PhosAgro is a strong opportunity for investors seeking long-term EM exposure and consistent dividends. Headquartered in Moscow, PhosAgro is a global leader in the production and distribution of phosphate-based fertilizer. The company has a fundamentally sound business, but trades at a discount due to external conditions in Russia that are beyond management’s control. We consider PHOR LI to be a dynamic investment opportunity that combines medium-term growth potential with a consistent and high yield dividend. Furthermore, in the long term, it is set to benefit significantly from changes in the global economy.
Key investment takeaways:
1) Management has a proven track record of efficient and disciplined capital allocation. The company’s fertilizer production has grown by over 50% since 2012, and is set to grow another 20% by 2020. Despite high growth, PhosAgro remains well capitalized, benefiting from very low leverage and strong liquidity. Accordingly, Fitch Ratings updated the company’s senior debt to investment grade in February 2018. PhosAgro’s capacity and output growth should continue to drive revenues and stock performance over the medium term.
2) Presently, the company offers a dividend yield of ~5.8%, in-line with its 5 year average of 5.3%. Management has indicated a dividend policy payout ratio of between 30% and 50% of profits. Strong, predictable cash flows will continue to drive dividend yield growth in the medium term.
3) Although PhosAgro’s P/E is above its MOEX commodity peers, one must also consider how the company’s relationship with the Russian state may affect its profitability. Agriculture, although strategically vital to Russia’s long-term economic survival, is not a cash-cow, and does not carry the same amount of Kremlin heavy-handedness as other industries like oil. The lack of oligarchic influence over both the industry and the company itself has led to a smaller corruption discount than is seen with other MOEX companies. Despite a P/E valuation premium, PhosAgro is less likely to see its bottom line undermined by geopolitical tensions.
4) Projections contend that global warming will likely affect the Russian permafrost and potentially open up access to new plots of arable land. With the global population estimated to reach 8.6 billion by 2030 and increase to 9.7 billion by 2050, food demand will consistently increase. As food demand surges, global dependency on a more productive Russian agriculture sector will support greater demand for Russian fertilizer.
While the worst physical impacts of climate change may only appear after 2040, financial markets will likely be affected much sooner. Experts at Cambridge University believe that revised impact projections, changing regulations, and herd mentality will all shift market sentiment in a sudden and dramatic fashion. Over the long term, PhosAgro is set to benefit from the adverse effects of climate change, population growth, and shifting investor sentiment regarding the importance of agriculture.
PhosAgro generates the vast majority of its revenue through two reportable segments: Phosphate-based products and Nitrogen-based products. 80% of revenues are derived from the production and distribution of Phosphate-based fertilizers, primarily Diammonium Phosphate (DAP). On the other hand, 16% of revenues are generated from the company’s Nitrogen-based products such as ammonia and urea. While it is worth noting that PhosAgro does produce more complex NPK fertilizers, these serve to insulate the company from the cyclical price fluctuations of DAP and urea, and are not considered a main revenue driver for the company. Production of all NPK mineral fertilizers takes place at plants located in the cities of Kirovsk, Cherepovets, Balakovo, and Volkhov.
Between 64% and 70% of all production is exported. Europe is the largest importer of PhosAgro fertilizers, and responsible for ~35% of all exports, followed by South America and North America, at ~27% and ~15% respectively.
PhosAgro is traded on the London Stock Exchange as a GDR and the Moscow Stock Exchange. Three GDRs is equivalent to one regular, domestically traded share. PHOR LI is traded in USD.
Originally owned by Mikhail Khodorkovsky, PhosAgro is now under the control of the Guryev family and Vladimir Litvinenko. Andrey Guryev, the former CEO and current CEO’s father, became head of the company after Khodorkovsky was imprisoned in 2003. In no position to negotiate from prison and fearful that his PhosAgro shares would be seized by the regime, Khodorkovsky agreed sell the company to Guryev in 2004. Guryev remains at arms length from the regime, and maintains relations with the Kremlin as a way to uphold stability in his commercial interests.
The shares of Chlodwig Enterprises Limited and Adorabella Limited are held by a trust, the economic beneficiaries of which are Mr. Andrey G. Guryev, the current CEO (and former CEO’s son) and members of his family. Evgenia Guryeva is the elder Guryev’s wife and current CEO’s mother.
Vladimir Litvinenko, the company’s third largest shareholder, was Putin’s doctoral advisor and later his campaign manager. He gained his original stake in PhosAgro when Guryev the elder named him chairman, likely as a way to guarantee the company’s good standing with the Kremlin without having to become a personal ally of Putin. Litvinenko’s involvement in the company suggests the state is interested in its development and long term viability. This should not come as a surprise given how important agriculture is to the economy and how the Kremlin deals with almost every large company operating within Russia.
Igor Antoshin sold 4.81% of the company to Vladimir Litvinenko in early 2017. Antoshin served on the board of directors of the company from 2002 to 2004 and from 2006 until the present. He was CEO of PhosAgro’s holding company from 2002 to 2005.
Each stakeholder with more than 4% of the company has only made exchanges with other major shareholders recently. The size of the free float has remained consistent for several years.
Board of Directors:
In Russian corporations, foreign board members act as both overseers of foreign investment and as Russian owners’ business counselors. Furthermore, many foreigners are used for their political influence; it is not uncommon for foreign board members to lead international dialogues as unofficial spokespeople.
For many international investors, the inclusion of foreign board members is a must for investing in the region. Memories of the demise of Hermitage Capital Management are still fresh, while corruption and geopolitical struggles provide little comfort to those who are risk-averse. The involvement of foreign board members provides relief, as these exercise a monitoring function for foreign owners. In fact, results of a 2013 Oxelheim study indicate that there is a correlation between outward FDI activity and the internalization of boards. However, in Russia’s 50 largest corporations, the average foreign occupancy of the board is only 20%.
Half-Russian, half-international, PhosAgro’s board is one of its strong suits. Jim Rogers and Xavier Rolet are the two most recognizable names on the board, but the other eight also bring insight and experience. Marcus James Rhodes notably also serves on the board of QIWI, which is the most commonly held Russian ADR by American hedge funds. The Russians on the board all have leadership experience within their country, whether it be serving in public institutions or as executives in the business world.
Russia’s economic performance over the next year will remain dependent on oil prices and low inflation. Moody’s projects GDP growth at 1.6% in 2019, down from 1.8% in 2018. The EU’s December announcement of continued sanctions coupled with the potential threat of new ones will continue to undermine business confidence and foreign direct investment.
Despite an otherwise lackluster economic outlook, agriculture in Russia appears to be gaining steam. Agriculture accounts for 4.7% of Russia’s GDP, but its position has been steadily growing in recent years. With massive supply and a pricing advantage, Russian wheat has recently emerged as a dominant force in the global marketplace.
Russia’s serendipitous geography on the border of East Asian markets allows it to easily export wheat and other agricultural products to some of the world’s largest and fastest-growing populations centers from Indonesia to Israel. Russia has also replaced the US in Egypt, the world’s 14th largest country, as top exporter of grain, and has also become the largest exporter to Nigeria, the world’s 7th largest country. Russia’s dominance in the global agriculture market is becoming increasingly evident each year.
Western sanctions have had a multitude of negative effects on Russia’s economy and financial system, and may continue to negatively affect it over time for a number of reasons. First, they squeeze Russian liquidity, which has forced the Kremlin to spend through large amounts of foreign reserves. Once its “rainy day” fund has been run dry, taxes and spending cuts must be voted through or Russia will lose its hard-earned investment grade credit rating. (Russia, in February of 2018, was upgraded by Standard & Poor’s to BBB-, its first time having a non-junk credit rating since 2006.)
But on the flip side, sanctions have forced Russian enterprises to become more self-reliant and self-sufficient. Russian agriculture now relies almost entirely on itself since it cannot turn to Western products or services for help. The sanctions have paradoxically made some Russian businesses healthier over the long-term. As the deficient parts of the system have failed, the companies that have survived in the face of western sanctions have proven themselves to be resilient and durable, while those that faltered are no longer operating.
Some industries have even improved since the sanctions were introduced. Wheat output has skyrocketed since sanctions were first introduced in 2014; output in 2017 was Russia’s highest ever. Livestock production, most notably in the realms of beef and pork, has also seen an uptick, both in terms of quality and quantity. Part of this success is owed to the Kremlin deciding to ban food imports from countries that sanctioned Russia in the wake of the 2014 Crimea crisis. Since then, local businesses have not had to compete with Western counterparts. Though still reliant on Western machinery and technology, Russia is beginning to adjust to life without the West, and their modifications have begun in earnest in the agricultural sector.
The public markets tend to give a massive discount in oligarch dominated industries because of real and perceived corruption. However, agriculture in Russia is a fairly fragmented industry, shaped by diverse sectors, equipment procurement needs, and different export conditions. Unlike other sectors, which are dominated by a few powerful and well-connected oligarchs, agriculture is not.
Nonetheless, agriculture is a strategic priority for Moscow, albeit not currently a very lucrative one in comparison to energy. It is a priority because grain is the major component of Russia’s food supply. Any shortage could lead to major social unrest in a country that is famed for its revolutionary movements. Many historians argue that food shortages (again mainly wheat) snapped the patience of Petrograd and Muscovite workers and soldiers in 1917, ultimately bringing the downfall of the 300-year old Romanov dynasty. As Russia’s new tsar, Putin is keen to ensure he does not meet the same fate as Nicholas II. The Kremlin’s top domestic priority is making sure that domestic wheat prices do not rise. Moscow ensures that by investing billions of dollars in agriculture every year on top of providing the industry with cheap financing through the state-owned bank Rosselkhozbank.
Global warming’s impact on the planet is already being seen, yet financiers have been slow to respond. Oxford Sustainable Finance Program director Ben Caldecott has said that “markets are continuing to misprice environmental risks, in sectors from energy to agriculture.”
Because of population growth, increasing global wealth, soil erosion (among other factors), food sufficiency will be one of the major existential threats facing humans over the next century. As a result, agriculture should be considered to be among the most consequential economic sectors. With a projected global population of 11.2 billion people by 2100, global agricultural production will need to increase by orders of magnitude to feed an extra 3.5 billion people on earth. Global warming’s threat to food security will only exacerbate the situation.
Climate change will have two major impacts on agriculture. One is already happening, and the other will not come into full force for several years. Currently, the world is experiencing a greater number of droughts, floods, as well as higher temperatures. All of these environmental changes threaten the quality of harvests. In the long term, rising global temperatures will cause more water vapor to be discharged in the atmosphere, which will lead to considerable upswings in intense rainfall and soil erosion. Because of this, Earth is losing about 1% of its soil each year and 0.5% of its agriculturally productive land.
Although the environmental outlook is a bleak one for many parts of the world, Russia and much of the former Eastern Bloc may be set to benefit from the changes in certain ways. A 1C increase in the global temperature would give Russia a 0.83% increase in per capita output, per a recent IMF study. Much of this is due to agricultural output. Russia is forecasted to develop a warmer and wetter climate across its entire gargantuan landmass. This would allow Russian farmers to produce a greater variety and volume of crops.
Key Global Competitors:
PhosAgro is a dominant player in the Russian phosphate-fertilizer market. Its three main domestic competitors are URALCHEM, EuroChem, and Acron Group. URALCHEM, based in Cyprus, is Russia’s largest ammonium nitrate producer and its second largest ammonia and nitrogen fertilizer. EuroChem, based in Switzerland, is 90% owned by Russia’s 11th richest citizen—Andrey Melnichenko—and made $1.87B off of phosphate product sales in 2017, and just under $5B in total sales that same year. Acron Group, which is also based in Russia, is among the top 10 NPK producers globally, and competes with PhosAgro domestically in that space. It is worth noting that neither URALCHEM nor EuroChem are publicly traded.
Internationally, PhosAgro competes with 3 other players: Yara International, The Mosaic Company, and Nutrien. Based in Norway, Yara International is the world’s top producer of nitrates, calcium nitrate, NPKs, and is also allocating large sums of capital toward growing its portfolio in the phosphate space, having recently purchased a Brazilian mine. The Mosaic Company, based in Minnesota, is the largest US based producer of both potash and phosphate fertilizer. Lastly, there is Nutrien, the global leader in fertilizer production. Headquartered in Canada with a market cap of around $30B, Nutrien is the second largest seller of phosphate products and the largest provider of nitrogen and potash based products in the world.
The global fertilizer market is categorized into nitrogen (N), phosphatic (P), and potassic (K) products. Nitrogen-based fertilizers represent the majority of the global market, and include popular compounds such as urea. Diammonium Phosphate is the most widely used phosphatic fertilizer, while the use of potassic-based fertilizers, or ‘potash’ is also common.
Diammonium Phosphate ‘DAP’ prices declined ~35% between 2013 and 2017 due to a cyclical downturn driven by a surge in market supply. DAP prices have since partially recovered from the trough, having risen ~27% since 2017. It is expected DAP prices will remain stable in the medium-term due to the following global supply/demand dynamics.
On the demand side, India has become a key importer of DAP as high production costs continue to limit domestic DAP production. In 2Q 2018, India reported a year-over-year increase of 80% of DAP imports. In Brazil, demand for DAP dropped off in early 2018 due to the lingering effects of the truck drivers’ strike, which stagnated agricultural output for much of 2018. However, importers are forecasting a pickup in fertilizer demand in 2019. Previous agribusiness output levels are likely to be surpassed following the election of pro-business President Jair Bolsonaro.
On the supply side, Chinese exports of DAP declined ~13% during the first half of 2018. Despite an increase in plant utilization levels, Chinese supply was constrained by government efforts to close many small and heavy-pollutant DAP plants. However, increased capacity and output stemming from Morocco and Saudi Arabia continue to pose a risk to the near-term supply outlook.
Similarly, urea pricing is forecast to be marginally up in 2019 stemming from a) the closure of Chinese high-cost urea capacity plants in 2018-2019 and b) limited Middle-Eastern (and other gas-rich) capacity additions in the near-term.
PhosAgro is a global cost leader in the fertilizer industry. While the company benefits from a cheaper quality of ore, as well as low energy and low labor costs, we consider the company’s greatest differentiator to be management’s strict adherence to its low-cost and low leverage business model.
For example, in the depressed DAP price environment of 2016 and 2017, PhosAgro’s revenues declined a mere 1.0% and 3.4% respectively. PhosAgro responded to pricing volatility by switching roughly half of its DAP capacity to more complex NPK fertilizers, thereby limiting the impact of lower DAP prices. Furthermore, the company reported a positive operating cash flow and issued a 5% dividend, while still managing to reduce debt. While competitors OCP S.A. and The Mosaic Company both faced the pricing downturn of 2016-17 with leverage well above ~4x, PhosAgro was able to maintain leverage of ~2x.
Despite management’s commitment to low leverage and organic growth, PhosAgro’s output of nitrogen and phosphate products has increased over 50% throughout the past 5 years. Output is expected to continue to grow, following CFO Alexander Sharabaika’s stated intention to increase total capacity by 20% by 2020. The plan, announced in 2017, has been implemented via a highly efficient capex strategy intended to reduce reliance on third party purchases. The company opened its new Cherepovets ammonia and urea plants in mid-2017, and is currently focusing its investments on the expansion of subsidiary OJSC Apatit, a large mining and chemical complex. Despite Russian domestic fertilizer consumption having grown 13% in 2017, CEO Andrey Guryev has also indicated that he intends to boost sales in Europe by 20% and in Latin America by 50% by 2020.
Furthermore, Sharabaika and Guryev have provided investors with considerable clarity regarding the use of cash flows. The corporate dividend payout policy is outlined as ‘up to 75% of free cash flow generated’. Dividends have remained consistent for the past five years with a payout range of between 30% and 50% of profits. PHOR LI currently has a 5.86% 12m trailing net dividend yield, and 5 year dividend growth of ~9%.
Similarly, capital expenditures are capped at 50% of EBITDA. Despite the company’s reliance on earnings for high dividend payouts and a high (but capped) reinvestment rate, PhosAgro has still been able to report positive free cash flow in 4 out of the 5 last years (in 2017 FCF was impacted by higher costs of more complex NPK fertilizer production). In fact, in November 2018, Guryev reported quarterly year-over year revenue growth of 35%, EBITDA growth of 72%, and record-high FCF generation (RUB 12.4B vs. RUB 1.68B in 2017). Guryev also noted that the profitability achieved in 3Q 2018 is likely sustainable, as global demand remains strong and new projects will continue to bolster production. We expect strong cash flows to further the company’s commitment to reducing its leverage, to continue to grow a healthy dividend, and to provide flexibility to navigate suboptimal business conditions.
Although PhosAgro does not hold high levels of cash on hand, liquidity is certainly strong. In 3Q 2018, the company reported RUB ~12.3B of cash against short-term bank debt of RUB ~4B. While current asset levels are not as plentiful as comparable value opportunities we have evaluated in the EM space, it is worth noting that debt levels are low, EBITDA margins are high (37% in 3Q 2018), and cash flow is both consistent and growing. In fact, Fitch Ratings recently updated the company’s senior unsecured rating to BBB-, an investment grade level, behind strong liquidity, strong management, and consistent cash flow generation.
PHOR LI currently trades at 9.07x FWD P/E, which is above its historical valuation of 7.8x and well above the MOEX average P/E of 5.43x. Unlike many of its Russian peers, PHOR’s P/E ratio is approaching double digits. Although we cannot ascribe exactly causality, this is likely because the market understands that PHOR is less privy to corruption than other Russian corporations. As noted above, companies that are highly connected to the state are also subject to internal corruption; money gets siphoned off to suit the state’s needs instead of returning value to shareholders. This happens much less at PhosAgro. Although P/E levels do not scream ‘bargain’, PhosAgro is certainly not expensive at 5.8x FWD EV/EBITDA; The company trades at a considerably lower valuation than its fertilizer peers while maintaining a high dividend yield and strong prospects for future growth.
Continued improvement in DAP prices as well as a decline of the Ruble could serve as strong short-term catalysts. However, even without these drivers, management’s enterprising expansion plans provide an opportunity for capital appreciation, while strong, consistent cash flows continue to provide comfort while investing as a dividend play.
First, there is the long-term impact of population and demographics on agriculture. Food supply has experienced muted growth in the past years due to resource constraints and limited private investment. However, demand for food and other agricultural products is expected to increase, driven by high population growth, longer life expectancy, and improved purchasing power of the emerging market middle class. While agricultural supply is somewhat limited to existing resources, the impact of a larger and wealthier global population bodes very well for PhosAgro.
A 2015 OECD report revealed that almost every single country will lose between 1.5% and 6.5% of annual GDP due to the costs associated with climate change. That same report noted that only Canada and Russia would benefit from global warming. As other countries’ agricultural sectors suffer reduced output due to soil erosion, drought, and other extreme weather conditions, warmer weather in the northern hemisphere could allow the historically cold regions of Russia to be exploited for agricultural production. This, in turn, will lead to both increased global demand for fertilizer as international soils will be depleted of nutrients, and greater domestic demand for fertilizer as the world will rely Russian agriculture to an even greater degree.
Improved profitability projections, paired with developments in food safety and security, have painted an improved risk-reward picture for investors. As both investors with interests in agriculture and agricultural focused investment funds continue to rise in popularity, market sentiment will turn increasingly positive towards companies favorably impacted by the larger global population and impacts of climate change.
Jeremy Grantham’s most recent GMO letter describes grain productivity as being at the heart of the world’s food problem. He argues that grain production is “barely keeping up with population,” and “there is no safety margin.” He points out that “in the Green Revolution [global grain] was growing at 3.5% per year, and now on average since 1995 it’s come down to about 1.2%, with the world’s population growth also at 1.2%. A dead heat. We are producing as much grain as we are producing people.” Once Grantham’s sagacious words become more widely held and people realize that Northern climates, such as the US, Canada, and Russia, are positioned to be the primary beneficiaries of ice cap melting and increasing temperatures in northern lands, agricultural stocks in Russia, especially those with sound management, consistent generation of cash-flows, and low leverage, could rise.
Investing in PhosAgro carries risks, some which are inherent in the structure of the business, some which relate to Russia’s political realities and others still that relate to its geopolitical isolation. Although this section does not discuss every possible risk, it considers the most significant ones.
While most prices for the company’s products are denominated in US dollars, costs are primarily in Rubles. A sharp appreciation of the Ruble will raise production costs, compress margins and reduce profitability. In 3Q 2017, PhosAgro reported an 19% increase in expenses following a 9% appreciation of the Ruble; Higher import duties, an increase in freight, port and stevedoring costs, and greater transportation and storage expenses drove up quarterly expenses. Accordingly, we estimate that each ~1% swing in the average RUB/USD exchange rate has an impact of ~2-3% on USD earnings per share.
The company is subject to seasonality in fertilizer demand due to the nonuniform timing of fertilizer application and purchases. Furthermore, there is little capacity rationalization behind fertilizer production; in 2015-16 the market faced an oversupply stemming from high production despite a drop in global demand. Currently, record-setting levels of Chinese urea exports are expected to continue in the near term regardless of demand. However, experts have indicated that increased production costs and high plant closure rates will eventually limit state-backed exporters and serve to correct market supply.
Domestic Political Risks:
Greater government involvement may preclude some of the aforementioned catalysts from boosting profits and share price. If fossil fuel revenues decline, as they may do in the case of more robust global climate policy and waning demand for hydrocarbons, the Kremlin may have to turn to other industries in Russia for its rent-seeking. Agriculture is a prospective landing spot, and this would undercut the potential growth that this report envisions in PhosAgro.
Investors should be aware that since the state is close with a major shareholder, Moscow may intervene in the company. In such instances, the state can act in such ways that are not profit-maximizing if they serve the state’s long term interests. But concurrently, state involvement almost guarantees long-term survival. Companies that have some sort of oversight from Moscow are also more likely to last longer: if the state feels that they are necessary, it will do whatever it can to keep them afloat. In this sub-optimal route, investors would have long term dividend returns as their worst-case scenario.
PhosAgro is exposed to the economic and financial conditions of the Russian Federation, which has been acutely impacted by its pariah status in the international community over the past several years. Since 2014, the US and the EU have imposed and expanded economic sanctions on individuals and entities based in the country. Sanctions have led to a reduction in FDI and a significant tightening in the availability of credit. While Russian fertilizers have not faced direct export duties, PhosAgro has been indirectly affected by the aforementioned economic implications of Russian sanctions. It must be noted that future tariffs on fertilizers should not be considered ‘out of the question’—this is especially true considering that the US implemented tariffs on Chinese phosphate and urea imports in September 2018. SSU expects these tariffs to have a muted impact on global DAP and urea pricing.
Even with Trump’s proclivity for protectionism, it is important to distinguish between the trade-war-related tariffs, and outright geopolitical punishing sanctions, as these are subject to different political processes and are controlled by different bodies in the US. Additionally, Russian businesses not close to oligarchic interests, like PhosAgro, should make it less likely (as with all Russian agriculture) to become subject to sanctions. Furthermore, European states, especially Austria, Italy, and Germany, have been averse to implementing sanctions that hit ordinary Russians in any way, and agriculture might be far down the list of priorities, even if Moscow’s relations with Brussels deteriorate.
Sanctions, hyped by Russian and American media alike to be an complete ban on all Russian exports, has persuaded already uneasy asset managers to believe that all potential Russian investments are poisonous and politically vulnerable. This belief is categorically false, and is simply not the intention of US or EU sanctions.
In a newly-published report that covers 90% of the UK banking sector, the Bank of England’s Prudential Regulation Authority found that only one in ten financial institutions are taking a “long-term, strategic approach” to managing climate risks. The report follows comments made in April by Bank of England Governor Mark Carney, who said that climate change could have “catastrophic impacts” on the financial system if adequate safeguards are not put in place. This is true not only of the UK, but of every developed country’s asset management space.
Last year, an Oxford University survey of 150 British and Australian institutional investors found that a majority were unfamiliar with basic climate-related concepts, while only one in four could identify an employee within their organization who was responsible for evaluating climate risks. Any portfolio manager would be wise to protect his/her portfolio against climate change, and we contend PhosAgro is a suitable, prudent option.
With its long history of earnings and dividends, unlevered balance sheet, and strong free cash flow, PhosAgro deserves the attention of investors seeking EM exposure. Its devoted management, compelling and balanced board, as well as its strong quarterly financials all point to it being an undervalued company. Furthermore, SSU contends that PhosAgro also provides some medium to long-term climate change protection for any portfolio.
Disclaimer: This article is not intended as investment advice and is intended for informational and entertainment purposes only.