CF Industries: A Cash Machine Thriving On Cheap Natural Gas – Seeking Alpha

CF Industries' (CF) outstanding cash flow generation has been well-documented here on Seeking Alpha by pretty much every author covering the stock. I will briefly touch on this aspect for readers not familiar with the company, but the main focus of this article will be the way cheap U.S. natural gas benefits the company. From that perspective, I view CF Industries as not only a solid business but also as a worthwhile hedge for investors exposed to natural gas producers.

Over the past 18 months, CF Industries has been generating considerable free cash flow. The company invested heavily in new production capacity between 2013 and 2016 and has since been reaping the benefits, selling higher volumes into a recovering nitrogen market. CF Industries currently trades at a P/E ratio of 21, hardly a bargain on the surface. However, net earnings underestimate the company's performance. With investment needs now limited to maintenance CapEx, CF Industries' free cash flow generation vastly exceeds its net result. This comes from the mismatch between Depreciation and CapEx, which were $440M and $154M respectively in H1 '19:

Source: company's 10-Q

CapEx is expected to be higher in H2 (in the region of $250-300M), but CF Industries is still on track to deliver more than $1B of FCF in FY '19. This would confirm the company's leading position in its peer group when it comes to FCF yield:

Source: company's Q2 earnings slides

Tellingly, the debate in most articles about CF Industries revolves around how the company should use its excess cash (dividend hikes or buybacks), which is a testament to the company's good health. Now, let's dig into one particular aspect that also makes CF Industries interesting, in my opinion: its exposure to U.S. natural gas.

The main driver of CF Industries' profits is obviously nitrogen fertilizer prices. But when it comes to costs, natural gas is the key input, accounting for approximately 40% of production costs in 2018 (as per the company's 10-K report). Natural gas is used both as a feedstock and as a fuel:

Natural gas is the principal raw material used to produce nitrogen fertilizers. We use natural gas both as a chemical feedstock and as a fuel to produce ammonia, granular urea, urea ammonium nitrate solution, ammonium nitrate and other nitrogen products. Because most of our nitrogen fertilizer manufacturing facilities are located in the United States and Canada, North American natural gas comprises a significant portion of the total production cost of our products.[...] Our facilities utilize the following natural gas hubs: Henry Hub in Louisiana; SONAT in Louisiana; TETCO ELA in Louisiana; ONEOK in Oklahoma; AECO in Alberta; Ventura in Iowa; Demarcation in Kansas; Welcome in Minnesota; Dawn in Ontario; Parkway in Ontario; and the National Balancing Point in the United Kingdom.

(Source: company's 10-K)

In the 2013-2016 period, North American producers faced increased competition from U.S.-bound Chinese exports. Since then, however, the volumes have receded significantly as Chinese producers struggle to compete with domestic producers. The latter's market share has, in fact, increased since 2017:

Source: company's Q2 earnings slides

A quick look at energy prices in various producing regions show why North American producers have the upper hand. Despite its volatility, the Henry Hub price has consistently been much lower than international benchmarks over the past few years:

Source: company's Q2 earnings slides

Unsurprisingly, North American producers, in particular, CF Industries' modern facilities, find themselves on the low end of the cost curve:

Source: company's Q2 earnings slides

With market prices influenced by the marginal producers' costs, CF Industries enjoys substantial margins. There are contrasting views as to where U.S. natural gas prices are headed in the next few years, including bearish reports such as this recent one from Markit. There are also reasons to be bullish. However, barring a nationwide fracking ban, it's reasonable to assume that U.S. prices will remain extremely competitive on the world stage. Therefore, CF Industries can be expected to keep its competitive advantage. With regard to competitors from North America itself, like Nutrien (NTR), there are no major capacity increases planned for the next couple of years.

This is not to say that CF Industries should be complacent. Russian exports shouldn't be overlooked:

Our competitors in Russia continue to benefit from non-market pricing of natural gas, allowing continued exports from the region, and have significant nitrogen fertilizer export capacity. The 2016 revocations of U.S. antidumping measures on solid urea and fertilizer grade ammonium nitrate from Russia has allowed for increases in imports from that country in recent years.

(Source: company's 10-K)

However, with Chinese volumes still hampered by higher energy costs and more stringent environmental restrictions than in the past, CF Industries' competitive position remains secure. That being said, even if U.S. natural gas prices remain consistently lower in relation to other benchmarks, they do fluctuate in absolute terms. How much of a difference does the price variance make? In last year's Q4 presentation, CF Industries provided the following sensitivity analysis:

Source: Company's Q4 '18 presentation

A $1 per MMBtu change is seen to have an impact of about $250M on CF Industries' EBITDA (and free cash flow). This is a material impact, which equates to approximately 25% of the expected FCF for FY '19. The important thing to note in the table below is that the solid H1 '19 results were recorded at an average price of $3.15, which is significantly higher than Henry Hub market price registered in recent months (the average includes higher UK prices, but UK volumes do not make a big impact on the weighted average):

Source: company's 10-Q

CF Industries uses the first-in first-out accounting method for its natural gas inventories and some hedging instruments, so it takes time for low prices to be reflected in the P&L. But given the low market prices since April, investors can expect cheaper gas in the Q3 and Q4 cost of sales.

Of course, quarterly prices are of little importance. The point here is to show that the company's excellent results of late were not based on particularly low natural gas prices. If bearish projections for natural gas materialize, investors could be looking at an additional $250-300M in FCF on a yearly basis. Natgas producers' loss is CF Industries' gain, and in that sense, CF Industries offers some protection to investors exposed to natural gas.

CF Industries is a solid option for investors looking for exposure to the fertilizer sector. It enjoys a cost advantage related to natural gas, its fuel and main feedstock, that protects it from most foreign competitors. This translates into high margins and substantial free cash flow generation, which the market has been slow to recognize. Because natural gas is such an important component of its cost structure, I also view the company as a hedge should the bearish projections on U.S. natural gas materialize.

Finally, for investors not afraid of MLPs and micro caps, let me mention another nitrogen producer which offers plenty of potential: CVR Partners, LP (UAN). This MLP also benefits from low natural gas prices, even if one of its facilities uses petcoke as feedstock. The bull thesis on CVR Partners has been well covered here on Seeking Alpha.

Disclosure: I am/we are long CF, NTR, UAN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The opinions and views expressed in this article are for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector.

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CF Industries: A Cash Machine Thriving On Cheap Natural Gas - Seeking Alpha