A Perfect Storm for Terra Industries

Terra Industries (TRA) is enjoying a perfect storm for its business. Terra produces nitrogen based fertilizer products. As I'm sure everyone has heard, there is an agriculture boom taking place in the U.S. right now. Farm commodities are trading at their highest prices in decades. Ethanol and overseas food demand has led to a boom in corn production, as per-bushel prices have increased nearly threefold over just 2 years ago.

Nearly as important is the fact that natural gas prices, Terra's single largest input cost by far, have come way down over the past few months. Completing the trifecta of profitability for this company is the fact that international bulk shipping rates have remained high, which puts Terra's overseas competition at a disadvantage.

The results on Terra's business have been dramatic. Sales jumped 29% last year, and are on track for another 20% expansion this year. The one-two punch of high corn and low nat gas prices have kicked gross margin to near 30%, vs. a 5 year average around 10%. This has pushed trailing twelve month net income to $466 million. To put this in perspective, $466 million in net income is more than twice as much as Terra has ever earned in a single year. Current MFI return on capital is a nifty 72%.

But this is a classic case of the Magic Formula digging up an unattractive investment. The first question that MagicDiligence asks is: "Can the company sustain its high return on capital?" For Terra, it is highly unlikely. First, let's just take a look at history. Before this "perfect storm", Terra had 6 consecutive yearly losses from 1998-2003. Its average MFI return on capital for the profitable years was about 6%, utterly pathetic. The company was barely earning enough to cover debt interest payments. To maintain current profitability, Terra has to hope corn prices can hold levels near $6, natural gas prices hold steady, and shipping rates stay high for the foreseeable future. Is this likely?

MagicDiligence thinks it is not likely. Corn has traded in the $2.50-$3.00 range for nearly 20 years, and while it's conceivable that the median range will rise due to demand, it strikes me as unlikely that $6 is a sustainable level. In any case, corn supply is fairly easy to increase. More and more farmers will plant more and more acres of it, trying to take advantage of high prices. Of course, this fills the market with a glut of supply, and prices crater. It happens all the time with commodities. It is such a fragmented market that there is no hope of rational production when prices rise. SmartMoney even had a recent article about how well farmers were doing... a sign of a bubble if there ever was one.

Also, fertilizer production is a no-moat business. Fertilizer is fertilizer, and farmers will buy based primarily on price. While Terra has some domestic price advantages right now, a decrease in shipping rates can swing the pendulum back in favor of it's overseas competition. And that's not even mentioning natural gas, which accounts for over 70% of product cost.

Terra as a company has little control over its future. Its fate is dependent on external factors outside the company's control. This makes it extremely unpredictable, and a stock that MFI investors should avoid.