Given recent gas supply situation in the country, the fertiliser sector has proven to be the most volatile sector at KSE. Despite gas curtailment, 2011 has been a fruitful year for the fertiliser sector in terms of profitability, particularly FFC which has outperformed the market by 59 per cent YTD. However, with persistent gas load shedding and the approval of Gas Infrastructure Development Cess (GIDC) by the National Assembly indicates tough times ahead for the fertiliser sector. This is also highlighted from the price performances of ENGRO, FFBL and FFC off late down 51 per cent, 25 per cent and 22 per cent from their respective peak levels during 2011.
The question that arises is whether the recent price meltdown has fully priced in the negatives or not? We believe the implementation of GIDC and the equalisation tax to pose downside risks for FFC, said Naveed Tehsin at JS, adding that currently our fair value for FFC is Rs208, however, we recommend cautious stance on it due to the uncertainties that may hurt FFC earnings moving forward.
GIDC: The incremental cost pass-through:
According to some sources, on account of GIDC the government has decided to increase fertiliser feedstock gas prices by 193 per cent to Rs299 per mmbtu from Rs102 per mmbtu. The incremental cost impact of GIDC and the extent that urea manufacturers are able to pass it through to end consumers has emerged as a key question. GIDC is likely to impact old urea plants only, while ENGRO’s Enven and Fatima are expected to get feedstock gas supplies at their previous subsidised rate because of their agreement with the government. Therefore, incremental cost impact on ENGRO due to GIDC will be 50 per cent compared to FFC. FFC so far has been a major gainer of urea price hikes by ENGRO. However, in this situation we believe ENGRO will only raise urea prices to cover its incremental cost impact, he added. Whereas, FFC can see taking a brunt on its earnings as the company will only be able to pass 50per cent of the incremental cost impact, because it won’t be in a position to justify price raise by itself. ‘Consequently, we foresee FFC’s 2012-14 earnings estimate will be revised downwards by 15-17 per cent and its target price will drop down to Rs192,’ he added.
Proposals to tackle urea prices:
The uncertainty pertaining to the fertiliser sector doesn’t end here. Due to uproar by the farmers amid higher urea prices, the government is considering different proposals to tackle with the urea price issue. Amongst them, includes the shifting of Engro’s Enven plant from SNGP network to SSGC and equalisation tax which plans to tax those fertiliser producers facing lesser gas curtailment. This measure is being undertaken to compensate those manufacturers facing excessive gas shortages. Consequently, it may result in urea prices to get under control. These issues have caused uneasiness amongst investors and prompt them to rethink their investment case for FFC which managed to report record level of 3Q2011 gross margin of 58 per cent i.e. abnormal compared to its average historical gross margin of 38 per cent from CY05-09. Resumption of gas supply to ENGRO either through SSGC or any other mean on stable basis may further hurt FFC’s earnings. Though at this point in time it seems a distant probability keeping in mind gas has again being suspended by SNGP to Enven plant despite commitments from the government, however, we can’t rule it out completely, he added.
If that happens, ENGRO may have to reduce its urea prices due to regulatory pressures, followed by others. To recall, urea manufacturers have increased urea prices worth Rs460/bag (including GST) during CY11. Moreover, the equalisation tax if implemented will further dampen FFC’s earnings and won’t impact ENGRO’s earnings and it will be maintained.