1 High-Quality Stock to Put on Your Radar

When CF Industries' stock dropped like a rock in April, I strongly felt that it was nearing a reversal. Urging investors to buy the stock, I backed it up with an outperform call on my CAPS portfolio.

Investors who took the dive are counting gains to the tune of 10% now, but those who didn't still have a chance. CF is doing a lot of things right, which should help the stock maintain the momentum.

Strategy in place
Natural gas is the key input for CF's primary product, nitrogen fertilizer. When gas prices plunged last year, CF's costs were cut by half and its margins soared. Investors were happy, until gas prices breached the $4 mark recently. Fears that rising costs will strangle CF's margin gripped the market, and the stock lost 25% of its value in less than three months by mid-April. The concerns appeared overblown as CF's recently released first-quarter numbers proved.

CF's natural gas cost in the first quarter averaged $3.57 per MMBtu, slightly higher than the $3.48 per MMBtu it paid in Q1 2012. The company's revenue too fell 13% year over year on low sales volumes. Yet, CF's net income jumped 10% to hit a record quarterly high, thanks to the company's aggressive hedging policy. Through derivatives, CF had hedged 90% of its first-quarter gas requirements by February. So it didn't have much to fear when gas prices increased. In fact, CF notched mark-to-market gains of around $23 million on derivatives.

A CF distractor asked me where those gains would be had gas prices moved the other way. Good question, I said, because luck is a factor. Natural gas is a highly volatile commodity, and its price movement is nearly impossible to predict. So hedging can also turn unfavorable. In Q1 2012, CF suffered a mark-to-market loss of $56 million despite hedging two-thirds of gas requirement because prices didn't behave the way CF expected.

That being said, hedging remains inevitable. After all, it is better to be safe than sorry. And it's not just CF that believes so. Rentech Nitrogen , a smaller but pure-nitrogen player, has already locked in 43% of its full-year gas requirements at an average cost of $4 per MMBtu. Rentech paid $3.98 per MMBtu of gas this past quarter. As for CF, it has hedged 90% of requirements through July. So investors shouldn't panic if gas prices rise.

A cut above the rest
While gains on derivatives boosted CF's nitrogen segment's gross margin to 59% from 52% a year ago, firm nutrient prices played a key role as well. Nitrogen is the most important nutrient for essential crop, corn. Expectations of record corn planting this spring are pushing up nitrogen prices, even as those of potash and phosphates are reeling under pressure. Urea ammonium nitrate, or UAN, was the top-performing nitrogen product in CF's last quarter, fetching 9% higher prices year over year.

To take advantage of UAN's better pricing, CF smartly cut down on urea to scale up UAN production during the last quarter. The capability to flex production mix according to market conditions is among CF's biggest strengths. UAN is a high-margin product, so focusing on it makes sense. In its last quarter, UAN specialist CVR Partners converted 72% of ammonia produced to UAN. If that sounds incredible, there's more. From 80,700 tons of ammonia, CVR churned out a whopping 196,200 tons of UAN.

Both CF and CVR see tremendous potential in the nutrient. While CVR will soon start upgrading nearly all of the ammonia it produces to UAN, CF is setting up two UAN units at its main complex in Donaldsville, apart from five ammonia plants with UAN up-gradation facilities. As a bigger player, CF cannot only produce greater amounts of UAN but also command better prices.

In the most recent quarter, while CF realized 9% higher UAN prices, Rentech and CVR reported 8% and 6% lower prices year over year, respectively. Since UAN makes up more than half of CF's total sales volumes and its prices are heading north, investors can expect a good boost to the top line in the forthcoming quarters.

Better option?
CF is not only the undisputed leader in the nitrogen space but also scores higher than PotashCorp on several counts. Farmers in the U.S. have increasingly substituted nitrogen for potash over the past few decades. Subsequently, nitrogen prices have shown greater strength. In its most recent quarter, PotashCorp sold its namesake nutrient at 17% lower prices year over year.

PotashCorp can still salvage some growth on the top line as it gets 30% revenue from nitrogen, but if the incremental revenue doesn't convert into higher income because of rising costs, it's useless. PotashCorp paid $6.1 per MMBtu of gas in the last quarter -- that's nearly twice what CF paid for gas. Severe supply disruptions from Trinidad, where PotashCorp sources gas, is to blame. Until the situation in Trinidad improves, PotashCorp will continue to feel the heat.

The Foolish bottom line
Leadership position, solid financials, good operational performance, and great returns make CF one of the best bets in the fertilizer industry. The stock has returned a staggering 148% over the past four years and currently trades at a paltry six times earnings. It's time to get CF on your radar, especially if you are looking to invest for the long term.

To stay updated on CF Industries as it strives to maintain the leadership position, click here to add it to your stock watchlist.

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The article 1 High-Quality Stock to Put on Your Radar originally appeared on Fool.com.

Fool contributor Neha Chamaria has no position in any stocks mentioned. The Motley Fool owns shares of CF Industries. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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