$UAN - Plum's Best Commodities Play

Aiming for a Double/Triple with Full Downside Protection

Introduction

I believe that the following idea requires upfront disclosure. CVR Partners (NYSE: UAN) is the biggest winner for my portfolio this year, and recently became my largest position (as a result of adding more above $80/unit). I fully expect subscribers to be skeptical – why is this person pitching a name that has already worked out great YTD? Didn’t the train already leave the station?

My answer is absolutely not, I truly believe that UAN remains one of the most compelling bets you can make in the commodities space, and the risk/reward has only improved throughout the year – so much so that I had to “average up” at various points in time, most recently as high as $84/unit. My proposition is that UAN offers a clear path to a double (or more!) in the next ~9 months or so, while providing full downside protection, which is a rare combination in the commodities space. The summary investment thesis is as follows:

1. Next 3 quarters will generate ~$38/unit in cumulative distributions, which derisks ~50% of cost basis if the units are purchased at prevailing market prices (~$76)

2. The Company forward sells product up to 6 months, which means that 1H’22 cash flows will be guaranteed in short order, barring any unexpected production issues

3. Sequential increases in distribution will invite incremental buyers, compressing distribution yields on market cap, exposing the units to nutty upside potential

4. Supply side response will be slow as greenfield construction takes 3-4 years to complete, while global demand grows 2% per annum. We could be entering a multi-year super-cycle, which would protect the multiple throughout 2022+

5. The GP here is CVR Energy, which is majority owned and controlled by Icahn Enterprises. I believe they will sell the asset to a strategic at the top of the cycle

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Business Overview / Company History

CVR Partners is a publicly listed manufacturer of nitrogen fertilizer products in the US. The Company produces ammonia and UAN, which are primarily used as feedstock for agriculture (particularly for corn), as well as for industrial applications. Quick clarification to avoid confusion – UAN is an aqueous solution of urea and ammonium nitrate used as fertilizer, and the Company’s ticker is also conveniently UAN! With that out the way, the Company operates two facilities – the Coffeyville facility in Kansas, and the East Dubuque facility in Illinois, which was acquired in 2016 (fka Rentech Nitrogen Partners, acquired for ~8.5x EBITDA). UAN is an MLP – the GP here is CVR Energy (NYSE: CVI), another publicly listed Company that is majority owned and controlled by Carl Icahn and his affiliates. The GP owns 34% of the common units, and the remaining 66% is free float held by the public.

It is helpful to review the assets in a little more detail. The Coffeyville facility is unique in that it is the only plant in North America that utilizes a pet coke gasification process to produce nitrogen fertilizer, as opposed to other facilities which all use natural gas as feedstock. About a third of the pet coke is sourced directly from the CVR Energy (i.e. the GP) under a long-term supply agreement. This arrangement is important, because pricing for the pet coke is determined by a formula indexed to the price of UAN (with a per ton floor and ceiling price). Why is this important? Because raw material inputs account for about ~30% of total cost structure and this introduces a highly variable component, with the implications being that it cushions the business on the downside and marginally offsets the increase in profitability when fertilizer prices increase. It is also worth mentioning that the Coffeyville plant is the offtake facility for 100% of the pet coke produced by CVR Energy’s refinery - so the GP benefits from getting rid of a byproduct under an economic arrangement.

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What is Mid-Cycle EBITDA?

Before we move onto the current state of the markets and the thesis, we need to get this topic out of the way. Fortunately, both CVR Partners and Rentech (i.e. the East Dubuque facility prior to acquisition) both have historical financials available, so we can easily spread the numbers and take a long-term average, making sure to include both the trough and the peak years. Please see the numbers below:

Although the simple number crunching arrives at $158mm of EBITDA as a long-term average (i.e. a good proxy for mid-cycle earnings), this is actually quite punitive. The analysis doesn’t account for $12mm/year of realized synergies for the pre-acquisition periods, and also does not adjust for the debottlenecking projects and brownfield expansions conducted over the years, which increased annual production volumes substantially. Making these PF adjustments to make each year comparable, we get almost exactly $200mm of EBITDA, and I’m happy to use this as a mid-cycle number for our purposes.

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Recent Macro Developments

Much ink has been spilled on the macro drivers of fertilizer prices, so I will be brief and only focus on the most recent developments. Nitrogen fertilizer is a global commodity, produced in most regions of the world - but many countries are not self-sufficient (US and India are good examples) so there is an active import/export market, and prices are largely determined by the global cost curve. As a result of the energy crisis and shortage of raw materials in many corners of the world (esp. nat gas and coal), the cost of producing fertilizer has increased substantially - which makes the marginal ton of production uneconomic. This is leading to significant curtailment of supply, particularly in Europe, as nat gas prices have reached stratospheric levels.

At the same time, governments around the world are very sensitive to food inflation - and therefore have taken measures to limit fertilizer exports, making sure that domestic needs are met first. Russia and China are probably the best examples, and this is a remarkably positive development for US producers - given that 20% of nitrogen fertilizer applied in the US is typically imported from foreign producers. I understand this is a high level summary and is glossing over many other important considerations such as low corn stocks, acres planted, and so on. A more comprehensive discussion is out of the scope of this writeup, so I encourage interested readers to conduct further research - there is plenty of discourse and helpful industry information out there in the public domain.

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Projection Model

To provide context and numerical support to my thesis, I will outline my assumptions for the model. As is customary for my investing framework, I tried to be as conservative as possible, so don’t be surprised to see the upcoming quarterly performance beat the numbers presented here. Regardless, this is what I am comfortable presenting to the investing public for dissemination.

Key assumptions are as follows:

• UAN prices based on CME futures

• Ammonia prices based on 1.8x multiplier (consistent with recent history)

• Volumes flat on a YoY basis, with the exception of 3Q’22 (turnaround activity)

• Nat Gas prices based on futures curve

• Pet Coke does not have liquid benchmark indices, therefore use conservative estimates. Note: about a third of input volumes are sourced from an offtake contract with CVR Energy at a ceiling price of $40/t, which is helpful

• 50/50 fixed/variable split for all other direct costs ex input materials

• SG&A up 5% YoY to account for some cost inflation

• $26mm capex for 2021 (guidance), $30mm for 2022 (estimate)

• 10% of FCF set aside as a reserve for any unforeseen headwinds. All remaining FCF paid out to unitholders

• Stub 9.25% notes repaid with proceeds from the tax equity investor, as guided

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Investment Thesis

The thesis is very simple. This is a capital return story, with a free option on a multiple rerate. I know that there are cheap stocks everywhere in commodities - coal, copper, gold and steel, to name a few - pick your poison. However, I am yet to come across a situation as clear-cut as UAN: underlying prices are still going up, capital allocation is 100% transparent, up to 2 quarters of visibility from forward selling, and promising longer term outlook. At the risk of being repetitive, let’s discuss the most salient points in a little more detail:

First and foremost, I love the downside protection afforded by this investment - as seen above, there is little risk in the ~$38/unit distributions over the next 3 quarters. So that’s 50% of your cost basis locked up. When you come out the other end, you have a Company with $550mm of debt (6.125% rate) and ~$200mm of mid-cycle EBITDA, which suggests the equity will trade at reasonable levels even if the outlooks turns negative. If you don’t believe me, the units traded between $30-40 (PF for the split) during a massive bear market from 2017-2019 when the Company’s EBITDA was firmly at trough levels, along with a higher quantum of debt at a substantially higher interest rate ($645mm of 9.25% notes). Even for the most pessimistic value investors on the planet, can we really price the equity at below $40/unit in 9 months’ time? I have truly a difficult time figuring out how we could possibly lose money on this investment. An alien invasion or if the Singularity is reached, maybe? Jokes aside, I’d love to hear a coherent bear case where I end up with a large impairment - you have my undivided attention.

Now for the sexier parts of the thesis. What do you think will happen once the quarterly earnings are announced and incrementally fatter distributions hit the screens? Let’s be clear - this is cold hard cash directly into your pockets - not some wishy washy value creation or financial engineering. We’re betting on human nature to be greedy, and I have no doubt that LO/HF generalists, unsophisticated yield-chasing retail, and even some passive flows (trend followers and others that are allowed to buy MLPs) will gradually pile into the units, compressing the LTM distribution yield further and further. This will then open the door for even greedier folks - i.e. the kind of speculators who get complacent and project out the upcycle forever - which should remind you of the Buffett quote: “what the wise man does in the beginning, the fool does in the end”. Just for fun, let’s see what the implied unit prices are at various LTM yields, once we get the distributions for 2Q’22 announced (less than 9 months away):

The final leg of the thesis is the endgame for this Company. The key here is that CVR Energy is the GP, which is a public company majority owned and controlled by Icahn Enterprises. CVR Partners is a non-core asset and a small, rather insignificant part of their overall portfolio. In fact, the management team has been on public record saying that the GP is more likely a seller than a buyer (i.e. taking UAN private). Refer to the snippet below for evidence:

While a buyout possibility is rarely good enough on its own as an investment thesis, it is a free kicker here and provides the investor a second way to win. If anything, I know that Carl Icahn is much smarter than I am, so I doubt that he would miss out on an opportunity to sell the asset at the top of the cycle. Again, we don’t need this to win here, but it’s not crazy to imagine that the Company is sold for $200+/unit next year to a strategic because transactions like that happen all the time at the peak of the cycle. I’m going to laugh all the way to the bank.

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Miscellaneous Observations

• Management sees value at current prices - on 11/16/21, the CEO bought 5,000 units at $77 (~$385k buy) and the General Counsel bought 2,200 units ($170k buy)

• Wholesale physical prices are significantly higher than CME paper prices that I used in the model. US domestic volumes are currently being offered at $610-630/t for UAN and $1,350/t for ammonia – however this is difficult to track for public investors unless you have proprietary data sources or broker access, hence I decided to stick with CME quotes

• I suspect that the MLP status, sub billion market cap and the fact that UAN is somewhat of an orphaned asset is keeping a lot of buyers away. However, this is all part of the opportunity and why the units remain very attractively priced

• Relative illiquidity is an issue as well. But about ~$4mm trades a day, which should be good enough for most small to mid sized funds to build a position over time

• The key reason that many commodity names trade at low multiples is because most investors do not expect current levels of elevated prices to last. However, as can clearly be seen from historical financials, nitrogen fertilizer cycles tend to last several years on the way up and down. I just don’t see a good reason why prices would fall off a cliff anytime soon (though we would likely see some degree of normalization in 2H’22 or 1H’23)

• If the outlook remains strong (or at least stable) over the next 12-18 months, I would expect to see a great deal of distribution reinvestment into the units. This could act as a serious catalyst, given the size of the expected distributions

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Disclosure

Plum Capital is long UAN units and 5/22 call options of various strikes