Deals

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Sometimes you hang out with a couple and think: "Really? You're with him/her? Huh."

That's kind of how I feel about the merger talks between Potash Corp. of Saskatchewan and Agrium.

As fellow Gadfly Brooke Sutherland explained here, both companies are suffering from a fertilizer market that looks like, well, fertilizer.

Cropped
Potash prices have collapsed from almost $1,000 a tonne to just over $200
Source: Green Markets, Bloomberg.
Note: U.S. cornbelt potash granular spot price.

Any time commodity markets nosedive, the temptation to merge and strip out costs is strong. Steve Hansen, an analyst at Raymond James, puts a ballpark figure of $250-$500 million on potential annual synergies if Potash and Agrium wed. In rough terms, taxed and capitalized at 10 times, that's worth between 6 and 12 percent of the combined market cap of the two companies -- and that's after Tuesday's pop. Even so, Hansen confesses himself "a little perplexed" by the proposal.

Both companies are headquartered in Canada, ostensibly in the plant-nutrient business, and even members of the same marketing joint venture, Canpotex. But the similarities peter out pretty quickly after that. Potash is a miner, while Agrium has a mining business but gets almost four fifths of its revenue from its global retail operation selling fertilizer, seeds and other farmer must-haves. Take a look at the two companies' gross profit margins and the difference becomes clear:

Do Opposites Really Attract?
Gross profit margins show how very different these two companies really are
Source: Bloomberg
Note: Trailing 4-quarter margins. Data for 3Q and 4Q 2016 incorporate consensus estimates.

Those big swings in Potash's margins are the fingerprint of a cyclical, wholesale mining operation. That's precisely why, back in 2008's summer of the supercycle, its market cap was more than 4 times the size of Agrium's. Today, they're pretty much neck and neck.

Sure, Potash's margins have been higher than Agrium's for much of the past decade, but Agrium's have been more dependable. Even factoring in the latter's recent cuts to guidance, its gross margins are expected to hold up better than for Potash.

And that really counts when it comes to something investors are demanding from many commodity producers: safe dividends.

Pay Differential
Agrium's payouts have risen faster and, most importantly, look stable versus those from Potash
Source: Bloomberg
Note: Trailing 4-quarter dividends. Data for 3Q and 4Q 2016 incorporate forecasts.

So it's easy to see why Potash might welcome a deal here. Besides cost synergies, Agrium would inject some stability into the business.

Conversely, Agrium risks diluting its chief attraction in a volatile market, namely its relatively steady performance. Joining with Potash would also fly in the face of a message delivered by CEO Michael Wilson at the company's investor day less than three weeks ago:

It's a real advantage to us to be in retail from the leverage point of view and also from the growth perspective. This is a very stable [business] -- and I'll show you a slide later on, on the stability of the earnings and gross margin that comes out of retail -- but it gives us the ability to grow this business in a stable fashion and we will continue to grow it.

The only real rationale for merging with Potash at this point is that it represents an option on a cyclical recovery in the prices of potash and other nutrients. In other words, Potash looks cheap (and maybe a little desperate), so why not?

Here's one reason to hold back:

Ashes To More Ashes
Potash capacity keeps growing and looks set to push utilization below 68 percent by the early 2020s
Source: Green Markets
Note: Data for 2015 onward are estimates.

The thing is, while Potash may control a fifth of current global production capacity, that can't support prices in a market where competing supply is growing so rapidly -- this makes OPEC's job in oil look easy. As Bloomberg Intelligence analyst Jason Miner points out, adding Agrium's mine to Potash's portfolio might offer some chance to optimize it overall, but wouldn't really have much of an impact on the overall potash market.

Agrium's North American retail operation, on the other hand, is three times the size of its nearest competitor. That's real market power. Messing with that for the sake of a long-term bet on commodity prices would require some leap of faith -- or maybe even more of a discount in whatever terms Potash might demand.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net