CVR Partners (UAN): Forget oil, fertilizers are the real ‘inflation trade’ today
In recent weeks, soaring market volatility has led to dramatic increases in commodity prices. Crude oil is now firmly above $100 a barrel, wheat and gold are near record highs and soaring nickel prices have temporarily broken the London Metals Exchange. To be fair, commodity-driven inflation has had a huge impact on the market for over a year; as I have said for some time, Russia’s invasion of Ukraine has only exacerbated these pre-existing problems.
We’ve discussed the potential fallout from natural gas, oil, coal, and shipping, but one of the biggest trends this season may be in fertilizers and food. Russia is the world’s largest fertilizer exporter. Due to its immense size relative to its population, Russia has extreme export power and is the world’s largest exporter of many raw materials. Russia is also the top exporter of natural gas, the most expensive ingredient in fertilizer production, and many other key fertilizers. Fertilizer prices were skyrocketing long before the “Russian problem” due to high natural gas prices (especially in Europe). Just when fertilizer prices began to fall, the global fertilizer supply chain was thrown back into disorganization.
Stocks of fertilizer producers such as CVR Partners, LP (UAN) have seen dramatic gains over the past six months as the shortage has turned quite dramatic. While UAN has benefited from the near-multiplication of fertilizer prices, the company’s bottom line is also negatively impacted by rising input costs. Despite this, the company’s cash flow per share has fallen from around zero at the end of 2020 to $17.6 today, giving the company an attractive “P/CFO” TTM of 6.1X. See below:
Similar to shipping companies, today’s unique situation poses a mixture of positive and negative factors for the CVR. The company will likely face increased uncertainty throughout 2022. On the one hand, it looks like the fertilizer shortage will continue to grow due to even higher natural gas prices. Of course, soaring input costs may mean that companies like CVR see no increase in revenue and may even see revenue drop. Much will depend on the trade dynamics between countries, which indirectly impacts fossil fuel and fertilizer prices. Let’s take a closer look.
Shortages are good and bad for fertilizers
Manufacturers today are facing shortages on many fronts. This includes energy and electricity as well as other material input costs. Other areas of production stress include labor shortages, shipping slowdowns, and specific regulatory actions. On the one hand, this has led to dramatic increases in producer selling prices, but it has also led to substantial cost increases. For example, rising natural gas prices caused the temporary closure of many fertilizer plants, especially in the UK, where the energy crisis is worse, which meant that these fertilizer plants were losing money. in terms of costs despite high sales prices. As fertilizer supply dwindles, farmers have to pay more to produce, which is incredibly inelastic for agricultural chemicals. This leads to higher food prices, but may still mean no profit gain for farmers. See below:
Food prices, fertilizer prices and energy prices are closely linked. Over the past two years, we have seen fertilizer prices rise faster than energy prices. For example, fertilizer prices have doubled since last year while natural gas has risen about 60%, pushing up CVR’s margins. Currently, natural gas accounts for approximately 47% of CVR’s raw material costs, with most of the remaining portion going to petroleum coke (43%). Importantly, CVR’s Coffeyville plant is the only plant in North America that uses a Pet Coke-based fertilizer production process. This gives the company a competitive edge in today’s expensive natural gas market since, according to the company’s latest investor call, available supplies of Pet Coke have increased.
CVR also has the advantage of being located in the United States. Natural gas prices in Europe are currently €113/MWH, which translates to around $37/MMBTU, more than 8 times higher than current natural gas prices in the United States. It is important to note that fertilizers and their derivatives are traded internationally worldwide via dry bulk transportation. Natural gas is relatively difficult to transport overseas because it must be compressed into liquid natural gas. Since the creation of LNG is an expensive and timely process, it still does not result in globally increased North American gas exports to Eurasia. Thus, natural gas prices are relatively high in Europe while fertilizer prices are only slightly higher.
This situation is beneficial for US fertilizer producers even if they do not export since they benefit indirectly from the very competitive pricing power of exporters. Russia has even more competitive pricing power than the United States since it has more natural gas and other free energy products. So while Russia halts fertilizer exports to maintain its food supply, the few countries like the United States with sufficient domestic energy supplies enjoy significant price advantages.
Overall, I think this is definitely bullish for CVR’s bottom line growth. Although the company will continue to pay significant sums in energy costs, it has a higher cost profile than its domestic and foreign competitors. As such, its selling prices will likely remain well above its input costs, and that gap could continue to widen due to Russia’s freeze on fertilizer exports. Of course, even higher fertilizer costs can limit North and South American farmers. Although their short-term demand is inelastic, I can only imagine that some farmers will end up leaving land open if fertilizer prices rise so much that they cannot make a profit. Thus, I only expect this situation to benefit CVR in 2022 and 2023, but the company’s margins will likely return to “normal” levels in the long term.
What is UAN worth today?
As is the case with many commodity-focused companies today, CVR Partners was in a tough spot before 2020. Previously, fertilizer prices were relatively low as overseas production increased, in particularly in China. With prices falling, CVR could not turn positive raw profit, and the company’s balance sheet debt soared as its working capital approached zero.
Since then, cuts in fossil fuel production, labor and shipping issues have upended the market, forcing many countries, including China, to restrict fertilizer exports. For now, this change has been a saving grace for CVR Partners and other fertilizer producers, finally allowing the company to turn a profit large enough to slightly reduce liability charges and build up a small working capital. . See below:
CVR is a limited partnership as opposed to a C corporation, so it typically pays out a very high portion of its EBITDA in the form of dividends which, for investors, are taxed as long-term capital gains. Given the company’s past financial situation, it’s no surprise that it isn’t looking to pay all of its income in the form of dividends and instead reduces its heavy indebtedness. Of its total EBITDA of $93 million last quarter, it reserves about $37 million (~40%) for interest and debt payments as well as planned capital expenditures. Today, this equates to a high TTM yield of 9.4% which could increase further as debt is reduced.
Of course, at this point, I don’t expect CVR’s incredibly high revenue to last much beyond 2022-2023. Fundamentally, the company’s increased profits come from the fact that US fertilizer producers have lower input costs than most foreign competitors. As long as Russian natural gas imports to Europe decline and developing countries restrict fertilizer exports, this price advantage will persist. However, in the long term, I expect US natural gas prices to eventually rise in line with Europe due to increased US LNG exports and production of limited energy in the United States. At the same time, many factors give the CVR an immense short-term advantage, but few structural changes today give it a permanent competitive advantage. So while the company may see a stellar EPS of $20-30 in 2022 and likely equally strong revenue in 2023, it could fall back into weak or even negative territory thereafter.
Short-term investors looking to ride “inflation” or partially “War in Russia” trends can see substantial gains in UAN. It is part of the small but fascinating basket of stocks that are making a net gain from the current high uncertainty. Moreover, its dividend yield could easily be over 20% in 2022-2023, given its high expected earnings. Basically, the company now has a clear competitive advantage despite higher input costs since its foreign and domestic peers generally face even higher input costs.
However, from a longer-term perspective, I see plenty of reasons to be cautious with UAN. The company has extremely high debt, which leaves it little room to maneuver in case prices fall again or, more likely, if energy prices in the United States rise enough for CVR Partners to become unprofitable. . In my opinion, there is a bit more risk of a continued rise in natural gas prices than fertilizer prices, so the company’s cash flow is volatile. If we assume that its earnings will inevitably return to near-zero levels, its stock would be expensive today, even with temporarily high distributable cash flow.
Overall, I’m neutral on UAN and would generally avoid the stock as a long-term investment at its current price. That said, I wouldn’t be surprised to see the stock climb much higher in the near term as investors scramble for those few “inflationary hedge” stocks. Finally, if its profits remain high enough to significantly reduce its leverage or if the energy crisis in Eurasia worsens significantly, CVR Partners could become a more robust long-term investment.