I’ve found a situation that would make any business owner salivate…
Trust me, it doesn’t happen often. Cutthroat competition and other factors usually prevent it. But when an opportunity like this arises, companies (and their stockholders) can rake in extraordinary gains while it lasts.
There are two powerful market currents converging.
Let me explain…
In the simplest terms, a company makes money by selling what it produces.
But, of course, it’s not what you make that counts — it’s what you keep.
The gross profit is the difference between the revenue that flows in and the product manufacturing costs that flow out.
This is the fundamental idea behind any business activity…
Normally, if a company wants to increase profits, then it has two options. First, it can raise the price of its product. But this can be extremely hard to do without scaring away customers, especially if there’s a lot of competition.
The second option is to reduce costs. This is usually an easier route, but again, it can be difficult… there’s only so much a company can do to lower its costs.
But every now and then, a company finds itself in a rare situation where outside market forces do all the work and accomplish both goals at once — raising the ceiling price for the product and lowering the floor for the costs to make it.
Again, this doesn’t happen often.
But when it does, it’s usually wise for investors to climb aboard.
Take CF Industries (NYSE: CF) for example.
CF Industries is a fertilizer company whose nitrogen and phosphate-based crop nutrients are commonly used to grow corn. To harvest 150 bushels of corn from an acre of land, farmers typically have to apply 150 pounds of nitrogen fertilizer.
U.S. farmers are expected to plant about 96 million acres this year, an area larger than Pennsylvania, Florida and Michigan combined. Due to increasing demand from China and rising grain-based ethanol usage here at home, the price of corn has been elevated for several years, leading to a surge in the price of nitrogen fertilizer.
In the past 12 months, ammonia (a nitrogen compound) prices have climbed to $672 per ton from $410 per ton, while granular urea — a solid nitrogen fertilizer product — has risen to $461 per ton from $371 per ton.
As you might expect, these price increases have served CF Industries well… after all, the company ships more than 1 million tons of fertilizer to customers per month. As a result, revenue jumped 30% last quarter to $1.5 billion in comparison with the same period last year.
But here’s the kicker: fertilizer prices are marching higher, while the costs to make the stuff are sliding lower.
You see, the secret ingredient needed to manufacture nitrogen fertilizer is natural gas. And as we are all aware, natural gas prices have plummeted to decade lows below $2.50 per thousand cubic feet (Mcf).
Thanks to lower costs, and rising output prices, CF Industries has been able to boost its profit margins substantially…
With revenue rising much faster than the cost to produce its fertilizer, the firm pocketed $712 million in gross profits, or 47% of sales — up from a gross margin of 45% a year ago.
This has led CF Industries to be one of the most profitable companies out there.
Of the $1.5 billion in sales mentioned earlier, the company squeezed out $424 million in adjusted net income. This means it is converting every dollar of revenue into $0.28 of profit. That’s higher than Apple’s (Nasdaq: AAPL) 27% net profit margin.
Of course, expanding margins have worked wonders for CF Industries shares as well. In the past five years, the stock has surged more than 370% — quadrupling from $34 a share to nearly $160 a share. But if you missed out, then fear not — I believe there’s room for more.
It could take years to whittle down the nation’s natural gas supply gut. Even then, prices could rebound to $4 or $5 per Mcf and still be cheap by historical norms.
Meanwhile, with China’s economy growing 8% annually and domestic ethanol usage swallowing up 40% of the nations corn crop, I can see corn prices staying high for years to come…
CF Industries’ profit margins are dependent on three factors. For the company to continue harvesting record cash flows, it needs cheap natural gas, tight global nitrogen inventories, and strong corn plantings.
Check. Check. And check.
Action to Take — > So for now, it looks like CF Industries (NYSE: CF) margins are safe… at least until there’s a major shift in market fundamentals. Better still, not only is the company’s bottom line well-supported, but the undervalued stock is currently trading at just 6.8 times earnings, about half of its 5-year average of 13.0.
The market is in a sour mood right now. But when it starts pricing stocks for what they’re worth, I think CF could once again top the $200 per share mark.
– Nathan Slaughter
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Nathan Slaughter does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.