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All price data is as of 15.10.2014, unless otherwise noted.
Is it possible to find a more boring business than one that sells fertilizer chemicals and salt? Perhaps, but it’d be tough. What most people find boring though, can be a great find for an investor – and I believe that K+S AG (FRA: SDF) is one of these boring gems.
I took notice of K+S because the company has been delivering very strong operating cash flow, and ranks high based on a cash flow-based performance indicator that I use. Looking deeper into the business beyond the cash flow, I have found a lot to like and very little to dislike.
First things first
Let’s take a closer look at this salt and potash giant. The following table provides an overview of the three business units into which K+S is divided:
|Business Unit||Product examples||Contribution to 2013 revenue|
|Potash and magnesium products||Fertilizers, raw materials for industrial purposes, high quality salts for the use in the health care and food industry||52%|
|Salt products||De-icing salt, food grade salt, industrial salt, salt for chemical use, pharma salt, pool salt, animal feed salt||44%|
|Complementary activities||Waste management, animal hygiene products||4%|
As we can see, the company earns the bulk of its revenue by selling a wide variety of products, mostly based on the commodities potash and salt — each of the two business units contributes roughly half to the top line of K+S.
These are not the most exciting products for most people. But let me present five reasons, why I think that this company has potential.
1. K+S operates a commodity business but differentiates itself from competitors
In recent years, K+S has divested COMPO and K+S Nitrogen with the intention to “focus management resources and financial means on the Potash and Magnesium Products as well as Salt business.” The company has been following its strategy consequently by purchasing Potash One and Morton Salt, which made them the world’s largest supplier of salt and a strong Potash supplier:
|Company / Consortium||Salt business unit global market share*||Potash business unit global market share**|
|China National Salt||14%||–|
|Compass Minerals (NYSE: CMP)(FRA: CM8)||12%||<1%***|
|Belarus Kali + Uralkali *****||–||29%|
Source: K+S Presentation at the K+S Compendium September 2014 and Compass Minerals 2013 annual report
*Estimated based on capacity, ** Based on sales in tonnes, *** Market share estimated based on Compass’ potash production capacity (40,000 tons) and world production (58.5 mn tons), ****Canpotex is a legal export cartel consisting of Potash Corp (NYSE: POT), Mosaic Co (NYSE: MOS), and Agrium Inc. (NYSE: AGU), ***** Belarus Kali and Uralkali OAO (LON:URALL) have formed a legal export cartel which has been dissolved in 2013
What the table also indicates is that none of the competitors offer the same product mix as K+S, except for Compass Minerals, which has a small share in the potash market. According to K+S management, “the broadly comparable mining processes make the realisation of synergies between [these two businesses] possible.”
This sounds like K+S is in a unique position to realize cost advantages. On the other hand, its main competitors offer a wider range of fertilizer products — which is the main use of potash — by including nitrogen-based fertilizers in their offering. This could be more attractive to customers looking for a “one stop shop” for their fertilizer needs.
2. It’s a high margin business – but K+S needs to improve
K+S shows very strong operating margins in 2013 of 27% in the Potash & Magnesium business and 7% in the salt business (operating margin tells us what’s left from a company’s sales after deducting costs to operate the business). I can only dream of seeing these numbers for many of my current investments. However, two years ago K+S achieved margins of 35% and 12%, respectively, with similar revenues. The picture is put even more into perspective when we compare K+S with its competitors:
|Company||Potash business||Salt business|
Source: 2013 annual reports of the respective company
*Potash Corp doesn’t provide the margin of its Potash business separately, so it includes its Phosphate and Nitrogen businesses.
And suddenly K+S isn’t doing as well as we first thought. The good news is that management has recognized that and initiated the “Fit for the Future” program in November 2013. This program aims at cutting 500 Mio. Euro from its current cost basis by 2016. This is ambitious, considering that 350 Mio. Euros would be sufficient to achieve the same margins as the best competitors.
According to CFO Burkhard Lohr, however, K+S has “seen good progress” in the first half of 2014.
3. Very healthy financial situation
A look into the balance sheet should bring a smile on a Foolish investor’s face. An equity ratio — that is, the ratio of equity to total assets — of 45% is very solid. This means that almost half of K+S total capital is stable financing from stockholders and retained historical earnings, while the rest is financed by debt such as bank loans or bonds issued. According to data from Capital IQ for the latest quarter, non-financial companies in the DAX had an equity ratio of 36% on average — putting K+S’s balance sheet on the more stable end of the spectrum.
In general, an equity ratio in the order of 30% is considered healthy from a value investor’s perspective — though higher is better — because it means the business has a cushion against the pressures of debt financing. Hence, K+S compares quite favourably and has more financial room to play than its peers.
In addition, K+S’s cash flow from operations is strong enough to pay back its net debt in less than one and a half years. Compare this to paying back your mortgage with just 18 months of your gross salary.
4. Uncertain pricing environment, but healthy long term prospects for K+S products
Overall the financial situation of K+S is promising. A relatively low level of debt and high cash flow from operations will allow management to further improve and grow its business or return to paying a healthy dividend to its shareholders – if it continues to allocate its capital smartly.
The income situation doesn’t look as rosy though. 2013 revenue was up 0.4% compared to 2012, but down 15% compared to 2010, which was mainly caused by declining prices and overproduction. K+S won’t be able to influence this development significantly, but according to Burkhard Lohr, the Potash prices have bottomed in the first half of 2014.
What K+S can and should improve (and aims to with its “Fit for the Future” program) are operating results. Margins in the salt business have continuously decreased and are now half of what they were in 2010. Margins in the potash business are comparable to 2010, but have been fluctuating between 16% and 35% in the last five years.
Despite the current pricing and capacity trend, the long-term prospects for K+S products puts Foolish investors into a good mood: the global demographic development will drive demand for salt – needed for food or pharmaceuticals for more and more people, or to de-ice ever increasing road infrastructure — and potash — more fertilizer usage since more and more people need to be fed with less and less agricultural area available.
5. Management doesn’t shy away from unpopular decisions
Management has decided to reduce dividend payments to shareholders. This might be unpleasant news for income investors. However, management believes that reinvesting in the company will be more beneficial for shareholders in the long term. As evidence of this investment, capital expenditures have been consistently and significantly higher than depreciation in the last three years.
One major investment is the so-called “Legacy Project”, a potash production site in Canada which aims to increases current K+S production capacity of 7.5 million tons by 27% in 2017, and by 38% by 2023. Critics say that K+S should have waited with this investment until the market for potash stabilizes, in particular due to the danger of overcapacity and low prices. But CEO Norbert Steiner leaves no doubt that this is a sensible long-term investment:
“As a commodities company, we think and act long term. The potash market rewards patience and we are not going to allow ourselves to be deflected from our path by temporary upheavals. The global population will continue to grow. There will be as many as 10 billion people living on our planet in 2050. This means that the demand for food will increase, while, at the same time, usable arable land per capita will decrease.“
As a Foolish investor, this is exactly the kind of long-term view that I want to hear from management.
In sum, what I like about K+S is the following:
- A clear strategy that is consistently followed
- Weaknesses are recognized and worked on
- A great balance sheet
- Long-term demand for its products
- Management that thinks long-term and acts against conventional wisdom if necessary
What I don’t like:
- Uncertainty about the price and capacity development
- Lower margins than competitors
Right now, based on data from Capital IQ, K+S’s stock trades at a price-to-earnings ratio of around 11. I believe that this valuation already captures all the pessimism entailed above though and the current price may offer an attractive entry point for Foolish investors.
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Bernd Schmid does not own any of the shares mentioned. The Motley Fool owns shares of Potash Corp.