“Manure! I hate manure!” - Biff Tannon: CVR Partners $UAN, CVR Energy $CVI

Probably Not a Value Trap

Welcome back to the “Probably Not a Value Trap” series where I discuss businesses with a 10%+ dividend yield which I believe probably won’t get cut and why, but don’t come after me on Twitter if they do.

Generally nitrogen fertilizer is a boring business, with massive upfront capex for machinery that absolutely must run at 95%+ capacity at all times to capture the thinnest of margins, but this is a great time to be a US domiciled nitrogen fertilizer manufacturer.  About 50%-70% of the cost of nitrogen fertilizer is the natural gas used as an input, and another 10%-20% of the cost is electricity.  Nitrogen fertilizer is still made using the Haber-Bosch process invented in Germany over one hundred years ago, so let’s check in on the competitiveness of the German chemical industry recently…whoops!  Angela Merkel, who had a degree in chemistry, sabotaged the chemical industry of Germany by driving up electricity costs and banning fracking.  With the trade sanctions on Russia, Dutch TTF natural gas is now trading in a range between 3x and 6x of Henry Hub natural gas.

Well, what about the rest of the world, fertilizer is so important to human life, certainly they would have wanted to develop their own national fertilizer supply?  If only the International Monetary Fund were willing to lend for dirty, filthy, fossil fuel industries.  China and India have built out enormous fertilizer industries, but these are to feed their populations, and they are not low cost manufacturers for an export market.  Only Canada and Russia can compete with the US for low cost nitrogen fertilizer production, and with the world breaking up into spheres of influence, the US seems to have a somewhat captive export market in the form of Europe and the non BRICS Latin American countries.  

This thesis might not be nearly as popular as copper, but it seems to be sound to those in the industry.  Koch Ag and Energy Solutions surprised a lot of people last December when they announced their acquisition of the Iowa Fertilizer Company from OCI Global for $3.6 billion.  

CVR Partners LP (UAN) is the 37% owned affiliate of CVR Energy Inc. (CVI) which is 66% owned by Carl Icahn’s eponymous Icahn Enterprises (IEP).  UAN is a nitrogen fertilizer manufacturer and CVI is an oil refinery business.  Not only is UAN 37% owned by CVI, but Carl Icahn took a separate 36% ownership of UAN just this past March.  CVI has announced they are seeking strategic options for their ownership stake in UAN, which might include taking it private, but probably means they were so surprised by the price that Koch paid for the Iowa facility, they figured, what the heck, let’s see what we can get by selling ours.

CVI, backed by Icahn, is bidding on the Citgo refinery assets seized by a Delaware court in finding against the Venezuelan government for past expropriations.  Rumors are swirling, is CVI selling UAN to be able to afford the Citgo assets?  Will UAN be taken private by Icahn?  Does Icahn need to sell UAN due to his depressed IEP share price after the short report last year?  Will UAN sell for a similar price to Iowa Fertilizer?

My best take on the situation is that the announcement to explore strategic alternatives by CVI for UAN is unrelated to the Citgo bid.  The time it would take for a buyer to do due diligence and to execute a transaction on CVI’s stake would preclude use of the funds for the Citgo auction.  I also think Icahn’s March purchase of 36% of UAN is an indication that he likes the fertilizer business enough to keep on owning it once he no longer owns any of it through CVI.  Icahn currently has $5.6 billion in current assets in IEP, so it also seems unlikely that Icahn bought UAN just to do a quick flip for cash, I think that Icahn wants to own UAN for the distribution income, and I base this opinion on Icahn’s capital allocation policy with Sandridge Energy (SD) which focused on dividends to the detriment of acquisitions even when targets were cheap.

There is a risk that CVI could use their GP position to force an acquisition of minority shares of UAN, and if this is done at a market downturn, could force the purchase on unfavorable terms.  This was done by CVI and Icahn to the prior subsidiary CVRR.  At one time CVI was just a holding company, and CVRR was the refinery business.  A major difference in this instance is that CVI owns much less of UAN, they must own 80% of the shares outstanding to execute this strategy.  It could be possible that Icahn bought the 36% stake in UAN to sell them to CVI to get closer to that 80% threshold, but they are still 7% short.  And in the CVRR case, Icahn was sued and settled out of court for damages, but the shareholders were not made whole, so Icahn might consider this just a cost of doing business.  Icahn repeating this strategy is a nonzero probability, but I do not believe this is the most likely path forward.  If I saw Icahn or CVI increase their stake to the point that the combined ownership was over 80%, I would be a seller of UAN immediately.

In the case of UAN for the purpose of this Probably Not a Value Trap series, if you are looking for stable dividends, UAN has Carl Icahn breathing down their necks reminding them to watch costs, and to return all capital to shareholders in the form of distributions. If the last distribution is indicative of the next four, then UAN is currently trading right around a yield of 10%.  It is possible that an external offer to take UAN private could come, and if so, the comparable with the Iowa facility which sold to the Kochs is somewhere between $112 a share or a 45% premium and $175 a share, or a 125% premium.  I wish I could narrow the range down more, but there are a lot of structural differences between the facilities.

UAN has two nitrogen fertilizer plants, one in Kansas and one in Illinois.  They produced 1.4 million tons of fertilizer in 2022, somewhere in the neighborhood of 10% of the US supply.  The Kansas facility still uses petroleum coke instead of natural gas, but management is in the process of converting the facility to dual fuel so they can switch to whatever feedstock is cheaper at the time.  That should occur later this year and the capex was described by management as to be so small as to be non material.  There is also some efficiency capex spending planned for later this year, with some profits from the last six months already withheld from distributions to fund this spending.  

Regarding the stability of the dividend, until Russia is on friendly terms with Europe, or new fertilizer capacity is brought online, perhaps by Brazil or Argentina, the US will maintain an incredible input cost advantage. That advantage seems to be durable for at least the next ten years.

I’m not saying that UAN cannot yield less than a 10% dividend going forward, they are a variable distribution LP.  But if they did yield less than 10%, it would probably be because US natural gas prices were high, in which case, our last Probably Not a Dividend Trap stock, Black Stone Minerals (BSM) would be earning fat stacks of cash.  This means that UAN and BSM make very complementary portfolio positions as they should be somewhat negatively correlated based on inverse relationships to natural gas prices.  

The only threat to UAN’s dividend that can’t be hedged by owning equal parts BSM would be a collapse in fertilizer prices.  Fertilizer prices follow the pattern that whenever there is a crop failure, the remaining farms over earn as crop prices are set at the margin, but profits are earned on the average price.  We have had two solid years without a crop failure in a major staple, and despite this, UAN is still earning enough to support a 10% dividend yield at these prices due to the structural decline of the German fertilizer supply. 

UAN Gross Profit

Looking at the gross profit above, and comparing it to farm incomes, it looks like fertilizer profitability is about two to three times what it was before the effects of German industrial policy and the trade sanctions on Russia.  UAN is at relatively moderate to low earnings right now due to the bumper staple crops for the last two years, and any agricultural disruption would lead to higher fertilizer demand, higher fertilizer prices, and a dramatic over-earning by UAN.  Fertilizer is a cyclical business, and is notoriously unprofitable for years at a time, but the Koch purchase of Iowa Fertilizer for $3.6 billion makes me think the smart money believes we are now in a world where trough earnings are much higher than before.  

So in summary for CVR Partners, the structural tailwinds are very strong, there is a potential risk of being taken private by Carl Icahn at a disadvantageous price, there is a potential opportunity of being taken private at a very advantageous price, the industry is notoriously cyclical, but the smart money says the payouts are likely to keep coming, and it is reasonably hedged by being long Black Stone Minerals.