After the Agrium-Potash merger, a search for pure-play alternatives

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With shareholders of Potash Corp. of Saskatchewan Inc. and Agrium Inc. voting on Thursday to approve their merger, the companies have taken another step toward history: If regulators bless the deal next year, two of Canada's biggest agricultural success stories will become one.

Investors, however, need not wait until 2017 to … sell their shares. Call me churlish, but while this bottom-of-the-market deal may help the companies make it through a rough time in the fertilizer industry, it also dilutes the primary reason investors should put their money in either one. And it suggests investors should look at some other options.

This is not an original idea, but it's one I've been pushing for some time.

You may recall when activist investor Jana Partners targeted Agrium in 2013, the firm questioned why the company had an appealing agricultural retail chain yoked to a wholesale fertilizer business. Agrium shareholders ultimately brushed off Jana, endorsing the company's diversified business model.

I've held on to the thesis longer than Jana did, and the question seems more relevant than ever. For the first three quarters of 2016, Agrium's retail business provided more than 80 per cent of the company's sales and profit. By adding Potash Corp.'s sales to the mix, retail drops to about two-thirds of the company. And if (or when?) there is a rebound in fertilizer prices, the Agrium retail operation will become an even smaller part of the company.

Meanwhile, Potash Corp. shareholders, owners of arguably the crown jewel of the wholesale fertilizer industry, will soon own about half of a company that's still dominated by its retail network.

Prior to this merger, investors had a clear choice: If you believe in the diversification model, pick Agrium; if you want to go all-in on wholesale, choose Potash Corp. By next year, the choice is gone.

Given that framework, the postmerger options are primarily U.S.-based. CF Industries Inc. and Mosaic Co. both offer the fertilizer pure play, but not with as much potash or Canadian connection as Potash Corp. (To say nothing of Potash Corp.'s track record of operational success and, until recently, increasing shareholder value.) The much smaller Intrepid Potash Inc. comes closer to the Potash Corp. product mix, but at a market capitalization of just $85-million (U.S.), it may be too tiny for most Canadian investors.

As for Agrium investors who value the retail network, I can offer this suggestion: Tractor Supply Co. It also is not an original idea, as Jana's case for an Agrium breakup was built largely on the idea that its retail chain could achieve Tractor Supply-like multiples if it were simply set free from the wholesale business. And it's not a perfect comparison: Agrium's stores sell largely to commercial farmers, while Tractor Supply has a large number of casual customers.

In fact, one analyst I approached for research refused to supply his notes, saying "Tractor Supply is a retailer that works with hobby farmers, and has almost no overlap with Potash-Agrium. They would hold no insight to your story."

Here's the insight, however: Tractor Supply offers pure retail-based exposure to the rural and agricultural market in a way that Agrium can't, now or especially postmerger.

For now, that hasn't been a good thing, as its stores have recently suffered, particularly in markets with exposure to energy. Tractor Supply reduced its outlook in September, and analysts do what they usually do in such circumstances: Rate the company a "hold."

Bradley Thomas of KeyBan Capital Markets Inc. is an example: He says Tractor Supply remains one of the most expensive in his coverage area, despite posting negative same-store sales (revenue in locations open at least one year) in three of the previous four quarters and decelerating earnings growth.

However, he is forced to acknowledge the long term: The company had posted positive same-store sales growth in 25 of the past 28 quarters, year-over-year gains in the number of transactions in its stores for 34 consecutive quarters, and operating margin expansion for eight consecutive years.

If you believe the last year is more of a secular problem for Tractor Supply than a cyclical issue, then you can pass; otherwise, the "expensive" valuation, at a little less than 19 times forward earnings, is the cheapest the stock has been since the postfinancial crisis period in 2010, according to S&P Global Market Intelligence. The forward P/E has typically pushed or topped 30 in recent years.

With the shares off 35 per cent from their 52-week high, closing Thursday at $65.61 (U.S.) some analysts with a long-term view see an opportunity.

Jaime Katz of Morningstar calculates the fair value of the shares at $81 and believes the company can grow from 1,500 locations to nearly 2,400 in the next 10 years as it expands through the western U.S.

"We believe Tractor Supply is positioned to reach critical mass in its consumer segment over the next decade," she writes, noting the company can expand margins via better customer data analysis and improved deals with suppliers.

It sounds like a great opportunity – for investors with an eye for the pure plays in agriculture.