Norway's Yara International (Nasdaq:YARIY) is no run-of-the-mill commodity company. Not only is the largest supplier of mineral fertilizers in the world, holding 9% share of the global nitrogen fertilizers market, but Yara has a rare record of consistent double-digit returns on capital and assets.
While the quality of the company's assets, the benefits of nitrogen fertilizers, and the discipline of management speak well to the company's future, a surge in Chinese exports and energy costs is squeezing the company's profitability. Making matters worse, it's likely to get uglier from here, as the company could be looking at EBITDA bottoming out in the 2014/2015 timeframe. Although Yara is a little undervalued today and is likely to continuing paying a healthy dividend through the lows of the cycle, holding commodity stocks through the bottom of the cycle can be painful for shareholders.
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More Chinese Urea, And More Expensive Gas
When Yara reports later this week, the company is expected to confirm that the company is facing a continuing squeeze from surging Chinese exports (pushing down urea prices) and rising natural gas prices (a key input for the company).
While prices peaked at around $440/ton in February, they've gone as low as $315/ton in recent weeks and every $100/ton of urea pricing translates into about $1,100 of EBITDA for Yara International. The issue for Yara, as well as producers like Agrium (NYSE:AGU) and CF Industries (NYSE:CF), isn't so much North American demand (though cold, wet weather has hurt the ag sector) as surging exports from China. Between low coal prices and a major drop in export taxes, Chinese exports have been soaring (up 108% in May of 2013), and producers like Yara are price-takers in this market.
Low coal prices in China are allowing marginal producers there to break even at prices as low as and estimated $300/ton for urea. At the same time, Yara has to deal with expensive natural gas in major markets like Europe. As an aside, every $1/MMBtu change in the price of European gas works out to about $150 million in Yara EBITDA.
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Exercising Discipline To Preserve Returns
Unlike the potash sold by companies like Potash (NYSE:POT) and Mosiac (NYSE:MOS), the large majority of what Yara sells does not depend upon discovering/owning naturally-occurring deposits. As a result, companies can build plants if/when they wish, and that makes supply a little more challenging to forecast.
It looks like the recent decline in prices is leading to some capacity reduction, but Yara is also making longer-term decisions. The company recently announced that it was delaying the expansion of its Belle Plaine facilities in Canada, due both to the evolving supply/demand/price equation, but also the spiraling cost of construction (perhaps as much as $1.6 billion for a 1.3M tons/year expansion). Coupled with Agrium's decision to delay 1.8M tons in new North American capacity, that's a meaningful amount of delayed capacity.
Even so, most industry-watchers are looking for ongoing pricing pressure sufficient to push the industry to a bottom in 2014/2015. In the meantime, Yara will do what it has always done relatively well – manage costs at its existing facilities, look for synergistic business opportunities (including, perhaps, a joint venture with Agrium), and pay out a healthy dividend (30% or more of earnings).
The Bottom Line
Investors need only look at industries like aluminum to see how barely economical Chinese exports can wreck pricing for an extended period of time. While I do believe that Yara is built to withstand this upcoming cyclical decline, it still is rarely ever pleasant to own commodity companies during these declines (though it's also worth noting that the shares will often turn up before the actual bottom has been reached).
I'm willing to give Yara a slightly higher-than-average EV/EBITDA multiple than I might normally give in the face of the pricing/margin pressures. But even 6x forward EBITDA only suggests a fair value of about $46.50. Investors may point to the strong dividend – a trailing yield of 5% and a strong history of growth – but I'm not sure the dividend will compensate for the potential declines in the share price if urea prices decline further and/or gas prices head higher. Accordingly, Yara looks like a great candidate for the watch list today, but I'd be very careful about buying ahead of what I believe will be additional cuts to EBITDA estimates for 2013, 2014, and maybe 2015.