Mosaic Stock is good, but CF Industries is better (NYSE:CF)
The investment thesis
This article takes a look at two of the top stocks in this space, Mosaic (NYSE: MOS) and CF Industries (New York Stock Exchange: CF), from close. The thesis is twofold. First of all, now is a good time to consider adding agricultural stocks to your portfolio given underlying catalysts including high community prices, record grain and oilseed stocks and persistent inflation. The following comments from the CEO of MOS Joc O’Rourke summarized these catalysts very well (abbreviated and underlined by me).
Looking ahead, we continue to see agricultural market strength extending well beyond 2022. The year started with a tight agricultural market and high prices reflecting to Global grain and oilseed stocks at 20-year low. The conflict between Russia and Ukraine has exacerbated the situation and pushed commodity prices even lower. Together, these two countries represent 16% of the world grain and oilseed export market. With Ukraine’s planting season now under threat next year and exports of Russian crops potentially also limited, the market is grappling with the potential for reduced supply of a number of key crops… This situation has has amplified food security concerns and is translating into protectionist government policies that are likely to drive up commodity prices further.
Second, even though MOS and CF are attractive candidates in this space, this article will explain why CF is the most attractive. In the overall context above, MOS and CF stock prices rose significantly while the overall market suffered significant declines. As you can see from the following chart, MOS has generated a total return of over 61% over the past year and CF over 77%. The S&P 500 remained essentially flat (with a small loss of 0.7%) in contrast. The stronger price appreciation of CF shares has resulted in a relatively more expensive valuation than that of MOS. However, as I will argue next, its valuation premium is more than justified by its superior profitability and operational efficiency.
The MOS-CF comparison in a nutshell
MOS and CF are currently enjoying very healthy profitability, as you can see in the following graph. Take the example of net profit margin. MOS has a net margin of about 19% and CF 19.7%, both about 2 times higher than the average profit margin of the overall economy of 8% to 10%. Although a closer look would reveal that CF’s profitability is even stronger. Its gross profit margin, EBIT margin and EBITDA margin are all significantly above the MOS.
In particular, as a manufacturing-focused company, CF is simply much more efficient overall. As you can see, its revenue per employee is around $2.2 million, more than double that of MOS. And its net income per employee of $552,000 is also more than double the MOS. As detailed in my previous writings,
DuPont’s analysis shows that, especially for manufacturing companies, there are three buttons that management can use to increase profitability: profit margin (“PM”), asset turnover rate (“ATR”) and leverage. Through simple calculations, we can show that the ultimate profit is just the product of these three factors.
And then you’ll see why CF is more efficient and profitable than MOS on a more fundamental level, and also why its higher valuation is well justified.
CF offers higher headroom than MOS
Based on the DuPont method, the following graph shows the top buttons for MOS and CF over the past decade and the profit margin. As seen in the top panel, MOS’ profit margin fluctuated between a low of minus 16% and a high of around 19%. And its long-term average is around 6.8%.
In contrast, CF shows a much higher profit margin. Its profit margin has fluctuated between a low of minus 11% and a high of around 34% over the past decade. And its average profitability is about 14% over the past decade, more than double that of MOS.
You can also understand why both companies are attractive now. Due to the aforementioned macroscopic factors, they now enjoy lucrative margins. Their current margins of 19% are only above their historical average, but are actually among the highest levels in a decade. And looking ahead, shortage, inflation and the situation between Russia and Ukraine are very likely to keep the margin high for both.
CF uses its asset more efficiently than MOS
The second graph shows the second driver. ATR measures how effectively a company uses its assets to generate revenue. As seen in the top panel, the asset turnover rate for MOS fluctuated from a trough of 0.15x to a peak of around 0.32x. And its long-term average is around 0.23x.
And again, CF shows much more efficient asset utilization (0.40x vs. 0.31x, around 30% more). The bottom panel shows that the asset turnover rate for CF fluctuated from a low of 0.07x to a high of around 0.47x. And its long-term average is around 0.19x. So even though their long-term averages are similar, CF currently performs more efficiently than MOS by about 30%.
CF and MOS are operated conservatively
This third and final graph shows the leverage factor. The comparison is a bit more complicated here.
In absolute terms, CF is more leveraged than MOS (albeit slightly). Its total passive to active ratio is currently 0.53x, about 8% higher than MOS’ 0.49x. However, by their historical norm, CF is under-leveraged while MOS is over-leveraged. As you can see from the top panel, MOS’ leverage ratio has been between 0.23x and 0.55x over the past decade with an average of 0.44x. And its current leverage ratio of 0.49 is above its historical average of around 11%. On the other hand, CF is underleveraged compared to its historical average of around 5%, as you can see on the bottom panel.
Overall, I feel like both are being operated conservatively at the moment. Their debt levels are close to their historical average. combined with the fact that profitability is at a secular high, investors shouldn’t worry too much about the difference in their leverage. As MOS CFO Clint Freeland commented below (emphasis added by me), MOS is generating plenty of cash to further reduce debt, pay dividends and also engage in share buybacks important. The situation at CF is very similar. CF also generates plenty of cash to support its dividends and actively buy back its shares. CF spent about $540 million on share buybacks in 2021, and buybacks are expected to continue in 2022.
I also believe we have an opportunity to meet our debt target later this year with the maturity of another $550 million of debt that would allow us to meet the debt reduction target of $1 billion. And again, as we review the balance sheet for the year and our expectations for the amount of free cash flow that we should generate, we should also be able to return a significant amount of cash to shareholders consistent with what we talked about earlier.
Projected return and final verdict
As detailed in our previous writings,
In the long term, the return on investment (“ROI”) is simply the sum of two parts: the return to the owner’s income when we made the investment (“OEY”) and the growth rate (“GR”) of the owner’s income. That is: ROI = OEY + GR
And the long-term growth rate is given by:
GR = ROCE (return on capital employed) * Reinvestment rate
Thus, the puzzle of our return consists of three pieces: OEY, ROCE and the rate of reinvestment. And the table below summarizes these elements for MOS and CF based on the fundamental profit drivers analyzed above. As you can see first, MOS provides a higher OEY due to its lower valuation, as mentioned above. However, CF offers much better profitability, as evidenced by the much higher ROCE. its ROCE of 52.6% is about twice as high as CF due to better profit margin, higher asset utilization and also slightly higher leverage ratio as analyzed above.
Now, assuming a reinvestment rate of 10%, the long-term growth rate of MOS would be 2.6% (21.6% ROCE * 10% reinvestment rate = 2.6%). And CF would grow by 5.3%. Now adding the growth rates to the OEY, the total return would be 18.1% for MOS and 19.7% for CF.
So the final verdict is that CF’s higher profitability may more than offset its higher valuation, making it a more attractive investment by comparison.
Final thoughts and risks
Now is a good time to consider adding agricultural stocks as a hedge against inflation and geopolitical uncertainties. High commodity prices, record grain and oilseed stocks, and the Russia-Ukraine situation may all persist longer than expected and create tailwinds for the sector.
MOS and CF are attractive candidates in this space. Although both are well valued and enjoy strong profitability, I prefer CF. Its higher profitability can more than offset its valuation premium over MOS and leads to higher total returns.
Finally, there are risks to both stocks.
- Both stocks face substantial short-term volatility risk. As mentioned earlier, both have grown significantly (61% for MOS and 77% for CF) over the past year amid an overall market decline. These rapid recoveries, combined with ongoing macroeconomic uncertainties, could trigger high price volatility.
- Both companies also face similar pressure to control their own costs in areas such as energy, labor and raw materials.
- Global supply chain issues can be a double-edged sword. As mentioned above, this led to a supply and demand situation that benefited them both in terms of commodity prices. But it could also create headwinds in terms of logistical disruptions and shortages of raw materials.
- For CF, one of its factories in the UK is undergoing greater maintenance activity and production could take longer to return to full capacity.