This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, our headlines feature downgrades for two of the biggest names in fertilizer — Potash Corp./Saskatchewan (USA) (NYSE:POT) and Mosaic Co (NYSE:MOS). But the news isn’t all bad, so before we get to those two, let’s find out why one analyst says…
Take two shares of Herbalife Ltd. (NYSE:HLF), and call us in the morning? George Soros and Carl Icahn have gained a new ally in their battle with Bill Ackman over whether Herbalife Ltd. (NYSE:HLF) is a “pyramid scheme” or not. This morning, analysts at tiny Argus Research joined this battle among hedge fund titans, weighing in with their relative two cents, and assigning the much maligned Herbalife a buy rating and an $80 price target.
According to Argus, you see, Herbalife Ltd. (NYSE:HLF) isn’t just healthy — it’s positively prospering. Earnings growth is said to be strong, and with Herbalife Ltd. (NYSE:HLF) accelerating its program of share buybacks, earnings-per-share growth should be even stronger. Argus is raising its estimate for fiscal 2013 earnings to $5.15 per share, and projecting $6 per share profits in 2014 — a 16.5% increase. What’s more, I think Argus is right about this.
Priced just a shade over 14 times earnings today, and still generating significantly more free cash flow ($524 million) than it reports as GAAP net income ($499 million), quality of earnings at Herbalife Ltd. (NYSE:HLF) looks very strong indeed, which is not what you’d expect to see at a bona fide pyramid scheme. Most analysts see the stock growing earnings faster than 15% per year over the next five years. At that growth rate, today’s valuation of a bit more than 14 times earnings, or less than 13 times free cash flow, looks quite cheap. Add in a modest 1.8% dividend yield, and I think Herbalife Ltd. (NYSE:HLF) shares are priced to move.
In deep… fertilizer
Turning now to the day’s bad news, both of the biggest names in fertilizer got hit with significant negative news this morning, as big banker HSBC announced that it was cutting them to underweight. The cut at Mosaic Co (NYSE:MOS), a single notch from neutral, is bad enough — but the 180-degree turnaround against Potash Corp./Saskatchewan (USA) (NYSE:POT), which got downgraded all the way from overweight to underweight, must really sting.
So… what is it that turned HSBC against the fertilizer producers? Really, this is the same story we’ve been talking about all month — the fact that a recent breakup in the Russian-Belarusian potash cartel is likely to unleash price competition in the potash industry, reducing pricing power at Potash Corp./Saskatchewan (USA) (NYSE:POT) and Mosaic Co (NYSE:MOS) in consequence, and torpedoing both companies’ profits as a result.
Crunching the numbers, HSBC has determined today that potash prices globally are likely to be “very weak” following the very public dispute between Uralkali and Belaruskali. Spot prices on the fertilizer are expected to fall by at least $25 per ton, with contract prices likely to settle around $300 per ton — which is a complete reversal of the trend that Goldman Sachs, for example, had predicted we’d see in the second half of this year, when prices were supposed to approximate $486 per ton.
Result: HSBC sees prices being depressed for at least the next year, and perhaps longer than that. The analyst is cutting its price target on Potash Corp./Saskatchewan (USA) (NYSE:POT) to $22.50, and predicting Mosaic Co (NYSE:MOS) will sell for as little as $33 a share within a year — declines of 24% and 20%, respectively. And of course, this all comes on top of the roughly 29% declines we’ve seen at both stocks already, over the past year.
What do do?
So… is now the time for investors to panic and sell? Actually, no — that time was probably somewhere around mid-July, before the bad Belarusian news broke. But there’s still time to avoid suffering further declines, and so a word of thanks to HSBC for pointing out the risks here is probably in order.
On the surface, you see, neither Potash Corp./Saskatchewan (USA) (NYSE:POT) nor Mosaic looks particularly pricey after their sell-offs. Potash Corp./Saskatchewan (USA) (NYSE:POT) shares today cost only 11.5 times earnings; Mosaic Co (NYSE:MOS) shares, a mere 9.3 times earnings. Both stocks pay significant dividends, too — 4.6% at PotashCorp, 2.3% at Mosaic.
The real problem is the growth rates. Neither PotashCorp nor Mosaic Co (NYSE:MOS) are currently expected to grow particularly briskly over the next five years. Analysts have been positing a 4% annual growth rate for PotashCorp, 8% for Mosaic. But if HSBC is right, and potash prices are going down rather than up, then even these modest expectations could be too optimistic. Rather than growing earnings, we could see profits at these companies shrink — expanding the P/E multiples, and showing these stocks to be more expensive than they appear.
Kudos, therefore, to HSBC, for its modest suggestion that the time to exit these stocks is before this overvaluation becomes apparent, rather than after.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has the following options: long January 2015 $50 calls on Herbalife.
The article Wednesday’s Top Upgrades (and Downgrades) originally appeared on Fool.com is written by Rich Smith.
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