CF ($15.20) <CF Industries > by ruby831

**blast_investor** Fri Nov 04, 2005 2:39 am

CF ($15.20) <CF Industries > by ruby831
9/19/2005 10:42:00 AM CF ($15.20) <CF Industries > by ruby831 Rating 5.6 (21 users)

Description:
CF Industries (“CF”) offers an opportunity to invest at 2.6x TTM EBITDA or 5.0x TTM FCF, and below recent management purchases and stock options. We believe cash-flow will continue to be robust, and the company may take shareholder friendly actions. The recent spike in natural gas has created this opportunity, as the market is concerned about the company’s ability to push increased costs through...More

Catalyst:
• Company reports 3Q results and gets a couple of quarters under its belt as a public company

• Natural gas spike receeds somewhat, and/or fertilizer companies are able to withstand

• Morgan Stanley and JP Morgan initiate coverage

• Company potentially announces a stock buyback

**blast_investor** Fri Nov 04, 2005 2:38 pm

9/19/2005 10:42:00 AM CF ($15.20) <CF Industries > by ruby831 Rating 5.6 (21 users)

Description:

CF Industries (“CF”) offers an opportunity to invest at 2.6x TTM EBITDA or 5.0x TTM
FCF, and below recent management purchases and stock options. We believe cash-flow
will continue to be robust, and the company may take shareholder friendly actions.
The recent spike in natural gas has created this opportunity, as the market is
concerned about the company’s ability to push increased costs
through.

Shrs: 55MM
Mkt cap: $836MM
Net cash: $107MM

Overview:

CF is a leading manufacturer and distributor of nitrogen and phosphate based
fertilizer products in North America. The company was founded as a cooperative in 1948 –
and owned by its customers (agricultural cooperatives). The company was IPO’d at
$16/share on August 11th, with the sale of 47.4 million shares. All proceeds went to
selling shareholders, and most selling shareholders sold 100% of their stake. We
believe there were a number of interesting dynamics in play, which caused the IPO to
be priced at a discount to fair value:

• The selling shareholders, agricultural cooperatives, are not private equity
investors, and to a certain degree this was “found money” for
them

• Management, which did not previously have significant ownership, was granted 2.7
million shares struck at the IPO price. Therefore, the lower the IPO price, the
better for management.

• To the extent the company was trying to maximize the price they could get, it
would seem strange to do such a large deal in a boring business in
mid-August

• To the extent the sellers were savvy, it seems like they would not have sold
100% of their holdings in most cases – but instead, would have helped the supply/demand
dynamic by selling some at the IPO price and some at (presumably) a higher price
some time from now

• While the company has almost $2/share of net cash, management indicated that
they planned to look at doing a bond offering subsequent to the deal as they believe
this business should carry some debt. Again, to the extent the sellers were trying to
maximize their value, why didn’t they simply dividend themselves cash and put $200
million of debt on the business before IPOing it rather than letting it happen
post-deal

• This also raises an interesting question of what will the company do with all of
this cash, especially since it generates significant free cash flow and there are
limited acquisition opportunities. We believe management may do a stock buyback to
realize value for shareholders

The fertilizer industry is cyclical, with low (but generally steady) demand growth
and lumpy supply growth – especially with nitrogen, where large-scale facilities
are required and the global industry is fragmented. There was a major dislocation in
demand for five years after the fall of the Soviet Union, but in general the market
cyclicality is supply driven.

Natural gas is the principal raw material used to produce nitrogen fertilizers,
and constitutes a substantial majority of the cash costs. High natural gas costs over
the last few years have led to a significant decline in North American capacity,
which has been displaced by imports from low natural gas cost parts of the world. On
the phosphate side of the business, North America has significant reserves and is a
net exporter. Declining phosphate buying from China – which has become more
self-sufficient – has largely been offset by increased buying from South
America.

The company’s primary nitrogen fertilizer products are ammonia, urea and UAN. It
operates North America’s largest nitrogen fertilizer production facilities in
Donaldsonville, Louisiana and North America’s third largest in Medicine Hat, Alberta,
Canada. The company’s main phosphate fertilizer products are DAP and MAP. Its
phosphate fertilizer manufacturing operations are located in central Florida and consist of
a phosphate fertilizer chemical complex in Plant City and a phosphate rock mine,
beneficiation plant and phosphate rock reserves in Hardee
County.

Importantly, the company also owns and operates one of the most extensive
distribution systems for nitrogen and phosphate fertilizers in North America. These
facilities are located principally in the grain-producing regions of the Midwest, and give
the company a competitive barrier vs. imports. This has insulated the company
somewhat from lower-cost natural gas nitrogen imports, and in some cases the company can
even make build/buy decisions to import ammonia and use its own distribution
system.

CF was historically run for the benefit of its owners, and not with a profit
motive. In late 2002, after suffering significant losses, the company started to adjust
the way it ran its business and conduct itself on an arms-length basis and with a
profit motive.

• Customer rationalization. Owner-customers accounted for 88% of sales in 2002,
but just under 60% in 2004. Previously, geographic and strategic realities were
ignored for the purpose of over serving an owner (in a remote geography) or being
prohibited from serving a non-owner who might be adjacently
located

• Irrational pricing programs have been eliminated. Previously, owners could
lock-in the price of nitrogen fertilizer for months ahead based on the prevailing
natural gas prices. If natural gas went up, CF was held to the contract. If natural gas
went down, the owner could re-cut at lower prices.

• Risk management programs have been introduced. The company introduced forward
pricing programs to reduce its exposure – and the exposure of its customers – to
natural gas volatility.

• Natural gas dependency management. The company is looking at a JV in
Trinidad/Tobago, which would be a world-scale facility with cheap natural gas. Secondly, the
company is looking at using alternative feedstocks (i.e. petroleum coke or
coal).

Earnings model & valuation:

2002 2003 2004 LTM(6/30) 2005
Revenue 1,014 1,370 1,651 1,891 1,980
Multiple 0.72 0.53 0.44 0.39 0.37

EBITDA 85 95 234 277 285
Multiple 8.6 7.7 3.1 2.6 2.6
Margin 8.4% 7.0% 14.1% 14.7% 14.4%

Capex 26 29 34 54 70

EBITDA-Capex 59 67 200 223 215
Multiple 12.4 11.0 3.6 3.3 3.4

FCF/s (txd/norm w/c) 0.69 0.79 2.36 2.64 2.54
Mult (ex-net cash) 19.1 16.8 5.6 5.0 5.2

3Q performance should be fine, and not particularly impacted by the recent natural
gas spikes – although it is seasonally a slower quarter. 4Q05 and 1Q06 are the
bigger question marks and so far it is too early to tell whether fertilizer producers
will be able to fully offset natural gas increases. However, industry management
teams we have spoken with seem reasonably comfortable – although it is difficult for
them to know (or say) much yet. To be clear, fertilizer prices have been moving up –
the question is not can they raise prices, but can they raise them fast enough and
high enough. Over a longer time horizon, we believe the company will do $160-180
million of mid-cycle EBITDA. With $50 million of mid-cycle capex, and giving
EBITDA-capex an 8-10 multiple, we would have a stock in the low $20s. Given that the company
is currently generating significant free cash flow above this, there should be room
for this value to grow toward the mid-$20s over the next 12
months.

Terra Industries (“TRA”) and Agrium (“AGU”) are probably the best U.S. comps.
TRA, probably the closer comp since it is entirely nitrogen fertilizer, trades at 4.4x
TTM EBITDA. AGU is more diversified and probably a better business, with modest
South American exposure as well as a potash and retail business, and trades at 4.5x TTM
EBITDA. At 4.4x TTM EBITDA, CF would be a $24 stock. This would equate to 8.5x
TTM FCF (ex-net cash) on a fully-taxed basis. Capital intensity is comparable at TRA,
and has been higher at AGU, so EBITDA is not a comparison that unfairly favors CF.
For example, FCF comparisons are slightly more favorable to
CF.

Catalysts:
• Company reports 3Q results and gets a couple of quarters under its belt as a
public company

• Natural gas spike receeds somewhat, and/or fertilizer companies are able to
withstand

• Morgan Stanley and JP Morgan initiate coverage

• Company potentially announces a stock buyback

Risks:
• North American nitrogen fertilizer producers are not able to pass through
explosive natural gas prices either due to customer rejection or displacement from foreign
sources

• Global/North American economy slows down, negatively impacting farmer demand
(although demand has been less cyclical than supply
historically).

• Management uses excess cash-flow and debt proceeds for poor-return capital
projects or overpriced M&A

Catalyst:

• Company reports 3Q results and gets a couple of quarters under its belt as a
public company

• Natural gas spike receeds somewhat, and/or fertilizer companies are able to
withstand

• Morgan Stanley and JP Morgan initiate coverage

• Company potentially announces a stock buyback