Compass Is Headed in the Right Direction

Compass Minerals CMP announced 2018 fourth-quarter snow data and provided general guidance on fourth-quarter salt sales volume. However, our key takeaway from this update was that the company was able to improve production at its low-cost Goderich mine. This news is in line with our thesis that the company will be able to fully ramp up production at Goderich and implement the new continuous miners throughout the mine to restore profitability. While management provided only directional commentary, we are encouraged by the announcement and expect more details during the fourth-quarter earnings call in February.

With our long-term outlook intact, we maintain our $81 fair value estimate for Compass Minerals. Our wide economic moat rating based on the company’s cost-advantaged salt production is also unchanged. At its current price, Compass is trading 45% below our fair value estimate.

We think the market is taking an overly pessimistic view of Compass’ long-term profitability, probably because of the company’s recent operational issues that have limited production at the Goderich mine. We liken the implementation of continuous mining equipment to starting up a new mine, where Compass faces a temporary learning curve while making the full transition. However, we expect the Goderich mine operation will be fully restored and forecast unit production expenses will fall nearly 10% by 2020 from 2017 levels.

Enviable Portfolio of Cost-Advantaged Assets Compass' Goderich rock salt mine in Ontario benefits from unique geology, and with access to a deep-water port, it can deliver deicing salt to customers at a lower cost than competitors. Additionally, the company controls one of only three naturally occurring brine sources that produces sulfate of potash, or SOP, a specialty fertilizer priced at a premium to standard potash. These operations at the Great Salt Lake in Utah can produce SOP at a significantly lower cost than producers that use a chemical process.

About 60% of Compass’ salt sales are to highway deicing customers. Sales volume is determined during the winter months and is strongly linked to the number of snow days per season. As such, weather has a big impact on Compass’ year-to-year results. The deicing salt business also exposes Compass to climate change risk. One effect of climate change is for climates to shift north, which brings warmer weather and fewer snow days to northern climates. As a result, we expect a small decline in normal deicing salt demand over time and limited prospects for sustained price increases. Pricing for deicing salt has historically been stable, especially compared with prices for other commodities. Deicing salt has a low value/weight ratio, and transportation costs make up a significant portion of total delivered costs to the customer. With mines close to waterways like the Great Lakes and the Mississippi River, Compass can typically deliver deicing salt at a lower cost than competitors.

Compass is also a cost-advantaged producer of sulfate of potash, a specialty fertilizer used for high-value crops that are sensitive to the chloride in standard potash (muriate of potash, or MOP). While marginal producers of SOP use MOP and sulfuric acid to produce SOP, Compass makes SOP directly from salt brines at a considerably lower cost. SOP prices generally track MOP prices, but a wider-than-normal gap has opened up between the two more recently, with SOP prices remaining elevated despite a drop in MOP prices. We think this spread will tighten, leading to slimmer per-ton profits for the company’s fertilizer business.

Solid Returns on Invested Capital We think Compass possesses a wide economic moat. It holds unique assets with geological advantages that are nearly impossible to replicate, which gives the company a sustainable cost advantage over other producers of both salt and sulfate of potash.

The company’s rock salt mine in Ontario is the world’s largest active salt mine. At Goderich, Compass mines deposits that are 100 feet thick, compared with many competing mines whose seams are only 20-30 feet thick. This allows Compass to use more efficient mining techniques and remove more salt for each 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 only be shipped economically by land 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, leading to a shipping cost advantage for wintry markets from Minnesota to Western New York.

In addition, Compass operates rock salt mines in Louisiana and the United Kingdom. The Cote Blanche, Louisiana, mine has a very thick deposit and access to markets in the Midwestern United States by shipping barge tons up the Mississippi River. The Winsford mine in northwest England has a thinner deposit but is still the largest rock salt mine in the U.K. At current production rates, Compass estimates that its recoverable salt reserves will last at least several more decades.

Compass also holds a cost advantage in the production of sulfate of potash. Sulfate of potash 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 and sulfuric acid at high temperatures to make 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 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 U.S.

Not all of Compass’ SOP production is 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, which over the past decade have averaged 20%. While we expect future returns to be pressured by lower deicing salt volume and 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 its cost of capital for the next 20 years.

Climate Change Is a Risk We assign Compass a high fair value uncertainty rating. In its salt operations, climate change could cause a permanent drop in deicing salt demand due to a reduction in snowfall from warmer winter temperatures as warmer climates shift north over time. Specialty fertilizer prices have experienced less volatility than commodity fertilizer prices historically, but we still think the potential for big changes in SOP pricing presents both an upside and a downside risk. Additionally, a sustained reduction in the spread between MOP and SOP prices is a risk to the company's realized specialty fertilizer prices. Project execution risk is a factor whenever Compass undertakes a large asset expansion project.

While headline credit metrics will fluctuate in the coming years according to variations in winter weather and fertilizer prices, we expect leverage to remain, on average, at manageable but elevated levels. Compass has a good amount of debt on its balance sheet; however, based on our forecasts, we expect the company to generate adequate cash flows to meet its financial obligations. Further, as its major capital projects at its Goderich and Ogden mines are completed, the company should have extra cash flow to begin deleveraging over the next couple of years.