CF Industries: Positioning Itself for a Strong 2014

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CF Industries (NYSE:CF), the largest producer of nitrogen fertilizers in North America, reported better-than-expected quarterly results. The company reported 4Q13 adjusted EPS of $5.04, above consensus estimates of $4.49. The headline EPS of $5.71 was adjusted for a $0.60 per share gain from natural gas derivatives and a $0.07 per share gain from FX.

Better-than-expected nitrogen sales volumes of ammonia, urea, and UAN largely drove the beat, with CF citing export sales opportunities as a driver of higher shipments. This is an encouraging sign of the company’s ability to place tons in the most opportune market available, even if those markets are offshore. Tony Will, CF’s CEO, said in a comment last month that he considers CF not a North American nitrogen producer but a global producer advantaged by its asset base located in the low-cost region of North America. CF’s quarterly results are a proof of its global reach.

Natural Gas Hedges a Positive

Investors were pleasantly surprised by CF’s 1H14 natural gas hedging. CF has locked in attractive hedges covering much of the company’s 1H14 needs in the mid-$3.50 range. This is in comparison to 1Q14 natural gas prices, which are tracking closer to $4.76/mmbtu on average. Investors were fearing increase in input costs due to extreme weather throughout the U.S., but it turns out natural gas headwinds are not as strong as feared. Although it was unlikely that elevated natural gas prices would have persisted throughout 2014, the locked prices are even below market expectations, setting up for a potential cost tailwind.

Cash Deployment

CF also bought back more shares in 4Q13 than expected. The company offers one of the best cash deployment optionality in chemicals sector. CF repurchased 1.5 million shares for $338 million in 4Q13 and now has $1.4 billion left on its current $3.0 billion authorization. The company is expected to complete this authorization in 2014, and should continue to buy back shares at a solid pace into 2015 thanks to $1.0 billion of after-tax proceeds from the phosphate sale and an expected debt raise, which should bring leverage closer to CF’s 2.0-2.5x mid-cycle target.

Orica Agreement Another Step to De-risk Nitrogen Business

CF also recently announced that it had entered into a long-term ammonium nitrate (AN) supply agreement with Orica International (MKTS:OCLDY.PK), an Australian explosives and chemical producer, and Nelson Brothers LLC, a joint venture between Orica and the mining explosives company Nelson Brothers Inc. Under the terms of the agreement, CF will supply Orica 700,000-800,000 tons of AN annually from its Yazoo City plant for 10 years starting in 2017. Product pricing under the agreement will be tied to natural gas, providing CF a defined margin.

The AN will be sourced from the company’s Yazoo City complex, which has annual gross ammonia capacity of 560,000 tons, AN capacity of 1.075 million tons, and also produces some UAN and urea. Starting this year CF will invest ~$65 million at its Yazoo City plant to increase loading and production capacity. As mentioned earlier, the contract runs for 10 years, however, Orica has the option to renew for another 5 years at the end of the term.

We believe the proposed supply agreement is a positive for CF, as it provides a more stable future margin. It is important to note here that Orica was already an existing CF customer; however, the new supply agreement roughly doubles CF’s existing sales to Orica at similar cost-plus economics. The Orica agreement follows the 15-year, natural gas-linked ammonia supply agreement CF made with Mosaic (NYSE:MOS) as part of the sale of CF’s phosphate business announced in October 2013. While maintaining the ability to capture high margins from the company’s competitive position in the agricultural fertilizer market, these agreements will allow the company to further establish baseline level of earnings from industrial sales of nitrogen.

Conclusion

We have a buy rating on CF. The company has laid out a very straightforward formula to grow cash flow per share by allocating capital in economically profitable ways, while also aggressively reducing the share count. We believe the current year remains the trough year for CF’s earnings and the market is beginning to give the company credit for this, as well as for increased transparency from a capital and corporate structure perspective.

The 4Q results also highlighted the strength of CF’s sales and marketing/distribution systems and export capabilities out of its Donaldsonville plant. Given the low import levels in the near term, the U.S. urea/UAN fundamentals should also remain healthy through the spring. CF is an advantaged nitrogen producer and a beneficiary of a long-term trend for low North American energy costs. The company is also positioning itself as a pure play nitrogen producer in its efforts to attract more of a traditional long-term shareholder base.

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