Compass Minerals Is Worth Its Salt

 Compass Minerals (CMP) currently trades just below our fair value estimate, but opportunities could arise with a mild winter. For now, the shares offer a place of refuge in a materials sector that we expect to remain under pressure as China's investment-led growth model falters. They also offer a nice dividend yield of roughly 3%.

Durable cost advantages in salt and specialty fertilizers afford Compass Minerals a wide Morningstar Economic Moat Rating, a rarity in the commodified basic materials sector. Not only does the firm control world-class geologic assets, but those assets are also close to key markets--a prerequisite for outsize returns in salt, a very regional market because of its low value/weight ratio. In fertilizer, Compass controls one of three salt brines in the world that currently produce sulfate of potash, a specialty fertilizer used on high-value crops. More important, the firm's brine-based production method is low-cost.

Our fair value estimate implies a price/earnings ratio of 20 times and enterprise value/EBITDA of 11.5 times, based on our 2014 estimates. These are lofty multiples, especially when compared with other resource extractors, but they are also warranted in our mind because of Compass' lower capital intensity, lower risk, and nice growth prospects both in the near term, as salt margins expand, and in the long term, as more capacity is eventually added in sulfate of potash.

Cost Advantage Gives Compass a Wide Moat
Compass holds unique assets that are difficult, if not impossible, to replicate, giving it a sustainable cost advantage over other producers of salt and sulfate of potash.

The company's rock salt mine in Goderich, Ontario, is the world's largest active salt mine. Because the deposits that Compass mines here are 100 feet thick, compared with seams 20-30 feet thick for many competing mines, Compass can use more efficient mining techniques and remove more salt per foot advanced in the mine.

Further, Goderich is located on a deep-water port on Lake Huron, giving Compass easy water-based access to the snowy markets near the Great Lakes. Because of its low value/weight ratio, salt can be shipped economically by land only over very short distances--roughly 150 miles. In its regions, Compass estimates that shipping by water is about half the cost of rail and one fifth the cost of trucking. Goderich is the westernmost mine serving the Great Lakes region in the United States, so it enjoys a shipping cost advantage for markets such as Minnesota and Iowa.

Compass operates rock salt mines in Louisiana and the United Kingdom as well. The Cote Blanche, Louisiana, mine also has a very thick deposit and access to markets in the Midwestern U.S., with the ability to ship barge tons up the Mississippi River. The Winsford mine in northwest England has a thinner deposit, but it is still the largest rock salt mine in the U.K.

In addition, Compass holds a cost advantage in the production of sulfate of potash. SOP is primarily produced by two distinct methods. Producers at the high end of the global cost curve use the Mannheim process, which reacts muriate of potash, or MOP--the more standard potash product that PotashCorp (POT) makes--and sulfuric acid at high temperatures to produce SOP. About half of the world's SOP is produced using this method, and the marginal cost fluctuates with input costs. Compass and other SOP producers at the low end of the cost curve use naturally occurring salt brines to make sulfate of potash. The company's assets in Utah are one of only three naturally occurring brines used for SOP production. Compass estimates that it costs 40%-50% less to produce SOP using brines compared with the Mannheim process. Other SOP brines are located in China and Chile, but Compass' Utah operations make the company the low-cost provider of SOP to its main markets in the Western and Southeastern United States.

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Not all of Compass' SOP production lies at the low end of the industry cost curve, however. The company also makes SOP in Wynyard, Saskatchewan, using a production process that sits in the middle of the cost curve. Compass must buy MOP from a third party in this process. But Wynyard accounts for only about 10% of companywide SOP production. The vast majority of Compass' SOP production is cost advantaged.

Compass' cost advantages have led to solid returns on invested capital. Over the past decade, returns on invested capital have averaged 24%, and though we expect future returns to be pressured by lower input costs (namely MOP) for high-cost SOP producers, we are still confident that Compass will continue to produce returns on invested capital that outpace costs of capital for the next 20 years.

Cost Reductions Are on the Horizon in Salt
We think salt prices for both the highway deicing and consumer/industrial end markets will expand at about 3.5% per year through 2018, more or less in line with historical averages. This gives us a 2018 nominal highway deicing salt price of $63 per ton, compared with slightly more than $53 per ton in 2013.

Salt volume will normalize following wintry conditions in fiscal 2013, when Compass sold 13.3 million tons of salt. We think a "normal" level of salt volume for Compass is roughly 12.5 million tons per year. However, we expect tons sold to increase as the company works to expand Goderich production and take share in markets where it doesn't currently participate. Our 2018 sales volume forecast is 13.2 million tons.

Investments in mining at Goderich will put downward pressure on operating costs per ton, with the company targeting a 20% reduction in real per-unit cash costs by 2018. Even with inflation of rates of 2%-3% per year, we expect 2018 nominal salt costs per ton to be below 2013 costs.

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Spread Between SOP and MOP Prices Will Contract
On the fertilizer side, we project price per ton of $600 in 2018 compared with $630 per ton in 2013. We think prices will decline, as sulfate of potash prices eventually reflect marginal costs of production, which have declined recently with the drop in muriate of potash prices. Offsetting some of the decline in SOP prices, we expect positive pricing momentum as the company's higher-priced Wolf Trax nutrients grow at a breakneck clip.

Why Compass Deserves a High Multiple
Altogether, we expect sales to grow at 5% per year over our five-year forecast period--materially ahead of the 2% annual growth of the past three years. We expect adjusted EBITDA to grow in the low-double-digit range annually through 2018. Cost improvement in salt will be a big driver of expanded margins.

We use an EV/EBITDA exit multiple of 9.5, which is higher than many other commodity miners that we cover. Compass merits a relatively elevated exit multiple for three reasons.

Lower capital intensity, or the firm's ability to convert EBITDA to free cash flow at a high rate. With its salt and potash operations already built and no greenfield projects on the horizon, incremental capital expenditures for maintenance should be relatively low. We expect Compass to convert almost 60% of its annual EBITDA to free cash flow over the long run.

Lower risk. As we mentioned, salt exhibits relatively low volatility, leading to revenue and profits that tend to fluctuate less with the overall market. We assign Compass a 10% cost of equity, which is lower than the COE we assign to most other commodity extractors (12%-14% is typical).

Attractive growth prospects. We think the growth prospects for Compass to further expand its salt and fertilizer operations (at attractive capital costs) beyond our five-year explicit forecast period are compelling. When the market eventually demands it, we expect Compass to expand its SOP operations at the Great Salt Lake. Our positive view of emerging-market caloric consumption gives us confidence that global food demand will continue to expand at a moderate pace over the next decade and beyond.

Fair Value Estimate Dependent on Salt and SOP Prices and Costs
Salt and fertilizer prices and costs are the primary levers in our valuation model. In our bull case, we assume Compass is able to take share from other salt producers in its prime selling regions without much impact on selling prices. In fact, this scenario assumes harsher-than-normal winter conditions, leading to robust prices and sales volume for highway deicing salt. We also assume that the company exceeds its target for cost reductions in the salt business. On the fertilizer side, this scenario projects that the spread between SOP and MOP prices will remain higher than normal, driven by the value proposition of SOP for specialty crops, such as fruits and nuts. Our bull-case fair value estimate is $132 per share.

In our bear case, we assume mild winter conditions going forward, leading to slightly lower prices and volume for deicing salt. This scenario also assumes further declines in MOP prices, lowering the marginal cost of production for SOP. This scenario projects a dramatic tightening of the spread between MOP and SOP prices. In our bear case, we think the shares would be worth $60.

Mild Midwest Winter Could Create Buying Opportunity
Dry winters pressure Compass' salt volume and thus its profits. The past couple of below-average winters for the firm (2011-12 and 2012-13) saw Compass' share price lag the S&P 500 by 12% and 15%, respectively. Obviously, with the shake-up in the potash market during this same period, other factors were at play, but we don't think this changes the fundamental effect that snowfall has on Compass. Investors looking for a more attractive entry point could hold out for a mild winter in the Midwest and look for lower highway deicing volume to put pressure on Compass' stock. That said, potash dynamics hold sway over Compass' share price as well, and there can be no assurances that a dry winter will create a buying opportunity in the shares of this wide-moat company.