Terra nitrogen company report

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


Company Capacity

% Share

of Total HH Index

# of Firms


# 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




(‘000 metric nutrient tons per year) (000's short tons)


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.


Company Capacity

% Share

of Total HH Index

# of Firms


# 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




***Source: USDA/ERS, see website www.ers.usda.gov/data/fertil izertrade/ for more information.


(‘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


FCFE Margin (Average 30%) 41%


Scenario 2 - Historical Nitrogen Demand


FCFE Margin 30% 30% 30% 40% 50% 41%


Scenario 3 - Expected Nitrogen Demand w/ Abnormal Profits


FCFE Margin 30% 30% 20% 7% 50% 41%


Scenario 4 - Expected Nitrogen Demand w/ Abnormal Profit, Overcapacity & Return to Normal Profits


FCFE Margin 30% 30% 30% 20% 7% 41%


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



Scenario 3



Scenario 4



Scenario 5



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).

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