As I've documented in this blog, beginning last June I established a sizable position in PotashCorp.  Since that time the stock has done about what I expected it to do, having more then tripled in value. 

When a stock moves the way that PotashCorp has, you can't help but wonder whether you are approaching fair value.  But what is the fair value of PotashCorp?

Well it has to come down to the price potential of the nutrient.  How high can potash go?  And that depends on the supply and demand dynamic in place and how that develops over time. 

The Price has Risen, but has it Risen Enough?


I'm less concerned about the demand side then the supply side, so that's what I'm going to focus on in this post.  Specifically, I want to focus on the economics of greenfield production.

Bill Doyle, the CEO of PotashCorp, has had a lot to say about the costs of bringing on a new potash mine, and in particular, how current prices don't yet justify new mines. 

At first glance, these comments were a head scratcher to me.  I mean, how could new mines not be justifiable with potash having risen from $150/t to almost $800/t?

Well, I've run through some numbers to get an idea of how those costs compare to the cashflow generation.  This is all very rough, and I can't promise its totally correct, but it should give us some idea of the economics.

Now usually I don’t like to go into hard numbers, because hard numbers inevitably turn out to be proven wrong.  In this case though we know that the banks are going to be doing this sort of evaluation when they are making the loan decisions, so here I think its worthwhile.


The Costs According to Doyle

Doyle has said the following:

“The cost of bringing on line a 2 million-ton-a-year mine has risen to $2.8 billion… That increases to more than $5 billion when supporting infrastructure such as roads and power lines is included”

What's the Cashflow?

The important question is how this compares with the cashflow stream from that mine.  So that's what I've looked at below.

Let’s start by assuming Doyle's number, a 2Mt per year potash mine.  This mine would yield about $600 per tonne net of freight (using RBC's 2009 potash estimate).  

Let’s then be generous and say the gross margins of this new mine are the same as POT’s at that a $600/t potash price (around 85% according to RBC).  This yields net about $1020M per year.  

Then we have mining taxes, which in POT’s case works out to about 10% of gross margins at $600/t net potash (again from RBC), so we'll assume the same percentage, or about $100M.  Then we have the interest cost on the loan of $2.8B (I am going to assume no additional infrastructure is required, which I think is pretty generous) and giving that loan an optimistic interest rate of 6% you get about $150M per year for the first 5 years (until the loan is paid).  Finally, we have taxes, which for POT are about 30%, so we'll assume the same, or $225M for this mine.
 
That’s leaves us with $545M a year in cash flow before the loan is paid off and then $645M per year after the loan is paid off.  

This cashflow stream is at least 5 years away.  I’m not sure what to use as an IRR for calculating a present value of that cashflow, but let’s say 12% just as a rough number.  Now if I back calculate the PV of that $545M and then $645 income stream, assuming it doesn’t start until year 6 and it goes on for 20 years, I get $2.5B.  At 40 years, I get a PV of $2.8B.
 
Just to be clear, I’ve made the following assumptions:

  • Potash prices net of freight of $600/t for, at minimum, the next 25 years
  • I’ve implicitly assumed that any inflationary rise in costs is made up for with a corresponding increase in the price of potash
  • Interest is based on $2.8B mine cost estimate.  So we are assuming no infrastructure costs such as rails, roads, electricity
  • Gross margins of the new mine are essentially the same as what POT earns on their existing mines that have been operating for years
The result is that the mine is just barely worth the IRR goal of 12%.  If this mine needs any additional infrastructure at all, the IRR won't be met.  

What It Means
 
Now this is all very rough and by no means meant to be anything but ballpark.  Still, you can begin to see why Doyle can confidently talk about how current prices don't justify new Greenfield capacity.  I would suspect that these sort of numbers, for a commodity with a spotty past with infrastructure costs still rising (who knows what the actual costs will be once the mine is actually built) and with uncertain energy costs, isn't not going to get the bankers rushing to the door.

And I wouldn't be betting on the wall of potash hitting the market anytime soon.