May 23, 2008
The agriculture bull market is in full swing and the prospects for the industry keep growing stronger. Agriculture is entrenched in supporting the basic needs of humans and is vital to the sustainability of a growing population. In fact, 45% of the world’s workers are employed in agriculture. Recently, prices for crops have skyrocketed as farmers produced less food last year than was consumed, and stockpiles have been drawn down to 30-year lows.
The primary demand driver has come from emerging markets including China and India as consumers emerge from poverty and move to a protein-rich diet. Each pound of meat produced requires ten pounds of grain for animal feed. Improved diet demand is skyrocketing as the pace of economic development around the globe increases, and there is still a long way to go still.
20% of Asia is living on less than $1 a day and a full 1.5 billion in the region are living on under $2 a day. As incomes rise from the $2 a day level to $10 a day, people tend to initially spend their incomes on more meat, dairy, fruits, and vegetables. Once diets improve, life expectancies will be prolonged and place further strains on food supplies.
The overall population picture is also positive with the world population expected to move from 6 billion today to 8 billion by 2030. During that period, world food demand is expected to double according to the World Bank.
Government mandates for biofuel production have also driven up the values for crops. The 2007 US Energy Bill mandates that 36 billion gallons a year of renewable fuels be produced by 2022, and the European Union has a target for biofuels to supply 10% of their fuel needs by 2020. In the US, 30% of this year’s corn crop will be siphoned towards ethanol use. There have been concerns that biofuels do more harm than good by actually using more energy than traditional sources, and also because they take away from the food supply. The fact is that even if biofuel production ceased, the fundamentals are still strong with the growth drivers from the emerging markets. After all, only 5% of the world’s grain production goes to uses other than food.
Furthermore, farmland across the world has been steadily declining as urbanization, deforestation, and continued population growth take away about 24.7 million acres a year. The US alone is losing about a million acres a year to development. These figures are alarming and raise the question of how the world’s growing food demand will be met.
The answer likely lies in genetically modified seeds produced by Monsanto (MON) and Syngenta (SYT), and also with adequate fertilizer usage. I believe the fertilizer arena presents the most attractive agriculture investment as significant barriers to entry, lack of resource availability, high costs of new plants, and long plant and infrastructure development time make the sector as attractive as oil was several years ago.
Fertilizer is necessary to replace the nutrients that crops remove from the soil, and a proper balance of the main three nutrients (nitrogen, phosphate, and potash) is necessary to maximize the yield and quality of crops. The value proposition for US farmers is $3 back for each $1 investment in fertilizer, $7.60 back per $1 investment in India, and $9 back in Indonesia.
Emerging countries including China and India have long under-applied fertilizer and triple cropped fields, which is not sustainable without chemical inputs. These countries are finally beginning to embrace the necessity of fertilizer. In fact, earlier this year China agreed to rates of $576 a ton for potash, nearly $400 higher than the year earlier and near spot rates. In the past China has commanded steep discounts for the large quantities they import but this year was different as supplies have become too tight. June spot prices have breached $1000 a ton and show no signs of stopping as no new capacity will be generated for at least 5 more years. Even now, farmers are not getting all the fertilizer they want because it’s just not available.
Industry giant PotashCorp (POT) has vigorously rallied almost 200% over the last year and now sports a market cap of $61.4 billion. Even though this seems rich for a fertilizer company, PotashCorp is trading at only 12 times forward earnings estimates, and these estimates are likely to be drastically increased moving forward. PotashCorp owns 75% of the world’s excess potash capacity and has significantly lower costs than its competitors: $94 cost per ton of potash produced vs. $135 for Mosaic (MOS).
With potash supplies so tight, PotashCorp has embarked on a project to increase its capacity by 70% by 2015. Several analysts on Wall Street have set price targets of $300 for the $200 stock, and these are based on conservative earnings estimates. PotashCorp is also part of Canpotex, an OPEC-like organization that markets and distributes fertilizer.
Mosaic (MOS) has also had a banner year adding 264% of value and now trading with a market cap of $53.2 billion. The company is majority-owned by Cargill and is close to achieving investment-grade credit ratings for its bonds. Like PotashCorp, Mosaic is one of the few companies with the ability to increase its capacity and plans to do so with a 50% increase by 2020. It may seem like these supply increases will flood the market and erode pricing power, but this is not likely as it will take about five years for these production increases to come on line, and by then demand will already be drastically higher.
Agrium (AGU) is also a large player in the space with a $13.3 market cap and a significant presence in the production of nitrogen. Nitrogen has the highest application rates of the three fertilizers, but faces high input costs from natural gas and ammonia. So far, producers have been able to pass these costs on to customers and should continue to be able to. Agrium is actually involved in the production of ammonia and has benefited from the increase in prices. They are also part of Canpotex along with PotashCorp and Mosaic.
CF Industries (CF) has the best financial position of all the fertilizer producers with cash on hand equal to 12% of its market cap, no debt, and a forward P/E ratio of just 8. CF is not involved in the production of potash but mines phosphate and nitrogen. CF won the rights to build new nitrogen operations in Peru due to open in 2012. The company has also been able to fend off increasing input prices by mark-to-market gains in natural gas derivatives, and through their ownership of phosphate rock mines in Florida. However, they have been negatively impacted by rising sulfur prices along with many other producers.
One of the year’s hottest IPO’s has been Intrepid Potash (IPI), which went public in April. The company is the largest US producer of potash and benefiting from all the same trends of the industry. In just over one month of trading, the stock is up 46% from its offer price. The company is considered to be speculative since it came to the market at an opportune time to feed investor appetite, but is merely trading at a forward multiple of 12. Intrepid uses solar evaporation technology at its plants and also produces Langbeinite, which could see a bigger market in the future.
The underlying fundamentals of the agriculture industry are very strong and comparable to what oil looked like two or three years ago. Each of these companies will benefit from the bullish trend and multiple growth drivers for many more years, but industry leaders PotashCorp and Mosaic should outperform because of their unique ability to add capacity of a rare good.
The recent limits on rice purchase placed at Costco and Sam’s Club, and subsequent hoarding are just a drop in the bucket of what is going to come for the agriculture industry. People will need to eat, and as the PotashCorp motto states, the fertilizer producers will be doing their part “helping nature provide.”