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Potash One Investment Report

Potash One Investment Report

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Published by Zain Khwaja
Analyst: Zain K
Date: April 20th 2010
Analyst: Zain K
Date: April 20th 2010

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Published by: Zain Khwaja on Jul 13, 2010
Copyright:Attribution Non-commercial

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10/25/2012

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Potash One Investment Analysis
Wolverine Asset Management
 
Recommendation: Hold
 The enormous returns made by potash producers in 2008, like potash corp. (graph 1) has attracted a lot of attention from players looking to enter the industry as well as investors looking to share in the potashindustry’s profits. Potash One, although not operating any potash mines currently, is an attractive suitor forinvestors as it had moved early and secured permits for potash exploration and mining; including landsitting on reserves that feed one of the biggest potash mines in the world, The Belle Plains Mine beingoperated profitably by Mosaic Co producing 2.8 million tons per year. PotashOne is scheduled to beginbuilding their flagship ‘legacy project’ mine, on that land in Q4 this year and begin potash production in2013. The plans entail a similar solution mine to the one operated by Mosaic, characterized by lower initialcapital expenditure but higher marginal costs. With 29 million tons of measured reserves and 222 milliontons inferred reserves, P1 is well placed to graduate from a junior potash player to a senior one in the next 5years. It also plans to be the first to production of several planned greenfield projects. The management has admitted that the $1.9B price tag is too much for the company to undertake on it’sown. However, there are members on the board of directors who are known to be connected in the miningindustry, and are reportedly capable of attracting the desired capital from Asia. China and India as some of the world’s leading and fastest growing consumers of potash, have significant incentive to gain a foothold inthe world’s largest potash basin and one in such a politically and economically stable climate. More likely isan acquisition by one of the larger potash producer who have shown appetite for junior potash companies. A large part of the reason the industry and indeed the legacy project are getting so much attention is thesudden and enormous upward price shock in potash prices over 2007/2008, reaching up to $1,050/ton.Investors have acknowledged the tripling of price within 12 months as a sign that the old days of potashproduction at less than 70% of capacity are over as world demand catches up to supply. The situation lastyear, while unique, does offer several insights into the future of the potash market. Specifically we saw twoof Potash Corp’s mines strike, record low inventories and sold out contract volumes. In a demonstration of market power, Potash Corp could have cranked up capacity and supply at other mines but instead chosenot to, and raked in humongous profits along with the other major potash players. The same graphs revealsthe striking correlation between potash prices and the earnings of potash producers and thus a very high‘potash price beta,’
β
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,
 
i.e the movement of the stock price with the price of potash.More recently however, potash prices tumbled down to a low of $350/ton, agreed between BelaruskaliPotash and China. The deal was heavily criticized Potash Corp’s CEO, who described the Russians as“panic sellers”. The rapid decline in price is attributed to the flexing of market powers by buyer cartels,enabled largely by the ability to forgo potash use for up to 2 years without significant decrease in yields.Canpotex refused to ink deals with China at the rock-bottom price and negotiated later for an undisclosedand ‘competitive’ price; supporting the view that potash prices are set to stabilize above their FOB Vancouver price of $380 currently. However it is the enticing long-term demand growth for potash thatmakes investors optimistic about future prices of, and therefore profits of, potash producers. India andChina have been strong sources of growing demand for fertilizers in the past decade, and are projected tobe a large portion of the estimated 20 mm tons of increased demand by 2020
1
(40% above current levels
2
). The key drivers of this growth are: the growing ranks of the global middle class and identifiable shift toprotein rich diets across the board, the historical underutilization of fertilizers in emerging economies likeIndia,China and Brazil coupled with the world’s rapidly declining arable farm land will result in massivedemand for increased yields, fuel price have tripled since 2003
3
leading to rising food/crop transportationcosts, hence the need for increased food production in proximity to it’s final consumption destination, andthe lack of commercial substitutes for potash, all point to substantially higher demand in the long-run.
 
 The risks associated with investing in Potash One is unique, i.e their exposure, pre-production and post-production, to potash prices are very high but differentiated in underlying risk. In the pre-production stage,the potash prices will determine their ability to find financing for a project of this scale, which will in turndetermine the attention (and hence premium) paid by the senior potash producers considering acquisition.Once the mine is in production, the
β
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should fall back in line with the large potash producers. Even thosewho hold mining operations portfolios diversified outside of potash, like Mosaic, are subject to very high
β
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. The potash producing industry is characterized by high concentration of suppliers in the market as well ashigh concentration of demand (facilitated by governments), no substitutes and no differentiation amongstproducts from different producers. This gives rise to a competitive market where producers competeprimarily by volume instead of the conventional price-wars. Even with prices at the levels they were in 2008,the senior potash producers cut their capacity utilization, a metric that had been growing gradually over thepast two decades (table 1). With yet some 17% capacity not-in-use, Canadian producers have a lot of ground to cover before demand can once again push prices above their long-term trend. This commodityprice risk is the main reason this company is recommended as a hold. Even though it has capitalexpenditure per ton (graph 4) advantages over the junior potash producers and some senior ones as well.CIBC world markets estimates that current world capacity for potash production is approximately 61.8million tons, and with current plans brownfield projects will add 5.6 million tons of capacity by 2015, anyincremental capacity from greenfield projects would have to be justified by faster rising demand volumes.Unfortunately, based on Morgan Stanley’s bearish, base and bullish estimates for global potash demand(table 3), only the bullish potash demandscenario makes greenfield projects viable in the short term. TheMorgan Stanley analysis was conducted before 2009 saw total potash trade shrink to almost 32 milliontons from 48 million tons the previous year. It seems as if the price shock has attracted over-investment(albeit still in pre-production planning). Long-run demographic trends may exert upward pressure on pricesif capacity utilization rates reach 90%, although now an unlikely scenario, given announced projects. The low traded volumes in 2009 (graph 5) have lead to estimates of reduced capacity utilized in 2010.Farmers and Industry experts surveyed
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say that even though many suspended use of potash while priceswere unreasonably high, they expect to revert back to normal potash consumption this year. With noprojects adding capacity in 2010, this creates a unique scenario that paves the way for a smaller temporaryrise in potash prices in the near future. This hypothesis is also supported by the relatively diminishedinventories of 2008 (graph 6) and following low trade volumes of 2009. This inflated potash price wouldhave a positive effect on share prices, but would also provide incentive for acquisition. While the possibilityexists of Potash One’s value appreciation in the short term, potash over-supply will place a long-run cap onprofits to be made in the industry, just as chronic over-supply had in the years prior to 2007. A DCF valuation of the legacy project being financed and built on schedule, and taking into accountparameters reflecting long-run over-supply scenario, justifies a share price of 3.95. The current price of 3.23tells us two things. The 12-month target price return is 24.1%, and it provides us with a benchmark minimum probability of the legacy project reaching production on time with adequate financing, of 82%. Thelegacy project cannot justify its investment if the perceived probability is below the benchmark probability.In conclusion, while Potash One is perfectly positioned for optimal returns in the potash industry, however itis the bleak outlook for equilibrium price in the coming decades that ultimately places too much risk on anon-producing assets such as Potash One’s reserves and permits. It is not clear whether all the plannedprojects will reach production stage, but it is less clear that price signals in the potash market will deter the‘optimal’ number of projects from being undertaken, to create strong potash price growth. Other Risks thatcomplicate return certainty are weather and environmental factors affecting the cyclical agricultural industry;Mine disruptions and the possibility of the Saskatchewan provincial government attempting to recover re-

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