CF Industries’ closest peers are CVR Partners, LP (UAN) and Terra Nitrogen Company, L.P. (TNH). While PotashCorp and Agrium Inc. also manufacturer nitrogen fertilizers, these companies have heavy exposures to potash fertilizers or retail businesses. CVR Partners, LP (UAN) and Terra Nitrogen Company, L.P. (TNH) are the two comparable pure play companies listed on the U.S. stock market.
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As limited partnerships, CVR Partners and Terra Nitrogen distribute earnings to shareholders on regular basis after allocating cash aside for maintenance. These companies have historically traded at ~13.0 times distributions available to investors who hold common units, which is equivalent to ~7.7% free cash flow yield that Third Point mentioned in its second quarter letter.
As the chart above shows, CF Industries has historically traded at a significant discount of close to 50% compared to the two limited partnerships. Since these companies operate in the same industry, CF Industries was likely undervalued because it paid close to zero dividends, as shown in the graph below.
While investors could use the price to free cash flow or free cash flow yield to value Terra Nitrogen and CVR Partners, calculating free cash flow is a bit troublesome. For example, CVR Partners’ general partner interests aren’t entitled to distributions from the nitrogen fertilizer business, but Terra Nitrogen pays distributions to the general partner and Class B common units. The general partner also receives incentive distribution rights, where their percentage share of the total distribution increases as distribution rises.
Free cash flow and partnerships
The simple formula for free cash flow is operating cash flow minus the capital expenditures. But when these partnerships show their cash flows on financial statements, they represent the partnerships as a whole. So investors would have to subtract the amount of cash for the general partner when calculating Terra Nitrogen’s free cash flow to the common units. Price to earnings valuation, on the other hand, uses earnings available to the common units.