Sunday, 11 June 2017

Compass Minerals International (NYSE:CMP): An alternative play of Agriculture: Part I

Compass Minerals International is a basic materials company whose principal products are rock salt, sulfate of potash and associated fertilizers. The company has been historically focused in salt mining particularly for winter roads both across the US, Canada and the UK. They also produce sulfate of potash which is an essential fertilizer for various fresh fruit and vegetable growers as bulk potash is too acidic. Most recently CMP acquired Produquímica in Brazil adding a wider array of fertilizer products to their portfolio.

In essence:

My view is that CMP is undervalued even at present product prices due to a weak cycle in salt sales in the past few years due to warm winters in North America. I consider the agricultural commodities space to be at the bottom of a lengthy downturn. Therefore upward revisions to my current relatively flat pricing for CMP's commodities would indicate substantial upside to fair value for the stock.

Why do I like CMP?

What I like about CMP is that it has a simple business. Dig stuff out the ground and sell it to people. Now what is sells are commodities. Commodities are by their nature things which are usually fungible and undifferentiated. Therefore if you want to sell a commodity the best position to be in is the low cost producer. If you can sell said commodity for less than everybody else then when the price of that commodity fluctuates and moves down the cost curve you can still make a profit selling it. Some examples of low cost producers; Australian Iron Ore ops (Rio & BHP), Canadian Potash (Potashcorp), Middle east onshore oil (Saudi Aramco) or Chilean Lithium (SQM).

[Now I should add that sometimes if you have a strong view on a commodity it is best to own marginal producers as they can have an equity value of zero at lower prices but being further up the cost curve they act like call options due to the much greater leverage to higher prices of the commodity in question. However in uncertain times looking through the cycle it is better on average to own the low cost producer]

CMP appears to have two key areas where it is a major low cost producer (a) Salt (b) Sulphate of Potash.

The Goderich salt mine owned by CMP in Ontario is the world's largest rock salt mine. The mine has therefore the advantage of great scale, a deepwater port on the Great Lakes and geographical proximity to the principal areas on the US and Canada requiring salt for deicing roads in areas like Ontario, Quebec, Michigan, Illinois, New York etc. 

CMP Annual Report 2016

What this means is CMP enjoys access to a unique asset despite selling a commodity. Therefore they have significant barriers to entry - salt is heavy so costly to import and CMP have vast scale within easy geographical access of their major markets. It would take a foolhardy competitor to try to disrupt that business as the necessary scale to compete would be hard to achieve. There is little pricing power for CMP in salt sales but they have an advantage in scale to undercut competitors. Therefore in road salt in North American I think CMP have a sustainable competitive advantage. 

The salt business is relatively low margin but is stable generating good cash flow - this is the 'cash cow' business of CMP although recent developments make it less significant than it has been historically. 

CMP Annual Report 2016

Whilst demand for salt varies due to the preceding winter as municipalities stock up their supplies before the coming winter. For as long as North America has cold winters and cars need to traverse the roads there will be demand for rock salt. CMP has other Salt mines in Louisiana and the UK but these are less significant in the overall picture although the UK Salt mine at Winsford in Cheshire is also the largest salt mine in the UK.

Cyclically in North America rock salt is not doing well at the moment. Several years of warmer winters mean that customers already have large stocks of salt and Q1 sales figures were not strong for the segment. However everything is cyclical - one or two colder winters could easily see an moderate upturn in prices and volumes. The weak Q1 sales seem baked into the current valuation to my eyes.

CMP is also the largest producer of Sulphate of Potash (SOP) in the western hemishere. 

SOP sells at a premium to Muriate of Potash (MOP) because it is more expensive to produce being less of a bulk commodity (only around 10% of Potash used globally is SOP). MOP is used for bulk crops like Corn whereas SOP is used for higher value fresh produce such as nuts and fruit due to the fact that it doesn't contain Chloride which damages crops like Tobacco and Tomatoes.

CMP has a salt facility in Ogden, Utah which produces SOP from salt flats. CMP lease the land from the State of Utah and use solar evaporation to extract SOP and Magnesium Chloride from pools of natural brine. As you can imagine this is a low cost operation as the sun does most of the work. 

[As a side note I am familiar with a similar operation in Chile being the salars of Sociedad Quimica y Minera de Chile (NYSE:SQM). SQM's salars also contain Lithium which may explain why that stock trades at such a premium to CMP - Lithium is a 'hot' idea at the moment due to its use in batteries. However people need to be aware that Julio Ponce, the controller of SQM, has serious longstanding problems with the regulators due to allegations of securities fraud and the company has a not inconsequential risk of losing its licenses to operate the salars in the Atacama. Unfortunately I think ETF based strategies do not really price this in.]

But I digress, the point is CMP has access to a unique resource in Utah because most SOP is expensive to produce requiring chemical facilities to add sulphuric acid to MOP. Therefore again CMP has a sustainable competitive advantage in its cost of production furthermore 92% of their SOP is sold within the US meaning lower distribution costs keep them competitive against imports. They are the only producer of SOP in North America. At present the strong dollar may be making imports more attractive but this is a cyclical factor - when the dollar weakens commodity prices tend to rise driving up the agricultural cycle. Most global SOP capacity is in China but much of that is not exported - CMP face import pressure from Chile, Germany and Belgium.

The market for SOP is less exciting than say Lithium and with a decent track record of harmony I see no reason why CMP would lose their leases on the salars in the near future. However it is noteworthy that this lease is renewed annually and all CMPs other assets have long leases or are owned outright.

The recent major development for CMP was the acquisition of the Brazilian agricultural supplier Produquimica. 

This company produces a variety of fertilizer products for the agriculture industry in Brazil. To my mind the timing of acquisition is positive for CMP by purchasing during depressed conditions in both the Agricultural industry and Brazil itself where the Real is very weak against the dollar at the moment. 

CMP Annual Report 2016

Produquimica offers CMP a wider product portfolio of specialized fertilizer products and alongside chemical mining facilities. There is therefore ample opportunity for cross pollination of products and extraction processes between the two businesses although the geographical / production synergies are limited. The acquisition seems like an attempt at vertical integration and a bit like horizontal integration as there are similarities in production but differences in sales channels between Produquimica and CMP. The acquisition is kind of bolt on which I quite like as it is easier to digest than a full on merger type job where the apparent synergies later evaporate. This may be a good acquisition for CMP if they can keep the associated debt under control (see Part II).

Why do I think the Agricultural sector could offer cyclical upside?

Well this chart has been doing the rounds;

Incrementum AG

What this tells you is that commodities are cheap relative to financial assets. Therefore the theory is that a reversion toward commodities being revalued upward would favour or at least be hedged by a financial asset (stock) which produces said commodities. As we saw in the Agriculture space in the 2007-2013 period of significant turmoil and monetary expansion.

Now I could be wrong but generally commodities follow cycles - prices are high, people plant more crops, there is a surplus of crops, crop prices fall, people plant fewer crops etc. And when they plant they use fertilizer.

CMP Annual Report 2016

Now Wheat prices are down since 2013 from $800+ a bushel to ~$440 today, Corn prices down from $700+ to $380 today, Soybeans down from $1600 to ~ $940 today. Go and look at the some point the prices of these commodities will pick up... we have a growing population the world over but presently a strong dollar is preventing commodity price rises. This may change as with any cycle and when it does CMP is well placed to ride a cyclical upturn in the industry. My thesis is agriculture is presently in something close to a depression - one of few sectors globally that looks genuinely cheap. 

I tend to focus on cheap sectors/countries to screen for stocks I might want to own. Much like my recent foray into gold miners.

Note: above I said CMP sells SOP not MOP which is not used for bulk commodities like Wheat and Corn but generally SOP sells at a premium spread over MOP as most producers have to add a chemical process to MOP to make SOP - therefore Compass can piggyback on that spread with their production.

So that is my qualitative thoughts on CMP. I think it has some sustainable competitive advantage from low cost operations and geographical positioning (hence a 10 year median ROIC of 14%). I think there is cyclical upside in the fertilizer space from an improvement in commodities and there is also some limited upside longer term from a series of colder winters in North America to firm up salt demand. 

In Part II I will look at why CMP offers an attractive valuation from a bottom up perspective.  

Disclaimer: I am long NYSE:CMP at present. These are opinions only, not investment advice. If in doubt read my disclaimer.

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