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Quick Take - Terra Industries (TRA)

Terra Industries (TRA) is a producer of nitrogen-based fertilizer products. The company is one of the largest North American-based producers, competing with CF Industries (CF) and Agrium (AGU).

Terra has been embroiled in a three-way takeover triangle over the past year with these two competitors. Last January, CF made a bid of about $20/share for Terra, which was immediately rejected. CF then took the bid hostile, nominating three directors for election to Terra's board. Meanwhile, in February of 2009, Agrium made a takeover offer to CF (at about $72/share), then took its own bid hostile by opening a tender offer for CF shareholders! This is important to Terra, as Agrium's offer is contingent on CF dropping their bid for Terra. Both of the hostile bidders achieved some victories, with CF getting its directors elected to Terra's board and Agrium achieving about a 63% subscription to their tender. However, neither offer has been closed.

The final offer of about $46/share was unanimously rejected (even with the three CF-nominated directors) in December, and CF did not seek to extend their financing past the end of last year. Indeed, CF formally withdrew their bid last Friday (Jan 15). MagicDiligence thinks that Terra's board made a bad decision not accepting CF's final offer. Let's take a look at the company as a stand-alone Magic Formula investment.

Fertilizer is a commodity product, distinguished by end users only by price. There are 3 types of fertilizers: nitrogen based, phosphate based, and potash based. Weekend gardeners might recognize these 3 numbers from the side of a fertilizer bag (nitrogen-phosphorous-potassium, or N-P-K). The different fertilizer producers generally skew towards one of the three types, and this greatly affects competitive position as the underlying dynamics are quite different. Potash (used for potassium) is attractive, as deposits are rare, very expensive to mine, and largely controlled. Phosphorus comes from phosphate rock, which is a commodity that is readily available.

Terra Industries is in the nitrogen business. Nitrogen-based products are created by combining the extracted hydrogen from natural gas with the nitrogen in the atmosphere. Obviously, both input components are readily available. This makes the production of nitrogen fertilizers a business with low barriers to entry, creating lots of competition (especially internationally) and severe pricing wars. There are no switching costs, unique assets, or regulatory barriers - and thus, Terra Industries has few durable competitive advantages.

Growth potential is very difficult to gauge. This is a company that posted 29% and 23% revenue growth in 2007 and 2008, but has suffered a 35% decline this year. Demand is largely tied to corn volumes. Corn prices soared in 2008 to levels near $7, after trading in a $2.50-3.00 range for decades, due in no small part to demand for ethanol. While crop volume remains at record levels, supply has caught up to demand and prices are now back into a more reasonable $3.50-4.00 range, still higher than historical levels. With expectations of continued high corn volumes, I believe Terra should be able to maintain fairly elevated revenue levels over a one year MFI holding period.

Less certain are gross margins, which are also wildly volatile, ranging from 7% in 2006 to 30% in 2008! Natural gas is the primary input, accounting for up to 80% of Terra's variable costs. It is also a notoriously volatile commodity, with prices ranging from $13 to $3 over a 2 year period! Terra can hedge these costs to some extent, but gross margin will continue to swing wildly. Combined with unpredictable revenue levels, it is extremely hard to predict this company's profitability with any accuracy.

The last point of analysis, financial health, is much simpler. Terra has used their windfall profits of the past 3 years to build up a very strong balance sheet, with about a billion dollars in cash vs. just $330 million in debt. A strong balance sheet is key with a heavy cyclical like this, and Terra is well positioned to survive any sharp downturns.

While there is some reason to believe that Terra can deliver continued strong results in 2010, this stock is way too unpredictable to qualify as a MagicDiligence Top Buy. Also, since there are so many less unpredictable and comparably cheap stocks in the Magic Formula screen, I recommend MFI investors pass on this one.

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