Here's a Company Whose Profitability Could Soon Suffer

Here's a Company Whose Profitability Could Soon Suffer

As the saying goes, timing is everything. That's especially true when it comes to fertilizer producers, whose profits are highly dependent on commodity price fluctuations. CF Industries saw profits dip slightly this year, due to a disruption in the global potash market earlier this year, but its focus on nitrogen fertilizer provided the company with a smoother road ahead—until now.

The sudden, dramatic rally in natural gas prices is bad news for CF Industries' strategic priorities going forward, meaning 2014 might not be as smooth as it seemed to be just a few weeks ago. Higher natural gas prices crimp margins for nitrogen fertilizer, meaning investors have a new set of concerns to consider before jumping in to CF Industries.

Until recently, CF Industries looked like the best bet in fertilizer
Heading into the new year, there wasn't much of a reason to doubt CF Industries. It operates in a different area of the fertilizer market than its peers, and as a result was spared much of the pain that Potash Corp. and Mosaic have endured this year. For starters, potash prices have been pummeled for most of 2013 due to the breakup of one of the world's largest potash partnerships. As potash prices declined, major buyers such as China held off purchases to see exactly how low potash could go. This meant not only lower sales prices, but also sales volumes for the major potash producers.

Consider the deterioration in underlying business conditions seen by Potash Corp. and Mosaic this year. Potash Corp. saw its year-to-date sales and diluted earnings per share drop by 8% and 6%. In reaction, the company is resorting to a sizable workforce reduction to keep costs under control. For Mosaic's part, its gross margin dropped by half in the third quarter. Not surprisingly, this caused profits to fall off a cliff. Mosaic saw its diluted earnings per share collapse by 70% in the third quarter.

Therefore, for most of 2013, CF Industries' focus on nitrogen fertilizers looked like a genius move. And, its planned expansion into ammonia next year would have given it even more shelter from the storms facing potash, meaning CF Industries had a much more certain outlook for next year than its peers. Unfortunately, here's why its own future may now be just as cloudy.

All of a sudden, a new potential headwind emerges
CF Industries' strategic priorities, which are set to fuel its future growth, have a dark cloud hanging overhead in the form of rising natural gas prices. Natural gas has rallied considerably in just a few weeks after spending most of 2013 at depressed levels. Natural gas recently crossed $4.25, representing a six-month high. CF Industries is making a significant push into ammonia, but those efforts may be derailed if the company can't reap a favorable margin.

CF Industries is set to outlay $2 billion next year on construction of its new Donaldson ammonia facility in Louisiana. In all, CF Industries hopes to increase its annual ammonia production by as much as 2.1 million tons. However, the estimated internal rate of return on this project is highest when natural gas prices are low. CF Industries cites strong and growing nitrogen demand as a key driver for its expansion, but at the same time, these efforts are reliant on low-cost natural gas feedstock. If natural gas rallies toward $5, the potential benefits of this project dwindle. This could throw a wrench into the company's aggressive expansion efforts, at just the wrong time.

Keep your eyes on natural gas
CF Industries is likely making a wise strategic move by expanding its operations, given the uncertain year ahead for the potash market. This is especially true when considering the troubles facing Potash Corp. and Mosaic heading into next year.

At the same time, the investment case for CF Industries' strategic initiatives may come undone should natural gas keep climbing. The sudden, dramatic rally in natural gas has caught many in the industry by surprise. Investors would be well advised to not be likewise caught off-guard, and to keep their eyes on natural gas in 2014.

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Bob Ciura has no position in any stocks mentioned. The Motley Fool owns shares of CF Industries Holdings and PotashCorp. 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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