CF Industries Holdings, Inc. (CF)

The analysis presented is based on a price of $79.54.

CF is an interesting double play stock. In addition to having good value qualities, the price may be augmented by a merger with a company that has reasonable value in of itself and, if it occurs, will provide an additional discount for receiving the acquiring company’s stock in the merger.

The most concerning aspect of this stock is that while the EPS has been growing meteorically, it is based on a relatively short history. The available data are only for the 2004-2008 period, and the EPS was zero for the first two of those years, however, the three most recent years have been positive and grew to $12.15 in 2008. Return on equity in the most recent two years, were 31% and 51%. In all five years, free cash flow has been positive and generally growing. In addition, the company holds about $15 per share in cash (19%).

Before I look at the valuations, I look at three indicators of financial safety. For this stock, all three are quite good. The Altman Z is 7.9; below 1.8 is risky, above 3 is the safe range. The Piotroski F is 7; 2 or below indicates caution, while 8 or 9 indicates that the stock is expected to rise within the next year. The Sloan accrual is -1.73; 5 or higher is high risk, while -5 or lower is excellent.

I use more than one valuation method to gauge intrinsic value; all of the first three provide a good margin of safety (MOS). The first three are standards in the valuation literature. The estimate based on Graham’s formula was $340 (77% MOS). The Earnings Power Value (value of the firm) was estimated, on a per share bases, to be $675 (88% MOS). The Discounted Cash Flow (DCF) estimate valued the stock at $194 (59% MOS).

The last two were based on a spreadsheet found on the AAII website; these are designed to mimic Buffett’s valuation methodology. One is based on projecting EPS growth 10 years into the future based on past EPS growth; I discount the resulting valuation to reflect the price at which the stock will realize a compounded earnings (including dividends when applicable) return of 15%. The results of this method, do not recommend purchase of this stock because the price of the stock is already greater than the valuation estimate of $73.

The second is based on estimating EPS growth through the sustainable growth rate. The per-share projected book value is estimated by taking the previous year’s book value, adding EPS and subtracting dividends (when applicable). The projected EPS is estimated by multiplying the projected book value by the average Return on Equity, and the projected dividend is estimated by multiplying the projected EPS by the average payout ratio. I then discount the resulting valuation to reflect the price at which the stock will realize a compounded earnings return of 15%. Based on this method the target purchase needs to be below $103, and at the current price there is a 23% MOS

To ascertain that the price is attractive to me, I take one more thing into consideration. At the current price, would I expect an immediate 15% return on my investment (ROI) based on earnings and dividends? In this, the EPS represents about 13.7% of the share price by itself, so the dividend yield is needed. However, the .5% dividend was not enough to achieve the desired 15%.

The second play is based on a hostile bid from AGU. CF’s board has rejected the AGU offer. The current offer is $86.90 which reflects a 9% improvement on $79.54. To see my assessment of AGU, see my recommendation there. However, my general assessment is that CF is slightly superior, but if acquired AGU, then there will be an additional MOS based on arbitrage.

CF looks to be a good investment based on its own merits, but the merger arbitrage gives it added potential. However, if you think CF will acquire TRA, then the purchase of TRA is the better way to buy CF – it effectively gives you a 17% discount (which improves all of the MOS calculations); the risk is that if you truly want CF, the merger may not happen.