Incitec Pivot: A smelly business

As the world’s population breached 3.5 billion people in 1970, there was widespread panic. How would they all be fed?

A flood of doom-laden books emerged, of which Paul Ehlrich’s The Population Bomb was the most famous. The Club of Rome’s Limits to Growth and the resurrected ideas of Thomas Malthus made much the same argument; that explosive population growth would, inevitably, lead to a shortage of food and mass starvation. The species was doomed.

Instead, humanity has thrived. Last year the population surpassed seven billion and still produced a food surplus. Fertiliser goes a long way to explaining how Ehlrich’s predicted catastrophe failed to emerge. The application of nutrients to the earth’s soil has massively increased food supply.

The case for fertiliser is relatively easy to make. Land productivity has been falling for decades while population has been rising (see Chart 1). Increasing the food supply has required a massive increase in fertiliser application (see Chart 2). As Asia develops, more fertiliser will be needed to feed more people. Does that make Australia’s largest fertiliser business, Incitec Pivot, worth buying? Before we can answer that, we need to know something about fertiliser itself.

Growth industry, or boring as...?

The productivity of plants is determined mainly by the availability of nitrogen. As this was understood in the 1800s, there was a rush to access sources of minable nitrogen. Bat droppings were best and, for a time, the continual growth of the human species came down to access to bat poo. A war, in 1865, was even fought for control of the best deposits in South America. (Fighting over oil seems so much more civilised—Ed).

Then, in the early 20^th century, a German chemist made a miraculous discovery. Fritz Haber separated nitrogen from air, turning it into distilled ammonia which could be applied to plants. The ‘Haber process’ has been among the most celebrated scientific discoveries in history and has turned agriculture into an industrial pursuit.

Today, 99% of all artificial nitrogen comes from the Haber process and about 2% of the world’s power goes into making ammonia that, indirectly, feeds 40% of the world’s population. Without fertiliser, we’d struggle to put food on the table.

Two businesses

Incitec has two businesses linked by common nitrogen chemistry; fertilisers and explosives. The fertiliser business makes nitrogen-based fertilisers (urea and ammonia) and phosphate fertilisers (MAP and DAP—see Shoptalk). The explosives business manufactures ammonium nitrate-based explosives but also sells a suite of services and advice.

Fertiliser is a commodity but, unlike metals and oil, the quantity of available nitrogen isn’t limited by nature. The only restraint to supply is access to lots of cheap power. Phosphate-based fertilisers are limited by nature but, in practice, supplies of phosphate rock are relatively abundant. As prices rise, new supply is quickly available, which inevitably sees prices fall again.

In this capital-intensive, high fixed cost business, the key determinant of profit is price. Incitec is highly exposed to international prices; A $10 move in the price of DAP will alter earnings before interest and tax (EBIT) by about $10m. Incitec last year generated $450m, about  55% of its EBIT, from fertilisers. Like agriculture, this is a cyclical business and, with DAP prices at historic highs (see Chart 3), times are good.

The inherent cyclicality of the business has been compounded by management’s ambitions. In 2008, as the global financial crisis was turning from disaster to calamity, management paid $3.3bn in cash and shares for Dyno Nobel. As commodity prices retreated and investment plans were shelved, Incitec slashed the value of its investment by $500m. A year later the company was forced into a $1.1bn capital raising to repay the debt incurred for that acquisition.

Dyno Nobel, the largest explosives supplier in North America (and the second largest in the world behind Orica), is riding the mining boom. Explosives are a technically challenging but vital part of mining, especially in bulk commodities like coal and iron ore. As an industry where small mistakes have huge consequences, the business is capable of high margins from selling explosives and ancillary products like detonators. Last year explosives generated about $370m or 45% of Incitec’s EBIT and there’s potential for that figure to grow.

Looking at recent measures of profitability suggest that despite the buoyant conditions, Incitec is reaping no bonanza (see Table 1). Return on equity of 12% is respectable, but consider that this is the greatest mining boom in a generation; that fertiliser prices are several times their historic average and that Incitec carries debt. In those circumstances, return on equity is modest. Return on assets is a measly 9%. If the company can’t turn a decent profit now, it probably never will. A great business, this is not.

Reasons to sell

If a chronically cyclical business with questionable management can’t make hay at the top of the boom, why would one ever own it? There are only two reasons: If it was very cheap, or if one had the view that fertiliser prices were going up.

Higher fertiliser demand is a near certainty but supply is growing just as fast. Between now and 2014, 65 new ammonia plants, 23 of them in China, will be built, which is why a surplus of nitrogen fertilisers is forecast for several more years (see Chart 4).

The situation for phosphate fertilisers isn’t much different; 40 new MAP and DAP plants are under construction, which should more than make up for the increase in demand. Higher DAP prices are often forecast, always hoped for but, given increasing supply, just as unlikely. Given the increase in production from these new plants, fertiliser prices are unlikely to rise much in the future.

Although it’s no basket case, Incitec isn’t cheap either. The PER of 11.5 isn’t exorbitant but free cash flow, as you can see from Table 1, has been modest despite favourable conditions. With Incitec trading at 1.4 times book value investors are assuming higher returns from a business that has typically struggled to achieve them.

No conservative investor should own a cyclical business like this, especially during cyclical peaks, unless it was priced very, very cheaply. Incitec Pivot isn’t. SELL.