Low costs offset cyclical risk

The outlook for fertilizers is bright. Rising populations in developing countries will prompt farmers to increase food production. As well, more countries are turning to biofuels, such as ethanol from corn, to cut air pollution and fossil-fuel use.

However, fertilizer prices have become highly volatile in the past few years. To cut your risk, we recommend low-cost producers that can withstand and take advantage of these price swings. For example, Potash Corp.’s large reserves will last decades. That means it won’t have to spend large sums on exploration. Agrium needs natural gas to make its products, so it will benefit from new gas discoveries in North America.

POTASH CORP. OF SASKATCHEWAN INC. $112 (Toronto symbol POT; Aggressive Growth Portfolio, Resources sector; Shares outstanding: 296.0 million; Market cap: $33.2 billion; Price-to-sales ratio: 7.8; Dividend yield: 0.4%; SI Rating: Average) is the world’s largest fertilizer producer. It has six potash mines in Saskatchewan and one in New Brunswick. Five of its mines have reserves of between 60 and 97 years.

Potash Corp.’s sales rose 145.5%, from $3.8 billion in 2005 to $9.4 billion in 2008 (all amounts except share price and market cap in U.S. dollars). That’s mainly because potash prices climbed from $143 a tonne in 2005 to $449 a tonne in 2008.

Thanks to the higher prices, Potash Corp.’s earnings soared from $1.63 a share (or a total of $542.9 million) in 2005 to $11.01 a share (or $3.5 billion) in 2008. Cash flow per share rose 411.9%, from $2.53 in 2005 to $12.95 in 2008.

In 2009, farmers cut their fertilizer use because of lower crop prices. Moreover, good weather and large amounts of residual fertilizer in the soil led to better-than-expected harvests.

In response, many potash producers, including Potash Corp., cut their production to keep inventories down and stabilize prices. Even so, the company’s average realized potash price only fell to $428 a tonne.

Lower prices plus lower potash production pushed down Potash Corp.’s 2009 sales by 57.9%, to $4.0 billion. Earnings dropped 70.5%, to $3.25 a share (or $987.8 million). As well, cash flow fell 64.7%, to $4.57 a share.

In January 2010, China, the world’s largest potash consumer, agreed to buy potash from a Belarussian company for $350 a tonne. That put further downward pressure on potash prices. However, fertilizer prices should move up again in the next year or two, as farmers exhaust the residual fertilizer in the soil and return to normal fertilizer usage rates.

Portfolio holdings an overlooked asset

The company is taking advantage of the weak economy to expand its investment portfolio. It recently paid $250 million to increase its stake in Israel Chemicals Ltd., the world’s sixth-largest potash producer, to 13.9% from 12.5%.

Potash Corp. also holds interests in potash producers in China, Jordan and Chile. These investments contributed $205.4 million to its 2009 earnings. As of January 27, 2010, their market value was $24 per Potash Corp. share.

The company’s strong balance sheet helps cut its risk: Potash Corp.’s $3.3 billion of long-term debt is a low 11% of its market cap. It holds cash of $385.4 million, or $1.30 a share.

Potash Corp.’s 2010 earnings will probably rebound to $6.10 U.S. a share. The stock trades at 17.3 times that estimate. It also trades at 14.2 times its likely 2010 cash flow of $7.40 U.S. a share. The $0.40 U.S. dividend yields 0.4%.

Potash Corp. is a buy.

AGRIUM INC. $67 (Toronto symbol AGU; Aggressive Growth Portfolio, Resources sector; Shares outstanding: 157 million; Market cap: $10.5 billion; Price-to-sales ratio: 1.1; Dividend yield: 0.2%; SI Rating: Average) makes fertilizers from natural gas at 10 plants in North America and Argentina. It also produces other fertilizers, such as potash and phosphate, from mines in Ontario, Alberta, Saskatchewan and Idaho.

Agrium sells its products to industrial users and individual farmers through 1,000 retail stores in Canada, the U.S., Argentina and Chile. Agrium’s retail outlets cut its reliance on bulk fertilizer sales.

Thanks to rising fertilizer prices, Agrium’s sales rose 204.5%, from $3.3 billion in 2005 to $10.0 billion in 2008 (all amounts except share price and market cap in U.S. dollars). However, sales fell 9.0%, to $9.1 billion on lower 2009 fertilizer prices.

Earnings fell 61.3%, from $2.12 a share (or a total of $283.0 million) in 2005 to $0.82 a share (or $109.1 million) in 2006. The drop was mainly caused by production problems and higher natural-gas costs. However, earnings shot up to $8.34 a share (or $1.3 billion) in 2008. Earnings then fell 72.1%, to $2.33 a share (or $366.0 million), in 2009. Cash flow per share fell from $3.27 in 2005 to $2.09 in 2006, but jumped to $9.81 in 2008. Cash flow then dropped 70.5%, to $2.89 a share, in 2009.

Agrium still wants to buy CF

Agrium is still trying to buy U.S.-based fertilizer maker CF Industries Holdings Inc. (New York symbol CF). This purchase would cost Agrium $5.2 billion in cash and stock. Agrium holds cash of $933.0 million, or $5.94 a share. Its long-term debt of $1.7 billion is just 20% of its market cap.

CF continues to reject Agrium’s offer as inadequate. However, Agrium aims to replace several of CF’s directors with its own nominees. That could prompt CF to negotiate a friendly deal.

Agrium trades at 14.0 times the $4.50 U.S. a share it will probably earn this year, and at 10.2 times its forecast 2010 cash flow of $6.15 U.S. a share. The $0.11 U.S. dividend yields 0.2%.

Agrium is a buy.