Top Fortune 500 stock: Why is MOS up 342%

As food prices rise, fertilizer producer Mosaic Co. is cashing in. And despite the massive runup in its shares, they actually look underpriced.

By Jon Birger, senior writer

(Fortune) -- How deep do you have to dig to find last year's best-performing FORTUNE 500 stock? Try a mile underground.

That's where I was one morning this past March, riding shotgun with Mosaic Co. mine superintendent Murray Schlamp as he navigated his pickup through an underground labyrinth so vast that we had to drive nearly half an hour just to get to the latest drilling site. (How we didn't get lost, I'll never know.)

Located in Esterhazy, a 2,500-person hamlet in the Canadian province of Saskatchewan, the mine produces potash--a reddish, crystalline mineral used as fertilizer by farmers all around the world. Esterhazy is the world's largest potash mine, and Mosaic (MOS, Fortune 500) is the second-leading producer of potash and the leading producer of another key fertilizer, diammonium phosphate, otherwise known as DAP.

See how Mosaic mines for giant profits
Not so long ago, those designations weren't worth much. As recently as 2006, Mosaic was losing money and was considered by analysts and investors to be one of the agriculture sector's weakest companies.

"The returns in fertilizer were very poor, and there just wasn't enough money to go around for all the players," says Mosaic CEO Jim Prokopanko, a former Cargill executive who took Mosaic's reins in January 2007.

Food riots raging in Haiti and Egypt demonstrate how much has changed. With global food demand rising and biofuels consuming an ever-bigger slice of the grain supply, the prices of corn, wheat, rice and soybeans have all doubled or tripled since 2006, driving up demand for fertilizer. Along the way, Mosaic has become to the "dot-corn" era what Cisco was to dot-com: the pick-and-shovel stock of a new boom. (You know the cliché: it wasn't the prospectors who got rich during the California gold rush but the folks who outfitted them.)

Since 2006, potash prices have increased 190% while prices for DAP have risen 400%. Mosaic's share price and earnings growth have followed similar trajectories. Mosaic's stock gained 342% last year--the best showing of any Fortune 500 company--and it's up another 25% so far in 2008.

As for Mosaic's earnings, they were up 1,134% in the quarter ended February 29th, to $521 million, from $42 million in the same quarter last year. That three-month profit tally was more than Mosaic earned in all of 2007, 2006, and 2005 combined. Yet Merrill Lynch analyst Don Carson declares in a recent report that while Mosaic's latest earnings rise is "significant, it will appear minor when compared to the margin expansion in coming quarters." Carson's rationale: Mosaic was selling both potash and DAP for less than half current market prices last quarter, on account of a time lag in its sales contracts.

Indeed, Mosaic's earnings are growing so rapidly that the stock looks underpriced despite the massive run-up. Its forward P/E--the ratio of Mosaic's stock price to next four quarters of projected earnings per share--now stands at 14. That's a shade lower than the forward P/E of the S&P 500 (whose collective earnings are projected to be up only 7%, vs. 160% for Mosaic). It also represents a discount to ag-sector peers Syngenta (SYT) (18 P/E), Potash Corp. of Saskatchewan (POT) (18), and Monsanto (MON, Fortune 500) (30).

Higher food prices, more demand for fertilizer
Valuation isn't the only reason Mosaic remains an attractive long-term holding. Fertilizer prices are tied to grain prices, and it's hard to see a scenario whereby food prices don't keep rising long-term, even if there are some dips along the way.

"If you look at the supply and demand numbers, you can see there's a lot of pricing momentum for fertilizer companies," says Robb Parlanti, a senior portfolio manager at Turner Funds, which owned 1.6 million Mosaic shares at year-end.

While much of the credit (or blame) for rising food prices gets heaped on ethanol, Prokopanko thinks ethanol is getting a bad rap. "It's still a food-driven market," he says. World population and world food demand are both growing at a 1.25% annualized rate, whereas about 5% of world grain and oilseeds are used to make biofuels. "So even if you were to take biofuels out of the equation," he says, "within four years that hole would be filled up with food demand."

The growth in food demand may actually outstrip population growth going forward. Why? The urbanization of the developing world--formerly rural populations in India and China adopting a more middle-class lifestyle--will lead to greater consumption of beef, pork and chicken. Thought it sounds counterintuitive, shifting from grains to meat actually increases demand for grains. For every pound of beef produced, a steer must consume approximately 15 pounds of grain. The ratios are only slightly lower for pork and chicken.

The impact of this shift can already be seen in the sharp decline in world food stocks, which are at their lowest levels in decades. Back in 1986, farmers grew 30% more grain and oilseeds than the world population consumed. This year, the so-called stock-to-use ratio will be 12%, even less in India and China. "At 10%, that means you have 36.5 days of grain left in the world," says Prokopanko. "You probably have more food in your refrigerator and pantry."

The only solution, he says, is to grow bigger crops. Whichever way that is accomplished--via higher-yielding seeds or by putting more land into farm production--it's going to require more fertilizer. "These plants are going to grow more vigorously," Prokopanko says of the latest generation of genetically-modified seeds. "My view is that GMO is going to require more crop nutrients to feed these plants."

GMO isn't the only advance in ag technology likely to boost fertilizer demand. So too will the push for cellulosic ethanol that was codified in the 2007 energy act. One goal of the act is to alleviate pressure on the food supply by creating a new kind of ethanol derived from agricultural waste (corn stalks, for instance) or from low-maintenance crops like switchgrass that can be grown on marginal farmland.

Prokopanko is dubious about making cellulosic ethanol from switchgrass: He believes the cost of bailing and transporting switchgrass will prove uneconomic. Corn stalks (also known as corn stover) may be a more viable feedstock, but there's a reason farmers traditionally leave stover on their fields after harvest.

"There is some residual phosphate and potash in it," says Prokopanko. "It's a closed system--you take the corn stover off the field, the soil deteriorates and the nutrients need to be replaced." In other words, any shift towards cellulosic ethanol would create even keener demand for fertilizer.

All this begs a key question: Won't rising demand and sky-high prices lead to new fertilizer supply coming online and eventually to lower prices? Over time, it probably will. But the barriers to entry for newcomers are high. The mine shaft in Esterhazy cost $50 million when it was completed in 1962. "To replicate that today would be $500 million--just to put the shaft down," says Prokopanko. "And it's going to take you five years minimum to develop a new mine complex and a mill and all the infrastructure. Total, it would probably cost you $2.5 billion." (Mosaic recently announced mine-expansion plans that will increase its annual potash production from 10 million metric tons to 17 million, a project expected to cost $3.2 billion over 12 years.)

This is not to say that Mosaic's stock is without risks. Agriculture remains a cyclical industry, and while the new floor for corn, for example, may prove to be $3.50 a bushel instead of $1.50, any big drop in grain prices would temper demand for fertilizer.

There could also be short-term pressure on Mosaic stock if its biggest shareholder--Cargill--were to sell. Mosaic was formed in 2004 by the merger of publicly traded IMC Global (which at the time was in some financial trouble) with Cargill Crop Nutrition, a spun-off unit of Cargill. The deal has been a big winner for all involved--Mosaic stock is up tenfold since the merger--but the payoff for privately held Cargill has been otherworldly.

IMC Global contributed all of Mosaic's potash reserves and about two-thirds of its phosphates, yet Cargill wound up with two-thirds of Mosaic's common stock. "The stupidest thing the former IMC Global ever did was agree to the merger with Cargill," says one Wall Street analyst who tracks Mosaic.

Cargill's stake in Mosaic is now worth more than $35 billion, and analysts are a little worried about what might happen to Mosaic's share price should Cargill decide to cash out, thereby flooding the market with a secondary offering.

Prokopanko won¹t speak for his former employer, but he does have a plan that could alleviate pressure on Cargill to take profits. Were Mosaic's credit rating to be upped to investment grade--an upgrade that could come "within the next few quarters," according to Standard & Poor's--it would free the company from debt covenants that currently prevent Mosaic from paying dividends. "Given tight fertilizer markets and very strong cash flow," reports Fitch Ratings, "the company continues to pay back debt and will likely reach its goal of achieving an investment grade rating in 2008/2009."

Once Mosaic gets an investment grade rating, Mosaic will likely start paying a dividend, Prokopanko says.

Add a dividend to triple-digit earnings growth, and Mosaic might even repeat as the FORTUNE 500's stock market champ.