogen's fair value is calculated using a free cash flow to equity holders model, as estimated
in the pro-forma cash flows. Fair value is the arithmetic average of all 5 scenario values. Shares
outstanding have been constant since the IPO at 18,502,000.
Fair Value: $95.59 Purchase Price: $65.48
RISK ADJUSTED MARGIN OF SAFETY
The purchase price was calculated using a model that determines the margin of safety through 5 risk
factors less the dividend yield.
(in thousands) Terminal 2014 E 2013 E 2012 E 2011 E
Scenario 1
Discounted Cash Flows 1,637,068 125,928 135,615 146,047 157,281
Value per share $119.01
Scenario 2
Discounted Cash Flows 1,188,477 116,517 127,941 140,484 154,257
Value per share $93.38
Scenario 3
Discounted Cash Flows 1,131,350 112,015 124,214 183,657 254,574
Value per share $97.60
Scenario 4
Discounted Cash Flows 1,131,350 112,015 82,810 32,140 254,574
Value per share $87.17
Scenario 5
Discounted Cash Flows 1,131,350 112,015 124,214 91,829 35,640
Value per share $80.80
5 Factors: Beta D/E - Debt to Equity ACR - Account Quality CFRF - Cash Flow Volatility GSF - Growth Estimate Sensitivity
Margin of Safety
Beta 0.70 0.14
D/E - -
AQR 0.12 0.02
CFRF 0.99 0.20
GSF 0.14 0.03
- Dividend Yield 0.08
RAMS 0.32
CONCLUSION
Terra Nitrogen is a well run business in a favorable competitive position with modest, but likely
attainable growth prospects. Financially, they are conservatively positioned and have not had a
history of large disruptions from other business risks aside from industry oversupply.
The generous payout policy is attractive to investors looking for total return, where income can be
reinvested back into Terra Nitrogen at favorable prices or into other opportunities. Because of the
residual policy, income investors bear extra risk that dividends are not paid every quarter.
It is not recommended that investors purchase Terra Nitrogen at this price. Current partners are
advised to hold the stock as no catalyst is expected to pose significant downside momentum in the
next 3 months. Partners are expected to be well compensated with generous income from the low
cost environment and aggressive corn acreage projections for 2011. Beyond this time-frame there is
considerable more uncertainty. If valuations remain high above fair value with no positive changes in
the outlook, a sell recommendation is advised.
REFERENCES
i Terra Nitrogen Company. (2010). form 10-k. Item 1. Business. (pp. 1-5). ii Terra Nitrogen Company. (2010). form 10-k. Item 1. Business, Competition. (pp. 4.) iii Agrium, Inc. (2010-2011). Agrium Fact Book. Industry Participants, 2010 Ammonia Plant Capacities & Location. (pp. 23). iv Johnson, W. Jay. Selecting Forms of Nitrogen Fertilizer. The Ohio State University Extension: The Department of Horticulture and Crop Science. Retrieved from http://ohioline.osu.edu/agf-fact/0205.html
Vitosh, M.L. (2005). N-P-K Fertilizers. Michigan State University Extension Bulletin. Retrieved from http://web3.canr.msu.edu/vanburen/e-896.htm
v Agrium, Inc. (2010-2011). Agrium Fact Book. Industry Participants, 2010 Ammonia Plant Capacities & Locations, (pp. 23)
Terra Nitrogen Company. (2010). form 10-k. Item 1. Business, Our Facilities. (pp. 4.) CF Industries Holdings, Inc.. (2010). form 10-k. Item 1. Business, Nitrogen Segment. (pp. 4.). Will, Tony. (2011). Scotia Capital Global Fertilizer Conference 2011: CF Industries. UAN: A High Value-Added Product. (pp. 12). Retrieved from http://phx.corporate- ir.net/External.File?item=UGFyZW50SUQ9OTc2OTZ8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1
vi Huang, Wen. Beckman, Jayson. (2011). USDA/ERS US fertilizer imports/exports 1995 - 2010. Data Files. Standard Tables, 1995-2010. Retrieved from www.ers.usda.gov/data/fertilizertrade/ vii Food & Agriculture Organization of the United Nations. (2010). Current world fertilizer trends and outlook to 2014. Annex 2. World & regional nitrogen fertilizer demand forecasts. (pp. 28). viii Terra Nitrogen Company. (2009) form 10-k. Item 1. Business. (pp. 4.). ix Malcolm, Scott. Aillery, Marcel. (2009). Growing Crops for Biofuels Has Spillover Effects. Retrieved from http://www.ers.usda.gov/AmberWaves/March09/Features/Biofuels.htm
x Will, Tony. (2011). Scotia Capital Global Fertilizer Conference 2011: CF Industries. UAN: A High Value-Added Product. (pp. 15, 18). Retrieved from http://phx.corporate- ir.net/External.File?item=UGFyZW50SUQ9OTc2OTZ8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1 xi IMF World Economic Outlook Database. (2011). Retrieved from http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/weorept.aspx?sy=2009&ey=2016&scsm=1&ssd=1 &sort=country&ds=.&br=1&pr1.x=64&pr1.y=10&c=001%2C110%2C163%2C119%2C203%2C123%2C998%2C20 0%2C904%2C901%2C505%2C511%2C205%2C406%2C603&s=NGDP_RPCH&grp=1&a=1 xii The Fertilizer Institute. (2011). Population Growth & the Food Crisis. Retrieved from http://tfi.org/factsandstats/foodcrisis.cfm xiii Brownlee, Wayne. (2011). Potash Q2 Market Analysis Report. Rise in crop prices has outpaced fertilizer prices. (pp. 19). Retrieved from http://www.potashcorp.com/media/SCGFC_June_2011.pdf xiv Brownlee, Wayne. (2011). Potash Q2 Market Analysis Report. World Agriculture & Economic Overview. (pp.12-14, 19). Retrieved from http://www.potashcorp.com/media/SCGFC_June_2011.pdf xv Park, Timothy. (2011). Farm Income and Costs: 2011 Farm Sector Income Forecast. Retrieved from http://www.ers.usda.gov/Briefing/FarmIncome/nationalestimates.htm xvi The Fertilizer Institute. (2011). Fertilizer is a Strategic Commodity. Retrieved from http://tfi.org/factsandstats/strategiccommodity.cfm
xvii CF Industries Holdings, Inc.. (2010). form 10-k. Item 1A. Risk Factors. (pp. 18-19).
xviii Brownlee, Wayne. (2011). Potash Q2 Market Analysis Report. World Agriculture & Economic Overview. (pp.15). Retrieved from http://www.potashcorp.com/media/SCGFC_June_2011.pdf xix Huang, Wen-yuan. (2009). Factors Contributing to the Recent Increase in U.S. Fertilizer Prices, 2002-08, USDA/ERS. Background. (pp.4). Retrieved from http://www.ers.usda.gov/Publications/AR33/AR33.pdf xx The Fertilizer Institute. (2009). The U.S. fertilizer Industry and Climate Change Policy. (pp.5). Retrieved from http://www.kochfertilizer.com/pdf/TFI2009ClimateChange.pdf xxi All data taken from respective firm form 10-k or 40-F
xxii Canadian Fertilizers Limited. (2011). Ammonia Production Process. Retrieved from http://canadian-fertilizers.com/AmmoniaProduction.htm xxiii Brownlee, Wayne. (2011). Potash Q2 Market Analysis Report. page 27 Nitrogen Outlook. (pp.27). Retrieved from http://www.potashcorp.com/media/SCGFC_June_2011.pdf xxiv The Fertilizer Institute. (2009). The U.S. fertilizer Industry and Climate Change Policy. (pp.5). Retrieved from http://www.kochfertilizer.com/pdf/TFI2009ClimateChange.pdf xxv Terra Nitrogen Company. (2010). form 10-k. Item 1A. Risk Factors. (pp. 6-12).