Takeaway: A flood of capital spend in resource-related businesses typically occurs in inflated price environments; the potash industry is no different
While we are not quite ready to make a short call, we wanted to outline 2 headwinds to the potash industry in the coming years to keep front and center:
1. Entry from a large miner like BHP, should its Saskatchewan project get pushed through, will immediately pressure potash prices in our opinion. Uralkali and Belaruskali, who have moved to a volume over price strategy after the disbanding of Belarusian Potash Company, have mine expansions planned. These projects have been sidelined for now, but both companies plan to move forward, so even if timing is not yet specific, the likelihood that future supply will accelerate is high.
2. While capital intensive at onset, participating in the potash industry remains a high margin business even as prices have retreated, so what will Mosaic and Potash Corp. do with their cash moving forward as margins continue to compress now that they’re producing under 2/3rds capacity? More buy-backs and dividends? If they are like other commodity producers, continuing to invest in future projects is also a reasonable scenario. Whether investing in potash, nitrogen, or phosphate capacity, the fertilizer industry faces challenges moving forward. The outlook for potash just happens to look most dire.
- Fortunately for the largest potash producers, their business is concentrated in the hands of few players, three of which seem to operate under a nominalcartel (for now).
- High margins over the last several years have given the large producers cash to invest, expand, and become more efficient.
However, as outlined in the charts below, capacity additions across the globe have been excessive in the last 6-8 years relative to a long history of very meager demand growth. In fact, over thirty years aggregate demand for Potash has remained flat.
Unique History of the Potash Industry:
The potash side of the fertilizer industry is much less exciting than phosphate or, in particular, nitrogen , which has been a major beneficiary of localized and cheaper natural gas.
The potash industry is dominated by a select few companies. (5 companies make-up a majority of potash production). For a long-time these 5 companies belonged to 2 cartels, or “marketers and distributors” as they call it, to make up a duopoly in the global potash market.
Considering Canpotex members (POT, AGU, MOS) paid over $100 million to settle a U.S. antitrust lawsuit accusing them of concerted action to raise prices as recent as 2013, we have nothing against calling it a cartel.
Belaruskali (Belarus) and Uralkali (Russian) belonged to the Belarusian Potash Company (BPC). The three North American producers, Mosaic (MOS), Potash Corp. of Saskatchewan (POT), and Agrium (AGU) still belong to Canpotex, which is an “offshore marketing and logistics company.”
Together, these five companies control more than 2/3rds of global potash exports. BPC failed as a joint venture in 2013 and has since put pressure on the Canpotex stance as a supply-controlling organization.
Canpotex produced at around 65-70% of production capacity in 2014. AND, more capacity is in the works from both Canpotex and most importantly BHP Billiton.
From here, we can expect to see either more investment or a continued transition from fixed investment to return of capital agendas. Any incremental investment into potash expansion projects will add to the likelihood of a price crash:
- Potash prices hovered around $100/Ton for decades until the de-regulation and low rate policy circa ~2004.
If BHP can follow-through with its greenfield mine project in Saskatchewan, the Canpotex position on the international market will be threatened immediately. It’s already facing pressure in the aftermath of the disbandment of BPC.
- BHP’s project is expected to bring on 7 MM/MT of production capacity which is close to 12% of current global consumption levels.
- Fortunately for Canpotex, should BHP continue with the project, initial production will be much less and not expected until 2018-2020.
BHP has consistently said that 1) they want potash to be part of their 5 pillars (already labeled “petroleum and potash”); and 2) they will not be a part of the Canpotex marketing and distribution company.
BHP failingly attempted a takeover of Potash Corp. in 2010. The bid was rejected and ultimately blocked by the Canadian government.
“The world needs new greenfield potash capacity to meet demand beyond 2020”
- BHP Investor Presentation
BHP Potash Demand Outlook
“Our large resource base can underpin the staged development of a low-cost potash business that will generate attractive investment returns.”
- BHP Investor Presentation
So the question becomes, if the Canpotex players continue to bring on even more capacity (like they’ve already done), yet they don’t utilize and flush it through Canpotex, won’t they shoot themselves in the foot? Then if Canpotex does disband or they are undercut in a big way, prices collapse. It seems difficult to be a swing producer when we’re this oversupplied and the threat of big entrants looms.
Is Canpotex trying to strong-arm potential entrants, much like BHP, Rio Tinto, and Vale with iron ore which unraveled in 2014? Many smaller companies have halted project plans. After-all, the cap-ex cycle is very long (6-8 years) and initial investment in a potash mine shakes out at $1,000-$2,500 MT range which is at least a 3 or 4 year payback at current prices for the best brownfield projects.
We don’t expect an answer, but a new entrant looking to become a big player in the space is probably the biggest threat to the Canpotex position.
The two former BPC members, Belaruskali and Uralkali are already shaking things up:
Uralkali signed a contract with Indian Potash Limited to deliver 800K tons of potash between May 2015 and 2016. At the end of March, Belaruskali was the first big producer to sign a contract with China. Both China and India still acquire potash via annual contracts.
The shift in the nature of the global potash trade is evidenced by the fact that independent producers are the first to sign contracts rather than an organization acting in the interests of all members.
Global trade also appears to be shaking-up the domestic potash market. Belaruskali has just started importing potash into U.S. again this year. Uralkali already jumped in front of the other players to sign the most recent China contract.
Luckily for Canpotex, the expansion projects from Belaruskali and Uralkali are on hold for now and Uralkali was forced to close a mine of significant size due to an unfortunate flood:
- The Uralkali mine that was flooded this past year will not come back online in the near future (this takes 2.3MM/MT, or ~4% of what was produced last year, off-line which is a sizable amount of global production). This mishap is a blessing for Canpotex considering the two big Eastern European producers have a volume over price strategy based on the two contracts they’ve signed with China, and now India (announced two weeks ago).
Despite the flood, Canpotex is filling the gap net of closing some smaller mines:
- Potash Corp.’s New Brunswick Mine, which only had 0.2MM/MT of capacity in 2014 is expected to ramp up (1.8MM/MT of capacity when fully completed)
- Agrium’s 1MM M/T Saskatchewan expansion is well on its way to being completed
- Mosaic has 0.6MM/MT of capacity coming online in 2015 with another 0.9MM M/T expected to be online by 2017.
It’s not as if any of the existing potash producers will disappear, but the likelihood of increased margin compression is accelerating.
Potash Corp. and Mosaic brought on more production capacity with the excess cash on their balance sheets in the heady days of the commodity bubble highs. Both used it as an opportunity to re-invest, expand, and become more efficient. We don’t question this corporate strategy. It’s logical, but the bottom line is that a supply glut has the potential to devastate prices in the future, despite efficiency gains.
With deflationary forces looming as a real risk over the intermediate to longer-term and crop prices that have retreated much further than fertilizer prices, one important question mark is the following:
Can prices collapse before planned projects are pushed-through?
Mosaic cash costs were $86/MT with brine management expenses of $17/MT for 2014. This is still 4x average potash prices globally but right around a normalized price level for many years prior to 2004.
While crop prices have retreated, fertilizer prices haven’t had nearly the fall:
- As evidenced in the chart below, Potash prices remained at around $1/MT for many years even before 1995.
- While prices have retreated from the bubble highs, they remain 3-4x this long-term historical average.
- The CRB Commodities Index is now below its 2004 levels; Corn and wheat are less than 2x
We expect potash consumption to continue with its slow, steady growth trajectory.
A growth trajectory moving forward of 2-3% YY is a best case scenario. Even the large producers are expecting demand to be worse YY in 2015.
- “North America is a very competitive market. Like the second half, we may find some of the additional Agrium tonnes are not required” – Mosaic Q4 2014 earnings call
- “India needs P&K imports. Stars and Moons are aligned.” –Mosaic Q4 2014 earnings call
The emerging market demand story is old news, and begging for emerging market demand doesn’t help either. The EM argument has been at the forefront of commodity-related agriculture investment for years, and global potash demand has been underwhelming.
On the other side of the “EM Demand Story” is the fact that increase in crop pricing and crop acreage (corn is nearly 50% of the North American market for fertilizer) is largely over. Starting in 2004 ethanol expansion drove the demand for corn for a 10-year period. Ethanol expansion is now flat-lining.
The most important development to follow over the next few years is the ability of a large independent producer to develop more capacity. The sooner this becomes a reality, the sooner that Potash industry margins return closer to their cash cost of production.
Black Box Sales, Traffic
Black Box released same-store sales and traffic estimates for the month of April last night that showed a nice improvement over a difficult March. Restaurant same-store sales increased +1.9%, while same-restaurant traffic decreased -1.5%. These numbers were up 110 and 90 bps, respectively, on a sequential basis, and up 50 bps a piece on a two-year basis. All told, it appears as though the restaurant industry is beginning to regain some of its former momentum.
Encouraging Employment Data As Well
All age cohorts, save the 20-24 group, had positive employment growth during the month – continuing a very impressive run. Although the 20-24 YOA cohort saw employment growth decline -0.22%, it was a marked uptick from last month’s decline of -0.84%. Seeing this sequential improvement is encouraging and leads us to believe that this cohort will soon return to positive employment growth, which would bode well for quick service and fast casual restaurants. Good news for the restaurant industry all around in April, bouncing back from a concerning March.
April Employment Growth Data:
- 20-24 YOA -0.22% YoY; +62.3 bps sequentially
- 25-34 YOA +3.17% YoY; +53 bps sequentially
- 35-44 YOA +0.51% YoY; +5.6 bps sequentially
- 45-54 YOA +0.36% YoY; -13.8 bps sequentially
- 55-64 YOA +3.52% YoY; +89.2 bps sequentially
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The May employment report was “okay”. The moderate rebound in net monthly payroll gains to +223K in April was largely offset by the negative revision to the March estimate with the revised +85K gain the lowest since June of 2012.
The early market vote is mixed but with a dovish shading as the $USD is up small alongside gains in both equities and bonds. More broadly, the return to middling – and the discrete lack of either collapse or escape velocity improvement – will mostly serve to perpetuate further uncertainty/volatility as another month is devoted to speculation and spurious investor activity in the attempt to front-run a Fed faced with somewhat equivocal data.
We’re not big on adding to the noise of manic data reporting on employment Friday but below are some quick highlights. If you have any specific questions or would like to dig/discuss a particular dimension of the labor market in more depth, let us know.
Earnings & Income: Average hourly earnings in the private sector accelerated +10 bps sequentially to +2.2% YoY. However, earnings for nonsupervisory and production employees – which BLS estimates to be ~80% of the workforce – grew just 1.8% YoY, marking a 3rd consecutive month of sub-2% growth. While labor slack continues its slow march towards tautness, a sustained acceleration in both wage and broader core inflation remains very much a phantasm.
In terms of the read-through to spending and aggregate personal and salary/wage income for April. The combination of little change in hours worked and earnings growth, a moderate gain in total employment and modest positive mix in high-wage/low-wage employment on the month should support continued Trend improvement in aggregate income in April.
As we’ve highlighted, with income growth accelerating alongside the rise in the savings rate in recent months, the capacity for consumption growth has increased more than actual reported household spending. That trend showed a moderate reversal last month with income gains softening, savings declining and spending rising. As it stands, consensus forecasts for accelerating PCE continue to buttress full year GDP growth estimates which remain at +2.8% despite what will be another 1st quarter of negative growth following revisions to the 1Q15 estimate.
Unemployment & Participation The U-3 Unemployment rate dropped to 5.4% while the U-6 rate (Underemployment Rate) ticked down 10.8% from 10.9%. In contrast to last month, the improvement stemmed from largely positive fundamental developments as the flow of workers out of the labor force ebbed, the number of total employed (+192K) changed at a premium to total unemployed (-26K) and the Labor Force Participation Rate ticked back up to 62.8% from last months multi-decade low of 62.7%.
Participation by prime working age adults has troughed but has yet to really inflect. Whether the nascent return to positive employment growth in the 45-54 year old bucket can tip the scale in that direction will take time to discover.
Energy Sector: Job loss in the energy sector extended into March/April according to both BLS and Challenger Job Cut data. Oil & Gas extraction employment - which includes data thru April - saw a employment decline -3K on the month, marking a 3rd month of negative gains in the last four. Broader energy sector employment - data thru March - showed a 5th consecutive month of net decline, dropping by -9K sequentially with the rate of YoY growth dropping to -0.6, the first month of negative year-over-year growth in 58 months.
The weakness accords with the Challenger Job Cut data for April released yesterday which showed energy sector job cut announcements re-ramping to +20K in April after a brief March respite. Note also that we’ll get the state level employment numbers on May 27th where trends in the shale states will again be the focus. Collective net employment gains across the primary basket of energy states was -56K in March, the first delta negative month since September 2010. The notable -26K decline in Texas led state level job losses as angst over a prospective state-level recession continues to percolate.
Industry Employment: Manufacturing employment followed-up last months brick with a paltry +1K estimated gain in April. The confluence of strong dollar, declining export demand, cratering energy sector investment, and residual port shutdown impacts all continue to weigh on the industry. The softness was not unexpected given the lackluster gains the last two months, the declines in energy sector employment and the slowdown observed in the ISM employment sub-indices.
Housing: Key housing employment demographics remained solid in April and should continue to flow thru to housing demand at a modest rate.
- 25-34 year old employment growth made a higher cycle high, accelerating +80bps sequentially to +3.2% year-over-year.
- Residential Construction employment rose +3K in April alongside the strong rebound in broader construction employment which was up a big +45K on the month as activity rebounded alongside the thaw in the weather. On a year-over-year basis, employment growth continues to hold in the mid-single digits as conditions in the resi construction labor market continue to tighten.
Christian B. Drake
Takeaway: Just because YELP may be for sale doesn't mean there would be buyer. All it means is that mgmt is terrified...maybe they finally get it.
This note was originally published May 08, 2015 at 07:58 in Internet & Media
- WHAT'S FOR SALE: A business that is facing declining revenue if it doesn't grow its salesforce in perpetuity. YELP's model is predicated on hiring enough new sales reps to drive new account growth in excess of its rampant attrition, which is the overwhelming majority of its customers annually. The issue is that its TAM isn't large enough to support its model. That has manifested into a persistent decline in salesforce productivity, which is now devolving into a mounting exodus of its sales reps (see note below). The latter means the story is going to turn much sooner, and get much uglier, than we initially expected. See note & deck below for detail.
- WHO'S THE BUYER? There are very few who can afford, and much fewer (if any) who would be desperate enough to consider. Remember that in any M&A transaction, the would-be seller has to open its books. If we all can see YELP's attrition issues in its public data, any would-be acquirer would see it in its private data. Combine that with the negative goodwill surrounding YELP's alleged business practices, and the likely sell-off of the acquirer's stock on the news, and it's basically Russian Roulette for any acquiring CEO (except there isn't an empty chamber).
- WHAT THIS MEANS: This could just be a manufactured story to squeeze the shorts. If not, then management is just terrified. The company went public in 1Q12 and now may be looking to sell in 2015 at what was a 52-wk low before yesterday's headlines. Management may finally be coming to the realization that its model is unsustainable. We suspect the wake-up call was what we believe was a sequential decline in its salesforce in 1Q15 after targeting 40% sales-rep growth for 2015 (see note below). Mgmt may be hoping to eject before the model starts crashing, but we doubt it can find a buyer. If we're wrong, let's hope none of us are long the acquirer.
For supporting detail, see below for our most recent deck and note . Let us know if you have any questions, or would like to discuss further.
Hesham Shaaban, CFA
YELP: Short Thesis Update Deck & Replay
Deck: [click here]
Replay: [click here]
YELP: The New Major Red Flag (1Q15)
04/30/15 08:53 AM EDT
Takeaway: We are removing Restoration Hardware from Investing Ideas.
Please be advised that we are removing Restoration Hardware (RH) from Investing Ideas today. Below is a brief note from CEO Keith McCullough explaining our decision.
* * * * * * *
This is not a fundamental research call from Brian McGough. This is more of the same in terms of me wanting you to take down your gross exposure to the US stock market as we head into what I believe will be a volatile summer.
RH has had a great run for us and I want to make sure you harvest some of those gains so that you can re-invest at lower-prices if/when small cap consumer stocks get hit again. Gas prices aren’t falling anymore and the rate of change in the US labor data continues to slow.