$CF Q2 Earnings Preview

by Enis August 5, 2013 2:56 pm • Commentary

Event:  CF reports their fiscal Q2 earnings on August 6th after the close.  The options market is implying about a 4.25% one day move, which is above the 4 qtr avg of about 2.25% and below the 8 qtr avg of about 4.75%.

Sentiment:  Wall Street analysts are neutral on the stock, with 9 Buys, 8 Holds and 4 Sells, and an average 12 month price target of around $211.  CF actually closed 2012 at $203.16, so it is one of the rare stocks that is down on the year in 2013.  The most important recent event though, is Daniel Loeb’s Third Point taking a new stake in the stock.  That announcement came when the stock was trading around $180 last week.  

Options Open Interest:  Open interest favors puts over calls by a ratio of about 1.2 to 1.  Even after last week’s announcement, puts have been more active than calls over the past 10 days.  The largest open interest is in August expiry, concentrated around the 190-205 strike calls and the 175-160 puts.

Price Action / Technicals:  Despite last week’s strong bounce on the Loeb stake news, CF is essentially unchanged over the last 2 years.  That’s major underperformance relative to the bulk of the U.S. stock market.  The weekly chart shows how the stock has muddled about in 2012 and 2013:

[caption id="attachment_28881" align="alignnone" width="640"]CF weekly chart, Courtesy of Bloomberg CF weekly chart, Courtesy of Bloomberg[/caption]

Even a generous rendering of the long-term uptrend line shows that it’s been broken in 2013.  In the short run, the key level to watch on the upside is the high from last week, which coincides with the unchanged mark on the year for CF, around $203.  Downside support comes into play around $185.

Fundamentals:  Here are the key lines from Dan Loeb’s recent investment letter detailing his investment in CF:

CF Industries is North America’s largest nitrogen fertilizer manufacturer and one of the lowest-cost producers globally.  CF currently trades at an unwarranted discount to fertilizer and commodity chemical peers.  We believe its structural cash flow generation strength is misunderstood and that management should deliver a much larger divided to its shareholders.  Such a dividend would highlight the sustainability of its cash flow generation and lead to a substantial re-rating.

CF’s access to low-cost North American natural gas – the primary input in nitrogen fertilizer production – gives the company a structural, sustainable margin capture relative to global peers with higher input costs.  These same competitors provide a floor for the nitrogen fertilizer price, because they idle production when the price nears their cost (“the cost floor”).  The spread between CF’s production cost and that of the higher cost producers is a sustainable stream of cash flow for CF, with limited volatility.  Using an onerous set of assumptions for this spread ($5 Henry Hub/natural gas input cost and $275 per ton nitrogen fertilizer price), we estimate this cash flow stream would be ~$1.2 billion annually (operating free cash flow less maintenance CapEx, post expansion).  On today’s equity value, that would mean CF is currently trading at an 11% free cash flow yield using these onerous assumption.  Given the low-risk profile of this portion of CF’s cash flow, it should receive a bond-like multiple (e.g. 7-8% yield), which alone implies significant upside to the current share price.

In the near term, investors will be closely eyeing management to see if executives take Loeb’s suggestion about an increased dividend seriously.  On the business front, I don’t expect much change.

After Loeb’s announcement, CF stock rallied above $200 from around $180, but sold off later in the week after the news from Urakali that it was breaking the potash cartel, likely leading to prices 25% below current levels.  POT and MOS were more severely impacted since CF only has about 15% of its sales in phosphate-based fertilizers (the rest is nitrogen), which produce only about 5% of its profits.  The long-term impact is much less negative for CF as a result.  However, CF’s valuation discount (about 8x forward P/E, vs. 10-11x for MOS and POT) relative to the rest of the fertilizer group is now less pronounced.

Volatility:   Implied volatility moved higher last week after the Loeb letter, which is to be expected since the stock was up almost 12% on July 29th.  That’s reflected in the spike higher in 30 day realized volatility (blue) in the chart below:

[caption id="attachment_28887" align="alignnone" width="667"]30 day implied volatility (red) vs. 30 day realized volatility (blue) in CF, Courtesy of LiveVolPro 30 day implied volatility (red) vs. 30 day realized volatility (blue) in CF, Courtesy of LiveVolPro[/caption]

Implied volatility is near the highs of the past year, though in about the same place it was prior to last quarter’s earnings release.  Given that CF has not moved more than 7% on an earnings event since October 2008, selling the earnings move might be an interesting way to structure a trade ahead of tomorrow afternoon’s release.