The Energy Report: We know that a growing population is a long-term driver of fertilizer, but what has driven the potash market so dramatically higher over the last six months?
Robert Winslow: Well, it's interesting and it's pretty simple. The key driver for all these Ag equities is rising grain prices—whether it's potash, phosphate, agricultural equipment manufacturers or any companies in the Ag space. These equities generally benefit when grain prices are rising.
It's a function of farm income—the grain complex drives farm income, which drives farm expenditures. We called the bottom of the grains back in July 2010. As the grains have come off the bottom, the obvious expectation of farmers is that they're going to make more money and they feel a little bit better. The result is that they'll spend a little bit more money perhaps on seed, fertilizer, tractors, storage bins—you name it. So, it's all driven by what the grains do.
TER: The potash stocks have had a good run over the last six months.
RW: I would actually suggest it's more like the last three or four months. Even though the grains really bottomed last summer, it took some time for the fertilizer stocks to move. When I say "the fertilizer stocks," I'm talking about the smaller-cap equities primarily; that's our focus area. And I think one of the big drivers of the move in the equities was that rising grain and food prices got picked up by the media. If you go back to December 2010, we started to see reports in leading magazines, newspapers and on TV suggesting that, based on UN data, food prices had gone back to 2008 levels. Once that kind of news gets picked up on the front page of newspapers, it does tend to drive investor interest.
TER: When the media picks up on it, retail investors come in. Is that what you're saying?
RW: Well, I think it does bring retail investors in, but not exclusively. There are also a lot of institutional investors—sophisticated investors—who are looking for the next cycle and, indeed, Ag equities are cyclical. You always want to be looking for cyclicals that are at or near a bottom or coming off a bottom; that's when you buy them. Then you want to sell them when they get toward the top. Ag was a sector wherein the fundamentals—the grain prices and supply/demand situation—were teeing up nicely and coming off a bottom, but the equities weren't moving.
TER: Does potash lag grains or other Ag crops?
RW: We've run correlations between our coverage universe of equities and the grains, and the short answer is no. I cover 15 equities in the Ag sector and when you run a correlation between those equities and the three major grains and oil seeds (i.e., corn, wheat and soybeans), it's almost a 90% correlation. So, really it's difficult to find a leader or laggard in there. They basically move together and are driven by the expectation of what the farmers will do. When I say "grains" are going up and farmers will spend more money, they won't actually spend the money until they've got it in their coveralls, so to speak; but, the investment community recognizes farmer enthusiasm and improving expectations. So, the grains and the equities move very closely to each other.
TER: The potash producers now have pricing power. But is this across the board to all the fertilizers—phosphates and others?
RW: Generally speaking, yes. Again, it's a function of higher grain prices. It's interesting; we saw this back in '08 when corn approached $8 a bushel. A lot of the major fertilizer companies were talking about $1,000/ton potash; in fact, some transactions were done at spot prices, which were around $1,000. There wasn't a lot of volume there, so, arguably, it wasn't a good indicator of price.
Depending on what part of the world you're in, potash pricing is $400–$500 per ton. And there's still some flexibility for those prices to stay there or go a little higher because it's not becoming a burden to the farmer. I would suggest that there's room to go on potash pricing still. I would say the same with phosphate because we've got pretty tight supply and demand dynamics for those fertilizers. But, I don't think that we're talking $1,000 potash again anytime soon.
TER: With the strength potash stocks have demonstrated, do you expect them to take a break?
RW: Yes, a lot of them already have taken a break. Again, coming back to the grain prices, we feel there is more risk to the downside than the upside. The grains have come off a little bit and the equities accordingly. So, yeah these sorts of breathers are healthy. I think it's important to recognize, however, that when we talk about risk to the downside versus upside, we are talking about the current cycle; we still have a bullish view for a secular uptrend in Ag commodities.
TER: Where can investors get an advantage?
RW: Well, interestingly enough, Allana Potash (TSX.V:AAA) put out a press release recently and announced another strategic investor. It's the International Finance Corporation (IFC), which is a member of the World Bank. IFC is putting $10 million into Allana; obviously, the company has done due diligence and likes what it sees there. Allana is developing the Dallol Potash project in Ethiopia, and we're quite keen on it because it's got some interesting advantages versus some of the other junior potash plays. Apparently, IFC has done its homework and has a view similar to ours.
TER: What does IFC's investment mean for the company?
RW: It's an interesting development for Allana because it provides credibility. In other words, it's not just an analyst saying it's a good project—it's a sophisticated investor saying it's a good project. And, it also helps mitigate finance risk. All of these junior fertilizer companies have to raise a tremendous amount of capital; for example, we believe Allana has to raise somewhere in the neighborhood of $800–$900 million (all in) for the total project. So, you want to be able to secure financing over time to make sure that it gets built.
When someone like the IFC steps up and puts $10 million of equity into a company, it's got some skin in the game and, arguably, will be around when it's time to raise more equity and/or debt capital. So, we think a development like this is a positive and, on the back of that development, raised our target on Allana nominally to $2.25 from $2.15. But, we do have a strong buy rating on that stock. Frankly, it's one of those stocks that could double or triple over the next two or three years as this theme plays out.
TER: Could that IFC investment have any negative implications, in terms of a potential takeover?
RW: I would say no. I think that, at the end of the day, IFC wants to help facilitate this project to help stimulate the Ethiopian economy. And if the company is taken out, it definitely would be by a bigger and better-capitalized company that should be able to ensure the project gets built. I think it'd be a win/win situation if there was to be a takeout.
TER: Your $2.25 target price has an implied +40% upside from here.
RW: Yes. It doesn't seem all that compelling but we had a $1.00 target on AAA when it was $0.40. This company is one that's gone very far, very fast and was due for a pullback.
TER: In a note, you compared Allana to the German fertilizer company K+S Aktiengesellschaft 's (Fkft:SDFG.F) acquisition of Potash One Inc. for CAD$434, I believe.
RW: Right. The interesting thing was that the Potash One multiple was estimated at 0.45 of the enterprise value (EV) to net asset value (NAV). But that was before grain and food prices had risen so much. It was closer to the bottom of the current cycle. As I said, these stocks are cyclical and I feel that we're closer to the top of the current upcycle here.
TER: Sounds like that $10 million investment from IFC really derisked this play.
RW: It helps for sure; it definitely helps. There's a long way to go yet—a lot of capital to be raised; but when you've got a partner like that working with you, that's impressive. That's well done.
TER: Allana's market cap is in the $265M range, which is high enough for mutual funds to buy the stock. You recommended AAA when it was a penny stock. Congratulations on that call, by the way.
RW: Thank you.
TER: You've seen Allana go from a level at which mutual funds couldn't buy it to where they can now. Is that where the next leg up is coming from—more institutional investors coming in?
RW: Well, that's a part of it; but I think the biggest part will come over time as the company meets and fulfills its milestones. Then, as you pointed out, when the market cap gets through certain thresholds, you can bring a new list of investors into the mix. A number that's often used here in Canada that many fund managers look at is CAD$100M market cap. When a stock gets through that level, they can start to look at it.
TER: You rate Allana a Strong Buy. Are there any other strong plays that you can mention?
RW: Yes. Another one that we follow is IC Potash Corp. (TSX.V:ICP; OTCQX:ICPTF). It's looking to develop an operation to produce sulfate of potash (SOP) from polyhalite in New Mexico in the U.S. Now, the company is working to confirm that the polyhalite-to-SOP conversion process can be done. About 50 years ago, Potash Company of America, which was acquired by PotashCorp (TSX:POT; NYSE:POT) in 1993, did some work on converting polyhalite to SOP that showed it could be done. Now, IC Potash is going back and duplicating those tests and getting favorable results.
It's early days yet and some pilot test work needs to be done, but it looks like the conversion operation will work—making it the lowest-cost (or among the lowest) SOP production in the world. It could be in the bottom 10% on the cost curve, and that's one of the reasons we like that project. Anytime a company can get costs that low, I'm intrigued; so, that stock is coming along nicely. It, too, has come off in the last three or four weeks and is not immune to the selloff in the space—but, that's one stock we like a lot.
TER: I see that IC Potash raised $20M in equity, recently. Is that enough to derisk the project?
RW: Well, it goes a fair way to derisking it. Again, the company will likely be looking at spending $600–$700 million. We estimate this recent capital raise will get IC Potash through its prefeasibility study (PFS) and into 2012. So, the company has at least a year's worth of capital to complete the milestones it plans. Then, it would have to come back to market at some point.
TER: You rate ICP a strong buy with an implied 75% upside from here.
RW: That's right, $2.50 target. We use 12-month targets.
TER: Is there a phosphate opportunity that you like?
RW: MBAC Fertilizer Corp. (TSX:MBC) is developing a phosphate project in Brazil. We like this one because, from a transport-cost perspective, it's advantaged logistically. Brazil is a large Ag-based, or Ag-centric, economy and about 25% of its GDP is driven by this sector. The country has a tremendous amount of arable land that can be expanded to help feed the world and also has an enormous amount of fresh water. So, it's got the fresh water and the land. We think agriculture will drive that economy for years and years to come. So, that's the macro view and the overlay on why we like Brazil.
Now keeping that growth in mind, consider that Brazil imports half of its phosphate and 90% of its potash. So, the country is beholden to imports for its fertilizer even though it's an Ag-centric economy. MBAC's phosphate deposit in the Cerrado is next door to the growing region that's like the Brazilian breadbasket. With this project, the company is looking at mining phosphate ore and converting it to single super phosphate (SSP)—a type of phosphate fertilizer that has sulfur in it. In phase one, MBAC is looking to bring on 500,000 tons of production by summer 2012; so, we're less than 18 months away from that. There also are prospects for phases two and three (in other words, not just 500,000 tons), but it could go up to 1.5 million tons (Mt.) of single super phosphate or other phosphate fertilizers over the next five years or so.
We estimate MBAC has a transportation advantage in the neighborhood of $60–$90/ton because, right now, the brunt of the phosphate rock that comes into Brazil comes from Morocco. Once it's on vessel in Morocco, it has to cross the ocean, land on the coast of Brazil and be offloaded and import duties will be paid. After the material is put on a truck or rail, it must be transported all the way up to the Cerrado. That whole transportation-and-logistics situation costs a tremendous amount. MBAC can eliminate that cost because it has this deposit right in the Cerrado. So, we think that advantage is competitive and sustainable. We expect MBAC to drive significant economics with this project. We're looking at about $65 million of EBITDA for phase one, and we believe that can grow to north of $200M of EBITDA with phases two and three.
TER: With that transportation advantage, it wouldn't take a lot of capital to double.
RW: Well that's the other thing. Unlike a lot of these junior stocks we talk about, the financing (on phase one) is largely done. MBAC recently raised a little over $40 million of equity and now has about $90 million of cash on the balance sheet. Now, the company's securing debt facilities with IFC and the local banks in Brazil. So, we're looking at the company just dotting the "Is" and crossing the "Ts" on these agreements. It has a bit of due diligence to do but it's very close to being done. We've got a $6 target on the stock. It's trading at around $3 now. We believe MBC could be a $15–$20 stock inside four or five years.
TER: I've enjoyed meeting with you. Thank you for your time.
RW: Thanks very much.
Before joining Wellington West Capital Markets, Robert Winslow had served as an equity analyst at Orion Securities and before that he was a strategy consultant in the Toronto and Brussels offices of Bain & Co. Robert was also employed at Caterpillar Inc. where he was a senior engineer. He earned his MS degree in engineering from Texas A&M University and his MBA from Cornell University.
Want to read more exclusive Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Expert Insights page.
DISCLOSURE:
1) George Mack of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Allana Potash.
3) Robert Winslow: I personally and/or my family own shares of the following companies mentioned in this interview: Allana Potash and MBAC Fertilizer Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None.
Robert Winslow: Well, it's interesting and it's pretty simple. The key driver for all these Ag equities is rising grain prices—whether it's potash, phosphate, agricultural equipment manufacturers or any companies in the Ag space. These equities generally benefit when grain prices are rising.
It's a function of farm income—the grain complex drives farm income, which drives farm expenditures. We called the bottom of the grains back in July 2010. As the grains have come off the bottom, the obvious expectation of farmers is that they're going to make more money and they feel a little bit better. The result is that they'll spend a little bit more money perhaps on seed, fertilizer, tractors, storage bins—you name it. So, it's all driven by what the grains do.
TER: The potash stocks have had a good run over the last six months.
RW: I would actually suggest it's more like the last three or four months. Even though the grains really bottomed last summer, it took some time for the fertilizer stocks to move. When I say "the fertilizer stocks," I'm talking about the smaller-cap equities primarily; that's our focus area. And I think one of the big drivers of the move in the equities was that rising grain and food prices got picked up by the media. If you go back to December 2010, we started to see reports in leading magazines, newspapers and on TV suggesting that, based on UN data, food prices had gone back to 2008 levels. Once that kind of news gets picked up on the front page of newspapers, it does tend to drive investor interest.
TER: When the media picks up on it, retail investors come in. Is that what you're saying?
RW: Well, I think it does bring retail investors in, but not exclusively. There are also a lot of institutional investors—sophisticated investors—who are looking for the next cycle and, indeed, Ag equities are cyclical. You always want to be looking for cyclicals that are at or near a bottom or coming off a bottom; that's when you buy them. Then you want to sell them when they get toward the top. Ag was a sector wherein the fundamentals—the grain prices and supply/demand situation—were teeing up nicely and coming off a bottom, but the equities weren't moving.
TER: Does potash lag grains or other Ag crops?
RW: We've run correlations between our coverage universe of equities and the grains, and the short answer is no. I cover 15 equities in the Ag sector and when you run a correlation between those equities and the three major grains and oil seeds (i.e., corn, wheat and soybeans), it's almost a 90% correlation. So, really it's difficult to find a leader or laggard in there. They basically move together and are driven by the expectation of what the farmers will do. When I say "grains" are going up and farmers will spend more money, they won't actually spend the money until they've got it in their coveralls, so to speak; but, the investment community recognizes farmer enthusiasm and improving expectations. So, the grains and the equities move very closely to each other.
TER: The potash producers now have pricing power. But is this across the board to all the fertilizers—phosphates and others?
RW: Generally speaking, yes. Again, it's a function of higher grain prices. It's interesting; we saw this back in '08 when corn approached $8 a bushel. A lot of the major fertilizer companies were talking about $1,000/ton potash; in fact, some transactions were done at spot prices, which were around $1,000. There wasn't a lot of volume there, so, arguably, it wasn't a good indicator of price.
Depending on what part of the world you're in, potash pricing is $400–$500 per ton. And there's still some flexibility for those prices to stay there or go a little higher because it's not becoming a burden to the farmer. I would suggest that there's room to go on potash pricing still. I would say the same with phosphate because we've got pretty tight supply and demand dynamics for those fertilizers. But, I don't think that we're talking $1,000 potash again anytime soon.
TER: With the strength potash stocks have demonstrated, do you expect them to take a break?
RW: Yes, a lot of them already have taken a break. Again, coming back to the grain prices, we feel there is more risk to the downside than the upside. The grains have come off a little bit and the equities accordingly. So, yeah these sorts of breathers are healthy. I think it's important to recognize, however, that when we talk about risk to the downside versus upside, we are talking about the current cycle; we still have a bullish view for a secular uptrend in Ag commodities.
TER: Where can investors get an advantage?
RW: Well, interestingly enough, Allana Potash (TSX.V:AAA) put out a press release recently and announced another strategic investor. It's the International Finance Corporation (IFC), which is a member of the World Bank. IFC is putting $10 million into Allana; obviously, the company has done due diligence and likes what it sees there. Allana is developing the Dallol Potash project in Ethiopia, and we're quite keen on it because it's got some interesting advantages versus some of the other junior potash plays. Apparently, IFC has done its homework and has a view similar to ours.
TER: What does IFC's investment mean for the company?
RW: It's an interesting development for Allana because it provides credibility. In other words, it's not just an analyst saying it's a good project—it's a sophisticated investor saying it's a good project. And, it also helps mitigate finance risk. All of these junior fertilizer companies have to raise a tremendous amount of capital; for example, we believe Allana has to raise somewhere in the neighborhood of $800–$900 million (all in) for the total project. So, you want to be able to secure financing over time to make sure that it gets built.
When someone like the IFC steps up and puts $10 million of equity into a company, it's got some skin in the game and, arguably, will be around when it's time to raise more equity and/or debt capital. So, we think a development like this is a positive and, on the back of that development, raised our target on Allana nominally to $2.25 from $2.15. But, we do have a strong buy rating on that stock. Frankly, it's one of those stocks that could double or triple over the next two or three years as this theme plays out.
TER: Could that IFC investment have any negative implications, in terms of a potential takeover?
RW: I would say no. I think that, at the end of the day, IFC wants to help facilitate this project to help stimulate the Ethiopian economy. And if the company is taken out, it definitely would be by a bigger and better-capitalized company that should be able to ensure the project gets built. I think it'd be a win/win situation if there was to be a takeout.
TER: Your $2.25 target price has an implied +40% upside from here.
RW: Yes. It doesn't seem all that compelling but we had a $1.00 target on AAA when it was $0.40. This company is one that's gone very far, very fast and was due for a pullback.
TER: In a note, you compared Allana to the German fertilizer company K+S Aktiengesellschaft 's (Fkft:SDFG.F) acquisition of Potash One Inc. for CAD$434, I believe.
RW: Right. The interesting thing was that the Potash One multiple was estimated at 0.45 of the enterprise value (EV) to net asset value (NAV). But that was before grain and food prices had risen so much. It was closer to the bottom of the current cycle. As I said, these stocks are cyclical and I feel that we're closer to the top of the current upcycle here.
TER: Sounds like that $10 million investment from IFC really derisked this play.
RW: It helps for sure; it definitely helps. There's a long way to go yet—a lot of capital to be raised; but when you've got a partner like that working with you, that's impressive. That's well done.
TER: Allana's market cap is in the $265M range, which is high enough for mutual funds to buy the stock. You recommended AAA when it was a penny stock. Congratulations on that call, by the way.
RW: Thank you.
TER: You've seen Allana go from a level at which mutual funds couldn't buy it to where they can now. Is that where the next leg up is coming from—more institutional investors coming in?
RW: Well, that's a part of it; but I think the biggest part will come over time as the company meets and fulfills its milestones. Then, as you pointed out, when the market cap gets through certain thresholds, you can bring a new list of investors into the mix. A number that's often used here in Canada that many fund managers look at is CAD$100M market cap. When a stock gets through that level, they can start to look at it.
TER: You rate Allana a Strong Buy. Are there any other strong plays that you can mention?
RW: Yes. Another one that we follow is IC Potash Corp. (TSX.V:ICP; OTCQX:ICPTF). It's looking to develop an operation to produce sulfate of potash (SOP) from polyhalite in New Mexico in the U.S. Now, the company is working to confirm that the polyhalite-to-SOP conversion process can be done. About 50 years ago, Potash Company of America, which was acquired by PotashCorp (TSX:POT; NYSE:POT) in 1993, did some work on converting polyhalite to SOP that showed it could be done. Now, IC Potash is going back and duplicating those tests and getting favorable results.
It's early days yet and some pilot test work needs to be done, but it looks like the conversion operation will work—making it the lowest-cost (or among the lowest) SOP production in the world. It could be in the bottom 10% on the cost curve, and that's one of the reasons we like that project. Anytime a company can get costs that low, I'm intrigued; so, that stock is coming along nicely. It, too, has come off in the last three or four weeks and is not immune to the selloff in the space—but, that's one stock we like a lot.
TER: I see that IC Potash raised $20M in equity, recently. Is that enough to derisk the project?
RW: Well, it goes a fair way to derisking it. Again, the company will likely be looking at spending $600–$700 million. We estimate this recent capital raise will get IC Potash through its prefeasibility study (PFS) and into 2012. So, the company has at least a year's worth of capital to complete the milestones it plans. Then, it would have to come back to market at some point.
TER: You rate ICP a strong buy with an implied 75% upside from here.
RW: That's right, $2.50 target. We use 12-month targets.
TER: Is there a phosphate opportunity that you like?
RW: MBAC Fertilizer Corp. (TSX:MBC) is developing a phosphate project in Brazil. We like this one because, from a transport-cost perspective, it's advantaged logistically. Brazil is a large Ag-based, or Ag-centric, economy and about 25% of its GDP is driven by this sector. The country has a tremendous amount of arable land that can be expanded to help feed the world and also has an enormous amount of fresh water. So, it's got the fresh water and the land. We think agriculture will drive that economy for years and years to come. So, that's the macro view and the overlay on why we like Brazil.
Now keeping that growth in mind, consider that Brazil imports half of its phosphate and 90% of its potash. So, the country is beholden to imports for its fertilizer even though it's an Ag-centric economy. MBAC's phosphate deposit in the Cerrado is next door to the growing region that's like the Brazilian breadbasket. With this project, the company is looking at mining phosphate ore and converting it to single super phosphate (SSP)—a type of phosphate fertilizer that has sulfur in it. In phase one, MBAC is looking to bring on 500,000 tons of production by summer 2012; so, we're less than 18 months away from that. There also are prospects for phases two and three (in other words, not just 500,000 tons), but it could go up to 1.5 million tons (Mt.) of single super phosphate or other phosphate fertilizers over the next five years or so.
We estimate MBAC has a transportation advantage in the neighborhood of $60–$90/ton because, right now, the brunt of the phosphate rock that comes into Brazil comes from Morocco. Once it's on vessel in Morocco, it has to cross the ocean, land on the coast of Brazil and be offloaded and import duties will be paid. After the material is put on a truck or rail, it must be transported all the way up to the Cerrado. That whole transportation-and-logistics situation costs a tremendous amount. MBAC can eliminate that cost because it has this deposit right in the Cerrado. So, we think that advantage is competitive and sustainable. We expect MBAC to drive significant economics with this project. We're looking at about $65 million of EBITDA for phase one, and we believe that can grow to north of $200M of EBITDA with phases two and three.
TER: With that transportation advantage, it wouldn't take a lot of capital to double.
RW: Well that's the other thing. Unlike a lot of these junior stocks we talk about, the financing (on phase one) is largely done. MBAC recently raised a little over $40 million of equity and now has about $90 million of cash on the balance sheet. Now, the company's securing debt facilities with IFC and the local banks in Brazil. So, we're looking at the company just dotting the "Is" and crossing the "Ts" on these agreements. It has a bit of due diligence to do but it's very close to being done. We've got a $6 target on the stock. It's trading at around $3 now. We believe MBC could be a $15–$20 stock inside four or five years.
TER: I've enjoyed meeting with you. Thank you for your time.
RW: Thanks very much.
Before joining Wellington West Capital Markets, Robert Winslow had served as an equity analyst at Orion Securities and before that he was a strategy consultant in the Toronto and Brussels offices of Bain & Co. Robert was also employed at Caterpillar Inc. where he was a senior engineer. He earned his MS degree in engineering from Texas A&M University and his MBA from Cornell University.
Want to read more exclusive Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Expert Insights page.
DISCLOSURE:
1) George Mack of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Allana Potash.
3) Robert Winslow: I personally and/or my family own shares of the following companies mentioned in this interview: Allana Potash and MBAC Fertilizer Corp. I personally and/or my family am paid by the following companies mentioned in this interview: None.
