Once again, I’ve been very pleased with the earnings and outlook reported by the majority of the companies we own. A few of our core holdings held their conference calls this morning so I wanted to provide a quick update.
CF Industries (CF) & Terra Nitrogen (TNH)
CF is our largest “Growth” holding and TNH is the largest stock position within our “Income” allocation. CF is actually the General Partner of TNH and we hold shares of the common partnership units. This means that roughly 40% of TNH’s earnings are paid to CF and the remaining 60% are paid to us as common unit holders.
Both companies produce nitrogen-based fertilizers and both stocks are down a good bit today after reporting that revenue and earnings fell year-over-year (as was expected) and commenting that fertilizer prices could remain under pressure through 2016. I always laugh at Wall Street’s inability to look beyond 1 year. All of the analyst questions during Q&A on the call were about pricing and international dynamics THIS YEAR. But investments in CF and TNH are not about this year or any one year in particular. They’re about the long-term earnings and cash flow generation capabilities inherent within their business model.
Fertilizer prices have fallen dramatically over the last year, along with just about every other commodity outside of the precious metals. Nitrogen-based products in particular have seen global supplies increase and producers that are being squeezed by lower prices try to make up for the difference by selling higher volumes – essentially dumping product on the market (not much different from what we’re seeing in the oil/gas arena). As with most commodities, the floor in prices is usually around the marginal producer’s cost to manufacture, which in this case are the Chinese anthracite producers that have been dumping product on the market the past couple of years as they struggle to operate profitably. CF & TNH, though, are some of the lowest cost producers in the world because they utilize natural gas as the main input and thus benefit from the US shale boom which has taken nat gas prices here in the US down to around $2/MMBtu while the anthracite equivalent is above $4. This allows them to operate at about 50% cash gross margins!
TNH is structured as a pass-through partnership where they essentially distribute all of their earnings (after retaining the cash needed to maintain the business) each year as a dividend. The stock price simply fluctuates up and down over time to adjust the dividend yield so drops in the price are expected if earnings drop. However, it’s a high margin, high return business and we own it as a pure yield play for the dividends.
As for CF, earnings and free cash flow look terrible right now because they embarked on a large expansion project over the past few years but it should be finished this summer. Timing wasn’t the best with costs rising at the same time that cash flow was dropping but they couldn’t foresee this drop in commodity prices 3 years ago. Once the project is complete, the company will be cash flow positive again and hold a tremendous amount of operating leverage. What this means is that the stock is like a coiled spring and if fertilizer prices rise, their profitability and free cash flow will be enormous and the stock would probably rise dramatically. I don’t expect this to happen this year but again, investing in CF is not about this year. It’s about their ability to generate a ton of free cash flow year after year which they’ll use to pay down the debt they took on for the expansion project and to buyback stock. Even if prices don’t change, cash gross margins are still very attractive and in the meantime we’re collecting a 4% dividend yield.
The average stock in the S&P 500 today is trading about 3x the forward valuation of CF. Sustainable long-term investing is not about top line revenue growth, it’s about cash flow, yield and capital allocation; revenue growth is just a bonus. I still believe CF represents the best long-term value in the market – it’s just a tough macro environment for commodities, for the time being.
As a side note, just to illustrate how irrational the markets are in the short-term, and how they’re totally dominated these days by computer algorithms, here’s a chart of CF (black line) and the yield on the 10-year Treasury Note (blue line). The two have been tightly correlated over the last year and only getting tighter as time passes. As computer algorithms pick up the correlation, they’ll trade large baskets of stocks that they “group” into categories. In this case, it’s purely an inflation/deflation story. If the 10-year yield is up, they buy all the stocks in the basket; if down, they sell… all day. It didn’t matter one bit what CF said on the call this morning. I knew the stock was going to trade lower today simply because the 10-year yield was lower. It’s not just CF though. It’s many other stocks and assets as well, including oil. I believe the culprit is actually eurodollar funding dynamics and the Chinese yuan, but that gets a bit complex. We can simply watch the 10-year yield as a proxy for the whole mess. For long-term investors, this should illustrate why short-term “noise” needs to be ignored but hopefully used to our advantage when we recognize short-term movements that are out of sync with the long-term fundamentals.
Church & Dwight (CHD)
Church & Dwight, another core holding, also reported this morning. They are the definition of consistency. So impressive! We absolutely want to be long-term owners of a company like this. But the stock has been, and remains, very expensive so I won’t be buying more unless it comes down.
Thanks for following!
-Nick