Friday, May 11, 2012

A Lot to Like About Potash (Archive Article

I originally wrote this article in late 2010, shortly after BHP's  attempt at acquiring Potash Corp. I post it now because current market turbulence may provide a very fertile opportunity to buy what I think may be one of the most underrated businesses in the world. Gad Capital Management, via Gad Partners Funds, has in the past owned shares in Potash Corp and may own or dispose of shares at anytime. 

Some of the numbers may be need to be updated, but the central thesis remains the same. This article was written prior to Potash Corp's 3 for 1 stock split. Please adjust share prices accordingly. 

-Sham Gad
Managing Partner

I can now thank BHP (BHP) for bringing to light just how undervalued Potash Corp really is. Those in favor of BHP’s current attempt to snatch Potash Corp, the world’s largest fertilizer company, point out to an opening bid of $130 (~$43 post split), suggesting it represents a “substantial” 32% premium to Potash shares’ 30-day average. Further, proponents of the deal will point out that the $130 offer is also a 46% premium to the low of $89 hit last month.

If those same proponents want to get technical in this fashion, then they also know that BHP’s offer is also a near 50% discount the $230 share price back in 2008. I mean if you are going to cite an $89 share price amidst falling markets then you need to also remember what this company is capable of when the cycle is not at rock bottom.

And what exactly is Potash capable of? During the food craze that peaked in 2008, Potash earned $11 a share. As a value guy, I will admit that I am not defending my position by anchoring on 2008 EPS. BHP’s swipe at Potash is brilliant. Thankfully Potash CEO Bill Doyle and the rest of the Board realize just how low this offer really is. For what it’s worth, BHP clearly has to start negotiations with its lowest offer - Negotiation 101, if you will.

Even though I won’t try to value Potash based on its peak earnings in 2008, this company, unlike many others, can actually match or beat that profit figure within the next 3-5 years. And it can do that without potash prices hitting the levels of 2008.

According to the company, it costs anywhere from $3 to $4.5 billion to construct a 2 million ton capacity, ready to go Greenfield potash mine. Morgan Stanley estimates that it would cost $3 billion to produce a 2 million-ton Greenfield mine without reserves in place. Not too long ago, Vale (VALE) purchased potash reserves alone from Rio Tinto (RTP) for $850 million, so a Greenfield mine that's ready to go will easily cost as much as $3.8 billion, or $1,800 a ton. Brownfield mines, which are very tough to find today, may cost $2.5 billion or so.

With over 12 million tons in current potash capacity, replacement cost is anywhere from $30 to $45 billion. One very important fact: in addition to the capital outlay, it takes 7 years to develop a fully operational Greenfield mine. In other words, in addition to actual costs, the time required adds an additional premium to the replacement costs of those assets.

Potash also owns a 14% stake in the Israel fertilizer company ICL, a 28% stake in Arab Potash Company, a 32% stake in the Chilean fertilizer company SQM and a 22% stake in Sinofert Holdings, the largest fertilizer enterprise in China. The value of Potash's interest in these publicly traded businesses currently about $7.4 billion, getting us to a potash asset valuation of $38 to $50 billion. BHP’s total offer of $43 billion (including $4 billion in debt assumption) appears to ignore these extremely strategic assets.

Factor in another $7.5 billion Potash is expending for brownfield mine expansion, $7 billion in nitrogen and phosphate assets, and the company's equity replacement cost is can start to approach $60 billion, compared with the $39 billion BHP offer. At $60 billion, Potash shares are worth approximately $200 a share. So if BHP’s offer is at the low end and $60 billion is at the high end, then a midpoint of $175 a share may bring Potash management to the table.
By 2015 Potash Corp will have spent about $7.5 billion to add an additional 6 million tons of potash capacity. This implies that Potash is bringing this additional capacity at a cost just over $1,000 a ton versus $1,800 a ton for competitors. Potash can do for $7.5 billion what it would cost someone like a BHP $13 billion.

Understand that this capacity expansion accounts for over 50% of all new capacity coming on board during that time. In other words, simply having the capital to construct a mine is just that. You have to first locate the reserves, of which nearly 40% is held by Potash and its equity investments and another 28% is held by Russia. The folks at BHP know this; more importantly Potash management knows this.

So add it all up: $30 to $45 billion for the existing assets, $7.4 billion for the equity stakes, $7 billion for nitrogen and phosphate assets, plus $8 billion or so in new capacity - which is worth more to a competitor - and an equity value of $51 to $66 billion gets you in the ballpark. With 297 million shares outstanding, that’s a share price range of $171 to $222. Given the lack of available reserves on this scale, I would narrow my range to a minimum $180 a share.

No surprise then that the market voted by sending shares to nearly $150 the day the $130 offer was announced. Thankfully, Potash insiders truly understand the value of their business. In the words of CEO Doyle, “we are not opposed to sale, but are opposed to letting someone steal the company.”