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Karachi, May 02, 2011 (PPI): Despite having a record year in terms of profitability, the fertilizer sector has been an underperformer at the KSE off late as there are growing concerns over the sustainability of these profits.
According to AKD Securities, the issue of urea pricing has become highly politicized while the imposition of Gas Development Cess (GDC) would also be very negative for the sector, where any attempt to pass on the impact of higher gas pricing could potentially be met with stern regulatory action. Recall, fertilizer manufacturers have raised fertilizer prices four times in CYIITD on account of gas curtailment, while they have reduced it just once on improved gas flows to ENGRO. Note that regulated sectors like Refineries, OMCs, IPPS and Gas Distribution Companies trade at a discount of 30%45% to the broader market.
| Urea Price Changes in 2011 (Net Basis) | ||
| Month | hkMlbeg | Reason |
| Jan’11 | 190 | Gas curtailment |
| Mar’11 | 135 | GST applied |
| Apr’11 | 70 | Gas curtailment |
| Jul’11 | 125 | Gas curtailment/GST adjustment |
| Aug’11 | 16 | Fuel gas price hike |
| Oct’11 | 174 | Gas curtailment/GST adjustment |
| Nov’11 | (86) | Price lowered on improved gas supply |
| Source: AKD Research | ||
Taking India’s example: Urea in India is tightly regulated with urea price being fixed at INR242/bag. Total urea subsidy in FY11 amounted to INR528bn of which subsidy for indigenously manufactured urea was at NRl6Obn. Furthermore, urea is priced under the Retention Pricing Scheme (RPS) where retention price is defined as the cost of production as estimated by the government plus a 12% RoE, while subsidy is the difference between the retention price less the fixed price.
Akin to some of the sectors at home, urea manufacturers in India are subject to delays in subsidy payments leading to a receivables pile up, particularly for those manufacturers making urea on imported LNG. Adoption of the Indian model in Pakistan seems highly unlikely especially given the fiscal constraints of GoP, however regulation may manifest in the form of tightly controlled prices and less than full pass through of the GDC, especially as general elections draw near. Additionally, the GoP is planning to undertake cost audits of fertilizer industry which could be used in future to implement a similar pricing mechanism as the RPS in India.
Earnings to fall 30%-40% in case of zero GDC pass-through: Assuming the worst case scenario of imposition of GDC (PkR197/mmbtu, incremental cost of PkR225/bag)) on feedstock for all plants and corresponding zero cost pass through, earnings of AKD Securities’ fertilizer cluster falls by 30%-40% from our base case (feed stock gas price hike of 10% pa) over a five year horizon. Urea heavy FFC will bear the brunt of the feed stock price hike with earnings estimated to fall by 41% over next five years while earnings fall for FFBL, ENGRO and FATIMA is similar at -30%.
In case GDC is applied only on old plants, then FATIMA’s estimates will remain unchanged while for ENGRO, earnings will fall by an average of 24%. Dwelling more on ENGRO, assuming GOC is applied on both old and new plants, but Enven is supplied with 80% gas, earnings would be more or less maintained (-3% decline from base case).
Outlook: Assuming the worst case scenario, AKD Securities sees an extension in the fertilizer sector bear rally, where based on CY12F earnings estimates, FFC would be the most expensive followed by FFBL and FATIMA, while AKD Securities believes that down side in ENGRO will be limited. Regulated sectors like Refineries, OMCs, IPPS and Gas Distribution Companies trade at a discount of 30%-45% to the broader market.