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By John Helmer in Moscow

In antique legend, Icarus was the boy who, ignoring his father’s prudential warning, flew too close to the sun, melting the wax from his wings, and plummeting to his death as a consequence. In W.H. Auden’s modern reflection on the incident, noone witnessing the plunge cared much, while “the expensive delicate ship that must have seen/Something amazing, a boy falling out of the sky/ had somewhere to get to and sailed calmly on.”

The commodity market has been like that recently, sailing on, as high-flyers like Uralkali, the leading Russian potash stock (ticker URKA:LI, URKA:RU) dropped into the sea.

The current standing for Uralkali, at the end of trading on September 9, is a share price of $7, and market capitalization of $14.9 billion. Since June 20, ten weeks ago, Uralkali has fallen from $16 per share, with market cap of $34 billion; a decline of 56% and $19 billion in value.

A report, issued this week by Renaissance Capital analyst, Maria Alexeenkova, notes that over the past three months, the drop in market value by Uralkali, amounting to 41%, is just ahead of the 38% decline of the Russian index as a whole. It is steeper than the fall registered by listed Russian fertilizer peer, Silvinit (-40%), but not as bad as complex fertilizer producer Akron (-45%), and phosphate producer, Apatit (-48%).

Compared to the international potash producers, Uralkali’s share price decline over the three-month interval is significantly greater than the decline for Potash Corporation at 30%, Mosaic at 33%, and Agrium at 20%. Including Israel Chemicals, Arab Potash and other complex fertilizer producers, the average loss for the internationals is 26%; the Russian average is 12 points worse at 38%.

September 9 was a black day for Uralkali, losing 8.1%. But it was almost as black for Potash Corp, which dropped 7.5%. Why is the market discounting so heavily the positive financial results reported by Uralkali, and the positive projections for the fourth quarter?

Last week, the company released its first-half financial results, calculated according to international Financial Reporting Standards. Net revenue surged 158% year on year to $998 million, propelled by a sharp increase in potash prices, and moderate growth in production and sale volumes. The company’s average realized potash price in the six-month period jumped 139% to $378 per metric tonne, while volumes sold increased by 8%. EBITDA and net income increased to $762 million — growth of 230% year on year — and $575 million, up 284%. The figures, reported Moscow brokerage analysts, were in line with expectations.

The company also reports a 62% increase in costs, owing to sharp increases in labor, fuel and energy, and depreciation, which were up 73%, 43% and 43%, respectively. Distribution costs rose 51% as a result of soaring freight costs, which grew 148%. Profitability continued to accelerate, compared to last year: EBITDA and net income margins increased to 76% and 58%, respectively. Alfa Bank analyst Roydel Stewart reported the profitability trend can be expected to continue: “we expect margins to continue to expand in the near term, as the deficit in the potash market should allow growth in potash prices to outpace escalating costs.”

After-tax profit for the company came in at $576.8 million, a gain of 293% over the same period of 2007. Finam, a Moscow investment house, forecasts “the company to demonstrate even stronger financial results” in the second half of the year, as its new contracts come into play, including those on spot markets at USD 1,000 per tonne.”

In a conference call with analysts, Uralkali management said that its latest contract negotiation, with Bangladesh, set a record of $1,100 per tonne. This indicates the further tightening of the commodity supply market as the unionized miner strike at Potash Corporation, which began on August 7, continues. Uralkali expects to open fresh potash supply negotiations with Chinese buyers in October, with a benchmark of $1,000 to $1,100 per tonne.
The company said that it has now completed its feasibility study on its greenfield Mine-5 project, announcing that the decision has been taken to start construction in the fourth quarter of this year. First ore output is projected in 2013, and full-capacity production of 3.7 million tonnes in 2015.
This welter of good news over the past week did not restrain the Russian stock market — Uralkali was cut by 22% over the past week.

Alexeenkova reports that the source of the heat melting Uralkali’s share price is a combination of international grain price retracement, and increasing Russian government intervention to limit domestic fertilizer prices for farmers. A global correction in agriculture commodity prices, which started in June, triggered a 13% decline for wheat a week ago; a 16% drop for soybeans in the month of August; and for corn, a drop of almost 30% since the year peak in June, and a 5% decline since September began. The burn in US grain prices more than singed the potash producers.

Uralkali management has responded to the new trend, briefing investors in London and New York over the past week. In a conference call for analysts, Uralkali said last week that the current to rising potash price is sustainable in the US market at a break-even point for farmers of $3 to $3.50 per bushel for corn, $11 for soybeans. At present, these levels are well below the current spot-market prices for both commodities. And there is plenty of farmer and trader margin still. In theory, then the global demand and supply balance should continue to sustain the potash commodity price, and accordingly lift Uralkali’s year-end financial performance.

Domestically, however, Mineweb has reported that the Russian government’s drive to control inflation in the price of raw materials in agriculture and industry is curbing profitability and margins for the fertilizer producers, like the coalminers and steelmakers. In April, the government introduced export duties of 8.5% for nitrogen and complex fertilizer producers, and 5% for the potash companies. Further measures, still being considered, could include the introduction of regulated prices for domestic customers and the negotiation of long-term supply agreements. Such measures have already been adopted by the Federal Antimonopoly Service (FAS) and ordered for the Mechel coal and steel group, and the Evraz coal unit, Raspadskaya.

But potash differs from coal and steel in an important respect. Much less potash produced by the Russian miners is consumed domestically; much more is exported. The share of domestically
consumed potash as a proportion of total output is just 15%. Thus, despite the relatively rapid growth rate of Russian farm demand for the product, the volume and financial impact of the price curtailment measures is small.

The jawboning by the Kremlin has been effective in extracting price for profit bargains. Viktor Zubkov, the deputy prime minister supervising the fertilizer producers, has signaled that the content to leave Uralkali’s profit margin on exports untouched, and untaxed, on condition the management agrees to supply fertilizers for domestic customers at a discount to international prices set at 16%-30% for 2009. Uralkali has already fixed its price at Rb3,000 per tonne ($125) for farmers and Rb3,500/tonne ($145) for industrial producers of complex fertilizers (NPK), who in turn then supply the farmers. According to alexeenkova, “even with domestic price growth below inflation, potash companies will have a relatively good margin from domestic sales, taking into account a cash cost of $54/tonne for Uralkali.”

Stewart of Alfa Bank responds that the domestic price controls affect too small a volume of Uralkali’s production to make a significant dent in its financial growth. “The company has set prices for domestic agriculture consumers at seven times below their recent Bangladesh contract. With current domestic demand at just 200,000 tonnes, the overall effect on the company is insignificant, but should keep the regulator away.”

That leaves the fundamental demand/supply imbalance for global potash more or less unchanged since Mineweb started reporting the phenomenon a year ago, as the potash stock boom took off. Analyst and company calculations and projections indicate that since the beginning of 2000, global potash demand has grown 40%, or almost 16 million tonnes. About 90% of that growth has come from Asia and Latin America, Uralkali’s biggest markets. But over the same interval, new capacity to supply potash has increased by only 7 million tonnes., eroding excess capacity within the industry by 2007, and then depleting supply stocks and merchant inventories.

Projecting forward in time, Uralkali expects that incremental potash capacity will be 15.5 million tonnes in 2008-2014, compared with incremental demand of 15.6 million tonnes (4% per annum) over the same period, assuming problem-free conditions at mines, and a 100% operating rate. With the industry now running at or near full capability, world production in 2008 is expected to be limited to an increase of just 2%-2.5%. This compares with the 5.6% rate of growth of potash demand over the past five years, and the 4.6% demand growth rate estimated for the first half of this year.

These are the numbers cushioning the further fall of Uralkali’s share price. They are also firing up target share price projections for Uralkali. According to Alexeenkova, “the current market valuation of the fertilizer sector looks very cheap, taking into account the strong fundamental story, good cash-flow generation and high dividend payouts. Sector companies… might consider buyback programmes as a measure against depressed shares in the current market; however, we believe this would be inefficient (resulting in share-price appreciation only) if the sell-off is over. The sector looks fundamentally attractive in both the short and long term.”

RenCap is forecasting a new target price for Uralkali of $15.47, an upside to the current price of 121%. Alfa Bank is setting a target of $14.10, an upside of 101%. Unlike the legend, this Icarus may have wings to take off again.

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