A pop quiz: What is fertilizer? Where does it come from?
If both your answers involve a cow, count yourself about 70 years behind the times.
The cattle and horse manure of old gave way long ago to mined and manufactured phosphates and potassium, and to nitrogen-based fertilizers refined directly from natural gas.
It's no wonder that most people aren't familiar with the modern fertilizer industry. Most investors relegate it to the "watching grass grow/paint peel" category.
That's changing. Since June 2003, chemical fertilizer stocks have climbed more than 250%. In that time frame, Potash Corp. of Saskatchewan (POT) soared 474%. Mosaic (MOS) rose 336%. Agrium (AGU) rocketed 380%.
The segment as a whole has ranked in the top 40 of IBD's 197 industry groupings, most recently at the No. 1 spot.
What turned this seemingly feeble group fecund?
No. 1: the rise of fertilizer demand in China and India.
China's need to feed its 1.3 billion citizens drove it to become the largest global user of fertilizer products in 1986.
Rising income levels and desire for more and increasingly nutritious foods have extended its lead. By 2003, it used 39.8 million tons of manufactured fertilizer compared with the 19.7 million tons in the U.S. India, with more than a billion mouths to feed, is close behind.
A second and equally important development has been the rise of demand for ethanol and biofuels.
The leading ethanol feedstock is corn. And among major U.S. field crops, corn is hands down the heaviest user of fertilizer, soaking up 1.5 to 2 pounds of fertilizer nutrients per bushel.
"When corn growers are happy, the fertilizer industry is happy, too," Fertilizer Institute spokeswoman Kathy Mathers said.
The Department of Agriculture forecasts that the amount of corn used each year to produce ethanol will increase almost 80% in three to four years to 2.5 billion bushels.
The combined demand of China, India and ethanol has drawn global grain reserves to more than 40-year lows. U.S. corn prices have topped $4 a bushel in some cases, up from near $2 last year.
Are corn growers happy? Rick Tolman, chief executive of the National Corn Growers Association, measures the enthusiasm in acres planted. Estimates place the acres of corn planted as high as 88 million acres — a 10% increase over last year.
"You used to have the traditional 50-50 rotation between corn and soybeans," Tolman said. "This year, there are a whole lot of folks that are 60-40, 75-25 — even at 90-10."
1. Business
Like farming itself, the fertilizer business is deceptively complex.
Fertilizer usually is made with nitrogen and smaller amounts of potassium and phosphates. The co/cktail is to soil and crops what multi-vitamins are to humans.
Nitrogen is refined out of natural gas or, more rarely, coal. Phosphates and potassium are processed from mined materials. All are increasingly global businesses, which creates difficult logistical and pricing challenges.
Most fertilizer makers produce a combination of fertilizer components. They tend to control various aspects of transportation and distribution.
Agrium, of Calgary, Alberta, paid $515 million last year to acquire the U.S. retail distributor Royster-Clark. The move doubled the size of Agrium's retail business and grew 2006 sales by 30% to $4.2 billion.
But Agrium, like other fertilizer producers, was also grappling with the post-Hurricane Katrina spike in natural gas prices. Gas prices, 90% or more of the cost to produce nitrogen, more than doubled after the storm.
The company reduced its North American production and bought pricey, but comparatively cheaper imported nitrogen.
When a combination of factors reduced U.S. fertilizer demand, Agrium was left holding the feed bag. Agrium's earnings declined through four of the past five quarters, even as gas prices fell back to profitable levels.
"They bought product at very high prices, then 2006 demand wasn't that strong," said BMO Capital Markets analyst Edwin Chee.
Name Of The Game: Produce as much fertilizer as possible to feed burgeoning demand. Manage supply costs carefully with an eye toward the next cyclical downturn.
2. Market
Farm fertilizer makers sell products through two channels. Their wholesale operations sell to large-scale distributors. Their retail sales forces market directly to growers or cooperatives.
Of these, Agrium leans most heavily on retail; it expects about a third of 2007 sales to come from its retail arm.
The companies also export a large piece of their production.
North American sales accounted for about 70% of Potash Corp.'s 2006 sales of $3.76 billion. On the flip side, Mosaic, of Minnesota, exports more than 70% of its product.
Canpotex, a joint venture owned by Agrium, Mosaic and Potash Corp., handles the overseas export of the firms' potassium-based compounds from Saskatchewan.
The key exception in the group is Scotts Miracle-Gro. (SMG) A producer mainly of home and garden products, its customer base is skewed toward home improvement centers, hardware chains, nurseries and garden centers.
3. Climate
Conditions in U.S. and other fertilizer markets hinge increasingly on the growth of ethanol and biodiesel fuels.
While Brazil's ethanol industry is based on sugar cane, U.S. plants are specifically designed to distill corn into alternative fuel.
Fortunately for corn growers and fertilizer makers, programs aiming to make economically viable cellulose-based ethanols — using switch grass, wood chips and other raw materials — have a substantial technological gap to close.
In the meantime, estimates call for a 78% increase in the amount of corn used to produce ethanol between 2005 and 2011.
For corn growers and fertilizer makers, the prescription for now: Make hay while the sun shines.
"Last year in Minnesota the average corn price given to the farmer was about $1.65," said David Centko, a senior analyst with industry consultant Blue, Johnson & Associates. "This year, he can book it right now for almost $4.50."
4. Technology
Refined from natural gas, nitrogen-based fertilizers are in themselves a form of technology, enabling a rapid build-out of the U.S. corn crop.
For decades, federal price controls managed grain supply by requiring farmers to leave a portion of their crops unharvested.
Today, farmers are harvesting the "government rows" of corn they once turned back into the soil — along with anything else they can get their combines on.
In the process, nitrogen-fixing crops such as soybeans, alfalfa and others, which recharge soil with nitrogen, are being set aside for corn-on-corn crop rotations.
That's good news for fertilizer companies. Fields that go without the nitrogen-fixing crop cycle are doubly sapped of the vital nutrient. Farmers make up the deficit with a double dose of manufactured nitrogen fertilizer.
But as rising gas prices and international demand force fertilizer makers into an increasingly global stance, capacity and supply chain issues have become an increasing challenge to the industry (see related story, this page).
5. Outlook
The future of corn and fertilizer industry profit hinges on the capitalist market bugaboo: price.
Few forecasts see the current $4-a-bushel price continuing.
But as ethanol makers gear up for more production amid rising demand, corn producers are under intense pressure to supply enough to keep prices reasonable.
A corn price spike could quickly make other alternative fuels comparatively more attractive.
"We know there is a lot riding on it, in terms of wanting the market to keep growing, keep expanding," Tolman said. "The question is, can we keep that up without having and adverse effect on prices?"
Upside: Continued overseas growth and interest in corn-based ethanol should buoy demand.
Risks: Capacity and logistics have become major challenges. If prices rise too high, buyers may look harder for alternatives.
