The ASX stock with a three-year bull case

It's no secret that Australia has borne the brunt of some extreme weather in the last few years. The bushfires of 2019 devastated more than 3,500 homes in nine months. One Western Australian town equalled the record for the hottest recorded temperature in history. Queenslanders are being told to brace for a third consecutive year of above-average rainfall and flooding. Then, there is the drought across the United States and frequent heatwaves this past European summer. 

The floods have also caused mayhem for the listed insurers while raising the price of fresh food at a time when farmers are supposed to benefit the most. 

But there's one company that has been benefitting from the floods. This has been due to sustained farmer demand and knock-on effects from the Russian invasion of Ukraine. It also happens to be a key bullish call for Ramoun Lazar and the Firetrail Investments Absolute Return Fund. 

EDITED TRANSCRIPT

Eliza Clarke: Hello, and welcome back to the Firetrail Analyst series. I'm Eliza Clarke,  Investment Specialist at Firetrail.

La Nina brought some wild weather and a lot of rain along the east coast over the past year. It's caused mayhem for insurers and even caused the price of our fresh food to skyrocket. But one company that did benefit was Incitec Pivot. Joining me today is Ramoun Lazar, Portfolio Manager of the Absolute Return Fund.

Ramoun, welcome, could you start by taking us through a bit about Incitec Pivot?

Ramoun Lazar: Incitec is not a household name that you hear about every day, but Incitec plays a very important role in providing farmers with the inputs they need to put food on our table. Incitec has two businesses: It's got the fertiliser business, and it's got an explosives business. I'm going to focus a lot on the fertiliser business today, given that's really topical.

So if I start with supply and demand, on the demand side, what we've seen is that the price of some of the most fertiliser-intensive crops, such as corn and wheat, skyrocket over the last two years. Some of these prices have doubled over that period.

What we've had is a very strong period of demand coming out of COVID, combined with supply chain issues globally, and then also some pretty poor seasonal conditions over the last couple of years, combined to really constrain the supply of some of these grains. It's going to take time for inventories of those grains to rebuild, and as a result, prices of these commodities are going to remain elevated for some time, in our view.

Eliza Clarke: And we're seeing those prices at supermarkets rising, aren't we?

Ramoun Lazar: We definitely are. It's not great for consumers, unfortunately, but fortunately, it is a good backdrop for farmers. So farmers are benefiting extremely, at the moment, from these higher crop prices. Farmer incomes and balance sheets haven't looked this good for over a decade, which simply means that they've got the ability to pay up for fertilisers and ensure that they're maximising the number of fertilisers that they use across those crops.

On the demand side, you've got a really good backdrop for soft commodities over the next few years, and you've got farmers in a pretty good position or a very favourable position to pay up for those fertiliser commodities that they need.

Eliza Clarke: What about the war in Ukraine? What impact is that having?

Ramoun Lazar: The war in Ukraine is making things tricky, both on the supply and demand side. So if we look at grains, Russia and Ukraine account for about 30% of global supply, so they're really needed in that global dynamic, which just means that things are going to remain tight on the grain side. 

There's very little margin for error. If we have supply disruptions, you're going to see the prices of those grains continue to increase, and that's likely to provide a supportive backdrop for demand over the next couple of years.

And then on the supply side, Russia's role is to provide or supply gas to Europe, to the Europeans. Now, you're probably asking, "Why am I talking about gas?" Gas is the major input that goes into producing fertilisers, so traditionally, the Europeans have bought their gas from Russia, but following the conflict, they want to diversify away from reliance on Russian gas. So what they've done is that they've looked elsewhere for those gas supplies, and they've drawn that gas from global markets.

Now, what this has done is that it's driven the price of gas from about $10 a unit to $60 a unit in Europe. That's a sixfold increase over a very short period of time. Now, the flow-on impact to fertilisers is that you've had the cost to produce these fertilisers go up exponentially over the last six or so months, so the cost for a European producer was $500 a tonne. It's now currently over $2,000 a tonne, so a fourfold increase over that period.

What that means is that fertiliser prices are going to remain very well-supported until we see the price of gas decline or we start to see the demand environment, from the grain side, start to wane. But at the moment, we've got a very favourable backdrop for supply and demand.

Eliza Clarke: When looking further out, how long will these high gas prices hang around?

Ramoun Lazar: We think that we're in for an environment of high gas prices until at least the middle of the decade. There's just no new supply coming online globally, so the first meaningful new supply comes on in 2025, which just means that gas prices are going to remain elevated. In turn, that's going to support the price of fertilisers over the next few years.

So, unfortunately, Eliza, everyone's paying more for their energy costs, given the higher price of gas, but similarly, consumers globally are going to continue to pay higher prices for their food, given input costs to produce some of these commodities have increased two, three, fourfold, in some cases.

Eliza Clarke: So Ramoun, why is Incitec so well-placed in this environment?

Ramoun Lazar: Incitec's really well-placed because it's going to benefit from the spread in gas between Europe and where Incitec operates. So Incitec's main plants are in Australia and the US. That means it's got a favourable gas price advantage, being located in those two regions. Incitec's currently paying $5, $6, and $7 a unit for its gas, versus those European competitors who are paying $60. So it's paying a 10th of the price of those European supplies of fertilisers.

What this means is that it's going to make that favourable spread, versus those European suppliers, and that's going to flow onto some very strong earnings for its fertiliser business over the next three or four years.

Eliza Clarke: All right, that's the fertiliser side of the business. You also mentioned they've got the explosives. Could you take us through what's going on there?

Ramoun Lazar: Explosives, similarly, rely on gas as a major input, so it's a similar dynamic to what's going on with fertilisers. The only difference, though, is that Incitec's major customers are the miners, and typically, it contracts out its explosive sales over a three to four-year period.

We're still expected to benefit, but it is just going to take a bit longer. So as those contracts come up for renewal over the next three or four years, Incitec's going to be in a much stronger bargaining position to ask those customers for higher prices.

Eliza Clarke: All right, sounds like a very positive backdrop. What has the market priced in for Incitec?

Ramoun Lazar: We just don't think the market's pricing in the favourable backdrop for these commodities over the next few years. So if I look at where consensus estimates are for fertiliser prices, a consensus has those prices reverting back to their long-term averages over the next 12, 18 months. We just don't think that's the case.

We think we're in an environment of higher prices for longer, at least until the middle of the decade, and that's going to underpin some very strong earnings flowing onto some very strong cash flow generation for Incitec, which should flow through much stronger shareholder returns over that period, which just isn't being priced into Incitec's valuation today. And as a result, that's why Incitec remains a key holding across the Australian funds within Firetrail.

Eliza Clarke: All right, sounds like one to watch. Thanks for that explosive update on Incitec today, Ramoun, and thank you for joining us for the Firetrail Analyst series.

About Firetrail Investments

Firetrail is an investment management boutique that specialises in high conviction investing. We build concentrated portfolios of our best ideas, to generate outstanding long-term performance for their clients. Click here to find out more. 

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