May 25 - 31, 1996Looking at Pakistan's corporate earnings over the past year and the story they tell for the future leaves investors with a lot left to hope for. Most sectors of the economy proved disappointing for shareholders, with some sectors being completely inactive. Amidst such a market, however, the fertilizer sector has shown stable and consistent results; with the key players performing extremely well in terms of profitability and being spurred on by racing demand. In 1995 alone demand for fertilizer grew by 11%, higher than the average rate of between 5-6% over the past few years.
Of course the growth in demand is beneficial not only to the industry since it will translate to a higher volume of sales but also to the economy as a whole since it signifies the development of the agricultural sector; Pakistan currently has one of the lowest rates of fertilizer utilization at only 92 kg per hectare of cultivated land as opposed to 400 kg per hectare for other agricultural economies.
Types of fertilizer
Urea, which represents 65% of total fertilizer consumed and di-ammonium phosphate (DAP), which accounts for 18%, are the main types of fertilizer used in Pakistan, but there is a total of eight different fertilizer products which fall into three categories.
Urea, along with calcium ammonium nitrate (CAN) and ammonium sulphate (AS) together make up almost three fourths of total fertilizer consumption and come under the nitrogenous category. Under the phosphatic category which makes up about 27%, is DAP, triple super phosphate (TSP), single super phosphate (SSP) and nitrophosphate (NP). And under the last category, potassic is sulphate of potash which makes up only 1%.
Since the soil in Pakistan generally tends to be deficient in nitrogen, urea is the most used fertilizer. DAP is used, as most phosphatic fertilizers are to counter the effect of the acidic urea and maintain levels of fertility in the soil.
The main market for urea is wheat growers, followed by cotton growers, rice and sugarcane cultivators. Wheat has the highest acreage under cultivation and therefore has the highest demand while sugarcane requires the highest application of fertilizer.
Considering a compound annual growth rate, the demand for urea has grown at a rate of 7.8% and DAP at 10% in the last 10 years. Although urea is produced in Pakistan, demand far exceeds local production capacity and therefore the rest is imported and distributed by the key players. As far as DAP is concerned, the entire demand is met through imports but this will change once Fauji Fertilizer Company-Jordan and Al-Noor fertilizer, both of which we discuss later in this article come on line in the near future.
Demand is affected by crop seasons with the second half of the year typically accounting for at least 60% of sales. This is because of the difference in consumption during sowing and planting times of the various crops. The Kharif season is for cotton and rice with sowing in April to June and harvesting in September to December. The Rabi season has sowing in September to December and harvesting in February to May for both sugarcane and wheat.
The most obvious way to increase demand is through increasing the acreage of land under cultivation; if this is not the case, however, the only way to get a higher yield is through a more widespread use of fertilizer; and as discussed earlier this is probably a likely case since fertilizer application is at a very low level.
It is expected that by 1998, when the FFC-Jordan urea and DAP facility goes on-line at Port Qasim, urea could actually be in surplus.
In 1994 local urea production was 3,140,000 tonnes and in 1995 the same figure was at 3,122,000 tonnes; imports were at 78000 tonnes in 1994 and 162 000 tonnes in 1995. Last year was somewhat of an exceptional case in that there was a surplus and 83000 tonnes was exported. Although there are a total of nine fertilizer companies in the country, the public sector accounts for only 28% of the urea market. The National Fertilizer Corporation, which oversees the public sector units sells fertilizer which has been produced locally and imported through the National Fertilizer Marketing Corporation. The main sources of imports are USA, UK, Norway, South Korea, Netherlands, Belgium and Finland and imports of fertilizer from July to April 1996 totaled about $15 million.
For DAP, the country is completely reliant on imports; the private sector imported 108,000 tonnes in 1994 and 193,000 tonnes in 1995 while the government imported 629,000 tonnes in 1994 and 618,000 tonnes in 1995.
Having established that demand is climbing at quite a pace, it is evident that imports will continue to rise, although a balance is expected in 1998 as the FJFC commercial production begins in the second quarter. DAP imports, too, will continue till the FJFC plant with a production capacity of 446,000 tonnes per annum is ready for commercial production and the Al-Noor plant with 429,000 tonnes per annum of urea. Imports of DAP are expected to fall by about 50% when FJFC begins commercial production.
Although the prices of fertilizer have been deregulated partially since 1986 and completely since 1993, frequent price rises have attracted a lot of attention. Urea, sold in 50 kg bags, was priced at Rs 290 per bag in the last quarter of 1995 and was raised to Rs 305 this year. More recently, amidst some controversy two companies, Fauji fertilizer and Dawood Hercules increased urea prices to Rs 330 per bag. Engro chemical, a major player, did not increase their prices; probably because they have a lower incidence of fixed charges. Their expansion cost was lower because they had purchased a second-hand plant and had added surplus ammonia capacity; in fact even further expansion will be cheaper. The minister of food and agriculture, Yusuf Talpur, has expressed his resentment to this increase and is planning to look into the matter the price of fertilizer in the international market has come down from $ 250 per tonne to $ 212 per tonne.
This recent price rise will have its most obvious effect in the reduction of the amount of fertilizer used by the farming community, which will result in a lower crop yield. Although it might be asked here why farmers won't simply switch to Engro, the issue is slightly more complex; the industry has rather strong although vaguely defined market segments, with Fauji having more control in Punjab, a larger distribution network country-wide, and being generally less regionalized than the Sindh-based Engro. And furthermore, it is an industry where price differentiation does not normally exist, brand awareness plays a very important role, and a switch from the Fauji "Sona" might not be as easy to accomplish.
Urea currently costs Rs 340 in the black market and Rs 371 for the imported variety. Current DAP prices are at Rs 560 par bag up from Rs 410 end 1994, and they increase in accordance with international prices. Analysts' forecasts for both urea and DAP prices are given below:
Problems and policies
Although the sector has seen buoyant growth over the recent past, it has also encountered some traditional problems. Natural gas, the main raw material and fuel for the production of urea, is in abundance in Pakistan; proven reserves of natural gas are estimated at 32 trillion cubic feet (TCF) and the fertilizer sector is the second largest consumer of natural gas.
The past few years, however, have seen the curtailment of gas supplies in the winter to the urea manufacturers on the Sui-grid like Dawood Hercules, Pak-Arab, and Pak-China because of increased demand for domestic consumption. Last year, supplies from the Mari Gas fields to Engro, Pak-Saudi and Fauji were restricted in the first two months and in the middle of the year in order to divert gas for power generation. Because this was done in the months when urea is at its peak consumption level, it has been estimated that had the supply of gas not been curtailed, the industry could have produced an additional 250,000 tonnes of urea. Urea was then imported by the government to meet the winter demand. What had happened was that in order to fetch a higher price of gas from the Mari gas field, the government diverted its supply from fertilizer manufacturers to WAPDA's Guddu Thermal Power Station and this resulted in the load- shedding of gas. The problem was resolved after August last year when negotiations were successful and it is not expected that it will recur. In any case two new gas fields are being added to the national grid at Qadirpur and Kundanwari; it is expected that 20% more gas will be made available. This, however, will only really benefit existing players since new players will either not have easy access to gas or will be charged higher rates. The government had initially declined to provide concessional rates to Al-Noor and commercial production which was supposed to begin in 1997 has been delayed. So the government's control over gas supply from Sui Southern, Sui Northern and Mari gas acts as a strong barrier to entry in the sector but this problem aside, new units are also discouraged by the high fixed costs of setting up; it costs $200 m to set up a 300,000 tonnes per annum urea plant.
The disruption in the supply of gas is usually due to domestic consumption, energy shortages and other uses such as power generation. Of the gas supplied to the existing fertilizer plants, about three quarters is priced at the concessional feedstock rate while the remainder is priced at the higher fuel rate. Both Engro and Fauji have entered into 10-year long agreements with the government of Pakistan for guaranteed supply of feedstock for the expanded capacity at Rs 9.98 per thousand cubic feet.
According to analysts though, these increases are pass-along items for producers whose margins remain unchanged as they pass on the increases to consumers in the form of higher prices. For present contracts, the government, had, at one point, expressed its intent to raise the negotiated price of gas used as fuel, but the inevitable effect on farmers had to be considered.
Another problem, as discussed by a leading manufacturer of urea was the transport and infrastructure difficulties involved in transporting from fertilizer plants to retailers. Both rail systems as well as trucks are inadequate, and because timing is of essence with this product and availability has to be ensured, a delay in supply will push prices up (since a black market exists) and this results in lower yields.
The fertilizer sector is heavily supported by the government because of its significant position in the agricultural sector. Producers are assured of a supply of gas at existing prices for the purpose of feedstock and there are concessional rates for feedstock at about one-sixth of international prices. Further both urea and DAP prices are deregulated and there is no excise duty or sales tax on fertilize sales. The import of plant and machinery is allowed duty-free as is phosphate rock.
FFC-Jordan Fertilizer Company Limited, FJFC, is sponsored by the Fauji Fertilizer Corporation, the Fauji Group and the Jordan Phosphate Mines Corporation. The sponsors are not only strong backing to FJFC but of considerable operational value as well. Fauji fertilizer is the largest urea manufacturing unit in the country and Jordan, which will have a 10% stake, is the world's third largest exporter of phosphate rock after Morocco and the US.
The $ 370 million project is located at Port Qasim with a capacity to manufacture 1350 tonnes per day of DAP and 1670 tonnes per day of urea. This translates to 446,000 tonnes per annum of DAP and 551,000 tonnes per annum of urea. The plant is expected to commence production in May 1998 and the first dividend is expected at the end of 1999.
The difference this plant will make to the industry will not only be a higher supply of urea but local production of DAP as well; reducing the import bill of DAP to half its current size. FJFC will be the first local producer of DAP because phosphorous, which is the main raw material for DAP is not available in the local market and because the project is highly capital intensive with typical costs at $ 350-$400 per tonne of capacity, and has a long waiting period. FJFC has a 13-year phosphoric acid supply agreement with Jordan at a 2% discount to international prices as well as a 10-year gas supply agreement with Sui Southern.
Another major benefit to FJFC will be that the marketing and distribution as well as the technical assistance will come from the already established Fauji fertilizer which has the largest distribution network in the country.
They will also have a 4-year tax exemption, and will pay only a turnover tax at the rate of 0.5%.
According to analysts, total sales in 1998 will be at 6,614,000 tonnes rising to 10,928,000 tonnes by 2001 with DAP accounting for more than 60% of total sales. Utilization rate is expected to be between 102-105% by the year 2000 and Profit after-tax is also to rise from Rs 903 million in 1998 to Rs 1392 million in 1999, Rs 1761 million in 2000 and Rs 2008 million in 2001. Gross margins will reach the 36% mark in 1999 and net margins will go to just over 18%.
EPS is projected at 2.7 in 1998 rising to Rs 6 by 2001 and P/E is expected to fall from 6 to 2 by 2001.
Al-Noor Fertilizer Industries Limited, a new DAP and urea complex, expected to commence production in early 1998 is backed by the Al-Noor group and will be located at Dhabeji near Port Qasim. The Rs 7.48 million project has achieved financial close and will have a DAP granulation plant with a capacity of 1300 tonnes per day and a urea plant of 1200 tonnes per day. This translates to 429,000 tonnes per annum of DAP and 315,000 tonnes per annum of urea.
The DAP plant will be supplied from Lurgi Chemie GmbH of Germany who will also train staff in Pakistan and a used ammonia plant worth 955 tonnes per day has also been purchased.
An agreement has been signed for the supply of phosphoric acid for a period of 10 years with Maroc Phosphore S.A. of Morocco. An agreement has also now been signed with Sui Southern for the supply of gas for a period of 10 years at the concessional feedstock rate available to other fertilizer companies. It is even expected that once FJFC and Al-Noor begin production, the supply of urea could actually be in surplus.
A major player, with a 21% share of the urea market (from 8% in 1993), Engro Chemical, following a strong expansion strategy doubled capacity from 278,000 tonnes per annum to 600,000 tonnes per annum in 1994. This expansion cost a total of Rs 3300 million, and was accomplished through the purchase of a second hand urea plant from Chevron, USA and a used ammonia plant from ICI. The result is that Engro has a significantly lower cost of production as much as two-thirds lower than other urea plants. The next expansion in August last year of 150,000 tonnes was done by BMR and capacity is now at 750,000 tonnes per annum. This was a very low cost expansion since they utilized the excess ammonia facility. It is expected that by the end of 1997, production capacity will exceed 1 million tonnes per annum.
They are also in the process of establishing a $ 83 million liquid chemicals jetty and storage tanks terminal at Port Qasim which is due for completion in 1997. This will be 50% owned by Engro and 50% by Pakistan International, Rotterdam, a subsidiary of Royal Pakhoed. A $105 million Poly Vinyl Chloride manufacturing project due for 1999 will also be located at Port Qasim. The 100,000 tonnes per annum project would be a first step towards lucrative the petrochemical market.
A fundamentally strong company, producing at beyond the 100% capacity level, sales revenue in 1995 was at Rs 4520 million depicting a sales growth of almost 27% over the last year, attributable to both higher prices and higher volumes. They sold 694,100 tonnes of "Engro Urea", 24,000 tonnes of imported urea, and 85,200 tonnes of DAP and TSP this last year. Gross margins dipped from almost 42% in 1994 to just under 40% in 1995, while net margins were at 17.32%. Profit after-tax was up 30% to Rs 783 million and dividend payout was also good with a final dividend of 20%. EPS was Rs 13.40 in 1995 and is expected to rise to almost Rs 23 by 1997.
Although the five-year mandatory holding period for the original shareholders ends in June this year, and there are some concerns about an excess supply of stock, most analysts feel that the company has strong fundamentals and recommend its stock as a long-term investment. There is added incentive in the fact that Engro employees have a 28% stake in the company after Exxon pulled out in the early 1990's.
Fauji Fertilizer, the largest player in the industry with a 43% market share and a capacity of 1,330,000 tonnes per annum, was established by the Fauji Foundation and is located in Goth Machhi, Sindh, near the Mari Gas Field which provides a supply of natural gas to the plant. The initial capacity of the plant was 570,000 tonnes per annum in 1982 which was increased to 695,000 tonnes per annum in 1991 and in 1994, a brand new 635,000 tonnes per annum urea plant was added. Capacity utilization is at 100% but expected to rise to about 105% by 1998.
Fauji has an eight-year tax holiday for added capacity but instead of choosing this exemption, they are charging an accelerated depreciation on additional capacity reducing their current tax bill to zero and preserving cash as well. Fauji normally has very large payouts because they have to finance their sponsors activities who hold 43% of the shares. EPS was 2.6 in the half year 1995 and is expected to rise to over Rs 10 by 1998.
Because the year end has been changed to June only half year results are available. Sales for the half year 1995 were at Rs 3375 million, and are expected to grow at a rate of 15% through to 1998. Profit after-tax was Rs 660 million in the half-year 1995 and is expected to reach almost 2600 million by 1998. Gross margin was almost 47% in 1995 but is expected to fall in 1996 due to the high cost of imported products; margins will rise again in 1997 when the impact of the recent rise in urea prices kicks in.
The government is likely to keep input costs low for some time to come because local manufacturers are determined to pass on all such increases to consumers. This will preserve the industry's growth, expansion and move towards self-sufficiency; the entry barriers for new firms have already been discussed.
This sector has offered excellent shareholder returns and demand is still on the rise as manufacturers expand aggressively to accommodate this increase. So it is probably fair to conclude that the industry has sound fundamentals and significant potential for the future.
A particularly bright spot for the sector is the capacity for the export of fertilizer; if investors are worried about over-supply in the next few years, both India and China are the world's largest urea importers, and other markets such as Iran, Bangladesh, Sri Lanka and Thailand are also not too far away.