2023-11-27 15:09:05 ET
Summary
- The recent drop in Nutrien Ltd.'s share price does not mean that the stock could now deliver satisfactory returns in the near term.
- Long-term investors should focus on evaluating the company's competitive advantages and its pricing relative to peers.
- Capital allocation is another key area of consideration for anyone willing to hold in the long run.
- Even after falling more than 50% from its all-time highs, I still see Nutrien as a hold within a well-diversified portfolio.
Investing in highly cyclical and commoditized areas of the equity market presents us with certain unique challenges that should be addressed accordingly.
A perfect example is the area of agricultural inputs or more specifically, fertilizers and agricultural chemicals where Nutrien Ltd. ( NTR ) has become the most dominant player following the merger between Agrium and PotashCorp a couple of years ago.
In a span of just 5-years, NTR has fallen well-below the broader equity market in the year leading to the pandemic, just to more than triple in price in the 2020-2022 period and to then retreat once again to levels far below the S&P 500 (SP500).
As these violent movements occur, analysts often compare Price/Earnings ratios, various yield metrics, margins, etc. in order to put forward a thesis that the stock is either over or undervalued. These metrics have their own merits, but in reality the vast majority of variance in NTR's share price could be explained by movements in certain commodity prices.
For example, the patterns of the global price of wheat and that of Nutrien are remarkably similar.
By plotting the two variables on a monthly basis for the past 5-year period, we see that the price of wheat could explain more than 80% in the variance of Nutrien share price.
prepared by the author, using data from Seeking Alpha and FRED
That's because agricultural commodities and fertilizer prices are closely linked, and the pricing of the latter is having a direct impact on Nutrien's top and bottom line.
Thus, expectations regarding Nutrien's EPS numbers are quickly revised downwards when fertilizer prices begin falling, but on top of that, in a commodity downtrend NTR tends to even surprise on the downside the already downward-revised earnings numbers.
Having said all that, it becomes nearly impossible to conceive either a bullish or bearish investment thesis for NTR, without having a strong conviction regarding the direction of commodity prices.
The impact that commodity and fertilizer prices have on share price performance, however, differs greatly from business to business.
With all that in mind, it is next to impossible to decide on whether a stock like NTR is either under or overvalued at any given point in time.
Instead, it is worth evaluating the long-term competitive advantage of the business through the lens of the stock's relative pricing against peers. This would tell us whether or not NTR is worth holding as part of a diversified portfolio, and if the stock has a much larger upside during periods of rising commodity prices.
Competitive Advantages And Relative Pricing
As a starting point, it is quite easy to see the cyclical nature of Nutrien's business by just plotting a period of roughly 5-years. Since 2019, the company's return on equity went up from 5% to more than 30%, but is now back below 10% for the past 12-month period.
prepared by the author, using data from Seeking Alpha and SEC Filings
During the same timeframe, the stock's price/book multiple has not changed materially but is now approaching levels of below 1.0, which indicates that the market does not see the company having higher return on capital than its cost of capital in the foreseeable future.
As the largest producer of potash and the third largest producer of nitrogen fertilizer in the world, this is a highly unlikely scenario over the long run. Nutrien's large size and significant economies of scale have also allowed the company to retain a much higher operating margin, when compared to some of its peers.
That is why, even though certain in-direct peers like Corteva ( CTVA ) have higher gross margins, they are still not able to compare to Nutrien in terms of operating profitability.
The low jurisdiction risk is another key trait of Nutrien. The vast majority of both sales and fixed assets are located in United States, Canada, and Australia, which also lowers risks related to logistics and international trade.
As we see from the table above, Nutrien's exposure to Brazil has also been increasing lately as the company engaged a number of retail acquisitions aimed at improving supply chain and operating efficiencies in the region. The region will also be one of the key drivers of future growth, as demand for Potash in the country is significant.
During the last conference call, Nutrien's management also indicated that Brazil and China were among the key drivers of global demand growth so far in 2023.
The two markets internationally that have really contributed to that demand growth in 2023 versus prior expectations are Brazil and China.
Source: Nutrien Q3 2023 Earnings Transcript .
Expansion in Brazil, however, will take time as Nutrien's management remains prudent regarding investing too aggressively into the market.
In Brazil, we believe the long-term prospects for agriculture are very strong and see opportunity for future growth of our retail platform. However, in the near-term, we have paused additional investments until there is greater stabilization of the market . We will utilize the spirit to integrate recent acquisitions and optimize our cost structure.
Source: Nutrien Q3 2023 Earnings Transcript (emphasis added).
Given Nutrien's strong competitive positioning in the sector, the stock still trades at a significant discount to its peers when taking into account current profitability. As seen in the graph below, NTR's Price/Book multiple is below the trend line, and as such is lower than what the company's current operating margin would suggest.
Moreover, NTR also has one of the highest tangible asset turnover ratios, in spite of its large size.
Capital Allocation Also Matters
Nutrien's competitive advantages and the company's conservative pricing relative to its peers, make it one of the attractive choices within the industry for anyone with long-term investment horizon.
In addition to all that, Nutrien's management is also prudent when it comes to capital allocation. On the graph below, we could see the relative share of cash outflows spent on capex, acquisitions, dividends and share repurchases.
What we first notice is that as the NTR stock became too expensive in 2021, the company has spent a relatively low amount on share buybacks. Consequently, as the price/book multiple fell in 2022-21 period, the relative share spent on stock repurchases has been increased. This is a very positive sign that Nutrien's management is mindful of the cyclical nature of the business when it comes to capital allocation.
Although the relative share of capex has fallen on the graph above, in reality the capital expenditure relative to the company's annual depreciation & amortization expense has been above 100% for nearly two years now.
This shows that Nutrien has been in growth mode as far as internally financed projects are concerned, but the management has now taken a more careful approach as far as expansion projects are concerned.
We are indefinitely pausing our potash ramp-up following the completion of in-flight projects in the second half. (...)
We have also made the decision to suspend work on our Geismar clean ammonia project and to defer the timing of capital spend on select brownfield expansions.
Source: Nutrien Q2 2023 Earnings Transcript (emphasis added).
This is likely to have a positive impact on free cash flow in the near term, but the share of Capex to Depreciation Expense is should not fall consistently below 100%.
Another area that NTR shareholders should follow closely is the overall debt levels and the different maturity profiles. The current interest coverage of below 7, is lower than the sector median and could be seen as a major risk factor, if the current downtrend in commodity prices is sustained.
Although the total amount of net debt has been relatively flat over the past 5 years, the higher share of short-term debt within the mix has caused a sharp increase in finance costs (see below).
It now appears that interest rates could remain higher for longer and in an event of widening credit spreads, this could put more pressure on Nutrien's share price.
Conclusion
As Nutrien's share price is falling from its cyclical highs in early 2022, the amount of analysts trying to catch a falling knife is gradually increasing. Even though the stock is now trading nearly 50% lower from its all-time highs, a turnaround would largely depend on future commodity prices, which makes short-term performance nearly impossible to forecast.
Having said all that, investors with long-term horizons and enough dry powder to cost average in an event of sustained downturn in fertilizer prices, could consider the stock as part of a diversified portfolio. Nutrien Ltd.'s strong competitive advantages and prudent capital allocation result in lower downside risk for the stock.
For further details see:
Nutrien: Focus On Competitive Positioning And Capital Allocation