All too often, we see investors fixated on commodity prices when looking at Materials sector stocks. Oil, natural gas, corn, sugar and livestock are all important commodities that receive much attention and often serve as many Materials businesses’ main inputs. While commodity prices may impact businesses’ profits and stock price in the short term, investors can count on strong fundamentals to increase the value of Materials businesses over the long term.
There are a few great companies hidden underneath all of the chatter about agricultural commodity prices -- and CF Industries (NYSE:CF) is one. CF is the country’s largest producer of a product that will always be in demand: nitrogen-based agricultural fertilizer. While many investors watch agricultural output prices — corn, soybeans and wheat — as indicators for demand for fertilizer, CF’s business is strong enough to generate cash flow no matter how cheap these crops may become in 2015. CF’s products are a key component in the productivity of farms nationwide and its fertilizer ensures that the world’s growing population will have enough to eat.
CF has been able to capitalize on this steady demand for its products. Since going public in 2005, CF has grown after-tax operating profits (NOPAT) by 47% compounded annually. And over that time, the company has increased its after-tax margins from 4% to an impressive 35% — quite a feat in the Materials sector where products are usually prone to commoditization and low margins. While its possible these margins will fall going forward, CF’s unmatched scale and cost advantage will allow it to maintain higher margins than competitors.
CF also earns a top-quintile return on invested capital (ROIC) of over 21% and has earned positive free cash flow almost every year since its IPO (the exception being 2009, when it paid $4.7 billion to acquire a rival fertilizer maker). This healthy free cash flow allows CF to sustain its quarterly dividend of $1.50.
In addition to these already great fundamentals, low energy prices this year will be a boon for CF. Natural gas alone accounted for 41% of CF’s cost of goods sold for fertilizers in 2013.
While CF’s great fundamentals brought the stock up 20% in 2014, there’s still value to be had here. At its current price of $314/share, CF has a price to economic book value (PEBV) ratio of 0.8. This number implies that the market expects CF’s NOPAT to permanently decline by 20%. This negative outlook seems rather off base given CF’s history of profit growth, the tailwinds of low natural gas prices and its $2.1 billion plant expansion in Louisiana scheduled to open later this year. We think CF is seriously undervalued at its current price and warrants a closer look from investors.
Disclosure: David Trainer and André Rouillard receive no compensation to write about any specific stock, style, or theme.