Potash Corporation of Saskatchewan Inc.: Undervalued or Value Trap?

With Potash Corporation of Saskatchewan Inc. (TSX:POT)(NYSE:POT) shares at an eight-year low, are shares currently a bargain or a trap for investors?

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Potash Corporation of Saskatchewan Inc. (TSX:POT)(NYSE:POT) has seen its realized prices for potash plunge from $411 per ton in 2011 all the way down to an expected $266 per ton this year and took Potash Corp.’s earnings as well as share price down with it.

While this is certainly negative, it is important to remember that potash is different from other commodities. Unlike coal, for example, which is largely tied to how much steel China produces, or oil, which is tied to GDP growth in major oil-consuming countries such as China and the U.S., potash use is tied to demand for food—which is growing.

These strong fundamentals will help limit the decline in prices for Potash Corp.’s key product and should also help protect Potash Corp. investors from a value-trap scenario where investors buy an undervalued stock only to see earnings and the share price plunge even further.

Potash Corp. shares seem affordable

Currently, Potash Corp. is trading at 14.5 times its estimated 2015 earnings per share of $1.64. Over the past 10 years, Potash Corp. has traded at an average of 21 times its trailing 12-month earnings, and over the past three years Potash Corp. has traded at about 18 times its earnings.

Looking at the previous three years is important, because during this period Potash Corp. was in an earnings free fall, and even during most of this period investors were still offering Potash Corp. a higher multiple than they are at this point.

Potash Corp.’s affordability really comes to light when looking at 2016 earnings predictions. Both RBC as well as TD Bank are projecting a 2016 year-end earnings per share of $1.77. Potash Corp. is guiding between $1.55 and $1.65 per share this year, and this means that even if Potash Corp. comes in at the high end of its range, it could see 7.2% earnings growth next year if RBC and TD are correct.

This would make 2016 the first year since 2011 that Potash Corp. grew its earnings. If RBC and TD are correct, Potash Corp. will almost certainly see an increase in share price as investors push the P/E ratio a little closer to average and away from the current levels, which are implying very low expectations for the stock going forward.

Of course, all this assumes RBC and TD are correct in their earnings forecasts for 2016, and this forecast depends on assumptions about what prices Potash Corp. will receive for potash as well as its production levels

The free fall in potash prices may be close to over

For 2016, both RBC and TD are expecting slight declines in potash prices from 2015 levels. TD, for example, is expecting realized prices to decline from $266 this year to $262 next year. Both banks, however, are anticipating an increase in sales volumes from this year, which explains the increase in earnings.

Are these predictions reasonable? It seems that they are. Almost all forecasts anticipate that global potash demand will increase next year. This year global shipments are estimated to be 58-59 million tons, and next year shipments are expected to increase over 60 million tons. The International Fertilizer Industry Association is expecting demand to be 65-66 million tons; Mosaic Corp. is expecting demand of 61-63 million tons; and Potash Corp. is expecting similar numbers.

While this year’s demand is a major decline from the all-time record of 62.7 million tons set in 2014, analysts attribute the drop to the fact that large inventories that were built up in 2014 were being drawn down—the decline is not due to an actual decline in demand. With inventory levels lower now, demand is set to rise once again.

This means that Potash Corp. will see its shipments grow next year along with the market as long as it maintains its market share, which the company should have no difficulties doing because it has plenty of spare capacity.

The demand growth should also help with prices, and while new supply is expected to come online, it is not expected for a few years, which means there should be little additional downside pressure on prices for 2016. The end result is that Potash Corp. is looking much more like an undervalued stock than a value trap.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Adam Mancini has no position in any stocks mentioned.

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