Wave of consolidation in the fertilizer market could benefit small exploration company.
Phoscan (43 cents)
I briefly mentioned in a February 1st StreetSignal report that I was following Phoscan (TSX: T.FOS, Stock Forum) closely at 40 cents. At the time I didn’t provide detail so I will elaborate more this week. We should soon see financials on Phoscan and if there are no surprises, they should have close to $65 million or 38 cents/share in cash.
I do not like the overhang of 172 million shares, but the cash and undeveloped phosphate project balance the risk. Strong demand is returning to potash and phosphate, and Phoscan is sitting on a very large phosphate deposit that the market (mistakenly) believes is worth next to nothing. If this is a big mistake, there may be significant upside potential in 2010.
In particular, what makes this story so appealing is all the merger and acquisition activity we are seeing in the global fertiliser industry - almost $11 billion worth of deals in the first 2 months of 2010.
Because Phoscan trades only a nickel above its estimated cash value, the market values its phosphate project at $8 million. This is a project it has so far spent $80 million on. With all this global activity, it’s hard to imagine this large phosphate deposit is almost discounted to zero. To understand the value, visit the company’s website and view the Martison Project presentation (.pdf).
Also note that Phoscan continues to look for an oil & gas project in hopes of putting this large war chest of cash to use - timing of this is unknown. The company highlighted this effort in its last financials.
Our hope is that the phosphate project eventually attracts a buyer from Agrium or overseas. Even recovering 1/2 of its investment in the project would result in a sale of $40 million or 23 cents per share (a 50% gain from current levels). Quite possibly someone would pay much more, but I think this is being realistic should a suitor emerge in 2010.
The stock has significant resistance in the mid 40-cent range, but it also has excellent liquidity at current levels.
Global supply & demand
The fertiliser industry in 2009 hit what many believe was its worst year in decades, but also an important low. When the price of commodities like grain went through the roof in 2007 and 2008, the price of fertilizers rose tenfold but then collapsed in 2009. This, combined with the credit crunch, made it hard to finance deals, and subsequently mergers and 
completely dried up. That has turned around dramatically in the past few months.
Not only are the biggest names involved globally, but speculation is rising that China and India will become aggressive players in an effort to secure their own supplies. With more than 2 billion people, food will become priority one for these two countries and they will fall mercy to pricing set by the majors if they fail to secure their own supplies.
Such a scenario cannot help but benefit companies like Phoscan. The capital costs of developing a phosphate mine and processing plant are not small. But when global demand is growing substantially, it makes no sense to assume a large undeveloped phosphate deposit carries such little value. Previous research has found that the industry has high barriers to entry (because of the high costs to start a mine) but it can also take up to seven years to put a mine into production.
If demand increases much quicker than expected, wholesale prices will jump dramatically. Large miners will do whatever they can to acquire medium sized producers and smaller companies (like Phoscan) with reserves or mining rights take on greater importance and value. It allows the larger conglomerate to replace aging assets, secure strategic supplies and fill gaps in its geographic footprints.
Nitrogen, phosphate and potash are the three macro nutrients used in fertilizers across the globe.
Food security for India and China
In Q4, 2009 the influential magazine Nature wrote of pending shortages in fertiliser inputs. This theory has been fuelled by the rash of acquisitions we are seeing in the industry by major players. Some have even referred to it as a Peak Phosphates theory similar to the Peak Oil theory. This is over-exaggerated but the following points are worth noting:
- there are no substitutes for phosphorus in agriculture. And phosphate fertilisers cannot be recycled like tin cans; they wash away forever.
- The USGS estimates the world has about 16 billion tons of mineable phosphate rock in reserves - enough for 100 years of production at 2008’s estimated extraction rate.
- One hundred years of production should not indicate a problem. However, the International Fertiliser Association estimates that China and India will need to double or triple their fertiliser usage if they convert poor land into productive farmland (at home) or continue their aggressive expansion plans by acquiring large tracts of farm land in countries like Africa.
The Martinson Phosphate Project
- located 70kms NE of Hearst Ontario and Phoscan owns 100%
- Chemical plant at nearby railheads and granulation plant in Brandon, Manitoba
- high quality, low cost phosphate permits production of a high valued product
- reserves estimated at 30 years
- cost advantages due to nearby access of sulphuric acid, railroads, natural and power
- Canada is a net importer of phosphate fertilizers plus it has rapid access to grain belt regions in the U.S.
- large reserves do not include room for further expansion as deposit is open at depth and to NW and SE.
- to date only 35% of the known prospective area has been drilled.
Conclusion
Phoscan’s share barely reflects its large cash reserves, let alone the potential value of its large undeveloped phosphate project (Martison). Continued consolidation within the industry can only mean good news for smaller companies sitting on reserves. Investors do not recognize the value so the unknown variable is how long it will take for this to occur – or if we see a merger or acquisition before then. The company has issued no news this past year other than financials, but we should be seeing developments on its search for an acquisition (possibly in oil & gas) and also further insight into the economics of the Martison project.
Either way, it’s a very interesting story and appears to represent excellent lower risk value.
Disclosure: Danny Deadlock owns 30,000 shares of Phoscan purchased in 2009
To send a confidential email (tips, rumours, research) for consideration in the StreetSignal