For a lengthy period of time, being an Agrium Inc. (TSX:AGU)(NYSE:AGU) shareholder was only for the most patient investors. In 2013 the company successfully fended off a takeover by activist hedge fund JANA partners, who wanted to split up the company’s retail and wholesale segments into separate companies to unravel valuation discounts in both businesses. When the takeover was fended off, the share price plunged.
Then in mid-2013, Russian-based Uralkali and Belarussian-based Belaruskali announced a break-up of their joint potash marketing cartel, which resulted in potash prices plunging over 25% as both companies independently pursued volume-over-price strategies. This was bad news for Agrium’s potash segment.
While Agrium shares languished for most of 2014, things are changing. Since October 2014 Agrium shares climbed 34%, spurred by activist investor ValueAct Capital initiating a position. ValueAct just expanded its position by 22%, giving them control of 6.8% of Agrium’s float. Unlike JANA, ValueAct is engaging in a more passive buy-and-hold strategy.
Here are three reasons why ValueAct upped its stake.
1. Agrium has a unique business model that offers a competitive advantage
The core of the bullish thesis for Agrium lies in its business model. Like Agrium’s fertilizer peers, Agrium has a volatile wholesale fertilizer segment, which produces potash, phosphate and nitrogen. This segment is subject to global fertilizer prices and is highly cyclical with both huge upside and downside potential.
Unlike its peers, about half of Agrium’s earnings come from its retail segment, which sells crop protection products, seeds, and crop nutrients. The CEO of ValueAct Capital described the retail segment as a “stable jewel,” and therein lies its advantage.
Agrium’s retail segment has been able to produce strong and growing earnings regardless of what is happening with corn or fertilizer prices. Retail earnings have steadily grown since 1997 from $50 million to $1.15 billion despite several downturns in corn and fertilizer prices. This stability allows Agrium to receive counter-cyclical cash flows. When wholesale prices are weak, Agrium can use retail cash flows to pursue growth opportunities, and when they are strong, cash can be funneled into the retail business.
2. Agrium is expecting huge free cash flow growth
Free cash flow is the most important measure of profitability. Unlike earnings, which take into account non-cash charges like depreciation, free cash flow looks at the company’s cash flow from operations and subtracts capital expenditures to arrive at how much cash was actually generated.
Thanks to a combination of potash and nitrogen sales growth, cost reductions due to the completion of its Vanscoy potash expansion project, operational improvements at its Carseland and Redwater nitrogen facilities, and the impending completion of its Borger nitrogen expansion, Agrium is expecting 15-20% earnings before income, taxes, depreciation, and amortization growth through 2017. This is combined with steadily falling capital expenditures.
As a result, Agrium should see its free cash flow grow from an estimated $600 million in 2015 to $1.4 billion by 2018.
3. Free cash flow growth will drive a potential 50% growth in the dividend
Not only is Agrium growing its free cash flow, but it has also committed to use that free cash flow to propel dividend growth, which should also reward the stock with a higher multiple. Agrium recently announced an increase in its payout ratio from 25-35% of free cash flow to 40-50% of free cash flow.
Agrium’s expected 133% growth of free cash flow, coupled with an increase in payout ratio, means Agrium can expect huge growth in its dividend. Assuming Agrium pays out 50% of 2018’s $1.4 billion in free cash flow, this would result in $700 million available for dividends, or $4.86 per share, up from the current $3.50 per share.
Agrium is also currently in the midst of a share buyback program (5% of common shares), and with excess free cash flow over the next several years, it is possible this could continue, and a 10% buyback of the float before 2018 could boost the dividend up to $5.46 per share.
