The KSE - Overview: Let's Move On

On the very first day of the trading week, the KSE-100 Index closed 3 points below at 1379 level from its previous close during last week at 1383. The market saw itself consolidating during last week to close only 4 points up at 1383 on steady volumes with hopes to gather some steam upwards after quarterly result announcement — especially the rumor of an interim dividend by PTCL's management. But the news regarding PTCL with no interim dividend had a dampener effect on the rumormongers and the speculators — and all the hopes for any major speculative activity in the market were thus slashed.

The slide of KSE-100 Index multiplied the very next day and it dropped almost 10 points before closing at 1370 for the day. The trading volume also fell by over 19% to 27.9mn shares for the day. We believe that the lack of buying interest in general before the holiday season plus absence of any institutional investors before the Paris Club announcement kept the traders and short-term investors at bay. However, there were some modest dividend announcement of 50% and 10% by Treet Corporation and Telecard respectively under the current bearish spell in the stock market.

The market however reversed and rallied as institutional investors returned to take benefit from the lower prices prevailing in the market on Wednesday. The trading volume surged 17% to 32.7mn shares as the market closed up 10 points at 1380.33. This we believe happened on the count of some interest by the institutional investors in Hubco and PSO, which led the market back to its last week's close.

The news of the Paris Club debt relief did not encourage the day traders and small/institutional investors to get into the market on two counts on the last day of the current trading week a) Friday being the last day of trading before the Eid holidays and b) Indian Issue. The investors seemed reluctant to enter the market with a longer than usual weekend due to Eid under the continuous barrage of verbal threats from India on the issue of the Parliament attack in New Delhi. Thus the market closed at 1380 level — just 0.05% above the last week's closure of 1379.35.

Debt Relief

The rescheduling of Pakistan's bilateral debt of US$12.5bn by the Paris Club comes as welcome relief to the external account. The outlined numbers for annual savings of US$1.1bn, US$1.0bn and US$0.9bn respectively over the FY02, FY03 and FY04 respectively are general approximations of the individual debt accords that Pakistan will negotiate with individual Paris Club creditor country. But in our view, the most important aspect of the Paris Club negotiations was the US$500mn debt swap and the prospects for more. The debt-for-social sector swap is a relatively new method for allowing debt relief to poorer countries, wherein the creditor gets assurances that an equivalent amount in domestic currency will be deployed for spending on social sector projects like education, health, etc. If monitored and deployed correctly, we believe that this, allied with the planned development expenditure by the GoP, could pull Pakistan out of a previously inevitable period of sluggish growth, as external demand dried up and domestic demand suffered from the greater geopolitical uncertainty surrounding the country. It is further important as the private Pakistani investor was likely to remain shy of further investment, and the ball hence rested in the government's court to try and stimulate demand via public sector investment.

As we have noted previously we expect growth to perk up from the 2Q02 onwards and continue to advise investors that up to 35% of their portfolios should be in growth/cyclical stocks. Our preferred sectors in this regard are cement, consumer goods and PSF.

The Market

In the context of the general market, we believe that debt relief, accommodative monetary policy and domestic speculative capital stock has taken the market as high as it can potentially go. The next upward spurt in the market will come from one of two sources. The first, improved corporate profitability. The onus here lies on scrips like PTCL and HubCo, and sectors like textiles. Our view on profitability of the major scrips like PTCL is well document, while we expect textile sector profitability to pick up by the end of the 2Q02 as demand conditions in the US and then EU begins to improve. The second trigger could be the reentry of foreign investors adding external capital to the mix. Here it is easy to get hyped up over the improved external account as attraction for foreign fund managers. This, in our opinion, is not so. Major fund managers are presently struggling with their portfolios in other markets, and do not necessarily have the funds to deploy here even if Pakistan offers a relatively investment proposition. We feel that they will need strong evidence that issues like corporate governance are being dealt with. In our most recent road show, fund managers could not stress enough their desire for solid reforms in corporate governance, particularly on the issue of transparency. Strong evidence could emanate from actions like the privatizations of companies like PTCL and PSO, or through stricter regulations from the SECP.

Fertilizer Sector:

Fauji Fertilizer Company Ltd

Being the largest player in the domestic fertilizer industry, Fauji Fertilizer possesses the strongest balance sheet amongst companies listed in Pakistan. We believe Fauji offers one of the few avenues of exposure to dominant agriculture sector. With its strategic importance, agriculture sector is always benefited from supportive government policies in the past and is likely to remain in focus of current efforts to improve the economy. Fauji is likely to benefit from a robust agriculture sector, as fertilizer demand remains firm.

However, in the absence of new investments avenue for Fauji, we are concerned about the company's earning potential growth in future. Though the company is interested in acquiring Pak-Saudi Fertilizer Company, up for privatization, but we do not expect management to be very aggressive on this front, as it already is in quite a quandary due to its loss making sister concern Fauji Jordan Fertilizer Company (FJFC). We believe returns in Fauji's core business are declining as well, and hence marginal ROCE is likely to fall for Fauji.

As marginal returns decline, we expect the company's payout policy to become even more aggressive, and expect dividends to rise in the future. This strengthens our view that Fauji is an attractive income stock, and should be valued as such. Only a dramatic new investment with positive marginal income would add value for shareholders, in our opinion.

Investment Strategy

Fauji has been an investor favorite, ranking high in terms of both turnover and market cap due to its defensive nature in the weak market and high dividend yield. The change in monetary policy, which has seen a decline of over 400bps in rates, have made Fauji an even more attractive proposition.

Fauji has an attractive dividend payout history, ranging between PkR6 - PkR9/share. As we have discussed earlier, in the absence of new investment prospects, the company is likely to continue to maintain its payout levels and perhaps be even more aggressive on this front. With current price of PkR41.05 this implies a very attractive potential dividend yield of 15% - 22%.

Fundamental Concerns

After the announcement of fertilizer policy 2001, things have been much clearer for the fertilizer sector. In the fertilizer policy government smartly tried to balance the pressures from the international financial institutions, phasing out subsidies, while attempting to attract new investments in the sector.

The main concern in the policy was regarding the gas prices, which have now been resolved by linking them with the ME parity in US Dollar terms. The subsidy will be phased out gradually in the period of five years after which the price should level out at around US$1.10 / MMBTU versus the current prices of 88 cents / MMBTU (at the interbank exchange rate of US$1=PkR60). The prices will be calculated in Pak Rupees at the average interbank rate, which will be fixed twice a year. The feedstock gas to the new plants will be available at 10% discount to the ME parity, which at current prices, comes to around 70 cents / MMBTU. (The prices are going to remain fixed for the period of ten years from the date of commissioning)

The overall policy is likely to bring neutral effect on the sector. The government is expecting to attract fresh investment of US$ 1.2bn, in shape of three new plants to overcome the projected short fall of 6.7mtpa by 2010. This policy is a relief in a sense that now the companies will be able to take decisions for BMR, new expansions and about acquiring existing plants available for privatization.

It is important to mention here that Fauji has benefited from a fixed rate on feedstock, which is PkR11.25/kcf (including GST), on in roughly 47% of its capacity through a 10-year agreement with government. This agreement is likely to expire In October 2003, at which time feedstock prices will equate to the floating rate, which is PkR50.32/kcf. This will give a full blow on the Fauji's net earning in FY04, where we expect a dip of 17%.