Higher prices drive Incitec to a re-rating

Incitec Pivot was one of the Firetrail Absolute Return Fund’s top performers in the September quarter. We remain confident in the near-term prospects for its earnings.

Longer term, we are also increasingly bullish on industry structure given the shifting sands around energy security and decarbonisation.

Incitec is one of a handful of Australian integrated industrial manufacturing businesses. It produces and distributes fertilisers and explosives in Australia and the US.

Nitrogen is typically combined with other elements such as hydrogen to produce products such as ammonia, ammonium nitrate, urea, and phosphate.

A key input of production is natural gas, which dictates the prices of the commodities Incitec sells. The company has long-term gas supply arrangements in Australia and accesses cheap gas in the US versus more expensive regions, providing a cost advantage when global energy prices are rising.

The current environment of higher global energy demand and prices is fuelling a much more positive earnings backdrop, which we believe could drive a multi-year valuation re-rating.

Commodities push earnings up

The current up-cycle in fertiliser commodity prices is in its second year, driven by higher demand and prices for soft commodities.

Prices for corn, soy and wheat, for example, are up 15-30% over the past year. Elevated crop prices are underpinning farmer balance sheets and their willingness to pay for key inputs such as fertilisers.

While demand has led the current cycle, supply issues are likely to extend it. The price of gas, the key input, is surging globally as the market tightens.

This is unlikely to improve any time soon as the key Northern Hemisphere winter demand period approaches and no meaningful additions to supply will be made until later in 2022.

Gas prices in Europe have surged above $25-30 per gigajoule. Fertiliser producers are idling plants, further tightening supply, and placing upward pressure on global prices.

These demand-supply dislocations typically take time to revert to the mean, which provides a structural element to the current pricing outlook for Incitec’s key products.

Industry structure is improving

Meanwhile, in China, we are seeing government intervention to halt fertiliser exports. Presumably, this is driven by a desire to control local prices and secure domestic supply for  the key cropping season.

China is an important supplier of fertiliser to global markets and previously accounted for as much as 40% of global exports of some commodities.

The nation's absence from exports adds fuel to the fire near term. However, we question China’s longer-term ambitions as a low-cost exporter.

As the charts below highlight, fertiliser exports have already been declining in recent years. A recent focus on decarbonisation in China’s steel industry appears likely to spill over into other high polluting sectors such as fertilisers.

Steel exports, for example, peaked at more than 150 million tonnes in 2016 but have declined to 40-50 million tonnes in recent years as structural reform has been implemented. We believe increased focus on decarbonisation will drive further consolidation in other industries.

China uses coal gasification technology to produce the gas needed to produce nitrogen. Other inputs such as phosphates use highly intensive, high-cost mining techniques.

The drive to decarbonise could mean China takes a backward step from its role over the past decade to export energy deflation.

Undemanding expectations

We believe 2022 earnings will build on current conditions and underpin Incitec’s share price performance as market upgrades for higher commodity prices flow through.

Consensus is currently sitting materially below spot prices for both ammonia and diammonium phosphate (DAP) in 2021-22 and 2022-23.

Using the company’s stated sensitivities and consensus forecasts, we see material earnings upgrades into 2021-22 if current prices persist.

Valuation also looks compelling, with the stock trading at a 20% price/earnings discount to the market on current 2021-22 earnings forecasts, compared to a 5-year average discount of 5%. This discount looks unwarranted, given the likely earnings upgrades I've discussed.

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