Potash Corporation of Saskatchewan (POT) is trading lower this morning after management released a statement dropping the firm’s quarterly earnings guidance from the range of $1.10 to $1.50, all the way down to $.70 per share. This is of major concern to us at Ockham because this not just a minor reduction, the new guidance level is about 36% below the low end of the previous range. The company is struggling with lower sales of potash because of deferred purchases, and lower realized prices on its phosphate fertilizers. The company must have know long ago that the quarter was going to be particularly weak, but they neglected to reduce guidance gradually as opposed to all at once. As John Ogg from 24/7wallst rightly points out, this starts to raise issues as to the credibility of Potash’s management.
“The question to ask yourself is just how much management knew about things looking very soft there. We aren’t going to blindly accuse anyone of not living up to their duties, but the reality is that if this was a minor warning the questions might not be brought up. But a warning of this size doesn’t exactly just get turned in on a slipped piece of paper on to the CEO’s desk while he is driving home and isn’t looking…
Our advice to management in the potash and fertilizer segment is simple. If you know your quarter is going to smell like raw fertilizer, you better go ahead and come clean now. Otherwise the credibility issues will come more frequently and the attorneys filing class action suits will have more ground to stand on with accusations that you had more than one instance to have assumed there were problems.”
There are really only two scenarios that seem to make sense here for why the downward revision was so severe, and neither one looks particularly impressive for Potash’s management. First, the company was blind-sided by far worse operating conditions than they were prepared to handle, or conversely and probably more likely was the company knew that the quarter was going to be really bad and decided not to revise its earlier profit predictions. Now, guidance is a slippery issue because I don’t know exactly what the possible implications are of misleading shareholders and investors, and as Mr. Ogg notes, it does raise the potential for a lawsuit, in an extreme case. What is clear, is that it does create animosity and distrust between management and shareholders. This will be a situation that we will monitor in the coming weeks.
The company is nearing the end of their fiscal second quarter, and they will report actual results in just under a month. At Ockham, our current valuation of Potash stock is Fairly Valued, but we are basing this analysis on future earnings that now appear to be well out of reach. We expect that earnings estimates will start to fall from their current levels and begin to make the seemingly attractive forward looking P/E ratio come back into more neutral levels. It is possible that Potash could be due for a downgrade, but with the sell off that has already taken place–down 22% in the last month–the price does not seem to be extremely out of line with fundamentals. More likely, we will reiterate our Fairly Valued rating and will keep a look out for what management says in the earnings conference call in about a month. We think it will be interesting to hear how they explain the situation.