I have to say that becoming bullish on fertilizer stocks in 2020 was fun. The market was extremely undervalued, and even the move back to "normal" resulted in high returns. At this point, I still expect returns to be high, except that it isn't fun anymore. Now, we're dealing with a global energy crisis, which has worked its way through the fertilizer industry. Especially in Europe, fertilizer producers are shutting down, causing supply to drop even further. In July, I wrote an article titled "Factors That Make CF Industries Way Too Cheap". Since then, CF Industries (NYSE:NYSE:NYSE:CF ) is up 15%, which includes a drop of 13% from its recent highs. In this article, I will explain why this bull market has legs and why CF Industries is still attractively valued despite generating outperforming returns for more than two years.

So, let's get to it!

I came very close to renaming my Twitter account to the Gloom & Doom Report as that's how it feels sometimes. By simply updating the energy and agricultural situation, I've tweeted so much bad news. It's truly unbelievable sometimes. The good news is that this bad news is actually bullish for CF Industries.

For example, we're now in a situation where the global food crisis is expected to go into overdrive. For example, it has caused China to curb exports. This year, Chinese urea exports are expected to be somewhere between 1.5 and 2.0 million metric tons. That's down more than 50% from usual levels close to 5.0 million metric tons. Moreover, 70% of Europe's fertilizer capacity has been taken offline as a result of rising prices. Producing fertilizer isn't just unprofitable, it is actually a risk to the existence of Europe-based producers. That's how high energy prices are.

For example, "Kalkammonsalpeter", which is the most important nitrogen-based fertilizer in Germany is now priced close to EUR 950 per ton again, which is up from less than EUR 250 prior to the energy crisis.

Yara, one of the world's largest fertilizer producers, is reducing its output to just 35% of capacity in Europe.

As reported by Agrarheute (translated):

At 300 euros per MWh of gas, compared to an average of 20 euros over the last 10 years, we have a big problem: it no longer works for everyone who produces ammonia because gas costs 10 to 15 times more than before," says Nicolas Broutin, head of the French subsidiary of Norwegian fertilizer producer Yara.

For Europe, this is a problem as food inflation is in high double-digit territory. This is hurting consumers on top of sky-high energy inflation and other items that have become scarce.

However, it is an even bigger problem for nations depending on imports. This includes Asian nations, but mainly African countries like Egypt.

Next season, global fertilizer usage is expected to decline by 7%. That's the biggest drop since 2008. The result will almost certainly be smaller harvests.

Bear in mind that growth in crop production over the past 30-40 years was almost entirely fueled by higher fertilizer application (and new technologies).

Related, in Brazil, fertilizer consumption is expected to fall by 7.2% this year as farmers are battling higher costs. On top of that, Brazil is battling droughts amid a third consecutive La Nina. In 2021-2022, this caused soybean production to drop by 10%. Now add lower fertilizer application going into 2023, and we're dealing with an even worse situation.

That's still not everything as nitrogen fertilizer production doesn't just produce fertilizer, it also produces carbon dioxide. While CO2 is basically what global environmentalists are combatting, it's a vital part of our food supply chain. It is used in, i.e., meat processing and other processes.

The graph below shows that natural gas is the key feedstock for ammonia-based fertilizers. Producing ammonia produces CO2. This is captured and used in different stages of the food supply chain. Reducing CO2 production is very inflationary.

EU ETS - Fertilizers Europe

EU ETS - Fertilizers Europe

With that said, natural gas prices continue to trade at high levels. US-based Henry Hub natural gas futures are trading close to $8 per MMBtu. It looks like the price is increasing again due to subdued supply and lower (expected flows from Russia) as I explained in this article. The lower part of the graph below shows the ratio between European TTE Natural Gas and US Henry Hub. The difference remains high, with TTE trading at prices that are 7.6x higher than Henry Hub.

TradingView (Black = Henry Hub, Orange = TTE/Henry Hub)

TradingView (Black = Henry Hub, Orange = TTE/Henry Hub)

Moreover, we're not only dealing with supply uncertainty tied to the war in Ukraine, but also the fact that fossil fuels, in general, are suffering from underinvestment. This is creating a fertile ground for long-term elevated fertilizer prices.

Years of under-investment during the attempt to transition away from the fossil fuels have left global supplies unable to satisfy the post-pandemic rebound in demand. "It's ultimately the revenge of the old economy: if you don't invest in the old economy, it comes back to haunt you," said Jeff Currie, head of commodities research at Goldman Sachs Group Inc. "The only way you're solving the energy problem in the long run is through investment - and oil companies are the conduit for the capex to solve the problem."

In other words, what we're dealing with here is a long-term bull case for both energy and agriculture. Or, as Goehring & Rozencwajg puts it:

We believe we are in a decadelong agricultural crisis that will take many unpredicted twists and turns and argue that all agricultural related equities are still excellent investments. We continue to prefer global fertilizer equities. Not only are fertilizer fundamentals excellent, but the stocks have never been cheaper.

That's where CF Industries comes in.

CF Industries is up 47% year-to-date, adding 130% over the past 12 months.

The company's history dates back to 1946 when it was known as the Central Farmers Fertilizer Company. The company was owned by a number of regional agriculture cooperatives for almost 60 years before it went public in 2005.

CF Industries owns five nitrogen facilities in the United States, two Canadian nitrogen facilities, two facilities in the United Kingdom, and a 50% interest in Point Lisas Nitrogen, an ammonia production joint venture in Trinidad and Tobago. In Louisiana, the company operates the world's largest nitrogen complex consisting of six ammonia plants, five urea plants, and storage for 140,000 tons of ammonia - among other fertilizers.

The table below shows the company's reportable segments, which are basically various fertilizer products. In 2021, the company produced 6.5 million tons of UAN, which is a solution of urea and ammonium nitrate.

Right now, urea is trading at $650 per ton. This is down from more than $800 when the Ukraine invasion caused some panic buying. And while the correlation with natural gas prices isn't perfect, the uptrend in natural gas should keep fertilizer prices high.

TradingView (Black = Urea, Orange = Henry Hub)

TradingView (Black = Urea, Orange = Henry Hub)

For every $50 ton increase in urea (realized) prices, the company grows its annual EBITDA by $750 million. Based on current conditions of $8.0 natural gas and $650 urea (painting with a broad brush), the company is likely to maintain $5.4 billion in annual EBITDA.

What we see below is the company's annual adjusted EBITDA history and outlook. Like pretty much every commodity-related company, 2022 is expected to be a blowout year due to strong pricing. After that, expectations are that margins moderate.

In the case of CF, I believe that the company is in a good spot to do more than $4.0 billion in EBITDA for years to come. As I believe in a long-term commodity cycle, I don't see margins coming back to 2021 levels anytime soon.

If we assume that EBITDA remains elevated on a prolonged basis, we can also assume that free cash flow remains elevated. So far, expectations are that the company's pre-crisis net debt load of $3.3 billion falls into negative territory this year as free cash flow is high enough to put more cash on the company's balance sheet than gross debt. This is allowing the company to boost buybacks, which it does whenever it believes that its stock price is undervalued.

As the company commented in its 2Q22 earnings call:

We also continue to execute our current $1.5 billion share repurchase program, which we view as both a return on and return of capital. Through the first six months, we have repurchased 6.6 million shares for $590 million.

As you can see in our level of repurchase activity in the second quarter, we stepped in opportunistically to repurchase shares as our stock price fell despite positive industry fundamentals.

This also helps the valuation tremendously.

The company's equity is currently trading at a value of $19.8 billion (its market cap). Next year, CF is expected to lower net debt to a negative $1.9 billion. We also need to add roughly $3.0 billion in minority interest.

All of this gives the company an implied enterprise value of $20.9 billion. That's 4.6x expected 2023 EBITDA.

Looking at the company's historic EV/EBITDA (next twelve months EBITDA) valuation range, we're dealing with a very favorable valuation, which is lower than any valuation since the summer of 2013.

The same goes for the implied FCF yield, which is much higher than in pre-crisis years.

Hence, I believe that if we're indeed in a multi-year bull market for energy and agriculture, CF has room to double in the 2-3 years ahead.

Things just keep getting worse - or better in the case of North American fertilizer producers. The energy crisis is unlikely to end anytime soon as gas flows toward European countries have been reduced even further. European nations are unwilling to boost domestic production for many reasons, including the environment, which is resulting in an implosion of industrial and chemical production. This includes the production of fertilizers. Especially energy-intensive fertilizers like everything nitrogen based.

This benefits CF Industries, which mainly produces nitrogen fertilizers in North America, benefiting from a very favorable price difference, despite high energy inflation in North America as well.

The company is in a good position to deliver high EBITDA on a long-term basis, allowing it to erase the gross debt on its balance sheet, boost share buybacks, and continue delivering outperforming returns for its shareholders.

Moreover, while the valuation is extremely attractive, investors need to be aware that fertilizer stocks are volatile. Do not invest too much if you decide that CF Industries is right for you, and be aware of the impact highly volatile stocks can have on your portfolio.

Other than that, I think CF is poised to do extremely well in the years ahead.

(Dis)agree? Let me know in the comments!

This article was written by

Disclosure: I/we have a beneficial long position in the shares of CF either through stock ownership, options, or other derivatives. 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: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.