TERRA NITROGEN COMPANY, LP TNH [NYSE] Style: Small Cap Market Cap: $2.01B Buy Price: $65.48 Industry: Agricultural Chemicals Last Price: $139.66 Recommendation: Hold Type: Cyclical Fair Value: $95.59 short-termSUMMARY RECOMMENDATION: Through at least 2014, the agriculture chemicals industry outlook is very Price data as of: attractive due to a number of factors discussed below in the thesis summary. Despite the positive outlook for the industry and Terra Nitrogen, 7/6/11 the stock is currently overvalued as compared to the estimated fair value. Prepared by: Regardless of the lofty valuation, the outlook through the 2011 third Matthew Scullen quarter is positive due to aggressive targets for corn production. I recommend holding Terra Nitrogen at least through the third quarter. Analyst does not own a position in TNH while Investors holding the stock are expected to be well compensated through initiating coverage an approximate 8% dividend yield. Terra Nitrogens MLP status means they have a residual payout policy with a rich history of paying dividends.BUSINESS DESCRIPTION i:Terra Nitrogen Company, LP produces and distributes nitrogen (N) fertilizer products essential forboosting key crop yields. The primary products are anhydrous ammonia (ammonia) and ureaammonium nitrate solutions (UAN). Ammonia, UAN and other N fertilizers are mostly applied tocorn, wheat, cotton, rice and sugar cane in the North American region. Corn is the main crop focus ofTerra Nitrogen. Growth is therefore dependent on global demand for these crops. Due to Nabsorption by crops and nitrogen evaporating or leaching, it must be reapplied every year to keepcrop yield and quality high. This typically results in steady demand for nitrogen fertilizer on a year-to-year basis. The application is seasonal, where spring and fall traditionally have higher demandbecause of planting and harvesting. Weather patterns can alter this trend if farmers decide to delayplanting or harvesting in anticipation of better conditions.The company is a wholly owned subsidiary of Terra Industries, Inc., which is a wholly ownedsubsidiary of CF Industries, Inc.The manufacturing facility is located in Verdigris, Oklahoma where it is the second largest UANproduction facility in North America. It has two ammonia plants, two nitric acid plants, two UANplants, all owned by the partnership and a leased port terminal. The facility is designed to operatecontinuously. The location is strategically located to serve the Corn Belt region. Capacity at the plantsis reflected below in Table 1:
Table 1 Product Annual Capacity (tons) % of Total N. American Capacity Ammonia 1,100,000 7% UAN (32% N Content) 2,000,000 14%Approximately 70% of the ammonia produced is used for upgrading to UAN.Products are sold to dealers, national farm retail chains, distributors and other fertilizer producersand users. Sales our exclusively wholesale, but ultimately the end-users are farmers. 26% of sales in2010 were concentrated with 5 customers and 1 customer accounted for 9% of total sales. CFIndustries, effective 1/1/2011, is now the only customer of Terra Nitrogen Company.Natural gas is the raw material used to produce N fertilizers. In 2010 it accounted for 50% of thecompanies’ cost of goods sold. Natural gas prices therefore have a significant effect on gross margins.The facility is served by the OneOK gas pipeline, which Terra Nitrogen states gives a basis advantageas compared to Henry Hub.Recent DevelopmentsCF Industries acquired Terra Industries during the first quarter of 2010. Previously, Terra NitrogenCompany was an indirect wholly owned subsidiary of Terra Industries. Subsequent to theacquisition, CF Industries through their holding company took all of the rights and obligations fromTerra Industries to conduct the operations of the limited partnership for Terra Nitrogen. As a result,Terra Nitrogen’s product is now sold exclusively to CF Industries.Another consequence of the acquisition was its affect on Terra Nitrogen’s credit facilities. The eventtriggered a “technical default” and terminated the $50 million credit facility in place. Fortunately,Terra Nitrogen has adequate cash flows and cash deposits and had no outstanding credit used fromthe facility; the “default” was non-material to the operations of the company.THESIS SUMMARY N fertilizer application is essential to The growing global middle class is high crop yields experiencing diet shifts to meats, Domestically, anti-dumping policy, fruits and vegetables. Feeding lower natural gas prices and a lower livestock requires abundant sources trending dollar protects against low of feed, which require more fertilizer. cost importers Consumption is outpacing production The global financial crisis reduced and historically low stock to use global production and curtailed ratios are sending agriculture prices expansion plans, but not population higher growth Fertilizers are the most efficient way Ethanol mandates require large corn to boost crop yields acreage devotion, which requires nitrogen fertilizer
COMPETITION:The competitive landscape for N fertilizer products is based from “price, supply, delivery time andquality of service”ii. Competition comes from both domestic and foreign N producers. Competition issubsequently analyzed from the perspective of Porter’s Five Forces: Threat of entry The fertilizer industry is fairly mature with many large established firms. Many of these producers already have large capital investments in PP&E, long established relationships with buyers and suppliers, in some instances well-known brand names and strategic locations centralized in the Great Plains region. Facilities located in the corn-belt region where known supply chains lead to production efficiencies and centralized product distribution advantages to customers create barriers to new entrants. Extrapolating from Terra Nitrogens 2010 PP&E and inventory balance along with total North American Capacity, an estimate can be made for the cost of start up, excluding labor costs. Table 2 represents a hypothetical entrant firm, Firm ABC, which represents a 1.5% market share. Table 2iii TNH Firm ABC* Gross PPE (in 000s) 273,600 4,350 Inventory, net (in 000s) 27,600 431 Total Investment 4,782 Domestic Firm ABC* Total Capacity (000 metric tonnes) 13,396 209 *Firm ABC represents 1.5% domestic market share The considerable start up cost and time to bring a new facility on line suggest new entrants are unlikely. Persistently high ammonia, urea and UAN prices could theoretically lead to new entrants as profits are typically higher than normal, especially in conjunction with low natural gas prices as is the state currently. Most likely, additional capacity would come from existing competition expanding their production capabilities. The cost represents little extra above existing capex. Competition from foreign exporters can be a significant source of new competitors. Many of these foreign exporters have subsidized natural gas costs, which can make them more competitive in price. This is especially true when the dollar has been strengthening and imports of fertilizer become relatively more attractive. A weaker dollar leads to the opposite conclusion, where imports become relatively less attractive. Foreign exporters also gain advantage when domestic prices of natural gas become relatively high due to their gas subsidy advantages.
Power of suppliers Specifically for Terra Nitrogen, they receive natural gas materials through the OneOK pipeline. While this pipeline is strategically located for abundant access, any disruptions or disagreements with suppliers could adversely affect production at the Vertigris facility. That being said, natural gas is a widely used, exchange-traded commodity. Its pricing is not controlled by suppliers in a material way. Terra Nitrogen does not rely on any single natural gas supplier and therefore the power of suppliers is not a significant factor.Power of buyers Farmers’ ultimately account for the majority of end users in N fertilizers. Due to the intensive needs of crops like corn and wheat, N fertilizer application is required annually from crops draining the soil of its natural N content. Therefore, buyers are limited in their power in that they must apply N to their soil at least annually and only have control over the timing of the application. In the case of Terra Nitrogen, a single customer accounted for 9% of their sales with 26% concentrated in the hands of 5 customers during 2010. Having a concentration of buyers in theory could limit the ability of Terra Nitrogen to pass along increasing costs and allow buyers to control terms by threatening to switch business to other suppliers. In reality, ammonia, UAN and urea are all commodity products with widely quoted prices. As a result, switching would most likely be triggered by untimely delivery and poor service.Threat of substitutesiv There are several types of nitrogen fertilizers with distinct properties, advantages and disadvantages available. Soil type, product price, application process, safety, storage, transportation ease/cost and weather conditions all impact the source of nitrogen farmers decide to use. There is not significant differentiation among crop yields between nitrogen sources if applied correctly. Depending on the relevancy of these factors, buyers can easily substitute products. The most widely used types are described below. Anhydrous Ammonia AA (82% N): Must be injected into the soil. Of all of the forms of nitrogen fertilizer, AA has the slowest nitrate conversion rate. Most AA is upgraded to urea or solutions. Benefits: No loss due to surface volatilization, low chance of leaching or denitrification. (defined below) Disadvantage: It is hazardous to handle, must be injected into the soil and erosion can occur on steep slopes. Urea (45-46% N): Has a relatively quick nitrate conversion, usually in less than two- weeks. It is available in prills or a granulated form. Best applied in spring when temperatures are cool. Benefits: Effective when applied correctly, is not hazardous, can be safely stored and cheaply transported. Disadvantages: Denitrification on wet or compacted soil, leaching in coarse soils, volatilization risk if surface applied.
Urea Ammonium Nitrate Solutions UAN (28-32% N): a water solution of both urea and AN. Benefits: Ease of application, handling and storage. Can be applied through sprinkler irrigation systems. Has both a fast acting component and slow acting component of N. Not hazardous. Disadvantages: Subject to the same N losses as urea (application through dribbling can make volatilization risk minimal), is more costly to transport than urea. Ammonium Sulfate AS (21% N): All of the N is in ammonia form. Benefits: Suited best for high PH soils and where low sulfur content is suspected. Generally not subject to high volatilization loss. Disadvantages: Most acidic of nitrogen fertilizers, requiring more limestone to neutralize it. Higher cost. Ammonium Nitrate AN (34% N): 50% ammonium, 50% nitrate. The ammonium quickly converts to nitrate when added to the soil. Benefits: Has no urea, therefore ideal for conditions where volatilization is expected. Disadvantages: It is potentially hazardous and is subject to leaching and dentrification immediately. Definitions: Denitrification: results in nitrogen escaping the soil as N gas due to a deficit of oxygen in the soil. Wet soils, compact soils and warm temperatures promote this condition. Leaching: when more water (rain) enters the soil than it can hold and the N moves through the soil with it. Coarse soils (sands) pose the most risk. This risk can be minimized by limiting the time N is in the soil before plant uptake. Surface Volatilization: occurs in urea forms of N where it breaks down into ammonia gas and escapes the soil because there is not enough water to absorb it. This most often occurs when the urea is spread so there is no direct contact with the soil or when spread on corn residue. Volatilization loss results from warm temperatures, high moisture content, and high surface ph of the soil.
Rivalry among existing firmsv North American production of N fertilizer is dominated by a few firms. AA was chosen as the product to analyze from because it is generally widely produced and upgraded and therefore more comparable. To properly analyze the competition, two separate landscapes of domestic producers are presented; one with Terra Nitrogen as a separate distinct firm (Table 3) and one as a consolidated subsidiary of CF Industries (Table 4). The reason is that technically Terra Nitrogen and CF Industries are competitors. Since the acquisition of Terra Industries, CF industries has control over the operations of Terra Nitrogen and is now the sole customer. This relationship more closely resembles co-opetition in which firms work together and share market.Table 32010 N. American Annual Capacity (‘000 metric nutrient tons per year) (000s short tons) Anhydrous Ammonia, Gross UAN Nitrogen Solutions % Share # of Firms # of Firms Company Capacity of Total HH Index w/ Even % UAN** UAN % HH Index w/ Even %CF Industries 5,461 41% 1,662 2 4,520 33% 1,101 3Koch 2,076 15% 240 6 1,700 12% 156 8Agrium 2,403 18% 322 6 1,200 9% 78 11Terra Nitrogen 980 7% 54 14 1,965 14% 208 7Potash Corp 1,067 8% 63 13 2,000 15% 216 7CVR Partners (est.) 447 3% 11 30 739 5% 29 18Other (est.) 962 7% 52 14 1,500 11% 121 9Total Production* 13,396 2,403 85 13,624 1,908 64*Data from Agrium 2010-2011 Agrium Fact Book**Data from CF Industries Scotia Capital Global Fertilizer Conference 2011Table 42010 N. American Annual Capacity (‘000 metric nutrient tons per year) (000s short tons) Anhydrous Ammonia, Gross UAN Nitrogen Solutions % Share # of Firms # of FirmsCompany Capacity of Total HH Index w/ Even % UAN** UAN % HH Index w/ Even %CF Industries 6,441 48% 2,312 2 6,485 48% 2,266 2Koch 2,076 15% 240 6 1,700 12% 156 8Agrium 2,403 18% 322 6 1,200 9% 78 11Potash Corp 1,067 8% 63 13 2,000 15% 216 7CVR Partners (est.) 447 3% 11 30 739 5% 29 18Other (est.) 962 7% 52 14 1,500 11% 121 9Total Production* 13,396 3,000 71 13,624 2,865 56*Data from Agrium 2010-2011 Agrium Fact Book**Data from CF Industries Scotia Capital Global Fertilizer Conference 2011 The glaring reality from observing these charts is that CF Industries is a clear market leader in AA production and a dominant leader in UAN production. In either case, the Herfindahl-Hirschman Index (HH Index) indicates competition that more resembles a monopoly than perfect competition. What isnt perfectly known is how many other firms represent the "Other" portion of gross capacity. If more than 14 firms are represented than more competition will be present. Of course, imports represent a significant portion of competition and the market structure cannot be analyzed without it. Table 5 shows the trend in imports of Nitrogen fertilizer. Canada is excluded because it is already reflected in Tables 3 & 4.
Table 5vi Imports (Metric Tonnes), excl. Canada 2010 2009 2008 2007 Anhydrous Ammonia 5,730 4,683 6,409 7,019 Urea 4,640 3,067 3,976 4,843 UAN 2,069 779 1,954 2,415 Source: USDA/ERS, see website www.ers.usda.gov/data/fertilizertrade/ for more information. There is a trend of decreasing imports, except during 2009 when the global financial crisis dislocated markets. This is most likely due to a weak trending dollar and domestic capacity beginning to expand as well as foreign natural gas costs exceeding domestic. Table 6 adds imports to the North American Capacity picture.Table 62010 N. American Annual Capacity (‘000 metric nutrient tons per year) (000s short tons) Anhydrous Ammonia, Gross UAN Nitrogen Solutions % Share # of Firms # of FirmsCompany Capacity of Total HH Index w/ Even % UAN** UAN % HH Index w/ Even %CF Industries 6,441 34% 1,134 3 6,485 41% 1,662 2Koch 2,076 11% 118 9 1,700 11% 114 9Agrium 2,403 13% 158 8 1,200 8% 57 13Potash Corp 1,067 6% 31 18 2,000 13% 158 8CVR Partners (est.) 447 2% 5 43 739 5% 22 22Other (est.) 962 5% 25 20 1,500 9% 89 11U.S. Imports*** 5,730 30% 898 3 2,281 14% 206 7Total Production* 19,126 2,369 104 15,905 2,308 72*Data from Agrium 2010-2011 Agrium Fact Book**Data from CF Industries Scotia Capital Global Fertilizer Conference 2011***Source: USDA/ERS, see website www.ers.usda.gov/data/fertilizertrade/ for more information. Market share among the domestic producers is noticeably reduced where imports are added to the picture. Unfortunately, the HH Index for this table provides very little information because there is no indication as to the number of importers, but a realistic assumption is that the number is not concentrated. Still, CF Industries (including Terra Nitrogen) has a dominant market share for N Solutions products.
INDUSTRY DEMAND:Terra Nitrogen identifies several factors that contribute to global demand for fertilizers.Long-term drivers population growth increases in disposable income rising use of bio-fuels improvements in dietShort-term drivers world growth rates crop mix weather patterns fertilizer application rates stocks to use ratios farm income agriculture commodity prices trade policy energy pricesDemand for N is expected to grow modestly through 2014 at a CAGR of 1.01% in North America. Figure 1viiPositive outlook for bio-fuels and corn acreage Corn represents approximately 46% of fertilizer demand in North America viii. A newer source of demand for corn through the emergence of ethanol as an alternative energy is driving marginal demand for fertilizer through increased acreage of corn. The Energy Independence and Security Act (EISA) of 2007 includes provisions for a Renewable Fuel Standard (RFS) to increase the supply of alternative fuel sources by requiring fuel producers to use at least 36 billion gallons of biofuel by 2022. The RFS provision establishes a level of 15 billion gallons of conventional ethanol by 2015 and at least 21 billion gallons of cellulosic (noncornstarch) ethanol and advanced biofuels (including ethanol from sugarcane and biodiesel) by 2022ix. Figures 2 and 3x show that acreage outlooks for corn remain positive through the next 4 years. A low corn stocks to use ratio and low natural gas prices combine to represent a favorable demand scenario and abnormal margins for nitrogen fertilizer for years to come and especially for 2011.
Improving diets As developing countries grow and technology and disposable incomes increase, diets switch from rice based to meat, dairy, fruit and vegetable based. IMF research predicts emerging and developing economies will grow at over 6% through 2016 while advanced economies will only grow at slightly over 2% during the same time framexi. This requires more use of fertilizers to boost crop yields. According to The Fertilizer Institute, “Production of a pound of beef requires 7 pounds of feed and every pound of pork produced requires 4 pounds of feed.” “With the increased world population, the United Nations Food and Agriculture Organization (FAO) estimates that the total world demand for agricultural products will be 60 percent higher in 2030 than it is today. FAO projects that more than 85 percent of this additional demand will come from developing countries.”xii We’re already witnessing signs of this as evidenced by world consumption of grains outpacing growth in production. Figure 4 displays four charts showing world consumption patterns and their respective affect on fertilizer prices. Potash predicts “fertilizer as a percentage of farm revenue remains below historical average levels. We believe this is a much more sustainable situation and provides greater opportunity for improved pricing levels in the coming months and years.”xiii Figure 4xiv
Farm income The 2011 forecast from the ERS for farm income is broadly positive as shown in Figure 5. Figure 5xvTrade policy China is the worlds largest producer of nitrogen fertilizers. Due to local conditions, the Chinese government has raised existing export tariffs to promote higher domestic use of fertilizers. Given that from 2007 to 2008 the United States imported nearly 1 million tons of urea from China, this trade policy could promote more production and capacity expansion domestically in North Americaxvi. Russia and Ukraine are the largest urea exporters, but due to subsidized natural gas costs they are able to sell product at below market prices. Anti-dumping orders have been in place since 1987, as a result very little urea has been imported as compared to their production capacity. A review by the International Trade Commission is set to complete in late 2011 to determine if the anti-dumping orders should remain in place. Anti-dumping orders are also in place for Russian and Ukrainian fertilizer grade ammonium nitrate where for Russia prices are set to market and volumes are capped at 150,000 metric tons. Ukrainian imports are subject to a 156% duty. These agreements are under review and a decision will be reached by 2012. xvii These anti-dumping policies serve to protect North American fertilizer producers from unfair trade practices. If the orders are removed in the future, added competition will bring price pressures on fertilizer prices and suppress production leading to a period of low margins and depressed earnings.
Current conditions Figure 6 provides a global breakdown of the current crop conditions. If conditions improve through the summer and into fall crop yields could be expected to improve. However, if conditions remain unaccommodating to crop growth fertilizer demand will be pushed forward. Figure 6xviii
INDUSTRY SUPPLY:From 1999 to 2008, rising natural gas costs and a long period of capacity additions from the 90s ledto a period of plant closures and low production volumes. Figure 7 illustrates this history. Figure 7xixDuring this time period imports rose to meet the demand no longer being served domestically,displayed in Figure 8. Below is a copy of previously referenced Table 5, which shows the trend inimports since 2007. Production has recently stabilized with imports falling. Table 5 Imports (Metric Tonnes), excl. Canada 2010 2009 2008 2007 Anhydrous Ammonia 5,730 4,683 6,409 7,019 Urea 4,640 3,067 3,976 4,843 UAN 2,069 779 1,954 2,415 Source: USDA/ERS, see website www.ers.usda.gov/data/fertilizertrade/ for more information. Figure 8xx
The distinction should be made, that the discrepancy in N imports from Figure 8 vs. Table 5 is due toN sources. Table 5 tabulates specific N sources where Figure 8 aggregates all sources.Operating ratesTable 7xxi 2010 Ammonia Capacity 2010 UAN Capacity 2010 N Segment Capacity Company Utilization Utilization UtilizationCF Industries 83% 60% Agrium 76% Terra 104% 98% Nitrogen Potash 100% CVR 94% 92% Partners**Represents annualized data Table 8 visualizes the utilization rates among the top domestic producers for N fertilizers. CF Industries represents a large share of the market and has considerable room to expand operations, as does Agrium.
COSTS:Natural gas is the primary raw material for producing nitrogen fertilizers. The process for producinganhydrous ammonia, the basic building block for upgrade products, is summarized in figure 9 in a 5-step process. For Terra Nitrogen, natural gas represented 50% of overall costs in 2010 due to lownatural gas prices. Higher prices lead to lower gross margins as overall costs rise. Figure 9xxii
Globally, natural gas costs can vary significantly. Figure 10 is a chart that shows production costsamong the largest producing regions globally. Currently, the US has a significant cost advantage overthe majority of other producers. Figure 10xxiiiFigure 11 breaks down N importers by country during 2007/08. Surely this profile has changed dueto the dramatic decrease in US natural gas prices, giving US producers a cost advantage over majorexporting countries. Figure 11xxiv
PRINCIPAL RISKS xxv:Business risks Reliance on the Verdigris facility as the sole operations center is subject to the risk of plant disruptions caused by accidents, natural disasters or severe weather. If any disruptions were to occur, sales could be materially affected. For the most part, disruptions of this nature are largely unpredictable. Natural gas costs are highly volatile and difficult to forecast. Because natural gas prices account for the majority of production costs, any unexpected rise in price that is not hedged will have an adverse impact on margins. The fertilizer industry is cyclical in nature, subject to periods of optimism where oversupply lowers profitability and may lead to losses. 1999 through 2003 represents such a period. Fertilizer products including N are commodity products with very little differentiation and are traded globally. Foreign competitors may have lower material costs and more abundant access to resources like in the Middle East. Other foreign competitors have subsidized natural gas costs, which can result in their fertilizers having a cost advantage. Agricultural demand for fertilizers is dependent on ideal weather conditions, inventory stocks, government policies, trade policies, price volatility and population growth to name some factors. Any adverse change in any of these factors can result in lower demand for fertilizers. Terra Nitrogen, through its operating agreement, relies on CF Industries and third parties to operate. If CF Industries were to experience hardship, Terra Nitrogen may be impacted adversely as a result. Third parties provide services such as deliveries and transportation subject to similar risks as the Vertigris facility. Any disruptions in the operations of third party servicers could materially impact Terra Nitrogen. Health, safety and environmental laws are numerous in the US. These include the Clean Air Act, the Clean Water Act, the Comprehensive Environmental Response, Compensation and Liability Act, or CERCLA, the Toxic Substances Control Act and various other federal, state, provincial, local and international statutes. Accidents are an ongoing part of operations and therefore any major accident could result in major disruptions or litigation, which could have a material impact on results. Derivatives hedging is used to manage price risk in natural gas costs. Ineffective hedging could result in reduced cash flows and profitability. Any demand forecast error could result excess inventories or too few inventories to meet demand. Terra Nitrogen relies exclusively on operating cash flow to carry business and fuel growth. In the event cash flows are insufficient, additional equity and/or credit would be necessary which may not be accessible if market conditions are depressed during the time of need. A weak global economy could result in insufficient demand for agriculture and fertilizer products. Dividends are paid on a residual basis after other working capital and investment needs have been met. If there is insufficient cash on hand or to meet these needs, a dividend may not be paid. Dividends may be in jeopardy during periods of oversupply when profitability is suppressed.
Financial risk In aggregate, Terra Nitrogens financial position in terms of solvency, liquidity, accounting quality, efficiency and profitability is conservative and does not pose serious risks. The following tables illustrate the analysis. DuPont Analysis Profit Asset Financial 2010 ROE = Margin x Turnover x Leverage Solvency Ratios 96.79% 0.36 1.90 1.41 Debt / Equity - Profit Asset EBIT / Interest 504.75 2010 ROA = Margin x Turnover Current Ratio 2.24 68.51% 0.36 1.90 Cash Ratio 1.52 The DuPont analysis reveals that Terra Nitrogen is well balanced in terms of profitability and not reliant on leverage to produce a profit. Their position is highly solvent and liquid with no debt. Operating leases are present, but would not be material if present values were included in the balance sheet. Margins 2010 2009 2008 2007 2006 Gross Margin 39% 32% 48% 35% 12% Profit Margin 36% 28% 47% 32% 11% Free Cash Flow Margin 41% 26% 32% 52% 21% Margins are volatile, mainly due to volatility in natural gas prices and UAN/ammonia prices. This makes quarterly predictions in earnings subject to a high degree of uncertainty. Payout Ratio 2010 2009 2008 2007 2006 Payout Ratio 64% 183% 89% 70% 79% Terra Nitrogen is a Master Limited Partnership, which requires that it pays all available cash to its partners (shareholders). The policy is a residual dividend policy, dependent on plans for capex, cash on hand and operating cash flows. The company has a history of paying quarterly dividends dating back to 1994. The year 1999 represents the only year it did not pay at least one quarterly dividend.
Accrual Ratio 2010 2009 2008 2007 2006Accrual Ratio (0.35) 0.43 6.65 (5.88) (0.23)Accruals have no apparent trend and have averaged only 0.12 since 2006, suggesting nosuspicious accounting gimmicks.Fixed Assets 2010 2009 2008 2007 2006Average Age 11.13 11.03 7.94 9.38 10.89Total Life 16.00 15.86 11.11 13.42 16.04Remaining Life 4.87 4.84 3.17 4.03 5.15PP&E investments are fairly aged, but Terra Nitrogen consistently replaces investments ata stable enough rate that no major capex should be expected to reduce cash flows in a waythat would significantly reduce cash available to partners.Efficiency 2010 2009 2008 2007 2006ReceivablesTurnover 19.71 16.40 20.60 14.58 12.19InventoryTurnover 12.15 8.00 12.30 19.72 15.05PayablesTurnover 14.55 14.37 17.50 14.63 19.57Days of SalesOutstanding 18.51 22.26 17.72 25.04 29.95Days of Inventoryon Hand 30.03 45.63 29.67 18.51 24.26Days of PayablesOutstanding 25.09 25.39 20.86 24.95 18.65Cash ConversionCycle 23.46 42.50 26.54 18.60 35.56Inventory and sales are generally sold and collected within 30 days. Sales collection timeshave trended favorably, while inventory holding times have been stretched. Payablesappear to have been managed more efficiently, signaling confidence by creditors. Since2006, with the exception of 2009 and the global financial crisis, Terra Nitrogen haseffectively improved its cash conversion cycle.Inventories are accounted for using FIFO. Because natural gas prices are so volatile, a FIFOpolicy for inventory accounting is not necessarily aggressive.
Valuation risk The forecast of fair value for Terra Nitrogen is based upon past growth and margin observations, historical demand growth for N fertilizers and expected demand growth for N fertilizers. The probabilities of these growth scenarios are unknown due to cost and product price volatility and the fair value calculation was equal weighted. The actual revenue growth and free cash flow margin outcomes may differ significantly from what was forecast. The range of prices in the forecast scenarios is $38.21. The standard deviation of the forecasted values (aka the growth sensitivity factor) is 14.55. In the analysts view, the wider the forecast range and larger the standard deviation relative to fair value, the more uncertainty is present in the forecast of fair value, and therefore more risk. The ratio of standard deviation to fair value is 0.15. The conclusion then is that the forecast itself is not based on wildly different assumptions and contains a normal amount of uncertainty. The cost of equity capital is not calculated by use of CAPM, GGM, ABT or other widely accepted models. Instead it is the percentage of capex to equity, averaged over 5 years. The theory to using this method is that the cost of equity capital is the amount of investment needed to maintain and grow the business. There is no empirical research to suggest using capex as a % of equity is a superior method.
PRO-FORMA CASH FLOWS:Free cash flow has been projected for Terra Nitrogen though 2014 based on scenarios of revenuegrowth estimates and free cash-flow margins. Margins are estimated using historically observedmargins. (in thousands) Terminal* 2014 E 2013 E 2012 E 2011 E 2010 A Scenario 1 - Historical Revenue GrowthTotal revenues (4% Growth) 686,922 660,502 635,098 610,671 587,184 564,600 Revenue CAGR 3% 3% 111.20%FCFE Margin (Average 30%) 41%Free Cash Flow to Equity 2,575,958 198,151 190,529 183,201 176,155 230,300 Scenario 2 - Historical Nitrogen DemandTotal revenues (2% Growth) 623,364 611,141 599,158 587,410 575,892 564,600FCFE Margin (Average 30%) 41%Free Cash Flow to Equity 1,870,092 183,342 179,747 176,223 172,768 230,300 Scenario 3 - Expected Nitrogen Demand w/ Abnormal ProfitsTotal revenues (1% Growth) 593,400 587,525 581,708 575,948 570,246 564,600FCFE Margin 30% 30% 30% 40% 50% 41%Free Cash Flow to Equity 1,780,201 176,258 174,512 230,379 285,123 230,300 Scenario 4 - Expected Nitrogen Demand w/ Abnormal Profit, Overcapacity & Return to Normal ProfitsTotal revenues (1% Growth) 593,400 587,525 581,708 575,948 570,246 564,600FCFE Margin 30% 30% 20% 7% 50% 41%Free Cash Flow to Equity 1,780,201 176,258 116,342 40,316 285,123 230,300 Scenario 5 - Expected Nitrogen Demand w/ Overcapacity then Return to Normal ProfitsTotal revenues (1% Growth) 593,400 587,525 581,708 575,948 570,246 564,600FCFE Margin 30% 30% 30% 20% 7% 41%Free Cash Flow to Equity 1,780,201 176,258 174,512 115,190 39,917 230,300*Terminal cash flow estimated using the Gordon Growth Model. cost of equity capital 12%. The cost of equity capital wascalculated by using average capex as a % of equity over the past 5 years.
VALUATIONTerra Nitrogens fair value is calculated using a free cash flow to equity holders model, as estimatedin the pro-forma cash flows. Fair value is the arithmetic average of all 5 scenario values. Sharesoutstanding have been constant since the IPO at 18,502,000. (in thousands) Terminal 2014 E 2013 E 2012 E 2011 E Scenario 1 Discounted Cash Flows 1,637,068 125,928 135,615 146,047 157,281 Value per share $119.01 Scenario 2 Discounted Cash Flows 1,188,477 116,517 127,941 140,484 154,257 Value per share $93.38 Scenario 3 Discounted Cash Flows 1,131,350 112,015 124,214 183,657 254,574 Value per share $97.60 Scenario 4 Discounted Cash Flows 1,131,350 112,015 82,810 32,140 254,574 Value per share $87.17 Scenario 5 Discounted Cash Flows 1,131,350 112,015 124,214 91,829 35,640 Value per share $80.80 Fair Value: $95.59 Purchase Price: $65.48RISK ADJUSTED MARGIN OF SAFETYThe purchase price was calculated using a model that determines the margin of safety through 5 riskfactors less the dividend yield.Margin of Safety 5 Factors: Beta 0.70 0.14 D/E - - Beta AQR 0.12 0.02 D/E - Debt to Equity CFRF 0.99 0.20 ACR - Account Quality GSF 0.14 0.03 CFRF - Cash Flow Volatility - Dividend Yield 0.08 GSF - Growth Estimate SensitivityRAMS 0.32
CONCLUSIONTerra Nitrogen is a well run business in a favorable competitive position with modest, but likelyattainable growth prospects. Financially, they are conservatively positioned and have not had ahistory of large disruptions from other business risks aside from industry oversupply.The generous payout policy is attractive to investors looking for total return, where income can bereinvested back into Terra Nitrogen at favorable prices or into other opportunities. Because of theresidual policy, income investors bear extra risk that dividends are not paid every quarter.It is not recommended that investors purchase Terra Nitrogen at this price. Current partners areadvised to hold the stock as no catalyst is expected to pose significant downside momentum in thenext 3 months. Partners are expected to be well compensated with generous income from the lowcost environment and aggressive corn acreage projections for 2011. Beyond this time-frame there isconsiderable more uncertainty. If valuations remain high above fair value with no positive changes inthe outlook, a sell recommendation is advised.
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