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Guest Blog by Mark Gulley

RSS By: Mark Gulley

Mark Gulley is a principal at Gulley & Associates LLC.

Nil Phosphate Pricing Flexibility

Sep 14, 2012

Phosphate Price
Stuck in Neutral - as is the case with potash, the phosphate price has been roughly flat over the course of around two years, since October 2010. The Central FL MAP price has round-tripped from $583/tonne in October 2010 to a peak of $667/tonne in October-November 2011, back to $573/tonne in August 2012. This is despite elevated crop prices, corn at $6.55/bu (Dec. '13), soy at $13.54/bu (Nov. '13), and wheat at $8.71 (Dec. '13).

I maintain a generally negative stance on P&K crop nutrient equities, except for Agrium (AGU), an event-driven situation. It's becoming increasingly clear that two conditions must both be met in order for P&K pricing flexibility; (1) fertilizer affordability driven by supportive crop prices and (2) tight operating rates.

Indeed, there's been nil pricing flexibility as the DAP price has been essentially flat for nearly two years. This report is a follow-up to my recent potash analysis.

Phosphate Capacity:
An inflection point in operating rates tied to capacity growth...

The global phosphate industry is at a crucial inflection point in 2013E and 2014E. This is because capacity is set to grow at a much higher rate 2010-15E (4.3%/yr) than 2005-10 (1.4%/yr). Over the 15-year period both demand and capacity grow at right around 3%/year, but with variability intra-period.

2005-2011: An eventful period. The operating rate averaged in the low 80's, from a low of 75% to a high of 89%. Demand (3.7%/yr) grew faster than capacity (1.4%/yr), so operating rates rose. The ethanol era began in 2005, there was the 2008 bubble, the great recession of 2009, and the recovery which began in 2010 and extended into 2011.

2013E-2015E: Capacity overhang brewing. The operating rate should again average in the low 80's, from a high of 90% to a low of 81%. Capacity (4.3%/yr) is now set to grow faster than demand (2.5%/yr), so operating rates should decline. Operating rates are expected to peak at a strong 90% in 2012E but decline to 81% by 2015E, which would be the lowest since 2007 except for the mid-70's 2008-2009.

Ma'aden Greenfield Capacity
Saudi's Ma'aden $6 billion large complex with capacity of 3 million tonnes per annum and which will take 6 full years to construct had been a disappointment in terms of completion date and ramp-up schedule. But it is finally expected to ramp-up during the course of 2013E and 2014E.

A marker for an inflection point in a basic material is when greenfield capacity is being built as this implies that re-investment economics has been achieved. This can occur even if larger incumbents insist that this hurdle has not been overcome because incumbents have the most to lose.

Phosphate Demand
The U.S. accounts for a third of global P&K consumption. Both potash and phosphate demand could potentially falter for the upcoming 2013/14E crop due to the drought in the U.S. corn belt. To be conservative, I have not yet reflected this impact in my N.A. phosphate demand forecast. P&K are usually applied together as the "dry" fertilizer every two years after soy harvest. Soil tests taken post-harvest will actually determine application rates.

Total crop production for the three major row crops (corn, soy, wheat) is estimated to be down 12% for the 2012/13E crop currently being harvested. Using this as a rough proxy for crop nutrient removal during this harvest, and all else being equal, growers could cut-back on application rates for the 2013/14E crop due to lower crop uptake. Demand should presumably recover for the 2014/15E crop to reflect more normal growing conditions.

Mosaic (MOS) forecast goes out to 2013E. It's currently looking for global phosphate demand to increase from 59.6 million tonnes in 2011 to a midpoint of 65 million tonnes in 2013E, a CAGR of fully 4.4% per year as detailed in its most recent outlook, its September 2012 Investor slide deck. This compares to a long-term phosphate growth rate estimated at 2-3% per year.

Summary & Investment Conclusion
I maintain a cautious stance on P&K crop nutrient equities due to lack of pricing flexibility despite elevated crop prices. The exception is Agrium (AGU, Buy), based on the potential for a break-up into retail and wholesale.
o Outperformance problematic: Since only one condition is being met over the next several years, and since pricing is a key driver of EPS and equity valuation, P&K equities could struggle.
o Nutrient affordability is satisfactory: At a long-term corn price of $5/bu, total fertilizer expense would account for 17% of corn revenues compared to a 10-year average of 19%. Of that 17%, phosphate would account for 4%, which is about the 10-year average.
o But phosphate operating rates continue to trend lower: The global phosphate operating rate is peaking at a strong 90% this year, 2012E. But we estimate it could decline at 200 bps per year from this 90% peak to an 81% trough in 2015E.

Investment Risks
AGU: My current 12-month price target of $120 for Buy-rated Agrium is based on 11x the current 2013E EPS estimate of $11 per share. This is based on an arithmetic average of four valuation approaches: DCF, EBITDA multiple, comparables, and sum-of-the-parts.

Risks to our Agrium price target as well as for neutral-rated Mosaic (MOS) and PotashCorp (POT) reflect the fact that the production agriculture business is subject to significant volatility owing to several factors that lie outside the control of the customer base of millions of individual growers that affect supply and demand for crop production, and therefore crop prices: (1) highly variable weather; (2) changing government policy; (3) highly varying crop yields (4) the relative value of the U.S. Dollar; and (5) the recent spike in the corn price; and (6) resulting overhang in the U.S. Ethanol mandate due to the prospect for high food inflation in a deflationary environment as evidenced by very low bond yields; and (7) the remote possibility that EPA could grant a waiver on the ethanol mandate due to the worst farm-belt drought since 1988.



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