The Real Reasons Fertilizer Stocks Are In the Dirt

Wednesday afternoon the sell-off in fertilizer stocks was reignited. Mosaic (MOS) released its latest earnings report and the results were good, but not good enough.

We were prepared for some rough times, but I don’t think any of us thought it was going to get this bad:

Mosaic (MOS) down $104.
Potash Corp (POT) down $139.
Agrium (AGU) down $70.
Sure, Mosaic is growing profits, margins, cash flows, and sales, but they missed expectations. In a market like this, missing by just a penny could easily result in a disastrous sell-off.

Mosaic missed, and paid the price. Shares plummeted 40% on Thursday.

For anyone looking to “buy on bad news,” there’s a lot more to consider. This sell-off in once-darling fertilizer stocks has happened for a lot of reasons. And those same reasons are what will limit fertilizer stocks' upside from here.

1. Great Expectations, Big Disappointments

As I stated back in early August in reference to fertilizer companies,

Expectations were just too high. Nobody could live up to them…

From here it could be a long way to go before the uptrend resumes in these stocks.

It has been a long way down since then. The fundamentals haven’t been able to stop the downward momentum.

Big expectations usually lead to big disappointments.

2. Basic Current Valuation

I know the basic arguments: Mosaic has a forward P/E ratio of 4, its margins have been regularly expanding, it sold off Saskferco, and the agriculture story (emerging markets, biofuels, no new farmland, etc.), but it hasn’t played out too well over the past couple of months for fertilizer companies

Nevertheless, they have done nothing but fall over the past two months and many investors are left scratching their heads. But this one isn’t too tough to figure out.

As the world is finally starting to realize, many of the forward estimates were a bit too high. After all, high commodity prices usually have some impact on demand. And in this case, although total revenues have increased steadily for the Big Three and margins have increased, no one is expecting the great times to last.

These are mining stocks and are highly cycle. You have to price those discounts into the market.

Granted, it’s going to take some time to bring new supply on line (it takes 5-7 years to bring a new potash mine on line), but it will come. Rest assured there will be more fertilizer supply coming, which will help bring fertilizer prices back down and significantly reduce the long-term profitability of many of these fertilizer companies.

3. Long-term Value

The long-term is probably one of the biggest issues holding back fertilizer stocks. We cannot forget the importance of fertilizer, after all, in the last 50 years the amount of arable farmland has dropped 37% on a per capita basis. So fertilizer consumption will not disappear.

High fertilizer prices have done one thing though; they’ve brought a lot of competition into the market. Potash is the perfect example. The following companies are expanding big into potash. Here are a few examples, though by no means all of them:

Mosaic – is still on schedule to ramp up its potash production by 50% over the next 12 years. In a plan laid out in April, Mosaic stated it will invest $3.15 billion in expanding its potash mines to increase production from 10.4 million tonnes to 15.5 million tonnes by 2020.

Uralkali (URALY.PK) – Despite some setbacks, Uralkali is on pace to increase its potash production by 35% by the end of 2010.

Rio Tinto (RTP) – Rio Tinto has been one of the top mining companies that has declared its intentions to move into potash mining. A little over a month ago the mining giant stated it will spend $3.5 billion to open a potash mine in Argentina.

At last report, Rio Tinto stated it expects this mine to produce about 2.3 million tonnes of potash in early 2012 and then ramp up to full capacity of 4.3 million tonnes by 2020.

BHP Billiton (BHP) – has been one of the most aggressive mining majors to jump into the potash race. BHP shelled out $284 million to buy out Anglo Potash last spring. Anglo held a 25% stake in BHP’s Saskatchewan potash project.

BHP expects this mine to start producing potash as early as 2012 and has not confirmed a timeline since the takeover. But it should be on line between 2012 and 2015.

Potash One (KCLOF) – is one of the leading potash “junior” companies. Potash One and a handful of others are still chasing after the big potash prize. Many are well funded and are actively laying the groundwork for a big joint-venture (i.e. with a foreign country that would put up a big loan in exchange for a supply agreement) or takeover.

These companies would need massive amounts of capital to go into production. If you look at some of their management teams, it would not be overly surprising to see one of them become a producing mine in the next few years.

4. Agriculture Commodity Prices have Plummeted

Finally, the price of agriculture commodities has quite a bit to do with how much fertilizer farmers are willing to use. If they’re getting record high prices for crops, there’s not much worry over some extra fertilizer costs. But when their profit per acre have dropped by 40% (which has happened recently) they’re going to tighten up the purse strings a bit.

Fertilizer demand does have some elasticity and it will be impacted by crop prices.Which are all interrelated. Corn prices might be high while soybean prices may be down, but they will reach equilibrium as farmers chase after the bigger cash crop.

So when you see Powershares DB Agriculture Fund (DBA) drop 35% from its highs earlier this year when the “food crisis” story really hit the mainstream, you know fertilizer demand (and profit levels of fertilizer producers) will surely follow.

As you can see, there is a lot more supply coming. We looked at a partial view of potash (Intrepid (IPI) has some plans, Russia’s Silvinet recovers from sinkhole problems, etc.), but as you can see, the same is true for most of the other forms of fertilizer as well. As long as we value fertilizer companies for their long-term profitability, it’s easy to understand how they all came crashing down to reality over the past couple of months.

There is a lot of supply coming and potash prices will likely stay around $500 to $1,000 a ton over the long term. They won’t be too high to attract aggressive amounts of new supply and they won’t be too low so that mines are going to have to be shut down. Potash prices will probably remain in a nice range where every company makes enough money (that’s even more likely since 2 cartels control more than 70% of world potash exports.)

Yesterday, Merrill Lynch (MER) analysts offered a pretty much bearish report on potash (all commodities in general for that matter) and I’m sure some others will follow. All of the downgrades will surely add to the selling pressure and will finally push these stocks to a bottom.

Of course, all this is pretty good news. There have been a lot of investors plowing money into the fertilizer sector over the past year (on the way up and the way back down) and it looks like most investors weren’t prepared. Fertilizer companies are still mining companies and there will be plenty of volatility.

Blame the hedge funds for pounding down the share prices or just look at it as a bubble that burst with the regular accompanying consequences, but I’m now starting to turn cautiously bullish on agriculture again.

This time around it won’t be a huge speculation fueled rising tide that lifts all boats. The long-term opportunity in agriculture is still there, but the biggest wins probably won’t be in fertilizer stocks, they’ll be in other agriculture subsectors.

Fertilizer stocks are in for a long period of ups and downs. I expect them then to have a few more months of rough going with plenty of false starts too. After all, there are still a few analysts with $300 and $400 price targets on Potash Corp that still have to turn negative before we can confirm a hard bottom.

Despite it all, anyone buying now should reasonably expect a 30% to 50% on Mosaic, Potash Corp, and Agrium despite any more ups and downs to come. Even with a lot of road blocks down the road, there is some significant value in the fertilizer producers.