Fertilizer Wars!

Are the sum of the parts worth more than the whole? When it comes to Agrium Inc. (AGU, Friday’s close $98.86) the company’s Board and its major shareholder (Jana Partners LLC, an activist hedge fund domiciled in New York which owns 4% of Agrium’s outstanding shares) find themselves at polar ends of a valuation spectrum.

Agrium has two major divisions: a wholesale segment that produces three types of fertilizers (i.e. potash, nitrogen and phosphates) and a retail component that sells these and other products to farmers.

Having a retail presence, argues Agrium, allows the company to preserve ties with the end user which makes it easier to concentrate production to meet the immediate needs of its customer base. One could argue that management is focused on building a sustainable long-term model and that its retail focus provides the foundation on which to secure future revenue.

Jana Partners LLC believes that splitting off the retail division will unlock short-term value, which is not being factored into the share price. With a caveat say analysts that it is difficult to value a publicly traded retail division when there are no comparables. Any value that Jana might apportion to a stand alone retail operation is at best an educated guess.

As often happens, the disconnect between two valid points of view comes down to timing with, in this case, Jana keenly interested in short-term gains and Agrium management looking at the longer term implications.

If there are real synergies in having an affiliated retail division it will enhance product flow and provide sustainability over the long term. That would be congruent with the interests of long-term shareholders.

If there is unrealized potential in an independent retail operation, then splitting the parts will enhance shareholder value. If management were to acquiesce Jana would most likely sell its stake, presumably at a profit, and seek out another “victim” or “partner” depending on your point of view.

If nothing else, this debate has helped shareholders and potential investors understand the contributions the retail division makes to the company’s bottom line. And has raised volatility expectations and the stock’s price over the past couple of months.

For option traders there are a couple of ways to play the fertilizer wars: one being a calendar or time spread on Agrium and the other, a covered call write on Potash, Agrium’s main Canadian competitor.

A calendar spread involves the purchase of a longer term call combined with the sale of a shorter term call. You could also use puts in a calendar spread, but the key with the strategy, is that both options have the same strike price.

With Agrium consider buying the AGU January 100 calls at $5.50 or better while writing the AGU September 100 calls at $1.80. The net cost for this calendar spread is $3.70, which is the difference between the premium received from the sale of the September 100 calls versus the cost of buying the January 100 calls.

For margin purposes, the long call effectively covers the short call. From a risk perspective, the most you can lose is the net debit (in this example, $3.70).

In some ways the calendar spread is like a covered call, with the longer dated option being a surrogate for shares of the underlying stock. The appeal is the certainty of time value erosion. The closer the option gets to expiration, the faster its time value erodes. Eventually declining to zero, if at expiration, the short call is out-of-the-money.

I would expect the time value on the September 100 calls (expiring in 5 weeks) to erode about three times faster than the January 100 calls (expiring in 22 weeks) assuming the underlying stock remains in a relatively narrow trading range.

If AGU is close to the $100 strike at the September expiration, this position will almost certainly be profitable. That’s because the January 100 calls will still have 17 months to expiry and at the September expiration should be worth approximately $4.00. Since the net cost for the spread was $3.70 you are now long January 100 calls worth $4.00.

Beyond the certainty of time value erosion you also benefit should we see a spike in volatility expectations. If the war between Janna and Agrium’s Board heats up, which it likely will, it will take some time to play out. I suspect it will be sometime in September before any new major developments come to bear on the stock’s price although any heated rhetoric could cause a spike in the volatility expectations which are priced into the options. If volatility expectations spike it will have a bigger dollar value impact on the longer term option.

The volatility implication is also the basis for my covered call strategy on Potash (TSX: POT, Friday’s close $43.67). I note for example, that the Potash January at-the-money $44 strike calls are trading at a 27.52% implied volatility versus 23.67% implied on the Agrium January at-the-money $100 strike calls.

I would expect one of two scenarios to unfold, volatility expectations surrounding both companies should edge closer which means implied volatility will either rise at Agrium or decline at Potash. The Agrium calendar spread takes advantage of the former, the Potash covered call write takes advantage of the latter.

With Potash, look to buy the shares and write the January 44 calls at 2.85 per share. The 22 week return if the stock remains unchanged is 6.98% and the return if the stock is called away is 7.79%. The downside breakeven on the Potash covered call write is $40.82.