THE KSE OVERVIEW: HOT FLASH: PSFL @ PKR136/SHARE

The KSE 100 Index closed around 77 points up last week at the 1851 level with a 3% decline in average daily volume (ADV). Four market drivers; PSO, HUBCO, Engro and Fauji went spot as the date of their book closure is in the coming week. Generally, in a market situation where several scrips go spot, the speculative investors shift out of the game resulting in a pressure buildup on the selling side. However, this time the market remained positive and major activity was felt in the fuel and energy sector.

Though this is not confirmed, but informed sources tell us that Fauji Fertilizers has won the bidding in the government owned Pak Saudi Fertilizer Company (PSFL) at approximately PkR136 / share, this is not confirmed but the range is between PkR130-137 / share. PSFL is a joint venture between the governments of Pakistan and Saudi Arabia and is the largest urea-producing unit in the public sector. It has a production capacity of 557ktpa and 330ktpa of Ammonia and Urea respectively, and its plant operates at more than 100% efficiency.

Here is rough look at some of the aspects of this transaction: Assuming purchase price of PkR130/share the deal is worth PkR7.8bn (US$130mn). FFC's earnings on average cash and short term investments was approximately 12%. Hence, its cost of acquisition in terms of earnings forgone (or cost of debt) comes to about PkR936mn (US$15.6mn) against PSFL's 99A and 00A EPS of PkR9.12 and PkR6.78 respectively, which translate into an earnings yield of (@PkR130/share) of 7% and 5.2% respectively. On this basis, FFC seems the loser. But PSFL does have the ability to double its capacity which could potentially add about PkR400mn to NPAT.

While we are not too sure at present about the impact on Fauji's price, time does not allow us to do a more in-depth analysis, we do believe that this will have a positive impact on the market. As we had noted in our Pakistan strategy "911: Pakistan, one of the three nations most affected," privatization is one of the key triggers that we mentioned which could cause the market to re-rate upwards. So the privatization of PSFL (and at such an amazing price!! "Meethahi (sweetmeats) being distributed at the Privatization Commission) should have a positive impact on the market in that respect.

SECTOR OUTLOOK

DEWAN MUSHTAQ GROUP: EXCESSIVE FINANCIAL LEVERAGE NOT A GOOD OMEN 

Excessive debt has always been a sign that investors take a close look at in the corporate entity they are investing in. Excessive debt not only means that high financial expenses become a drag on future earnings growth but it also raises the risk premium for the corporate entity as the vulnerability of the firm increases in case of any unexpected negative external or industry specific shock.

In terms of valuation, for example using the discounted cash flow model (DCF), what this means is that on the one hand, the forecasted EPS growth is dragged lower all other things remaining equal, while the discount rate in the model is raised. The net impact is of course, is that the valuation of the firm is negatively impacted.

Thus, while some observers say that debt issue is primarily a matter of concern to creditors, we believe that equity investors cannot ignore this issue. In our view there is a direct inverse relationship between EXCESSIVE financial leverage and the value perception of equity investors. The question is, what degree of financial leverage can be considered excessive? That depends on industry and specific firms capital structure. However, one-way to assess whether a specific company's financial leverage is on the excessive side is to compare it to similar peer groups. As a case study, we looked at the Dewan Mushtaq Group and compared it with several large Textile focused groups in the country.

PROFILE OF DEWAN MUSHTAQ GROUP

Dewan Mushtaq Group of companies (the Group) is one of the largest industrial groups in Pakistan with an estimated equity base of PkR8.015bn, as of September 2002. The diversified business interests of the Group are in synthetic fibers, textiles, sugar and automobile industries. Dewan Group is comprised Dewan Salman Fibers, Dewan Textiles, Dewan Mushtaq Textile, Dewan Khalid Textile, Dewan Sugar and Dewan Motors. Over the last decade, Dewan Group has continually strived to increase its business base by enhancing production capacities and diversifying its investment portfolio into complementary business activities and more recently into the auto sector. It has business collaborations with Mitsubishi Corporation of Japan, Sam Yang Company Limited of Korea, Hyundai Motor Company of Korea and Kia Motors Corporation of South Korea in its different projects.

Summary Financial Profile & Analysis

Recently, textiles and sugar units announced their financial results for FY01 while the remaining units had already announced their results in June. To analyze the overall financial performance of the Group, we have consolidated the accounts of the group concern companies. Here, it is important to mention that we have taken consolidated accounts of Dewan Salman (DSFL) and Dhan Fibers from FY99, although the companies merged last year. DSFL now constitutes almost 70% of the Dewan group.

In FY01 sales increased substantially by 56% from PkR15.52bn in FY00 to PkR24.14bn due to 1) 60 % jump in sales of DSFL, as the Acrylic plant started its commercial production during the year under review, and 2) Textiles units witnessed an increase of 12% in the overall sales during the year, which in our opinion was due to an increase in the exports of cotton yarn during FY01. However, this has to be confirmed by detailed accounts.

A huge jump of 58% in COGS, due to the increase in the raw material cost of PSF and increase of almost 40% in cotton prices during FY01, lowered the impact of above increase. However, the gross profits increased by 42%, but gross margins declined from 14.2% in FY00 to 13% in FY01. Similar with the operating profits, which increased by 46% even, when the operating cost jumped by 28% during the year in review. While, the operating margins declined from 11.4% in FY00 to 10.7% in FY01.

Financial charges, which are the main source of our concerns regarding Dewan group, have increased almost by 107% YoY from PkR802mn FY00 to PkR1.66bn in FY01. This is the main cause of declining profits of the group. In recent years, the Dewan Group has enhanced its business base using debt, due to which, the debt burden of the group was standing at PkR15.7bn against the shareholders equity of PkR6.9bn in FY00. In the absence of the detailed accounts of most of the companies we are not able to quote the actual debt in FY01, but the increase of 107% in the financial charges indicates further increase in loan liabilities in FY01. Due to this increase, the profit before tax fell by almost 21% from PkR1,071mn in FY00 to PkR844mn in FY01. An increase in the tax rate from 13.9% to 30% translated into a decline of 37% in the net profit of the group from PkR923mn in FY00 to PkR584mn in FY01.