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Learning from hedge funds: CF Industries' 70% outperformance

Part 2
Learning from hedge funds: CF Industries' 70% outperformance (Part 2 of 7)

Third Point’s view: CF’s valuation at a 32% discount can improve

Attractive opportunity

On July 29, it was revealed to the public that Third Point, considered to be one of the top hedge funds, initiated a position in CF Industries Holdings, Inc. (CF) during the second quarter of 2013. According to the investment firm, CF was an attractive purchase because the stock was trading at an “unwarranted discount” to fertilizer and commodity chemical peers. On the day of the announcement, CF Industries popped 9%.

CF Free Cash Flow YieldEnlarge GraphInvestment thesis

The firm believed CF Industries’ cash flow generation strength was misunderstood, given that the company benefits from structurally lower natural gas prices in North America. The firm felt “CF’s ability to tap lower-cost natural gas in North America was an advantage and the spread between CF’s production cost and higher cost producers is a nice benefit,” according to its second quarter letter to investors.

Recommendation

Third Point also believed management should distribute larger dividends to its shareholders. Dividend increases are often viewed positively by the market, because it shows management is confident with the company’s ability to sustain its cash flow. Consequently, shares often rise when dividends are raised.

Valuation upside

At the time, CF was trading at an 11% free cash flow yield, according to the hedge fund. Given the low-risk profile of this portion of CF’s cash flow, Third Point said the company deserved bond-like valuation at 7-8% yield. Free cash flow measures the amount of cash that a company is expected to be able to give back to its shareholders, after allocating money to maintain or expand capital assets.

One divided by free cash flow yield essentially gives you price of one share over free cash flow per share. A 11% free cash flow yield would mean investors are paying 9x the company’s annual free cash flow, and a 7.5% free cash flow yield would give us 13.3x. If CF Industries should trade at 13.3x free cash flow, then the company could have seen an upside of 48.7%. Since the end of June 2013, CF Industries has risen ~37%.

More upside

Note, CF Industries’ pro forma free cash flow yield could have been much higher on June 30, 2013, if the company hadn’t spend cash to fund two capacity expansion projects. Prior to the announcement of expansion projects in late 2012, CF Industries only spent ~$350 million on capital expenditures to maintain its existing assets.

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