engro fertilizer limited

For important disclosure and analyst certification, kindly refer to end of the report

Nov 13, 2013

Engro Fertilizer Limited Chemicals Much awaited IPO at PKR 20/share – Subscribe!

Engro Fertilizers Limited (EFERT) is issuing 75mn ordinary shares, from which 56.25mn shares (75% of the total issue) will be offered through book-building mechanism at a floor price of PKR 20/share whereas the remaining 18.75mn (25% of the total issue) will be offered to the general public at the strike price to be determined through the book-building mechanism. In addition, Engro Corporation Limited (ENGRO), the parent, aims to divest its existing shareholding up to 30mn shares in EFERT at the strike price determined by the same book-building.

Offtake expected to jump 4% and 19% in CY14 and CY15 respectively The company’s offtake is expected to increase 4% YoY in CY14, and a massive 19% in CY15, due to better production post long-term gas plan (discussed ahead in detail). Furthermore, gas diverted from the Guddu power plant is also expected to keep company’s production lifted till Mar-14.

Growth story – GP margins to hover around 41%, PAT to soar at 21% CAGR Gas flows from Guddu along with the long-term gas plan bodes well for the company, as gross margins are expected to clock in at a CY13-16 average of a fat 41%. Furthermore, with both of the plants fully operational from 4QCY14 onwards, the PAT of the company is expected to massively jump at a 4-year CAGR of 21%.

Financial highlights CY12A CY13E CY14F CY15F CY16FNet Revenues 30,627 48,842 49,373 58,590 61,401Net Prof it (2,935) 5,019 5,339 7,733 8,935 EPS (PKR) @ 1298mn shares (2.74) 4.10 4.11 5.96 6.89 DPS (PKR) - - - 2.0 3.0Div yield - - - 10% 15%P/E (x) n.m 4.87 4.86 3.36 2.90P/B (x) n.m 1.24 0.90 0.76 0.66ROE -19% 27% 21% 25% 24%ROA -3% 5% 5% 8% 10%Source: Company accounts and AHL Research

Strong cash flow generation ahead – dividend expected in CY15F We foresee strong cash-flow generation amid higher capacity utilization coupled with stable urea prices. Our analysis suggests, in CY15F, the company’s cash position will be strong enough to declare dividend after fulfilling the IFC requirement of retiring 33% of its senior debt.

No more worries – Debt restructuring approved, gas-related risks mitigated The company’s debt restructuring has been approved with all lenders. The principle payments of the senior debt, as at Jun-12, have been deferred by 2.5 years, which provides the company with enough time cushion to build cash. Company’s Gas Sale Agreements (GSAs) with KPD, Reti Maru and Makori East are intact. Currently, the company is drawing gas from MARI SML (~20mmcfd), while Reti Maru (~12mmcfd) flow is expected by end CY13.

Recommendation – Subscribe! Our ‘fair value’ for EFERT works out to PKR 32.8, translating into a massive upside potential of 64% (from floor price). The company is expected to be able to declare cash dividends by CY15. Thus, we recommend ‘Subscribe’ for the upcoming IPO.

Fair value 32.83

Floor Price 20.0

Upside 64%

KSE Code -

Bloomberg Code -

Market Cap (US$ m) -Market Cap (PKR m) -Outstanding Shares (m)Free Float -Major Shareholders Engro Corp.

New Equity (mn shares) 75.00Through book building 56.25Through initial public offering 18.75

Offer for Sale by ENGRO (mn shares)Private placem ent 30.0

Total transaction size (mn shares) 105.00

Floor price (PKR/share) 20.0

Book building time line (Both days incl.)19-Nov-13 Tuesdayto

21-Nov-13 Thrusday

AnalystTahir Abbas

[email protected]

+92-21-32462589

Subscribe

www.arifhabibltd.com

Shares

1,222

Com pany information

About the trasaction

Engro Fertilizers Lim ited is a public company incorporated on June 29, 2009 in Pakistan under the Com panies ordinance, 1984 as a w holly ow ned subsidiary of Engro Corporation Limited. The principle activity of the com pany is manufacturing, purchasing and m arketing of fertilizer.

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Engro Fertilizer Limited

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Contents CY13 goes green – A year of turnaround .......................................................................................................................................................... 5 Operational updates ............................................................................................................................................................................................. 5 Gas availability for EFERT ................................................................................................................................................................................... 5 Fight for the right! – Gas at USD 0.7/mmbtu..................................................................................................................................................... 5 Offtake to jump by hefty 19% YoY post long term gas plan .......................................................................................................................... 6 A growth story – GP margins to hover around 41%, PAT to jump at 21% CAGR....................................................................................... 6 Product pricing to remain stable ........................................................................................................................................................................ 7 What to expect in CY14? ...................................................................................................................................................................................... 7 Strong cash flow generation ahead – dividend expected in CY15F ............................................................................................................. 8 No more worries – Debt restructuring approved! ............................................................................................................................................ 8 Risk mitigated – Long term plan, gas fumes to be owned by the company................................................................................................ 9 Capex with respect to long term gas plan ........................................................................................................................................................ 9 Valuation ............................................................................................................................................................................................................... 10 S.W.O.T Analysis ................................................................................................................................................................................................. 11 About the Company ............................................................................................................................................................................................ 11 About the Sponsors ............................................................................................................................................................................................ 11 Key risks to the investment case ..................................................................................................................................................................... 12 Financial snapshot.............................................................................................................................................................................................. 14 Regional charm ................................................................................................................................................................................................... 16 Agriculture sector review................................................................................................................................................................................... 17 Fertilizer sector of Pakistan............................................................................................................................................................................... 18 Fertilizer policy, issues & sector performance............................................................................................................................................... 19 Demand drivers ................................................................................................................................................................................................... 20 Supply constraints - gas issues ....................................................................................................................................................................... 22 Gas Infrastructure Development Cess (GIDC)................................................................................................................................................ 25 What is the Long-term gas plan? ..................................................................................................................................................................... 26 Pricing scenario; price cut seems a far cry! ................................................................................................................................................... 27 Outlook ................................................................................................................................................................................................................. 28 Key risks ............................................................................................................................................................................................................... 29 Annexure .............................................................................................................................................................................................................. 31 Abbreviations....................................................................................................................................................................................................... 34 Disclaimer and related information .................................................................................................................................................................. 35 Contact details ..................................................................................................................................................................................................... 36

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Engro Fertilizer Limited (EFERT) EFERT is issuing 75mn ordinary shares, from which 56.25mn shares (75% of the total issue) will be offered through book-building mechanism at a floor price of PKR 20/share whereas the remaining 18.75mn (25% of the total issue) will be offered to the general public at the strike price to be determined through the book-building mechanism. In addition to the aforementioned transaction, Engro Corporation Limited (ENGRO) aims to divest its existing shareholding up to 30mn shares in EFERT at the strike price determined by the same book-building.

Biggest urea manufacturer – 2.27mn tons of urea capacities EFERT has two fully integrated fertilizer plants with a nameplate capacity of producing 2.275mn tons of urea. Both of the company’s plants are located in Sindh.

Offtake expected to jump 4% and 19% in CY14 and CY15 respectively The company’s offtake is expected to increase 4% YoY in CY14, and a massive 19% in CY15, due to better production post long-term gas plan (discussed ahead in detail). Furthermore, gas diverted from the Guddu power plant is also expected to keep company’s production lifted till Mar-14.

Growth story – GP margins to hover around 41%, PAT to soar at 21% CAGR Gas flows from Guddu along with the long-term gas plan bodes well for the company, as gross margins are expected to clock in at a CY13-16 average of a fat 41%. Furthermore, with both of the plants fully operational from 4QCY14 onwards, the PAT of the company is expected to massively jump at a 4-year CAGR of 21%.

Financial highlights CY12A CY13E CY14F CY15F CY16FNet Revenues 30,627 48,842 49,373 58,590 61,401Net Prof it (2,935) 5,019 5,339 7,733 8,935 EPS (PKR) @ 1298mn shares (2.74) 4.10 4.11 5.96 6.89 DPS (PKR) - - - 2.0 3.0Div yield - - - 10% 15%P/E (x) n.m 4.87 4.86 3.36 2.90P/B (x) n.m 1.24 0.90 0.76 0.66ROE -19% 27% 21% 25% 24%ROA -3% 5% 5% 8% 10%Source: Company accounts and AHL Research

Strong cash flow generation ahead – dividend expected in CY15F We foresee strong cash-flow generation amid higher capacity utilization coupled with stable urea prices. Our analysis suggests, in CY15F, the company’s cash position will be strong enough to declare dividend after fulfilling the IFC requirement of retiring 33% of its senior debt.

No more worries – Debt restructuring approved The company’s debt restructuring has been approved with all lenders. The principle payments of the senior debt, as at Jun-12, have been deferred by 2.5 years, which provides the company with enough time cushion to build cash.

Risk mitigated – Long term plan, gas fumes to be owned by the company Company’s Gas Sale Agreements (GSAs) with KPD, Reti Maru and Makori East are intact. Currently, the company is drawing gas from MARI SML (~20mmcfd), while Reti Maru (~12mmcfd) flow is expected by end CY13.

Recommendation – Subscribe! Our ‘fair value’ for EFERT works out to PKR 32.8, translating into a massive upside potential of 64% (from floor price). The company is expected to be able to declare cash dividends by CY15. Thus, we recommend ‘Subscribe’ for the upcoming IPO.

Fair value 32.83

Floor Price 20.0

Upside 64%

KSE Code -

Bloomberg Code -

Market Cap (US$ m) -Market Cap (PKR m) -Outstanding Shares (m)Free Float -Major Shareholders Engro Corp.

New Equity (mn shares) 75.00Through book building 56.25Through initial public offering 18.75

Offer for Sale by ENGRO (mn shares)Private placem ent 30.0

Total transaction size (mn shares) 105.00

Floor price (PKR/share) 20.0

Book building time line (Both days incl.)19-Nov-13 Tuesdayto

21-Nov-13 Thrusday

AnalystTahir Abbas

[email protected]

+92-21-32462589

Subscribe

www.arifhabibltd.com

Shares

1,222

Com pany information

About the trasaction

Engro Fertilizers Lim ited is a public company incorporated on June 29, 2009 in Pakistan under the Com panies ordinance, 1984 as a w holly ow ned subsidiary of Engro Corporation Limited. The principle activity of the com pany is manufacturing, purchasing and m arketing of fertilizer.

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Engro Fertilizer Limited CY13 goes green – A year of turnaround EFERT remains the key beneficiary with respect to gas availability, as the rota-gas allocation during 1H’13 alongside out-of-blue availability of the Guddu (Mari) gas has been propping up company profitability. Our industry channels suggest EFERT is expected to receive gas from Guddu till Mar’14. However, we still cannot rule out the possibility of any early diversion of Guddu gas from EFERT.

Operational updates Currently, EFERT is operating its new plant, EnVen, on the Mari gas network (gas diversion from the base plant). Total gas availability to the new plant stands at 93mmcfd. We expect EFERT to operate EnVen till the completion of the long-term gas plan (end 3QCY14), and the gas price to remain at USD 3.2/mmbtu. Even before the completion of the long-term gas arrangement plan through a pipeline, while the company is expected to contend for its original GSA price of USc70/mmbtu, the gas price contract for the pipeline is believed to have been finalized at USD 4.26/mmbtu (feed gas at USD 3.75/mmbtu, USD 0.51/mmbtu as tolling charge). EFERT is expected to operate both of its plants at 85% utilization levels once the pipeline becomes operational by the end of CY14.

CY12 Market share 9MCY13 Market share

Source: NFDC and AHL Research

Gas availability for EFERT The ECC has already extended the gas supply diversion from the Mari network to EnVen till the implementation of long term gas plan. However, as per our discussion with the industry, the gov’t is discussing several proposals with the EFERT’s request to supply the gas at a subsidized price of USD 0.7/mmbtu while USD 3.2/mmbtu has been continued at least for CY13.

Fight for the right! – Gas at USD 0.7/mmbtu EFERT’s management is continuously under discussion with the GoP regarding the concessionary feed stock price of USD 0.7/mmbtu for its new plant. While the chances of the concessionary feed stock price are quite slim, nevertheless, if the GoP honors the initial contract for EnVen, it would be a major trigger for the company.

FFC47%

FFBL5%

ENGRO18%

FATIMA7%

DH Fertilizer

1%

Agritech1%

Pak Arab0%

NFML21% FFC

42%

FFBL4%

ENGRO24%

FATIMA6%

DH Fertilizer

3%

Agritech4%

Pak Arab0%

NFML17%

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Engro Fertilizer Limited Offtake to jump by hefty 19% YoY post long term gas plan The company’s offtake is expected to jump 4% YoY in CY14 mainly due to 6-month operations of base plant (1QCY14 on Guddu gas and 4QCY14 with long term gas plan). Furthermore offtake is expected to surge by 19% in CY15 due to better production post long term gas plan (both plants are expected to remain operational at optimal capacity of 85%). In addition to this, before the long term gas plan materializes, the picture is expected to remain lucrative as the company would receive 3-month gas diversion from Guddu in CY14E. In our base-case, we have assumed that EFERT would receive gas from Guddu till Mar-14 and the long term gas plan would come online by 4QCY14.

Offtake and utilization Production and offtake

Source: AHL Research

A growth story – GP margins to hover around 41%, PAT to jump at 21% CAGR The company’s gross margins remained sluggish in the preceding year following massive gas curtailment resulting in one plant operational capacity. The Guddu gas flows along with the long term gas plan bodes well for the company, as gross margins are expected to clock in at CY13-16 average of a huge 41%. Furthermore, with both the plants fully operational from 4QCY14 onwards, the net sales are anticipated to jump at a 4-year CAGR of 8%, taking profit after tax of the company to boost at a 5-year CAGR of 21%!

GP margins maintained at 41% (avg. of CY13-CY16) PAT to grow CAGR of 21%


65%

70%

75%

80%

85%

90%

1,500

1,625

1,750

1,875

2,000

CY14F CY15F CY16F CY17F

Offtake Utilization (RHS)k tons

40%45%50%55%60%65%70%75%80%85%90%

800925

1,0501,1751,3001,4251,5501,6751,8001,925

CY12A CY13E CY14F CY15F CY16F

ProductionOfftakeUtilization (RHS)

k tons

0%5%10%15%20%25%30%35%40%45%50%

20,000 25,000 30,000 35,000 40,000 45,000 50,000 55,000 60,000 65,000


Sales GP Margin (RHS)PKR mn

10%

11%

12%

13%

14%

15%

4,500

5,500

6,500

7,500

8,500

9,500

CY13E CY14F CY15F CY16F

PAT Net Profit Margin (RHS)PKR mn

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Product pricing to remain stable As far as product pricing is concerned, EFERT is expected to maintain urea prices at current levels with little expectation of any price war in CY13 and beyond, with part gas provision during the year (Guddu gas). We derive our assumption from the demand-supply gap of urea, which is expected to remain wide as witnessed from regular imports being made by the gov’t. The GoP has already approved 0.5mn tons of urea for the Rabi season (commencing Nov-13 onwards). Even by 4QCY14, when both of EFERT’s plants are expected to be operational, we rule out any significant price cuts provided by massive increase in contract gas price, especially for EFERT (at USD4.26/mmbtu instead of EnVen’s original contract price of USc70/mmbtu), unless the gas price is revised downward to the original GSA.

Given huge financial burden and inability to absorb significant hike in the feed gas prices, increase in urea prices can be expected, instead.

What to expect in CY14? We have run sensitivity on EFERT’s earnings assuming various possible scenarios. For the base-case of CY14, we have assumed base plant to receive gas for 6 months (3 months from Guddu and 3 months from long term gas plan) and EnVen to operate at 85% capacity level (on Mari gas network) till the completion of the long-term gas plan (expected by end 3QCY14). Thus for CY14, the feed stock (gas) price for EnVen will be USD 3.2/mmbtu (PKR 320.42/mmtbu same as current level) while for the base plant, it would be PKR 320.42/mmbtu till 3QCY14 (plant operational for 3 months) and PKR 426/mmbtu for remaining tenure (expected for long term gas plan). In addition to this, from 4QCY14 onwards, we have assumed EnVen and base plant to operate at 85% utilization level, post implementation of the long-term gas pipeline plan.

CY14 Earnings ForecastCapacity UtilisationEnVen 85% 85% 85%Base plant 180 days 90 days 0 daysProduction (k tons)ENVEN 1,105 1,105 1,105 Base plant 400 205 - Total Production 1,505 1,310 1,105 Off take 1,511 1,347 1,143 Urea Prices (PKR/bag) 1,750 1,750 1,750 Gas prices (PKR/mmbtu)ENVEN (Mari gas network) 320 320 320 Base Plant (Guddu and Long term gas plan) 320 and 426 320 and 426 320 and 426Earnings (PKR/share)ENGRO Fertilizer (EPS) @ 1298 mn shares 4.11 3.41 2.02 Impact on Engro Corporation 10.44 8.66 5.13 Source: AHL Research

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Strong cash flow generation ahead – dividend expected in CY15F We foresee strong cash flow generation amid higher capacity utilization coupled with the stable urea prices. As per the companies’ cash sweep with the IFC, the surplus cash after adjustment with capex, principle repayment, pipe line capex and others, the company is expected to earn going forward would be used as prepayment to the IFC. Our calculation suggests that in CY15F the company’s cash flow per share would be PKR 5.6/share, which gives an idea that the company would be able to declare cash dividend after fulfilling the IFC requirement of retiring 33% of its senior debt.

Margins outlook EBITDA to Debt servicing


No more worries – Debt restructuring approved! The company’s debt restructuring has been approved with its local lenders. Principle repayments of the senior debt as at Jun-12 have been deferred by 2.5 years. We have assumed debt repayment of PKR 5.6bn, PKR 12bn and PKR 13.5bn in CY13, CY14 and CY15, respectively. Given the strong expected cash flow generation the company would be able to easily manage its debt servicing, in our view. The EBITDA of the company is expected to grow at a 4-year CAGR of 3%, to PKR 25bn by CY16.

0%

20%

40%

60%


GP MarginNP MarginEBITDA Margins

5,000

10,000

15,000

20,000

25,000

30,000


EBITDA Debt ServicingPKR mn

EBITDA to Current portion


22.0

22.5

23.0

23.5

24.0

24.5

25.0

25.5

5.0

7.5

10.0

12.5

15.0


Current PortionEBITDA (RHS)

PKR bn PKR bn

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Engro Fertilizer Limited Risk mitigated – Long term plan, gas fumes to be owned by the company Gas Sale Agreement’s (GSA) with KPD, Reti Maru and Makori East are intact. The company is drawing gas from MARI SML (~20mmcfd), while Reti Maru (~12mmcfd) flow is expected by the end of this year. The Economic Coordination Committee has yet to reconfirm the long term gas plan. However the management expressed the confidence, that ECC would shortly confirm the plan, while a delay of 2-3 months cannot be ruled out in the execution of the aforementioned plan (3QCY14 now vs. 2QCY14 previously). In addition, the company has signed Gas tolling agreements (GTA’s) with SSGC and SNGP.

EFERT gas availability and growth Long term gas plan (mmcfd)


Capex with respect to long term gas plan Given its share in the gas allocation, EFERT’s share in the long-term gas pipeline plan stands ~USD 48mn out of total estimated cost of USD 100mn, and we believe that EFERT will utilize the funds raised from IPO plus the internal cash flow generation. Furthermore, the capex with respect to Kunnar Pasaki Deep pipeline is on hold as the company is awaiting the reconfirmation of long term gas plan by the ECC. However going forward in CY14, we have incorporated USD 48mn KPD capex in our estimates.

0%

10%

20%

30%

40%

50%

60%

70%

- 20 40 60 80

100 120 140 160 180 200


Long term gas planGudduSNGPMariGrowth (RHS)

mmcfd

Engro , 79

Agri, 25

Pak Arab, 58

DH Fertilizer,

40

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Engro Fertilizer Limited Valuation Our DCF-based fair value for the scrip works out to PKR 32.83/share, translating into a striking upside potential of 64% from floor price level.

Our valuation is based on the cost of equity 20.6% and 8.5% after tax cost of debt translating into a WACC of 11.5%. However, as we expect debt to be retired, we have assumed separate WACC for every year to incorporate the rapidly changing capital structure. Following strong cash-flow generation, we expect the company to declare cash dIvidend by the end of CY15F. The stock is currently trading at a lucurative CY14F PER of 4.9x and PB of 0.9x. Thus, we recommend ‘Subscribe’ for the IPO.

Discounted Cash Flow ValuationPKR mn CY13 CY14 CY15 CY16 CY17 CY18 CY19 CY20 TerminalEBIT (1-t) 11,683 11,181 12,630 12,997 13,534 13,701 13,834 13,850 Add: Depreciation 5,065 5,351 5,211 5,147 5,083 5,014 4,940 4,923 Add: Changes in Working Capital 6,931 (5,027) (565) 147 145 123 108 148 Less: Capital Expenditure (2,139) (7,490) (2,076) (2,232) (2,353) (2,423) (2,489) (2,562) Free Cash Flow 21,539 4,014 15,200 16,059 16,410 16,415 16,393 16,359 102,368 WACC 11.5% 12.7% 13.8% 15.2% 16.1% 17.1% 18.1% 19.0%Present Value 21,539 3,561 11,733 10,501 9,018 7,455 6,041 4,830 Terminal Grow th Rate 4.00%PV of FCFF 74,679 PV of Terminal Value 30,226 Total PV 104,905 Less: Net Debt 62,293 Equity Value 42,612 No. of Shares (mn) 1,298 Fair value (PKR) - Dec-13 32.83 Source: AHL Research

Valuation Matrix

2% 3% 4% 5% 6%11.0% 35.87 37.68 39.74 42.10 44.83 12.8% 29.93 31.30 32.83 34.56 36.53 13.0% 29.28 30.60 32.08 33.75 35.64 14.0% 26.48 27.62 28.89 30.31 31.90 15.0% 23.94 24.93 26.03 27.24 28.60


Risk

Fre

e R

ate

Terminal Grow th Rate

WACC ParametersRisk Free Rate 12.8%Market Return 19.8%Beta 1.12 Cost of Equity 20.6%Cost of Debt 13.1%After tax Cost of Debt 8.5%WACC (CY13) 11.5%Source: AHL Research

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Engro Fertilizer Limited S.W.O.T Analysis

*Feedstock gas at a fixed rate for ten years*Fuel efficient plant "EnVen"*Urea as prime product that s tands with relatively inelas tic demand*High entry barriers in the sector amid non availability of natural gas *High government support to the agri sector *Opportunity to expand production through de-bottlenecking

*High financial leverage

*Insufficient gas reserves (risk of unavailability of raw material)*Interest rate volatility (increase)

Source: EFERT IM, AHL Research

Thr

eats

S.W.O.T Analysis

Stre

ngth

s W

eakn

esse

s

*Limited product mix (mainly Urea maker) to expose company to risks of varying gov't policies (changing support prices to support farmer)

*High government support to the agri sector

*Urea has relatively inelastic demand among other fertilizer products

*Local urea prices are considerably lower than international prices and any surplus can be easily exported

Opp

urtu

nitie

s

About the Company EFERT is a public company incorporated on June 29, 2009 in Pakistan under the Companies Ordinance, 1984, as a wholly owned subsidiary of ENGRO. The principle activity of the company is manufacturing, purchasing and marketing of fertilizers.

About the Sponsors EFERT is a 100% owned subsidiary of ENGRO. The holding company is a public listed company incorporated in Pakistan and its shares are quoted on all the three stock exchanges of Pakistan I.e; Karachi (KSE), Lahore (LSE), and Islamabad (ISE).

The principal activity of the holding company is to manage investments in subsidiary companies and joint venture, engaged in fertilizers, PVC resin manufacturing and marketing, food, energy, exploration, LNG and chemical terminal and storage businesses.

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Key risks to the investment case Discount rate The heavy debt burden of the company (PKR 62.5bn as of September 2013) makes the company more vulnerable in the rising interest rate scenario existing in Pakistan. Hence, any sharp rise in interest rate could dent cash flow and earnings of the company.

Gas curtailment Gas is the key input for manufacturing fertilizers. Pakistan is currently facing severe energy shortages, hence any partial or complete diversion cannot be ruled out. The major threat could the diversion of gas from long term gas plan to power sector. Therefore, going forward any such move by the gov’t could seriously distort the company’s performance.

Lower demand Due to unforeseeable natural disasters coupled with unavailability of water, the demand of urea may be lower than estimated. This could reduce the company’s earning substantially.

Gas prices a major dampener? - The 3-scenario analysis Gas price (feed stock) is expected to play a major role in the short-term for the fertilizer sector, especially for EFERT and FFC whose sales are solely dependent on urea. However, we do not foresee any massive gas price hike (i.e. feed equaling fuel). We see PKR 75-100/mmbtu increase that fertilizer manufacturers would easily pass on to end consumer (PKR 110-125/bag). Additionally, we have made three scenarios with respect to the gas prices increase. These include:

Feed stock would raise by 300%

Feed stock price hike would be around PKR 76.67/mmbtu (by reducing subsidy to

PKR 200/bag from the current subsidy of PKR 308/bag, the subsidy per bag due to the differential of feed and fuel stock prices), and

Feed stock price would surge by 100% excluding GIDC

The gov’t is yet to finalize gas prices, though the cause of delay is the fear of fertilizer price hike (substantial in case of equating feed and fuel) due to the aforementioned increase. The gov’t is working on different proposals to facilitate farmers (direct farm subsidy).

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Feed stock price (PKR/mmbtu)Current feed stock 320.42

Expected increase in feed stock 246.84 Expected revised feed stock 567.26 Source: AHL Estimates

Subsidy (PKR/bag)Current subsidy 308.00 Revised subsidy 200.00

Feed stock price (PKR/mmbtu)Current feed stock 320.42 Expected increase in feed stock 76.67 Expected revised feed stock 397.09 Source: AHL Estimates

Feed stock price (PKR/mmbtu)Current feed stock 320.42

Expected increase in feed stock 123.42 Expected revised feed stock 443.84 Source: AHL Estimates

1) 300% increase in the current feed stock prices One of the assumptions is to increase gas prices (feed stock) to 300% from the current levels. Incorporating this, we expect PKR 246.8/mmbtu increase in the feed stock prices (see table 01 alongside). Furthermore, in table 02, we have calculated the expected annualized after-tax EPS impact on our fertilizer universe earnings, and per bag price that would be required to be passed on to nullify the impact.

FF C 293 343 (6 .05) 15.37 -39%FF BL 332 388 (1 .40) 6.67 -21%Efert 272 318 (4 .28) 4.10 -104%Sourc e: AHL Es tim ates

Gas pr ices increase impact on fe rtilize r compan ies

C om panyPer bag

(pas s -on)Per bag inc l.

GST (pas s-on)EPS im pact (no-pass on)

C Y13E EPS

%

2) Reducing subsidy to PKR 200/bag from the current subsidy of PKR 308/bag As per meeting of the ECC dated Aug 15, 2013, the officials said that the amount of subsidy on each bag of the fertilizer would be around PKR 200/bag post gas tariff increase. Currently subsidy per bag stood at PKR 308. We have estimated the expected gas price hike (feed stock) by reducing the per bag subsidy to PKR 200. In the second table alongside, we have calculated the expected annualized after-tax EPS impact on AHL Research’s fertilizer universe, and per bag price that is required to be passed on to nullify the said impact.

F F C 91 1 07 (1. 88) 15.37 -1 2%F F BL 103 1 20 (0. 43) 6.67 -7%Efe rt 84 99 (1. 33) 4.10 -3 2%So urce: A HL Es tim ates

Gas pr ices increase impa ct on fe rtilizer compa nies

C om pan yP er bag

(p ass -on)Per bag inc l.

GST (pass -o n)EP S im pa c t (no -pass o n)

C Y13E EPS

%

3) 100% increase in the current feed stock prices excluding GIDC The last scenario is the expected 100% increase in the current feed stock prices. As per our estimates, the expected hike is PKR 123/mmbtu in the aforementioned scenario (see the RHS table). In the second table, we have calculated the expected annualized after-tax EPS impact on AHL’s fertilizer universe, and per bag price that is expected to increase to nullify the impact.

F F C 162 190 (3 .35) 15 .37 -22%F F B L 179 210 (0 .76) 6 .67 -11%E fe rt 148 174 (2 .34) 4 .10 -57%S ourc e : A HL E s tim a tes

G a s pr ice s in cre a se imp act o n fe r tilize r co mp an ie s

C om panyP er bag

(pas s -on)Per bag inc l.

GS T (pas s -on )E P S im pact (no -pas s on)

C Y 13E E P S

%

14


Financial snapshot Volumes to boost revenues Downward trajectory finance cost and debt to equity

Declining financial charges and borrowings Falling debt to equity

Earnings and distribution Flourishing net margins

Sources; Company Financials, NFDC, AHL Research

-

500

1,000

1,500

2,000

2,500

20,000

25,000

30,000

35,000

40,000

45,000

50,000

55,000

60,000

65,000


Net revenues

Total Volumes (RHS)

PKR mn k tons

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

5,500

6,250

7,000

7,750

8,500

9,250

10,000


Interest expenseDebt to equity (RHS)

PKR mn (x)

5,000

5,500

6,000

6,500

7,000

7,500

8,000

8,500

9,000

9,500

10,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

55,000

60,000


Long term BorrowingsFinancial Charges (RHS)

PKR mn PKR mn

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000


Equity Debt to Equity (RHS)PKR mn (x)

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

3.50

4.00

4.50

5.00

5.50

6.00

6.50

7.00


EPS DPS (RHS)PKR/share PKR/share

10%

11%

12%

13%

14%

15%

4,500

5,500

6,500

7,500

8,500

9,500


PAT Net Profit Margin (RHS)PKR mn

15


Financial Summary, Forecasts and Key RatiosPKR mn

Incom e Statem ent CY10A CY11A CY12A CY13E CY14F CY15F CY16FNet Sales 19,018 31,353 30,627 48,842 49,373 58,590 61,401 Gross profit 8,910 16,733 9,861 21,012 20,816 23,766 24,542 Gross margins 47% 53% 32% 43% 42% 41% 40%EBITDA margin 38% 55% 40% 47% 46% 42% 41%Operating Profit 6,615 13,938 6,778 16,961 16,438 18,525 19,040 Other income 458 1,164 379 916 1,041 1,236 1,295 Financial charges 1,351 7,644 10,703 9,363 8,772 7,278 5,974 PAT 3,730 4,588 (2,935) 5,019 5,339 7,733 8,935 Net m argins 20% 15% n.m 10% 11% 13% 15%Earnings per Share - (PKR) (Adjusted for 1298 mn shares) 2.87 3.54 (2.74) 4.10 4.11 5.96 6.89 DPS (PKR) - - - - - 2.00 3.00

Balance Sheet CY10A CY11A CY12A CY13E CY14F CY15F CY16FTotal Shareholders' Equity 13,640 18,617 15,798 20,967 28,805 34,068 39,110 Non Current LiabilitiesLong Term Loan 62,660 56,398 48,482 53,879 41,879 28,379 22,703 Total Non Current Liabilities 68,205 64,571 55,459 60,857 48,857 35,357 29,681 Current LiabilitiesTrade and Other Payables 3,911 5,153 7,960 13,253 8,159 8,706 9,215 Total Current Liabilities 16,209 17,689 26,250 22,664 23,927 26,274 19,273 Total Liabilities and Equity 98,053 100,877 97,508 104,488 101,588 95,700 88,064 AssetsNon Current Assets 84,631 86,540 83,123 80,198 82,338 79,203 76,288 Current Assets 13,423 14,337 14,385 24,290 19,250 16,496 11,777 Total Assets 98,053 100,877 97,508 104,488 101,588 95,700 88,064

Cash Flow Statement CY10A CY11A CY12A CY13E CY14F CY15F CY16FCashflow from operating activities 4,360 9,279 6,371 17,014 5,662 12,379 14,229 Cash used in investing activities (14,654) (3,517) (1,857) (2,139) (7,490) (2,076) (2,232) Cashflow from f inancing activities 12,903 (4,589) (4,920) (3,331) (3,145) (14,169) (17,079) Net increase/(decrease in cash & equivalents 2,609 1,173 (406) 11,544 (4,973) (3,866) (5,082) Cash 3,318 4,491 2,449 16,442 23,012 14,174 5,227

Analysis per share CY10A CY11A CY12A CY13E CY14F CY15F CY16FEPS 2.87 3.54 (2.74) 4.10 4.11 5.96 6.89 DPS - - - - - 2.00 3.00 BVPS 10.51 14.35 12.17 16.16 22.20 26.25 30.14 Profitability ratios CY10A CY11A CY12A CY13E CY14F CY15F CY16FGross margins 47% 53% 32% 43% 42% 41% 40%EBITDA margins 38% 55% 40% 47% 46% 42% 41%Net margins 20% 15% n.m 10% 11% 13% 15%Coverage ratio 4.90 1.82 0.63 1.81 1.87 2.55 3.19 P/E (x) 6.96 5.66 n.m 4.87 4.86 3.36 2.90 P/B (x) 1.90 1.39 n.m 1.24 0.90 0.76 0.66 Div yield 0% 0% 0% 0% 0% 10% 15%Debt to equity 6.19 4.42 5.17 3.98 2.53 1.81 1.25 Debt to assets 0.86 0.82 0.84 0.80 0.72 0.64 0.56 Return on capital CY10A CY11A CY12A CY13E CY14F CY15F CY16FROA 4% 5% n.m 5% 5% 8% 10%ROE 27% 28% n.m 27% 21% 25% 24%Source: Company accounts and AHL Research

16


Regional charm

0.002.004.006.008.00

10.0012.0014.0016.0018.0020.00

EFER

T

DPM

VN

TCC

C TB

0004

22 C

H

TTC

H IN

Price to Earning

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

0004

22 C

H

TTC

H IN

EFER

T

DPM

VN

TCC

C T

B

Price to Book

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

DPM

VN

TCCC

TB

EFER

T

TTCH

IN

0004

22 C

H

Return on Assets

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

TCC

C T

B

EFER

T

DPM

VN

0004

22 C

H

TTC

H IN

Return on Equity

17


Agriculture sector review The Agriculture sector alone is of immense importance to Pakistan economy; it is one of the sectors that provide maximum value addition by converting raw gas into urea granules and benefitting the country in terms of food availability, balance of payment, poverty reduction, economic growth and transformation towards industrialization. Even though this sector is one of the most competitive sectors, it still faces many gas curtailment issues and excess demand over supply.

Pakistan is an agrarian country as its prime exports consist of agriculture good; apart from ensuring food security, it contributes 21% to GDP and provides employment to 45% of Pakistani population. For sustainable agricultural growth, a prospering fertilizer industry is extremely crucial.

GDP and Agricultural growth Agricultural share in GDP

Source: Economic Survey 2012-13, AHL Research

5.0%

0.4%

2.6%

3.7%4.4%

3.6%

1.8%

3.5%

0.2%

2.0%

3.5% 3.3%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

2008

2009

2010

2011

2012

2013

GDP growth Agriculture growth

22%

23%

22%22%

22% 21%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

21%

21%

22%

22%

23%

23%

2008

2009

2010

2011

2012

2013

Agriculture Share in GDPGDP growth (RHS)

18


Fertilizer sector of Pakistan The fertilizer sector has a total market capitalization of PKR 333.2bn (USD 3.1bn) and the market capitalization of our sample companies (FFC, FFBL and ENGRO) stood at PKR 247.2bn (USD 2.3bn). The index weight of total chemical sector is around ~12.6% in KSE100 index while our sample companies (FFC, FFBL and ENGRO) comprise ~10.2% of the KSE100 index.

Pakistan fertilizer sector comprises seven companies (see table below). The prime product of the sector is urea, seconded by DAP. The major players of the sectors include Fauji Fertilizer Company Limited and Engro Fertilizer having total capacities of 2.05mn tons and 2.3mn tons per annum respectively and contributes 68% of country’s total capacity. Fauji Fertilizer Bin Qasim Limited is the country’s sole producer of DAP having capacity of 0.6mn tons per annum. In addition to this FFBL urea capacity stands at 0.5mn tons per annum. The snapshot of Pakistan’s fertilizer sector is summarized below in the table:

FFC Goth Macchi, Punjab and Ghotki, Sindh 2.05 2.46 120% Mari gas Operational UreaENGRO (Base) Ghotki, Sindh 0.98 0.91 93% Guddu gas (Mari) Operational UreaENGRO (Enven) Ghotki, Sindh 1.30 0.12 9% Mari gas (diversion) Operational UreaFFBL Bin Qasim, Sindh 0.50 0.28 56% SSGC Operational DAPFATIMA Rahimyar khan, Punjab 0.50 0.34 68% Mari gas Operational NP,CANPAK Arab Multan, Punjab 0.09 - 0% SNGP Rotational basis NP,CANAgritech Mianwali and Haripur 0.47 0.09 19% SNGP Rotational basis UreaDawood Hercules Sheikupura, Punjab 0.45 0.07 16% SNGP Rotational basis Urea

6.34 4.28 68%

3.54 74%

Operational Urea capacity in 9MCY13 (mn tons) Total Capacity utilization in CY12


Pakistan's Fertilizer Sector Snapshot

Company Location

Total Urea Capacity (mn tons) Operational Urea capacity in CY12 (mn tons)

Urea capacity (mn tons)

CY12 Urea production (mn tons)

CY12 Utilization Gas supplier Current status Primary

products

Total Capacity utilization in 9MCY13

19


Fertilizer policy, issues & sector performance Fertilizer policy was announced taking effect from 1st July 2001. The policy was initially operational for ten years and aimed for an estimated investment of USD 1.2bn in the sector meanwhile. However, it has completed its tenor and a new policy is awaited. The basic objective of this policy was to attract investment in the sector, support farmers through provision of fertilizer products at an affordable price and to ensure best optimal price and supply of gas to keep the plants’ utilization at max. The policy has brought fruitful results in the form of USD 2.0bn investment through green field projects and BMR activities but the rationalization of gas subsidy as envisioned in the Policy has not yet been materialized.

Investments through fertilizer policy EFERT expansion took place with the addition of 1.3mn tons of urea plant coupled with the 0.5mn tons of new plant set up by Fatima Fertilizer Company (FATIMA). In line with the fertilizer policy the GoP approved subsidized feed stock for both of the companies at USD 0.7/mmbtu for the tenure of 10 years. Conversely, the gov’t failed to honor its sovereign guarantee resulting substantial gas curtailment for EFERT and its new plant only received gas for 45 days in CY12.

However, to this date the problem has been cater as the Economic Coordination Committee (ECC) of the Cabinet has decided to revert the 60mn cubic feet per day (mmcfd) previously diverted gas back from Guddu Power Plant to Engro Fertilizer after which the plant will be able to operate on 80-85% of its installed capacity.

Historical urea and Dap capacities Urea demand/supply trend


3,000 3,500 4,000 4,500 5,000 5,500 6,000 6,500 7,000 7,500

CY0

5

CY0

6

CY0

7

CY0

8

CY0

9

CY1

0

CY1

1

CY1

2

CY1

3

DAPUrea

k tons

-

200

400

600

800

1,000

1,200

1,400

1,600

3,500

4,000

4,500

5,000

5,500

6,000

6,500

7,000

CY0

8

CY0

9

CY1

0

CY1

1

CY1

2

Urea ProductionUrea DemandDeficit (RHS)

k tonsk tons

20


Demand drivers Pakistan is an agricultural country thus need of fertilizers for agri growth and its contribution in the GDP is significant. There are numerous factors following demand of fertilizer products in Pakistan. The major demand drivers include increasing cultivatable area and guaranteed offtake (5 year average of 5.5mn ton) amid gov’t support to farmers through the mechanism of different subsidies. Apart from these, other demand drivers include commodity support prices, water availability, fertilizer prices and growing population.

Cultivatable area Cultivatable area is the major aspect in determining fertilizer demand. The higher area would lead towards growth in the fertilizer offtake and crops production. Despite being the disaster caused by the major floods back in CY10, the total cultivatable area of Pakistan showed a modest growth of 0.5% CAGR of 10 years. Likewise, urea offtake increased by 10-year CAGR of 2% for the same period. As a result, cumulative wheat and cotton production jumped by CAGR of 2.3% and 3.2% respectively in the last 10 years. Fertilizer offtake and total cropped area remained at its peak in CY09 and stood at 6.2mn tons and 23.8mn hector, respectively. Therefore, given lower flood-related devastations in the recent years, the total cultivatable area and fertilizer offtake is expected to grow going forward, in our view.

Urea offtake and Wheat and cotton production Cropped area and urea offtake

Source: Economic survey and AHL Research

Guaranteed offtake Pakistan’s urea demand stood at a 5-year average of 5.5mn tons with the installed capacity of 6.4mn tons (operational capacity of 4.9mn tons excl. Pakarab, DH fertilizer and Agritech). The situation shows guaranteed offtake as the local manufacturers historically managed to sell all of the locally produced urea during a year. Furthermore the wide demand supply gas is catered through import of urea by the gov’t to ensure any short fall of the commodity in the market.

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Urea offtake (k tons)Wheat Production (mn Tonnes)Cotton Production (mn Bales)

4,000

4,500

5,000

5,500

6,000

6,500

21.0 21.5

22.0 22.5

23.0 23.5 24.0

24.5

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Total Cropped AreaUrea offtake (RHS)

Mn Hect.

k tons

Production and local offtake


-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

CY10 CY11 CY12

Total offtake Production Local offtakeK tons

21


Gov’t support to farmers Traditionally, support prices for commodities have played a vital role to boosting up the fertilizer offtake. As an agrarian country, the gov’t always tends to support farmers through every possible mode including higher support prices. Wheat support prices are directly proportional to the fertilizer offtake. We have witnessed an upward trend in wheat support price since FY11. At present, wheat support price stands at PKR 1200/maund, which is expected to revise upward in the current month.

Wheat support prices

Source: Economic survey and AHL Research

900

950

1000

1050

1100

1150

1200

1250

FY09 FY10 FY11 FY12 FY13

PKR/maund

22


Supply constraints - gas issues Pakistan has always been rich in natural gas but increasing demand and limited exploration activities in the past have resulted in a limit on the availability of this resource. Currently, the country is facing seasonal outages typically during the winter. The situation may aggravate in the future as the country’s energy requirements and industrial growth potential will require a much higher availability of fertilizer resource when its import bill is already under oil shocks. In this case, the fertilizer sector, which already consumes 16% of total gas, has limited potential to induce further investors.

CY12 an ailing year for the fertilizer industry Currently the Industry is facing a major issue in the form of gas curtailment which is affecting the overall fertilizer production of the country. The 'Year 2012' resulted as the most challenging year for the industry as due to continuous unannounced gas shortages the industry was only able to produce 4.9mn tons of urea against an installed capacity of 6.4mn tons which was 33% lower than its productive capacity.

Plants on SNGPL network face the most severe As discussed above, one of the biggest reasons of this severe under productivity has been the widespread gas shortage in Pakistan. Due to this, the fertilizer plants operating on the Sui Northern Gas Pipeline Ltd’s network faced the biggest wrath, as they could only achieve a mere 20% of their productive capacity during CY12.

Due to such gas crisis, fertilizer plants such as Pakarab Fertilizers, Dawood Hercules (DH) Fertilizer, Agritech and EFERT have produced far below the envisaged level of production. DH Fertilizer could only manage to produce 17% of its installed capacity i.e. an accumulated 75k tons of urea production. Similarly, Agritech and EFERT’s new plant production also stood at a disappointing 17% and 20% respectively (CY12).

Sector gas supply on declining trend Severe gas curtailment has been observed since CY10TD and the gas consumption of fertilizer sector from SSGC and SNGP network has declined by 5% and 2% respectively. Conversely, the dedicated MARI gas field showed 5 year CAGR increase of 4%. However, cumulative gas consumption by the fertilizer sector dropped 7% YoY in CY12.

Gas supply for fertilizer sector Gas consumption by sectors

Source: EYB and AHL Research

-

50,000

100,000

150,000

200,000

250,000

2006

-07

2007

-08

2008

-09

2009

-10

2010

-11

2011

-12

Total SNGPLSSGCL Mari Gas Field

mmcfd

Gen. Industry, 23.0%

Cement, 0.1%

Fertilizer (feedstock),13.1%

Fertilizer (fuel), 3.3%Commerci

al, 3.1%

Domestic, 20.3%

Transport (CNG), 9.2%

Power, 27.8%

Urea production


3,800

4,000

4,200

4,400

4,600

4,800

5,000

5,200

5,400

CY08 CY09 CY10 CY11 CY12

K tons

23


Gas prices – Upward trajectory continues Feed gas is the basic raw material for making fertilizer especially urea. Initially with the low consumption of gas in the fertilizer sector amid lower capacity installed, gas prices were competent as compared with the other sectors, industries and international gas prices. However, with the incremental capacities coupled with depleting reserve of gas, the feed and fuel stock prices surged with 5-year CAGR of 34% and 13%, respectively. However, fertilizer manufactures easily managed to pass on this gas prices impact as urea prices jumped 5-year CAGR at 25% historically. This showed the ability of the manufactures to easily pass on the impact of gas prices increase to the end consumers. Even though, this massive passed to the consumers, local urea is still available at a discount of 22% to the international urea.

Gas and Fertilizer prices Historical Urea and DAP prices


0

100

200

300

400

500

600

180380580780980

11801380158017801980

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

UreaFeed stockFuel stock

PKR/bag PKR/mmbtu

- 500

1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500

CY

07

CY

08

CY

09

CY

10

CY

11

CY

12

CY1

3TD

Urea DAPPKR/bag

24

Engro Fertilizer Limited Imported urea and its cost to the national exchanger Moreover the country is facing problem of imported urea which consequently affects the import bill and costs heavily to the government. It is estimated that Government of Pakistan (GoP) has borne a subsidy of PKR 50bn on imported urea and PKR 47bn on natural gas for feedstock purpose (un-budgeted) by the fertilizer industry during FY13. Moreover, the problem of imported urea is posing a major challenge to the domestic market because imported urea is sold on a subsidy lower than local urea so local producers are forced to cut down their prices which is costly.

To make the problem even worse, there is a presence of plants that make inefficient usage of gas leading to shortages and, hence, an increase in fertilizer prices in peak seasons results in reduced product offtake.

Local and international Urea comparison Local and international DAP comparison

Source: Bloomberg, NFDC and AHL Research

0%

10%

20%

30%

40%

50%

60%

70%

400

900

1,400

1,900

2,400

2,900

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

PKR/bag Local ureaImported ureaDiscount (RHS)

-60%

-40%

-20%

0%

20%

40%

60%

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

PKR/bag Local DAPImported DAPPremium (RHS)

25


Gas Infrastructure Development Cess (GIDC) In CY12, the Federal gov’t applied Gas Infrastructure Development Cess (GIDC) to all the gas consumers including fertilizer companies, which led gas prices to surge by a massive PKR 197/mmtbu, translating into a hefty jump of 207% YoY. Following the imposition of the GIDC, the average urea price per bag went straight up 20% YoY in CY12. FATIMA and EFERT were the key beneficiaries of the abovementioned Cess due to their long-term agreements in place with the GoP at subsidized feed-stock price for ten years. However, only FATIMA enjoyed the aforesaid benefit as EFERT (EnVen plant) was facing fatal gas curtailment due to shortage of gas on the SNGPL network.

Revision in the GIDC As per the Budgetary Document for FY13, and the Finance Bill 2012, the gov’t had already approved the maximum price of GIDC, i.e PKR 300/mmbtu. However, GIDC for CY13TD remained intact at PKR 197/mmbtu, which is expected to be the same for the rest of CY13 as well. Our discussion with the industry reveals that urea manufacturers are not in a position to bear such a massive hike in gas prices (+52% from current levels) and, thus, passing on this impact in the urea prices, once increased, would be the eventual reality.

GIDC termed illegal On the other hand, the Lahore High court has issued the stay order on GIDC, terming it illegal. Though the sectors are still paying GIDC but the gov’t is not allowed to utilize these funds amid court stay order on the same.

IMF Extended Funds Facility: gas levy on the cards? To recall, in its Letter of Intent with the IMF, the gov’t is principally agreed to raise 0.4% of GDP, ~PKR 105bn, as gas levy. The gov’t could easily raise this amount by replacing GIDC to the proposed gas levy. The table below summarizes the collection of GIDC during FY12, which shows that gov’t could easily manage and raise PKR 111bn from this surcharge.

Domestic 261,915 256,676,700 - -

Commercial 39,627 38,834,460 - -

Gen. Industries 286,055 280,333,900 50 14,016,695,000

Pakistan Steel Mills 10,125 9,922,500 - -

Cement 1,266 1,240,680 50 62,034,000

Fertilizer (as Feedstock) 168,694 165,320,120 197 32,568,063,640

Fertilizer (as Fuel use) 43,134 42,271,320 50 2,113,566,000

Pow er 358,381 351,213,380 100 35,121,338,000

Transport (CNG) 119,000 116,620,000 232 27,030,183,600

Total 1,288,197 1,262,433,060 110,911,880,240

Source: EYB, AHL Research

Natural Gas Consumption By Sector

2011-12

m mcft mm btu GIDC

(PKR/mm btu) Collection from

GIDC (PKR) Sector

Gas prices trend for fertilizer sector

Source: EYB and AHL Research

0

100

200

300

400

500

600

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Feed stock Fuel stock

GIDC

PKR/mmbtu

26


What is the Long-term gas plan? The gov’t has approved long term gas plan for fertilizer consortium, from which all the companies on the SNGPL network would receive gas from dedicated gas fields. The companies includes, Engro Fertilizer Limited (79mmcfd), Dawood Herculus Fertilizer (40 mmcfd), PakArab Fertilizer Limited (58mmcfd) and Agritech Limited (25 mmcfd).

What’s in store for EFERT? EFERT would receive 79 mmcfd of gas from long term gas plan. The breakup of the aforesaid plan is given below in the tables. Furthermore, The ECC has already approved the diversion of allocated gas from EFERT's old plant to its new plant till the implementation of long term gas plan. However, the long-term plan is scheduled to take around 11 months for completion (operational from 4QCY14).

GSAs with the field operators As per the KSE notice, the Gas Sale Agreement (GSA) between EFERT and the two fields i.e. Kunnar Pasaki Deep and Reti Maru has been signed while the term sheet has been signed between EFERT and Mari SML. Furthermore, the company is drawing ~22mmcfd from Mari SML while Reti Maru is expected to come online by the end of CY13. As far as gas price is concerned, the weighted average gas price would be ~USD 4.0/mmbtu – ~USD 4.5/mmbtu.

Long term plan Fields mmcfd Availability Timeframe Kunnar Pasaki Deep 130 Oct-14 Mari SML 22 EFERT drawing Bahu 15 NA Reti Maru 10 Dec-13 Markori East 25 Jan-14 Total 202 Source: A HL Research

Short term plan

Fields mmcfd Availability Timeframe

Mari SML 22 EFERT drawing

Reti Maru 10 Dec-13 Sara West - NA

Total 32


Companies mmcfdEngro Fertilizer 79 DH Fertilizer 40 Pak Arab Fertilizer 58 Agritech Limited 25 Total 202 Source: AHL Research

Long term gas plan break up

27

Engro Fertilizer Limited Pricing scenario; price cut seems a far cry! On the product pricing side, we rule out any price cuts in CY13 and CY14 (post long term gas plan) mainly due to unavailability of gas on an immediate basis coupled with higher gas pricing scenario in long term gas plan. Instead, bright possibility exists for urea price augmentation (to pass on price to consumer), when OGRA is expected to increase gas sale prices expected soon.

Other side of the story post long-term gas plan With the successful implementation of the long-term gas arrangement plan assuming gas price, for plants operating on the SNGPL network, at USD 5.0/mmbtu or ~PKR 535/mmbtu (excluding EFERT, FFC ad FFBL), we expect urea price to rather be raised from 4QCY14 onwards.

In this regard, as per our calculations, the price for the 17% of the total urea production (or 0.9mn tons) should be increased by PKR 221/bag (see table below). Particularly, the cost for EFERT’s EnVen could jump by PKR 392/bag or 509% post gas-price increase (from USc70/mmbtu to USD4.26/mmbtu). However, weighted average gas cost for EFERT should lead to a hike of PKR 224/bag post long-term plan.

Hence, after the proposed scenario, cost of 34% of total urea production (~2.1mn tons) is expected to increase by an average PKR 224/bag. Conclusively, going forward, we do not expect any price reduction from fertilizer companies, hence as analysis shows on average urea prices are expected to increase by PKR 224/bag once the long-term plan is in place primarily on account of increase in gas costs. The table further elaborates:

FFC and FATIMA stand as key beneficiaries of price hike FFC and FATIMA would remain major beneficiaries with respect to any increase in urea prices ahead, post long-term gas plan. FFC being the major player in the industry is expected to enjoy windfall gains in this regard while FATIMA would benefit the most courtesy its subsidized gas agreement with MARI Gas at USc 70/mmbtu.

Gas Price (PKR/mmbtu) ProductionNew Old New Old mn tons New Old

FFC 320 320 24.00 7,680 7,680 2.04 120% 2.45 18,819 18,819 ENGRO (Old) 320 320 23.50 7,520 7,520 0.98 90% 0.88 6,599 6,599 ENGRO (Enven) 426 70 22.00 9,372 1,540 1.30 90% 1.17 10,965 1,802 FFBL 320 320 24.50 7,840 7,840 0.50 50% 0.25 1,960 1,960 FATIMA 70 70 21.00 1,470 1,470 0.50 90% 0.45 662 662 PAK Arab 500 320 24.50 12,250 7,840 0.09 90% 0.08 1,014 649 Agritech 500 320 24.50 12,250 7,840 0.47 90% 0.42 5,149 3,295 Dawood Herculis 500 320 24.50 12,250 7,840 0.45 90% 0.40 4,906 3,140

6.10 50,074 36,925

Gas Cost (PKR mn)Company Per ton Feed Gas Cost UtilisationCapacityConversion

Urea pricing in CY13TD

Source: NFDC and Bloomberg

1,600

1,800

2,000

2,200

2,400

2,600

2,800

Jan-

12M

ar-1

2M

ay-1

2Ju

l-12

Sep-

12N

ov-1

2Ja

n-13

Mar

-13

May

-13

Jul-1

3Se

p-13

Nov

-13

Imported LocalPKR/bag

PKR/ton PKR/bagIncrease in Feed gas cost for plants on SNGP excluding ENGRO 4,410 221 Increase in Feed gas cost for ENGRO's ENVEN 7,832 392 Weighted Avg. increase in Feed Stock Cost for Efert 4,475 224 Source: AHL Research

28


Outlook Macro outlook For the economy of Pakistan to prosper, it is important for agricultural yields to go up which is only possible through the application of fertilizers in the right quantity at the right time. However given the current situation of the Pakistan economy, the importance of fertilizers cannot be overlooked considering it has a direct impact on the growth, output and economic activity of the agriculture sector. Hence, the gov’t is making continuous efforts to tackle gas shortage issues through new exploration projects. However, at this point in time gas shortage and import threat continue to pose a major challenge to the entire sector.

Sector prospects As far as sector outlook is concerned, we expect the sector’s urea offtake to grow by 5% YoY in CY13. Our assumption with respect to growth in urea offtake mainly stems from: 1) increase in Wheat Support Price to PKR 1200/maund, 2) low interest rates to provide farmers with cheap agri-loans, and 3) better demand due to increased cultivatable areas with improving yields amid favorable weather conditions last year (absence of massive floods).

Urea production and offtake DAP production and offtake


Impact of the long-term gas plan As far as the long-term gas plan goes (gas pipeline to SNGPL network), we expect its materialization from 4QCY14 onwards and the impact on the companies’ earnings from there onwards. Product prices may then be interesting to track as we expect a notch-up given higher gas prices along with pipeline expenditures incurred by the beneficiaries.

2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0

2007

A

2008

A

2009

A

2010

A

2011

A

2012

A

2013

E

mn tons Production Offtake

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2007

A

2008

A

2009

A

2010

A

2011

A

2012

A

2013

E

mn tons Production Local Offtake

29


Key risks Gas unavailability The key risk remains the unavailability of gas to the fertilizer plants, especially on the SNGPL network. In this regard, the materialization of the long-term plan and its timings are very crucial for the plants operating on the SNGPL network.

Price reduction Alongside, pricing risk prevails, as the gov’t may pressurize the manufacturers to cut urea prices due to the plants utilizing its optimal capacities once the gov’t fulfils its commitment for the dedicated gas supply to all the companies operating on the SNGPL network. However, we believe the probability of this risk is low, as the gov’t is assuring gas supply to all the plants on SNGPL but at a significantly higher gas rate (56% higher than current levels) than the industry.

Imported urea Additionally, the imported urea could be a threat to local manufacturers due to its subsidized price. The difference between the subsidized and the local prices is negatively related to the local sales. The GoP has already approved import of 0.5mn tons of urea for the upcoming Rabi season. This remains a threat in the short term.

Political risk / GoP priority Political instability coupled with gov’t stance and how it prioritizes gas allocation to the fertilizer sector would clarify the future of the fertilizer sector. However, with the long-term gas plan already approved, chances of gas curtailment would minimize as the plants operating on the SNGPL network would receive gas from the dedicated fields.

30


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31


Annexure Essentially, Fertilizer products are variations of three primary soil nutrients, namely nitrogen (N), phosphorous (P) and potassium (K). It is the suitability of a nutrient for crop that determines the usage of a particular fertilizer product. Pakistan’s soil is deficient in nitrogen and phosphate; thereby an optimal combination of these nutrients is necessary to achieve higher yield levels. There are three types of fertilizer available in the market namely, nitrogenous fertilizers, phosphorous fertilizers and potash fertilizers.

Nitrogenous Fertilizer Nitrogenous fertilizers include Urea. It comprises of 65% of total nitrogenous, calcium Ammonium Nitrate (CAN), Ammonium Sulphate (AS). 99.3% of the current production capacity is used to produce these fertilizers. In CY12, the aggregate performance of urea plants was 68% of their installed capacity. Primarily, Pakistani soil is pervasively nitrogen deficient which also induces more production of Urea but currently, urea production has decreased by 12% compared to CY11.

Process of Manufacturing Urea Basic raw material for urea production is natural gas in ample and uninterrupted supply. As a nitrogen-rich fertilizer, Urea (NH2CONH2) is of great importance to the agriculture industry. It is produced from ammonia and carbon dioxide in two equilibrium reactions:

2NH3 + CO2 NH2COONH4 (Ammonium carbonate)

NH2COONH4 NH2CONH2 (Urea) + H2O

Ammonia is extracted from methane supplied in natural gas, this process makes production efficient. Urea manufacturing process is as follows:

Step 1: Synthesis: A mixture of compressed CO2 and ammonia at 240 barg is reacted to form ammonium carbamate. This is an exothermic reaction, and heat is recovered by a boiler which produces steam. The first reactor achieves 78% conversion of the carbon dioxide to urea and the liquid is then purified where as the second reactor receives gas from the first reactor and recycle solution.

Step 2: Purification: The major impurities in the mixture at this stage are water from the urea production reaction and unconsumed reactants (ammonia, carbon dioxide and ammonium carbamate). The unconsumed reactants are then removed.

Step 3: Concentration: 75% of the urea solution is heated under vacuum, which evaporates off some of the water, increasing the urea concentration from 68% w/w to 80% w/w. At this stage some urea crystals also form. The solution is then heated from 80 to 110oC to re-dissolve these crystals prior to evaporation.

Step 4: Granulation: Urea is sold for fertilizer as 2 - 4 mm diameter granules. These granules are formed by spraying molten urea onto seed granules which are supported on a bed of air. This occurs in a granulator which receives the seed granules at one end and discharges enlarged granules at the other all dust and air from the granulator is removed by a fan into a dust scrubber, which removes urea with water solution then discharges air to the atmosphere. The final product is cooled in air, weighed and conveyed to bulk storage ready for sale.

32


Phosphorous Fertilizer Phosphorous fertilizers, on the other hand, comprise of 27% of total consumption. The categories of Phosphorous fertilizers are: Di-ammonium Phosphate – DAP, Super Single Phosphate (SSP), Triple Ammonium Phosphate (TSP), and Nitrate Phosphate (NP). Basic raw material for the production of Phosphorous fertilizers is phosphoric rock. The reaction of this rock and sulphuric acid makes phosphoric acid; which is used to make the fertilizer. Currently, very less phosphoric rock is available in Pakistan and the quality of local rock is not good, nor do we have the production facility. Also, the production process is very costly and needs heavy investment. As a result, the entire phosphoric acid is being imported. 99% is imported from Morocco while small quantities are also imported from Middle Eastern countries and Saudi Arab.

Potash Fertilizer Potash fertilizers, third type of fertilizers are domestically produced and consumed in very less quantities. Sulphate of Potash is one of potash products. Potash is usually applied to fruit, vegetable, and sugarcane crops only, it is imported and only less than two percent of the farmers apply potash whereas 92 percent apply nitrogen and 83 percent apply phosphate.

Potash is a micronutrient fertilizer. Micronutrient deficiencies are common but less than five percent of the farmers apply micronutrient fertilizers. Worldwide, nitrogen is most widely used, followed by phosphate and potash. However, the availability and price of a product at a given point in time impacts the demand pattern.

However, lack of awareness among farmers also plays a role in determining the use of fertilizers. Not realizing the benefits of an optimal NP ratio, farmers tend to favor products available in the market at cheaper rates, this year NP ratio deteriorated to 5.06 due to increase in DAP prices over and above PKR 3900 per bag exceeding NP’s desirable limit of 2:1 and lowering the crop yield. On the other hand, considerable growth potential remains for the product which could be tapped by continuous education of the farmer community.

Crop Seasons Pakistan has two cropping seasons; Kharif being the first sowing season from April-June and it is harvested during October-December. Main Kharif crops include rice, sugarcane, cotton, and maize. Rabi, the second sowing season begins October-December and is harvested in April-May. Major Rabi crops include wheat, gram, lentil, tobacco, rapeseed, barley and mustard. With two crop seasons, the fertilizer offtake with respect to products also registers significant difference due to variations in fertilizer needs by each crop which consequently affects the demand situation. When talking about demand scenario, as stated earlier Pakistan is an agri-based economy and for a healthy crop yield farmers need optimal amounts of fertilizer to enhance crops’ growth. Consequently, the overall domestic demand generated is higher than local fertilizer production which stimulates extensive need for importing fertilizer products like urea, and DAP etc.

33


Crops Jan Feb Mar April May June July Aug Sep Oct Nov Dec

Rice

Sugarcane

Cotton

Maize

Jowar

Bajra

Wheat

Barley

Gram

Sowing period Growing period Harvesting period


Kharif Crops

Rabi Crops

Crops Calender of Pakistan

34


Abbreviations

~ - Approximately AGRI - Agritech Limited bn - Billion bps – Base points

CY- Calendar Year DAP - Di Ammonium Phosphate DAWH - Dawood Hercules Corporation Div. Yield – Dividend Yield DPS – Dividend per Share ECC – Economic Coordination Committee Efert – Engro Fertilizers EPS – Earning per Share

FATIMA – Fatima Fertilizer Company Limited FFBL – Fauji Fertilizer Bin Qasim Limited FFC – Fauji Fertilizer Company GIDC - Gas Infrastructure Development Surcharge GoP – Government of Pakistan GSA – Gas Sale Agreement Int’l – International KSE-100 – Karachi Stock Exchange 100 Index

MARI SML – MARI Sui Main mmbtu - Million Metric British Thermal Units mn - Million NFDC – National Fertilizer Development Centre NFML – National Fertilizer Marketing Limited OGRA – Oil Gas Regulatory Authority P/B – Price to Book P/E – Price Earning

PAK ARAB – Pakarab Fertilizers Limited PKR – Pakistani Rupee QCY – Quarter Calendar Year QoQ – Quarter on Quarter SNGPL - Sui Northern Gas Pipe Lines

USc – United States Dollar (cent) USD – United States Dollar YoY – Year on Year

35


Disclaimer and related information Analyst certification

The analyst for this report certifies that all of the views expressed in this report accurately reflect his personal views about the subject companies and their securities, and no part of the analysts’ compensation was, is or will be, directly or indirectly related to specific recommendations or views expressed in this report.

Disclosures and disclaimer

This document has been prepared by investment analyst at Arif Habib Limited (AHL). AHL investment analysts occasionally provide research input to the company’s Corporate Finance and Advisory Department.

This document does not constitute an offer or solicitation for the purchase or sale of any security. This publication is intended only for distribution to current and potential clients of the Company who are assumed to be reasonably sophisticated investors that understand the risks involved in investing in equity securities.

The information contained herein is based upon publicly available data and sources believed to be reliable. While every care was taken to ensure accuracy and objectivity, AHL does not represent that it is accurate or complete and it should not be relied on as such. In particular, the report takes no account of the investment objectives, financial situation and particular needs of investors. The information given in this document is as of the date of this report and there can be no assurance that future results or events will be consistent with this information. This information is subject to change without any prior notice. AHL reserves the right to make modifications and alterations to this statement as may be required from time to time. However, AHL is under no obligation to update or keep the information current. AHL is committed to providing independent and transparent recommendation to its client and would be happy to provide any information in response to specific client queries.

Past performance is not necessarily a guide to future performance. This document is provided for assistance only and is not intended to be and must not alone be taken as the basis for any investment decision. The user assumes the entire risk of any use made of this information. Each recipient of this document should make such investigation as it deems necessary to arrive at an independent evaluation of an investment in the securities of companies referred to in this document (including the merits and risks involved), and should consult his or her own advisors to determine the merits and risks of such investment. AHL or any of its affiliates shall not be in any way responsible for any loss or damage that may be arise to any person from any inadvertent error in the information contained in this report.

We and our affiliates, officers, directors, and employees may: (a) from time to time, have long or short positions in, and buy or sell the securities thereof, company (is) mentioned herein or (b) be engaged in any other transaction involving such securities and earn brokerage or other compensation or act as advisor to such company (is) or have other potential conflict or interest with respect to any recommendation and related information and opinions. The disclosures of interest statements incorporated in this document are provided solely to enhance the transparency and should not be treated as endorsement of the views expressed in the report. AHL generally prohibits it analysis, persons reporting to analysts and their family members from maintaining a financial interest in the securities that the analyst covers.

© 2013 Arif Habib Limited, Corporate Member of the Karachi, Lahore and Islamabad Stock Exchanges and Pakistan Merchentile Exchange. No part of this publication may be copied, reproduced, stored or disseminated in any form or by any means without the prior written consent of Arif Habib Limited.

36


Contact details

Management Designation Email Telephone Shahid Ali Habib Chief Executive Officer [email protected] +92 -21-3240-1930

Equities Research Designation Email Telephone Khurram Schehzad Head of Research [email protected] +92-21-3246-0742 Syed Abid Ali Assistant Vice President [email protected] +92-21-3246-2589 Saad Khan Assistant Vice President [email protected] +92-21-3246-2589 Tahir Abbas Investment Analyst [email protected] +92-2132460717-19 Ext : 248 Numair Ahmed Investment Analyst [email protected] +92-2132460717-19 Ext : 248 Rao Amir Ali Database Manager [email protected] +92-2132460717-19 Ext : 211 Ovais Shakir Database Officer [email protected] +92-2132460717-19 Ext : 211 Domestic sales Designation Email Telephone M. Yousuf Ahmed Senior Vice President [email protected] +92-21-3242-7050 Farhan Mansoori Vice President [email protected] +92-21-3242-9644 Syed Farhan Karim Vice President [email protected] +92-21-3244-6255 Afshan Aamir Vice President [email protected] +92-21-3244-6256 Faraz Naqvi Assistant Vice President [email protected] +92-21-3244-6254 Furqan Aslam Assistant Vice President [email protected] +92-21-3240-1932 Azhar Javaid Manager Corporate Sales [email protected] +92-21-3246-8312

Business Development Designation Email Telephone

Faisal Khan Head of Business Development [email protected] +92-21-3246-6076

Money Market & FX Designation Email Telephone

Zilley Askari Head of Inter Bank Brokerage [email protected] +92-21-3240-0223

Marketing Designation Email Telephone Atif Raza Head of Marketing [email protected] +92-21-3246-8282 Corporate finance and advisory Designation Email Telephone

M. Rafique Bhundi Head of Corporate Finance [email protected] +92-21-3246-0741 Mahmood Kamal Vice President [email protected] +92-21-3246-0741

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