The Real Story: Potash Has China Syndrome

The fertilizer giant has lost some ability to set prices; there's more risk than investors realize.
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Having a guaranteed contract to provide roughly 30% of the fertilizer potash to the most populous nation on earth seems like a pretty favorable spot. Perhaps that's why investors have bid up shares of Potash Corp. of Saskatchewan (POT) 24% since the beginning of the year and 7% since the company's first-quarter earnings release on April 26.

If Potash were a family-owned business whose primary concerns were to put food on the tables of its owners and employees, then there wouldn't be much of a story. The company makes money and will continue to do so for the foreseeable future. However, the stock may contain more risk than investors realize, even though it's already down 15% from its 52-week high.

China Questions

Potash is the world's largest fertilizer company, and it has 22% of the world's potash capacity. It is a major exporter to China through Canpotex, a consortium that is one-third owned by Potash.

Agrium

(AGU)

and

The Mosaic Company

(MOS) - Get Report

own the rest.

Canpotex has a multiyear contract with Sinofert, the largest fertilizer importer in China. Potash also owns 20% of Sinofert. Previously, Sinofert was responsible for negotiating and setting the contracted price of potash imports for the entire country. The price that was negotiated between Sinofert, and Canpotex influenced potash prices all over the world, leaving Potash in an enviable position.

However, this year, the Chinese Ministry of Planning is taking the negotiations away from individual companies and has directed a federal buying committee to settle on a price. Furthermore, Canpotex has been removed from the negotiating table. Instead, the government is working with Belaruskali, a new Belarusian consortium. Once Belaruskali and the Chinese buying committee agree on a price, it will be the same price at which Canpotex and others will have to deliver their guaranteed amounts of potash.

Potash prices rose nearly 40% last year. The average selling price in 2005 was $170 per ton, according to Credit Suisse First Boston. The potash industry was looking to push through another $40-per-ton increase in 2006. Potash spokesman Tim Herrod says China decided to negotiate with Belaruskali because of the perception that the new group would be a "weak-kneed seller."

So far that hasn't been the case. Belaruskali has only dropped the requested increase to $35 per ton, according to Credit Suisse. Not surprisingly, China was looking for a decrease of as much as $20 per ton.

Potash issued 2006 earnings guidance of $5.25 to $6.25 per share, largely dependent on where the China contract settles. Credit Suisse analyst Walter Young said a $10 or $20 increase, as opposed to a $40 increase, could cause earnings to fall to the lower part of the range.

While the negotiations are going on, Canpotex is not shipping any potash into China. That significantly affected first-quarter results for Potash, as there have been no sales to China in 2006, the company said

Excluding a 12-cents-per-share tax recovery related to a recent Candian appeals court decision, Potash reported first-quarter earnings of $1.07 per share, slightly lower than last year's $1.15. However, that figure included another tax item that most of the Street seems to be ignoring.

During the quarter, Potash paid $14.2 million in provincial mining and other taxes (these taxes are different from regular income taxes), $24.2 million less than it paid a year ago. That figure is partially tied to a percentage of the company's potash gross margins, which were markedly lower because of the China situation. If you add back in the $24.2 million more in provincial mining and other taxes that were paid last year, Potash would have earned 24 cents per share less in the first quarter. Remove that 24 cents per share from the equation, and you're looking at earnings of 83 cents instead of $1.07.

Perhaps once the shipments to China resume, those taxes will catch up to last year's levels as we get deeper into 2006 -- at which point be sure to check if they're labeled as a one-time item, since there was no special mention of the earnings advantage because of the lower taxes in the first quarter.

The Rest of the World

India is also an important customer for fertilizer. Last year, India paid $210 per ton for potash, significantly more than China. The Indian Department of Fertilizers is now seeking a $10-per-ton decrease. Should the price in China turn out to be lower than expected, I wouldn't be surprised if India demands an even larger decrease.

While Potash Corp controls a significant portion of the world's potash capacity, there are other sources coming online. The Chinese government expects to increase its domestic production by nearly 20% in 2006, to 3.1 metric tons.

Rio Tinto

(RTP)

is expected to approve a new potash mine in Argentina in mid-2006. The location in South America is important, as it is believed the vast majority of the potash mined will go to Brazil. The freight charges should be significantly less for potash coming from Argentina than for potash coming from Canada, where Potash is located.

The Looney

Another risk to Potash's earnings picture is the strength of the Canadian dollar. The looney is currently trading near 91 cents per U.S. dollar, a 22-year high. CIBC World Markets' Jacob Bout estimates that for every penny that the Canadian dollar rises, Potash will see an earnings haircut of 5 cents per share.

Jack Crooks, President of Black Swan Capital, said the Canadian dollar "is a proxy for North America without the baggage of the United States." He points to the fact that Canada is a surplus country and that its economy is closely tied to commodities as reasons that the Canadian dollar could continue to strengthen.

Because of the wild card of the China negotiations, it's a little difficult to assume a bearish or bullish opinion. However, I suspect that earnings will fall toward the lower end of the guided range, as the likelihood is strong that the company will see an unsatisfactory outcome in China, increased competition or an impact from currency exchange rates. Considering the risks that are out there, I believe Potash shares are more than fairly valued.

As originally published, this story contained an error. Please see

Corrections and Clarifications.

In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.

Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86,87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback;

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