Itafos (MBCF-OTC,$2.90 US) is an Interesting Business. It Seems a Shame not to Qualify for Inclusion in the Gnostic Portfolio, due to Cap Weight Restrictions.

As I continue to flesh out farmland purchases, my working knowledge of agricultural chemicals (better living through organic chemistry) requires a refresher. I am primarily a landholder rather than an active farmer; my fields are rented out to tenants who operate the holdings. Farm rents are assessed in North America using a basic formula that is less tied to land valuations or interest rates, more upon earned income from crop sales less the cost of production. So as not to overcharge my farmers, I am expected to thoroughly understand the tenant costs to conduct their business. Outside of fuel and maintenance expenses on equipment, the most significant direct expense associated with production for a farmer is purchased fertilizer.

Nitrogen (N), phosphorus (P) and potassium (K) fertilizers, nicknamed by farmers using the chemical symbols of NPK, represent elemental building blocks for virtually all crop production globally in some way shape or form. Most crops grown on fields, but specifically cereal crops and oilseeds, utilize NPK.

In general, nitrogen is responsible for increased yield (quantity) and as nitrogen rates increase, so does yield. Nitrogen increases the number of plants potentially grown per acre and the size of those plants.

The role of phosphorus is maintenance. Phosphorus aids in root growth, planet development, stalk and stem strength and improved development of a plant throughout the entire life cycle.

Potassium increases water use efficiency and transforms sugars to starch in the grain-filling process. Potassium is known as the “quality” nutrient, producing grains rich in starch and increasing the protein content of crops. Without a potassium content in fertilizers, plants would grow large and green, but would have far fewer grains on the plant stalks; those grains would have a lower starch and protein content and the plants themselves would be more susceptible to disease and drought.

To sum up; in layman’s terms, nitrogen is needed for above soil plant growth, phosphorus is required for a strong root system to pull nutrients from the soil and potassium is needed for optimal food quality produced by each plant. To boost output, NPK must be added to soil periodically to replace what is consumed through the growing of crops. An acre of corn requires about 180 pounds of N, 90 pounds of P and 160 pounds of K. All this nutrient must be replenished, somehow, before the next planting season. The addition of purchased fertilizer represents the typical solution to resolve deficiencies in soil nutrients due to crop production.

At todays prices, the wholesale cost for the right mix of NPK fertilizer for that acre of corn is about $200 US, about 13% of the gross value of the crop to be produced on that field. Furthermore, that does not take into account a distributor profit margin, the labor cost to apply fertilizer, the equipment direct expense & depreciation involved nor does it factor in the fuel cost to transport fertilizer from a depot to the farm and the fuel needed to apply those nutrients to the land. Crop prices are at record highs, this is true, as are input costs. Consumers look at current crop prices and envision windfall profits for farmers; were they to be provided with a fuller understanding of the input costs, they would be surprised to learn how much of that price increase goes, not to the farmer, but rather, to input suppliers in the mix.

It is estimated global crop output is farmed so aggressively that, absent the use of chemical fertilizer additives, crop yields would decline by almost half worldwide, within several years.

Some of the agricultural chemicals required in farming may be synthesized but synthesis is costly. One of the most important elements, potassium (K) is naturally found in a soft, water soluble, mineral rock called potash. Phosphate rock is mined (both open pit or underground), the rock is pulverized and either blended with other elements to produce premixed fertilizers or directly applied to agricultural fields.

Globally, the amount of potash mined is about 70 millions tonnes per annum.

Potash deposits are found all over the world but deposit grades vary significantly from region to region. Bulk tonnage low grade potash deposits account for most of the remaining undeveloped projects globally; these require concentration of the mineral in order to meet agricultural requirements (beneficiation), which can be ruinous for profit margins. The majority of deposits cannot be profitably mined due to the remoteness of locations, the presence of contaminants in many deposits or prohibitive cost of extraction when removal of other rocks covering the formation (stripping ratio) is required.

As a bulk mineral, the cost to transport potash is significant, often accounting for up to 50% of the value of the mineral. Natural and logistical barriers in potash mining have served to produce a sort of natural monopoly. Just a handful of relatively large producers control most of the world’s output. These firms act as price setters and are capable or earning abnormal profits on output. The sector is extremely well covered by investment firms; rest assured, there aren’t any retail investors who will “stumble” upon something institutional investors are not already aware of and have previously evaluated. This means that in order to profit, retail investors need to assume greater risks than institutional accounts.

One of the smaller potash producers, Itafos, has been around for some time.

Years back, Itafos owned a marginal, low grade, Brazilian deposit and a processing facility (Arraias). Management had envisioned that operation to serve as a springboard for the raising of sufficient capital for development of their best exploration property, a high grade mineral formation in Guinea-Bissau known as Farim.

Farim is considered to be one of the top four near surface deposits identified globally not yet actively mined. The grade is about as high as is found in the best underground mines presently producing and the deposit has the potential to exceed 130 million tonnes of total resource. Logistics are favorable with a potential deep water location, suitable for a terminal, located within 100 km of the proposed mine site.

Sadly, Guinea-Bissau has a long standing reputation for political instability, corruption and few bankers can even locate the country on a map of Africa. Guinea-Bissau is best known as a narco-transshipment hub for Africa to parts unknown and is rated in the bottom 10 countries globally for corruption. Frederick Forsyth, in his 1974 novel, “The Dogs of War“, reputedly based his book using Guinea-Bissau as the setting; to maintain the pretext of the novel to be a work of fiction, he changed the name of the African backwater to “Zangaro”. Apparently, little has changed since publication. Legitimate operating businesses are prey to shakedowns or outright seizure by the autocrat de jour, who almost never serve out a full term in office. Anyone prepared to invest in Guinea-Bissau assumes the risk of business success potentially resulting in expropriation, all the while continually paying for political protection to defer nationalization. The deposit, were it located almost anywhere else, would most certainly be in operation. Consequently, management of Itafos has never been able to raise external capital to develop the Guinea-Bissau project to an operating mine. Tiring of beating the bushes for development loans to take Farim to production (capital that was repeatedly promised but never delivered), Itafos needs to earn enough cash from existing operations to develop the deposit and the Arraias project in Brazil does not offer that avenue for cash generation. Nevertheless, in 2018, Itafos consolidated its interest in Farim by issuing cash and shares valued at $71 million US to bring the ownership interest in the deposit to 100%.

A moderately transformative opportunity fell into the lap of Itafos in 2018.

The two largest potash producers in Canada merged to become a firm called Nutrien Inc.. In the merger, a non-core asset, a modest producing potash mine in Idaho, USA. with a limited reserve base remaining was put up for sale. Itafos purchased this asset, the Conda phosphate mine, from Agrium Inc. for cash consideration of $108 million. Conda is capable of producing about 540,000 metric tonnes of phosphate annually and has roughly 4 more years of reserves left to be profitably extracted (current reserves will be exhausted mid-2026). Conda is mined on a contract basis by Kiewit and the output is delivered back to Nutrien Inc. on a pricing formula based upon the trailing 3 month quote for phosphate.

Conda has become the most primary source of revenue and cash flow for Itafos.

The current open pit reserves at Conda are scheduled to be exhausted in mid 2026. Free cash flows are being held for a new development plan and permitting process that envision two nearby phosphate deposits (H1 and NDR) to be mined, offering an additional potential 13+ year mine life.

Itafos is valued at roughly 4X – 4.5X the 2022 EV/EBITDA ratio.

According to the most recent management guidance, EBITDA is forecast to be a range of $190 million-$230 million US in 2022. The midpoint represents $210 million of EBITDA. With 190 million shares fully outstanding and total liabilities – short term assets = $304.1 million, the enterprise value of Itafos = $855.1 million USD.

Institutional pushback against a long investment thesis are numerous.

1. The cap weight is too small to be of interest; sub $1 billion in market cap attracts no institutional buyers whatsoever. Insiders also control more than 65% of the fully diluted outstanding shares.
2. The proposed new open pit mining permitting plan in Idaho on H1 & NDR is by no means assured. Public hearings and consultation could be hijacked by anti-mine interests. The Bureau of Land Management controls key leases needed for the mining plan and can shoot down the entire project in a heartbeat. A democratic controlled US federal government could also act to kill the plan. The present national administration is assumed to be “anti-mine”, no matter the strategic importance. If the new mine permits are denied by regulatory bodies, Conda would close by 2027 and Itafos would lose its cash cow. Any valuation then becomes a terminal net cash flow assumption and mine reclamation fees could eat up most of the EBITDA generated for the coming four years. This investment is not merely output dependent, it is good news dependent.
3. Fertilizer prices could be peaking. As a very small producer, EBITDA will swing more dramatically to the downside should phosphate prices decline in the coming years. Institutions could argue, quite convincingly, that current valuations represent a cyclical peak with far more downside than upside.

Longs have to make a case based upon a need for more non-Russian phosphate suppliers.

1. Itafos provides roughly 9% of the US market supply for premium dry phosphates, which are key for corn production. Should western governments be serious about quickly untangling the supply chain from Russia and its satellites, there would appear to be a pressing need for increased US domestic phosphate mining, not less. This might serve the corporate ends of Itafos as they push for approvals of the new mine plan in Idaho.
2. Itafos now looks to have more fully funded their mining reclamation funds in Idaho. 2021 year end liabilities include a provision of $170.2 million for Conda restoration, up from $87.2 million the prior year. The $83 million increased accrual (bonds were posted in that amount to cover the cleanup) appears designed to curry favor with regulatory bodies now pouring over the proposed mine plan extension in Idaho; a more fully funded reclamation fund goes some way towards assuaging doubt that Itafos may lack the capital to operate mines from opening through closure. Too often, smaller miners have left US government agencies on the hook for reclamation expenses that need to be handled by EPA superfunds.
3. Free cash flow for 2022 should permit the company to solidify capital growth plans. If Itafos management chooses to roll the dice on Farim in Guinea-Bissau (they have it held on the books as a potential spin-off or divestiture) and fund the project themselves, they may now look to have sufficient cash flow available to fund a portion of a capital plan estimated to be between $500-$600 million USD. As awful as the political climate is in Guinea-Bissau, there are very few phosphate projects out there with a combination of high grade, good resource base and a relatively good strip ratio. Somebody will eventually prove willing to take a chance on this project, and that somebody could still be Itafos.
4. Phosphate prices might stabilize at higher levels than currently forecast.. Monopolies take every opportunity to raise prices and prefer to hold back production when necessary, rather than reduce prices sharply. The key expenses in mining phosphates, (manpower, equipment costs and fuel) have all risen dramatically in the past several years and phosphate miners will do as much as they can to protect margins. A multiyear increases in food crop prices have provided larger farmers with sufficient profit, fertilizer producers feel, to continue to tolerate (albeit grudgingly) high phosphate pricing.

The Russo-Ukraine war has revealed a critical supply chain link in the agribusiness markets that has been overlooked and better needs to be addressed domestically.

Without phosphate and chemically formulated synthetic fertilizers, global food production falls by 1/2, just like that; this is how dependent the planet is on agricultural fertilizers to maintain existing food stocks, and that doesn’t take into account population growth.

Canadian phosphate miners account for most of the world’s non Russian and Belorussian phosphate production. Canadian mines are capable of producing more phosphates rather steadily but the bottleneck lies in cost effective and timely transportation of output. On a map, most Canadian mines are truly smack dab in the middle of nowhere, with end users often many thousands of kilometers from the mines. Canadian mines have the grades but are lacking on logistics.

This leaves America in a bit of a pinch, insofar as domestic supply is concerned. American government agencies are under enormous pressure from farm lobbies, if not to permit the expansion of the domestic supply of potash, at least to maintain production status quo. If the new mine plan of Itafos in Idaho fails to be approved, then not only will the shares fall precipitously, the US will also be permanently short 9% of domestic phosphate requirements.

Itafos, despite a real risk of a terminal cash flow valuation assessment, should the Idaho mine extension permitting fall through, presently sells for a discount vs large cap peers that seems intriguing.

Should the Idaho mine permits be approved, then for at least the first few years beyond 2026, Itafos Idaho operations should be able to boost net production well beyond 600,000 metric tonnes annually.

The shares are clearly a play on positive or negative news from the permitting front. 2022 revenues could exceed $560 million USD which prices Itafos at 1x forward sales. Nutrien, the largest publicly traded pure play phosphate fertilizer company, currently sells for 1.4X forward sales. Mosaic, another large cap phosphate miner, presently sells for about 1.3X forward sales.

The Model Portfolio has a large cap focus, and therefore, Itafos does not qualify for direct investment ownership.

I don’t normally write about equities that cannot be owned by the Gnostic account. If I can envision a potential market capitalization move, from mid-cap to small large cap, sometimes my inclination is to purchase an equity in advance of that possibility; Itafos doesn’t even offer that potential in its current form. Given the valuations associated with phosphate miners, Itafos would need to be capable of producing revenues in the $4 billionish range per annum, with a 40% EBITDA margin, to justify a $10 billion market cap. Only then might that start valuation workups from a few institutional equity buyers. For those sorts of numbers to be reported, the Idaho mine plan would need to be approved and expanded beyond the current proposal. Farim would need to be converted from a prospect to a producing asset. A large high-grade Idaho prospect called Paris Hills would need to move beyond an exploration property to an actual underground phosphate mine. These developments would require capital of at least $1 billion more than Itafos can access at the present. And even then, fully developing the existing pipeline of deposits doesn’t get Itafos into smallish large cap status. More phosphate properties would need to be added or moved from exploration into production, and nothing else of sufficiently high grade sits on the books.

Pipedreams don’t work out in phosphate mining; it is a very capital intensive business. Maybe this is the sort of industry that simply cannot tolerate the existence of a smaller independent producer and Itafos will ultimately be bought out by a major agribusiness, assuming that Idaho permitting comes to fruition. Maybe.

There are a lot of “ifs” attached to this company

“if” the Idaho permits are received and “if” phosphate prices remain buoyant for several years, then cash flow might permit Itafos to develop Farim, “if” Itafos chooses to keep the concession and provided that Farim doesn’t get seized, in the meantime, by a friend of a cousin of whomever pulls the strings in Guinea-Bissau. Maybe, just maybe, a deep pocketed agribusiness will proceed with Farim development by taking all of Itafos private, relying upon greater clout to fend off the rentiers in Guinea-Bissau, “if” Idaho mine permits are granted. Remove a single “if” from the thesis and the story unravels.

No, this is as small cap as one can find, sub $1 billion of total enterprise value. So, there is absolutely no reason to own it, or even to write about it. Yet, here I am, writing about it, because, frankly, to me, this is interesting and I also own a first edition signed copy of “The Dogs of War“. “If” Itafos can stay highly focused, the business seems to be almost in the right place, at precisely the right time, to turn the odds in favor of expansion rather than survival. It cannot be a large cap from here, but that doesn’t mean Itafos cannot be a midcap in the medium term. In the equity investment world, one doesn’t need to own every interesting business that comes across our desks. Itafos is, for lack of a better term, something I will keep my eyes on from time to time, to see how the business develops. Is the production of food cyclical or secular? Isn’t there an increase of caloric intake required every year, based upon population growth? Does that not suggest potash based fertilizers, critical to the maintenance and expansion of the global food supply, are one way to more fully participate in a trend? And finally, does the tiny global group of phosphate producers, several quite intertwined, represent, more of less, an informal natural monopoly capable of generating abnormal profits over a long period of time?

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