Potash Corporation of Saskatchewan Inc. (TSX:POT)(NYSE:POT) looks like an attractive turnaround pick, but investors should buy it for the right reason.
Let’s take a look at the current situation.
Potash demand and supply
In 2014 worldwide shipments of potash hit a record 61 million tonnes, and the final tally for 2015 should be close to that amount. With such strong demand, it would appear the 45% haircut Potash Corp. investors have taken over the past 12 months is somewhat overdone, but there are other forces at work.
The global potash market is dominated by a handful of large producers who are currently fighting a nasty battle for market share, and that is driving down the spot price for the commodity. At some point, everyone will learn to play nice again, but that isn’t likely to happen in the near term.
The pressure in the spot market is having a rollover effect on prices for fixed-term contracts with large buyers such as China and India. Last year the Chinese negotiated a lower-than-expected price of US$315 per tonne. That could drop to US$300 per tonne in 2016.
Cash flow impact
Potash Corp. reported Q3 2015 operating cash flow of US$358 million. The company spent US$333 million on capital programs, so the business generated enough funds to pay for the investments needed to keep the mines operating.
The fourth-quarter results are expected at the end of January, and they could be a bit lean.
In December management decided to shut down three of its mines for a three-week period and fast tracked the closure of an older facility in New Brunswick. The shutdowns were expected to reduce output by 500,000 tonnes, so investors should prepare for some ugly Q4 2015 results.
Dividends
Potash Corp.’s dividend now offers a yield of more than 9%. That has pundits and investors alike wondering if the distribution is sustainable.
The company didn’t generate enough operating cash flow to cover both its capital expenditures and the dividend in Q3 2015. The gap for Q4 will likely be wider.
The Q3 shortfall was paid using savings, but Potash Corp. will probably have to tap credit lines going forward, unless capital expenditures drop significantly. That’s par for the course with many names in the commodity space right now and not a big issue if the situation is a short-term problem. If the potash market weakens further, there could be some pain for dividend investors in the back half of 2016.
Mergers and acquisitions
Potash Corp. took a run at German competitor K+S AG last year. The US$8.7 billion offer was rebuffed as being too low and Potash Corp. abandoned the pursuit. That’s a good thing for Potash Corp.’s shareholders, but there have been rumours circulating that management might try again.
If that happens and Potash Corp. is successful, shareholders could take a hit. The company would have to issue new shares and/or load up the balance sheet with new debt to pay for the acquisition. With the near-term outlook for the market still negative, a deal could also result in the dividend being trimmed.
Is this the time to buy?
Potash Corp. is trading at 9.1 times trailing earnings, which is significantly lower than the five-year average of 17. Based on this metric, the stock looks pretty cheap right now.
The long-term outlook for the business is solid, and Potash Corp. is a low-cost producer in the industry. Considering the strong fundamentals, value investors might want to start nibbling on any further weakness in the stock. Dividend investors should expect a cut and hope it doesn’t happen.
