We initially became interested in CF after Dan Loeb’s Third Point fund announced its new stake in the company in late July, when the stock was trading around $180. The stock quickly spiked to around $200, before gradually tracing back into the mid-$180’s, where we got involved for a quick, profitable call butterfly trade.
Since then, CF has rallied quite strongly, up almost 20% since Loeb announced his stake. The stock reached its highest level since February on Monday, when it announced that it had sold its phosphates business to Mosaic. While the phosphates business only made up about 15% of revenues (and just 5% of earnings), its sale was welcome news for investors who want a pure play nitrogen company, particularly with the ongoing saga in the global potash market.
As we discussed in last quarter’s earnings preview, CF trades at a relatively cheap valuation. But unlike many other value stocks that attract investors due to their stable, high free cash flow yield, CF has a much more volatile earnings stream. The company earned around $8.50 per share in 2010, around $23 in 2011, around $28 in 2012, and is expected to earn close to $23.50 this year. Aside from its volatile earnings stream, there is a bigger reason why I am not optimistic about further gains for CF in the coming months – corn prices are near 5 year lows.
Nitrogen fertilizer is used most intensively in application to corn fields. Lower corn prices generally mean less demand for fertilizer, since farmers switch away from corn and plant other crops instead. CF stock has diverged now for many months from corn:[caption id="attachment_32067" align="alignnone" width="600"] CF daily (green), vs. corn futures daily (orange), Courtesy of Bloomberg[/caption]
I don’t necessarily expect CF stock to collapse just because corn is lower. Once again, CF does have significant free cash flow yield, and a cheap valuation. But low corn prices are a significant concern for a company that is already not expected to have earnings growth for the next 2 years.
In addition, the stock has not been able to sustain the strength from Monday’s pop, which also caught my attention because the stock has approached important technical resistance:[caption id="attachment_32068" align="alignnone" width="600"] CF daily, Courtesy of Bloomberg[/caption]
The stock has failed on several occasions in the 220-230 area over the last 18 months. Against that, the 200 level is important support which has not even been tested since the stock broke out in mid-September.
With implied volatility somewhat elevated ahead of earnings on Monday afternoon, targeting this range looks attractive to me. The stock’s downside is likely limited by cheap valuation, but upside is constrained by technicals as well as a still-falling corn price and no expected earnings growth.
TRADE: CF ($215.60) Buy Dec 20th 220/210/200 Put Fly for $2.00
- Buy 1 Dec 220 Put for 11.65
- Sell 2 Dec 210 Puts at 6.50 each, for 13.00 total
- Buy 1 Dec 200 Put for 3.35
Break-Even on Dec Expiration:
Profits: Between 202 and 218, make up to $8, with max profit of $8 at 210
Losses: Up to $2.00 between 200 and 202, and between 218 and 220, with max loss of $2.00 below 200 and above 220.
Trade Rationale: If CF does retrace here, we would still expect the 200-205 support to hold the downside. On the upside, we don’t anticipate a big break higher, but a clean breach of the 222-223 area would probably have us out of the trade. This structure will take time to decay, but the 10% range seems an appropriate area to wait it out, even on minor breaches to the upside or downside. Mean reversion is our expectation for CF given the various opposing factors at play.