Intrepid Potash: Long-Term Competitive Advantages At Reasonable Valuation

Investment Thesis

Source: icis.com

Potassium is yet another beaten down commodity suffering from overcapacity within the industry, however potash remains a key resource for the agricultural industry and with global population and food demand continuing to raise its price could easily reverse course over the next decade. Intrepid Potash (IPI) is the only potash producer in the United States. This gives the company some very important competitive advantages. Not only that but IPI also benefits from its solar evaporation production which is characterized as being less labor and energy intensive process than conventional mining.

The company has recently undergone a massive restructuring by putting on hold its conventional potash mine and significantly reducing debt. It also has access to strategic commodities such as langbeinite (marketed under the name Trio) and water, both of which hold significant potential for bottom line and cash flow expansion. In the short-run the company appears to be fairly priced, however long-term opportunities and competitive advantages remain. Despite the recent run in the stock price the low premium to book value of assets, strong financial position and skilled management make it an attractive value investment.

Potash Market

Source: Infomine

World potash market has been just another commodity market suffering from very high oversupply as a result of excess spending. As a result we have seen some wild swings in Potash price over the past decade. For those of you not that familiar of why potash is that important, this article briefly explains the importance of potash for the world food market.

The overcapacity created through the lets think big mantra and the following slump in potash prices has created an opportunity as world the consumption of potassium continues to increase and is foretasted to double by 2040 as the worlds population continue to grow while arable land is not likely to match that rate of growth (unless Elon sends us all to Mars by that time).

The global potash market is primarily supplied by miners in Canada, Russia, Belarus and China.


Source: investingnews

U.S. as one of the largest consumers of potassium in fact imports 92% of its potash from Canada, Russia, Israel and Chile. This was not left unnoticed by the U.S. government which now sees that imbalance as a threat. According to a very recent document in the Federal Register, potash appears among a list of mineral commodities that are heavily reliant on imports while at the same time vital to the nations security and economic prosperity.

Canada is the absolute leader in potash mining and a recent merger between two of the largest producers Potash Corp and Agrium has created the Goliath of the industry – Nutrien (NTR), reminiscent of the empire building behavior that led to the massive crash in potash prices in the first place. The newly created company is essentially the market maker as its production largely determines the prices of potash.

Source: Nutrien Investor Presentation Feb 2018

The ex-Potash Corp CEO has recently condemned the move saying that

the industry has sacrificed prices at the altar of volumes, chasing larger market share instead of seeking to firm up market conditions for the underlying commodity

Intrepid Potash at a Glance

With annual sales of $160m Intrepid Potash is a tiny miner within the industry that recently caught my attention after some significant insider activity, but more on that again later.

There are few things that make IPI a quite unique company:

Firstly, the company is the only producer of potash in the United States. Secondly, as opposed to its competitors which mine potash through mine shafts (shown below), IPI potash comes from solar solution mines (also shown below). Solar evaporation production is more cost-efficient as it uses less labor and energy.

Source: Nutrien Annual Report 2017

Source: USGS

Lastly, IPI is also one of the few produces in the world of langbeinite (marketed by IPI as Trio) unique combination of potassium, magnesium and sulfate largely used as a fertilizer for chlorine sensitive crops such as fruits and vegetables.

Source: Intrepid Potash Annual and Quarterly filings
IPI produces potash through three solution mining facilities in Wendover, Moab and Carlsbad. In mid-2016 the underground West facility in Carlsbad was put on hold as potash prices hit a new bottom. According to IPI management once potash prices recover they could restart production in that facility which ,however, would come at significant cost according to their annual filings.

Source: Intrepid Potash Investor Presentation June 2017

IPI Competitive Advantages

Although IPI is a price taker and must accept the price set up by the larger players it has a few key competitive advantages.

Firstly being the only producer in the U.S. gives IPI a close proximity to its clients which allows them to selectively participate in markets that provide the highest average net realized price per ton. Furthermore the lower freight costs also translate into higher average net realized sales prices per ton for IPI.

Source: Intrepid Potash, Nutrien and Mosaic Annual and Quarterly filings

The companys location also allows it to sale potash, water and other by-products to shale oil frackers in the Permian Basin. Water and byproducts sales to oilfield operators gave IPIs margin a significant boost in Q1 2018 with quarterly sales of $5.5m, and $3.7m received in cash under a separate agreement. With margins within 85%-90% range this business is adding the much needed cash flow at a time when the company is deleveraging its balance sheet and investing in key turnaround initiatives such as trucking fleet that will improve IPI’s competitive advantage of timely deliveries.

Most of the water contracts were also negotiated when oil prices have been in the mid- to high 40s range, while right now WTI crude trades at around $70 a barrel. This is likely to provide some further upside to IPIs water and byproduct business not only in terms of pricing but increased volumes as well. Moreover, as of FY 2017 around 10% of IPI potash sales were to industrial customers within the oil & gas industry. Historically this ratio has been as high as 21% in FY 2013 when WTI traded at around $100 a barrel.

Closer proximity to clients also has a positive effect on IPI asset turnover which is high relative to its peers given IPI’s significant smaller size and lack of economies of scale.

Source: Intrepid Potash, Nutrien and Mosaic Annual and Quarterly filings

Apart from the positives it is perhaps worth mentioning here that the small size of IPI and the lack of phosphate and nitrogen facilities puts IPI at a disadvantage to its peers when it comes to SG&A spending. This, however, in my opinion makes IPI an attractive target for other fertilizer businesses that could generate significant economies of scale through acquiring IPI.

Source: Intrepid Potash, Nutrien and Mosaic Annual and Quarterly filings

The second key competitive advantage of IPI is its Trio business. Trio is an unique mix of potash, magnesium and sulfate which gives IPI exposure to higher margin growers of fruits and organic products. Although Trio is currently a significant drag on the business bottom line profitability with a negative gross margin of $9.9m in FY2017, the CEO has repeatedly stressed during the last few earnings calls the fact that taken separately these three nutrients actually trade at around $100 premium to the combined Trio product. A trend that he sees reversing over coming years.

After the closure of the conventional potash mines, the Trio segment remains the only loss making facility of IPI at the moment. The true long-term benefits of the product however are key focus of IPI management as it has successfully increased volume sales during last year and is working hard on increasing sales to Central and Latin America where magnesium-deficient soils make Trio an attractive product for farmers.

Source: Intrepid Potash Annual and Quarterly filings

Source: Intrepid Potash Investor Presentation June 2017

Finally, the solar solution potash extraction provides IPI with another competitive advantage to its peers. Since the closure of its conventional mine in mid-2016 IPIs Capital Expenditure to Depreciation Expense has decreased considerably.

Source: Intrepid Potash, Nutrien and Mosaic Annual and Quarterly filings

Although a ratio of below 1.0 is unsustainable in the long run, this lower capital intensity of IPI would allow it expand its Free Cash Flow and increase investments at a time when prices of both potash and Trio are putting significant pressure on bottom line profitability.

Valuation

Based on yesterdays closing price IPI trades at only a slight premium to its book value of assets with a P/B ratio of 1.58. It is therefore not surprising that its exposure to the value factor (HML) is quite high.


Source: Author’s calculations based on Fama & French 5 factor portfolios

Relative to its largest peers, IPI valuation is somehow mixed, with Nutrien not surprisingly trading at a very high multiple of nearly x3.99 given its large size and ability to dictate prices. Mosaic, although trading at a much lower multiple has almost 10% of its assets in goodwill which depresses the P/B ratio and poses the risk of impairment. At the same time MOS has large sales exposure to Brazil where its likely to face increased competition.

Source: Morningstar

Looking at historical P/B ratio of IPI, it might seem like the ship has already sailed. While true that IPIs current valuation seem to already price in the water sales opportunity and the improved profitability in potash it is the long-term opportunity that I am focused on.

Moreover, the risk of bankruptcy has been significantly reduced over the last year which for me justifies the higher multiple. Debt-to-Equity ratio is now only 12%, compared to around 40% in 2016 and 45% and 46% for Nutrien and Mosaic in 2017. IPIs $60m of debt has also been pushed out to $24m in 2020, $18m in 2023 and another $18m in 2025.

As one famous value investor once said:

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price

Source: Author’s calculations based on Intrepid Potash Annual and Quarterly filings

I have therefore initiated a small position in IPI and would be interested in expanding that, should the price falls as a result of broad market or industry trends.

After making the following conservative assumptions for FY 2018:

potash gross margin for FY2018 to be the same as that reported in Q1 with seasonal adjustment for Q3 keeping Trio gross margin unchanged from that reported in the last twelve months water and byproduct sales of $25m (based on midpoint of the provided guidance of $20 million to $30 million) and a margin of 90% constant D&A expense and constant operating expense to sales ratio as that reported in Q1 2018

I calculate FY2018 EBITDA of $51m, compared to $32m for the last twelve months. Based on IPI’s current price this would value the company at x13.5 EV/EBITDA multiple.

Although this is in the high end of both the historical IPI and current competitors valuations, it is still based on some very conservative estimates.

It does not take into account that potash prices have rebounded in recent months and based on the management guidance and higher industrial demand potash volume sales would likely continue to improve over the course of 2018. Trio volume growth has also seen some momentum in Q1 2018 which is likely to continue as a result of the managements increased efforts to increase sales to Central and Latin America. Finally, the current guidance for water and byproduct sales is likely to prove very conservative given the increased activity in the Permian basin and the pricing tailwinds.

Ownership & Insiders Activity

Heavy insiders activity was what initially triggered my insiders transactions screener and prompted me to research IPI in more detail.

Source: Author’s calculations based on data from openinsider.com

It was when the stock hit hard rock bottom in 2016 when insiders started buying heavily. This highly contrasted the insiders selling activity pre-2015.

The CEO Robert P. Jornayvaz, a co-founder of IPI, was among the buyers since 2015 and now holds 19.4m of IPI stock or nearly 15% of all shares in circulation. Hugh Harvey, Executive Vice Chairman and also co-founder of IPI, was also among the insider buyers in 2017, adding 3.2m of stock which brought his total share count to 11.9m or 9% of all shares outstanding.

Another key owner of IPI is Prem Watsa, who has been called the Canadian Warren Buffet. He holds around 10.4 of IPI stock through Fairfax Financial Holdings.

Conclusion

At this point for me IPI still represents an excellent long-term value investment despite the recent stock price increase. It appears that short-term catalysts of the stock are fairly priced in, nevertheless long-term opportunities remain while at the same time management guidance for 2018 could prove to have been overly conservative.

IPI has also significantly improved its financial heath over the last year and by successfully leveraging on its strategic resources has turned free cash flow positive. This would allow IPI to successfully compete for market share in the potassium market.

Last but not least, IPI’s key competitive advantages and access to strategic resources would allow the management to significantly expand bottom line profitability and free cash flow generation.

Disclosure: I am/we are long IPI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies’ SEC filings. Any opinions or estimates constitute the author’s best judgment as of the date of publication, and are subject to change without notice.

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