ECONOMY OF PAKISTAN: AN OVERVIEW

Pakistan was one of the few developing countries that had achieved an average growth rate of over 5 percent over a four decade period ending 1988-89. Consequently, the incidence of poverty had declined from 40 percent to 18 percent by the end of the 1980s.The overall picture that emerges from a dispassionate examination of these indicators is that of a country having made significant economic achievements but a disappointing record of social development. The salient features of Pakistan’s economic history are:

Pakistan is self sufficient in most food production. Per capita incomes have expanded more than six-fold in US Dollar terms. Pakistan has emerged as one of the leading and successful producers of Cotton

and cotton textiles.Pakistan has developed a highly diversified base of manufactured products for domestic and world markets. Physical infrastructure network has expanded with a vast network of gas, power, roads and highways, ports and telecommunication facilities. These achievements in income, consumption, agriculture and industrial production are extremely impressive and have lifted millions of people out of poverty levels. But these do pale into insignificance when looked against the missed opportunities. The largest setback to the country has been the neglect of human development. Had adult literacy rate been close to 100 instead of close to 50 today, it is my estimate that the per capita income would have reached at least US$1200 instead of US$640. Pakistan’s manufactured exports in the 1960s were higher than those of Malaysia, Thailand, Philippines and Indonesia. Had investment in educating the population and upgrading the training, skills and health of the labor force been up to the level of East Asian Countries and a policy of openness to world market would have been maintained without any break, Pakistan’s exports would have been at least US$100 billion instead of paltry US$13-14 billion. Had the population growth rate been reduced from 3 percent to 2 percent, the problems of congestion and shortages in the level of infrastructure and social serviceswould have been avoided, the poor would have obtained better access to education and health and the incidence of poverty would have been much lower than what it is today.But as if this neglect of human development was not enough, the country slacked in the 1990s and began to slip in growth, exports, revenues, and development spending and got entrapped into external and domestic indebtedness. This was due to both fundamental structural and institutional problems as well as to poor governance and frequent changes in political regimes. With short life spans, succeeding governments were hesitant, if notoutright unwilling to take tough and unpopular economic decisions to set the economy right. Moreover, the average lifespan of two to three years was clearly inadequate for implementing meaningful policy or institutional changes. The external environment had also become unfavorable after the event of May 1998, when Pakistan conducted its first nuclear test. The aftermath of this test led to further economic isolation of Pakistan and a considerable erosion of confidence by domestic and non-resident Pakistanis. Economic sanctions were imposed against Pakistan by the western governments. By the late 1990s Pakistan had entered almost a critical state of paralysis and stagnation in its economyparticularly in its external sector. There was a significant drop in workers’ remittances, export growth was negative, IMF programme and World Bank assistance were

suspended, bilateral donors had terminated their aid while debt payments due were in far excess of the liquid foreign exchange resources the country possessed. Pakistan was almost at the brink of default on its external payments. Economic growth was anemic, debt ratios were alarmingly high, and the incidence of poverty had once again risen to 32 percent. It was at this stage that the military government under General Pervez Musharraf assumed power in October 1999. The initial period was devoted by the economic team of the new government in managing the crisis and making sure that the country avoided default. A comprehensive programme of reform was designed and implemented with vigour and pursued in earnest, so as to put the economy on the path of recovery and revival. The military government did not face the same constraints and compulsions as the politically elected governments. It was therefore better suited to take unpopular decisions such as imposing general sales tax, raising prices of petroleum, utilities and removing subsidies so badly needed to bring about fiscal discipline and reduce the debt burden. The IMF and the World Bank were invited to enter into negotiations on new stand-by and structural adjustment programmes.Although the canvas of reform in Pakistan was vast and corrective action required on a number of fronts, there was a conscious effort to focus on achieving macroeconomic stability, on certain key priority structural reforms and improving economic governance. The structural reforms included privatization, financial sector restructuring, trade liberalization, picking up pace towards deregulation of the economy and generally moving towards a market-led economic regime. A stand-by IMF programme was put in place in November 2000, which was successfully implemented followed by a three-year Poverty Reduction and Growth Facility (PRGF), which was successfully completed inDecember 2004. It is a matter of pride that Pakistan decided not to draw down the last two tranches although it was eligible to do so. The IMF has also decided that Pakistan will not be subject to the usual post-program monitoring due to its good economic standing. Pakistan’s economic turnaround during the last five years is even more impressive because the country was faced with a critical and fragile regional and domestic environment with constant threats to security (a result of playing key role as a frontline state in the war against terrorism) a prolonged and severe drought, tensions with India and high oil prices.

Gas Marketing Sector of Pakistan

Natural gas in Pakistan has been strictly an internal fuel historically, grown out of oil exploration and development efforts. It is one of the cheapest and most efficient energy sources for Pakistan, surpassing oil as country’s leading energy fuel in 2002. In FY09, it contributed 48.3% to serve the energy needs of Pakistan’s 160.97mn population. Pakistan’s first gas distribution pipeline was laid in 1955 in the city of Karachi. Natural gas became available through gas distribution system to industrial, commercial and domestic consumers of Karachi in October 1955.

Sui Northern Gas Pipelines Limited (SNGPL) and Sui Southern Gas Company Limited (SSGC) are the two major companies of the country which are involved in transmission and distribution of natural gas throughout the country. SNGPL supplies gas to consumers in the northern part of the country. Its franchised areas include two of the four provinces of Pakistan - Punjab and Frontier. SSGC is responsible for the southern part of the country and supplies gas to customers in the remaining two provinces of Sindh and Balochistan.

Gas distribution system can be classified into three categories: a) Supply Mains Pipelines, b) Distribution Mains Pipelines, and c) Service Pipelines. Gas supply mains pipelines represent relatively high or medium gas pressure and large-diameter gas pipes are just like major roads in a city. Gas distribution mains consist of low-pressure interconnected pipeline networks which carry natural gas from supply mains to points adjacent to consumer premises. Natural gas runs from the distribution main to the consumers’ gas meter through a service pipeline. The gas distribution system is comprised of varying pipe seizes ranging from ¾-inch to 42 inches in diameter with steel and polythene material.

Return formula for Sui Twins: Internationally, regulated return of utility companies is designed so as to keep the companies motivated toward serving more consumers. Following suit, return of gas distribution companies was decided as part of a covenant of ADB loan. With the repayment of ADB loan under whose covenants the gas companies were guaranteed a fixed return, rumors of return formula modification became stronger day by day with some expecting a change to an equity based return formula while others counting on interest rate based return formula for the sui twins. However, no such development has ever materialized and both companies still calculate their return based on the same formula.

Regulated return calculation under current formula: As per the Provisions of OGRA, Sui twins earn a fixed (17% for SSGC, 17.5% for SNGP) annual return before tax on the net average operating fixed assets (net of deferred credit) for the year, excluding financial and other non operating charges and non operating income. The determination of annual required return in reviewed by OGRA under the terms of the license for transmission, distribution and sale of natural gas, targets and parameters set by OGRA. This means that the only factors that determine the bottom line for these two gas distribution companies are the net average operating fixed assets, average deferred credit, non operating charges and non operating income. Any disallowances (like UFG losses) determined by OGRA are then deducted from the return formula to arrive at earnings before interest and tax for these companies.

Unaccounted for Gas (UFG): The net volume difference of gas purchase and sale after adjusting internal consumption in the company’s operations is termed as Unaccounted for Gas (UFG). The term UFG is used for units, which are not billed (due to theft) or lost during the transmission of gas to the consumers.

Gas marketing companies are facing considerable difficulty in maintaining past momentum of UFG losses reduction due to inefficient T&D systems and seasonal increase gas theft in areas which are difficult to monitor as well as increasing gas theft and pilferage culture owing to higher gas prices,. Moreover, constant shift from bulk sales (where UFGs are minimal) towards retail sales has also led to increase in UFGs. In addition to that, considering that gas marketing companies are expanding into more theft prone areas (northern areas, Balochistan and Interior Sindh), controlling UFGs seems to be an uphill task for Sui twins. Balochistan’s share in total gas sales in 5% while it contributes 25% to the total UFG losses.

According to a OGRA’s decision on 24th September 2010 with regard to petition filed by SSGC, SSGC’s UFG benchmark has been increased from 5.5% to 7% for FY10.

Iran-Pakistan gas pipeline: A bridge too far

Ever since an agreement on IP pipeline was signed, vibes have been in circulation about IP pipeline and its positive impact on Sui twins. Given that modalities of the aforesaid project have not been finalized yet, it is too early to incorporate any impact on gas distribution companies. However since gas distribution companies will be distributing the gas received via IP-pipeline, controlling UFGs might get more important considering that cost of gas or IP Gas Pipe-line will be considerably higher. The project cost is estimated at $1.25bn (within Pakistan boundaries) with debt equity composition of 70:30. The target date for completion is 2013 and the pipeline is expected to deliver 750mmcfd gas. The pricing of IP Gas Pipe-line has been settled at 80% of Japanese Crude Cocktail (JCC). This pricing arrangement seems very expensive. For crude price of $70/barrel, local gas fields under Petroleum Policy 2001 in Zone – 1 (Zone-1 is the most attractive zone in terms of pricing) are priced at $3/mmbtu, whereas the recently announced Petroleum Policy 2009 offers $4.62/mmbtu. This is in sharp contrast to $9.82/mmbtu price applicable for IP gas pipeline at crude price of $70/barrel. Moreover, there is no cap on crude prices so the cost of gas from IP pipe line can potentially be several times the cost of gas under Petroleum Policy 2009. One possible solution can be to supply the gas received to bulk consumers where the UFGs are nil.

Company Overview :

SSGC is primarily involved in operations and maintenance of gas transmission pipelines (iii) gas compression facilities and gas distribution pipelines. It purchases natural gas from 5 different sources and sells this gas to its customers in Sindh and Balochistan. SSGC manufactures gas meters for domestic and commercial consumers under a licensing arrangement with Schlumberger of France since 1976. SSGC was established in 1989 as a result of the merger of two gas companies - Sui Gas Transmission Company Limited (SGTC) and Southern Gas Company Limited (SGC). SGTC was formed in 1954 with primary responsibility of purification of gas at Sui Field and to transmit the sweet gas to the consumer centre in the southern part of the country. Two distribution companies established in 1955 were responsible for the distribution of gas to consumers in Karachi and in towns en-route to the transmission pipeline between Sui and Karachi. These two distribution companies were first merged in 1985 to form SGC and later in 1989, SGC and SGTC were merged together to form SSGC.

Shareholding Pattern: Being the holder of more than 60 per cent shares, government nominates/appoints most of the directors. About 10per cent shares are held by individuals and foreign shareholders and remaining 24 per cent by companies and institutions.

Transmission and distribution network: SSGCL transmission system extends from Sui in Balochistan to Karachi in Sindh comprising over 3,200 KM of high pressure pipeline ranging from 12 - 24" in diameter. The distribution activities covering over 1200 towns in the Sindh and Balochistan are organized through its regional offices. An average of about 357,129 million cubic feet (MMCFD) gas was sold in 2006-2007 to over 1.9 million industrial, commercial and domestic consumers in these regions through a distribution network of over 29,832 Km. The company also owns and operates the only gas meter manufacturing plant in the country, having an annual production capacity of over 550,150 meters.

Return Formula for SSGC: Under the provisions of World Bank loan 3252-PAK, the company is required to earn an annual return of not less than 17% per annum on the value of its average fixed assets in operation (net of deferred credit), before corporate income taxes, interest and other charges on debt and after excluding interest, dividends and other non operating income. In order to bring down unaccounted for gas (UFG) losses to international standards, OGRA (Oil and gas regulatory authority) introduced UFG benchmarks in 2004. UFG losses above those benchmarks are deducted from the formula return.

SSGC is engaged in the business of transmission and distribution of natural gas in Sindh and Balochistan. It is also involved in construction contracts for laying of pipelines, sale of gas condensate and also owns and operates the only gas meter manufacturing plant in the country, having an annual production capacity of over 550,150 meters.

SSGCL transmission system comprises over 3,200km of high pressure pipeline ranging from 12 – 24 inches in diameter. The distribution activities cover over 1200 towns in Sindh and Balochistan through a distribution network of over 29,832km.

Fundamentals Analysis

Event

Sui Southern (SSGC) has underperformed broad market for couple of years due to increase in UFG losses and financial charges of the company. However, subsequent to OGRA’s decision to increase the UFG targets and allow higher non operating income, SSGC PA is set to outperform broad market driven by significant positive impact on earnings

We revise our target price for SSGC PA from PKR12.2/share to PKR42.2/share after incorporating the regulatory changes in our model. Along with a dividend yield of 18%, the stock offers 53% upside to our June 11 target price of PKR42.2/share. We upgrade SSGC from Underperform to Outperform.

Impact

UFG benchmark raised to 7%: SSGC had requested OGRA to increase the UFG benchmark from existing 5.5% in FY10 to 7.5% for three years with the condition that disallowance should not be more than 20% of profit before tax. OGRA, in its 24th September decision, has decided to increase the UFG target from 5.5% to 7% for FY10. UFG targets for next year will be determined on year on year basis by taking into account the circumstances prevailing at the relevant time.

JJVL royalty to be treated at non operating income: SSGC had requested OGRA to include JJVL royalty in its non operating income since it is not a regulated activity and does not require a license from OGRA. OGRA has allowed SSGC to classify royalty income from JJVL as non-operating income in its 24 th

September decision. Royalty income from JJVL is expected to be around PKR2.57bn, resulting into positive after tax impact of PKR2.49/share on SSGC’s FY10 earnings. Considering that gas volumes are gradually declining from Badin field, we expect royalty income from JJVL to decline going forward.

Gas condensate, meter manufacturing profit and late payment surcharge to be treated as non operating income: OGRA, in its 24th sep decision, has allowed SSGC to treat its late payment surcharge as non operating income. Late payment surcharge is expected to be around PKR1.0bn during FY10 which translates into an after tax impact of PKR1.00/share. OGRA has also allowed SSGC to include income from gas condensate as non operating income. Income from gas condensate is expected to be around PKR370mn during FY10 (after tax per share impact of PKR0.36). Moreover, OGRA has finally accepted to include the profit from meter manufacturing plant in non operating income for SSGC. Income from Meter manufacturing plant is expected to be around PKR75mn (after tax impact of 0.07/share) during FY10.

Earnings Revision

Earnings revised upwards to reflect change in fundamentals of company

Target Price and Price catalyst

June-11 price target: Rs42.2/share on Justified P/B and relative P/E methodology.

Catalyst: Relaxation in UFG benchmark and higher non operating income allowed by regulator.

Action and recommendation

TP revised from PKR12.2 to PKR42.2: Due to significant change in fundamentals, we have raised our target price for SSGC to PKR42.2/share. Buy!

Important factors to determine the bottom line

Operating fixed assets: In order to support its operations, SSGC has appropriate infrastructural facilities spread over the two provinces of the country. SSGC's major infrastructure components comprising of gas transmission/distribution pipelines and compressor stations. SSGC is expected to build its operating fixed assets to PKR38bn by end of FY10.

Deferred credit: Deferred credit is deducted from operating fixed assets to arrive at net operating assets to calculate return of 17% for SSGC. Deferred credit has increased by average 25% per annum since FY06 for SSGC. Owing to higher leverage and insufficient funds, SSGC’s reliance on deferred credit has increased from 10% of fixed assets in FY06 to 13% in FY10.

Net operating assets: Net operating assets are calculated by subtracting average deferred credit from average operating fixed assets. Though operating assets increased by average16% per annum during FY06-09 period, net operating assets increased by average 15% per annum during the same period owing to higher (average 25% per annum) increase in deferred credit. Since SSGC earns 17% on average net operation assets, the return has been rising in line with the increase in net operating assets.

Non operating income for calculation of formula return

As discussed earlier, income from non operating sources is added in return on net operating assets to arrive at formula return for SSGC. Previously SSGC was only allowed to classify limited heads from income from financial assets to be included in non operating income. However, after the decisions taken by OGRA on 24th September 2010, following incomes will also be treated as non operating income FY10 onwards for SSGC:

a) Royalty from Jamshoro Joint Venture Limited (JJVL): SSGC receives royalty from JJVL for making Badin gas available at its Liquefied petroleum Gas (LPG) extraction plant at Hyderabad. SSGC had requested OGRA to include JJVL royalty in its non operating income since it is not a regulated activity and does not require a license from OGRA. Moreover, since the royalty income from JJVL is received without any incremental investment (pipeline from Badin was not specially laid to supply gas to JJVL), SSGC petitioned that it should be treated as non-operating income. OGRA has allowed SSGC to classify royalty income from JJVL as non-operating income in its 24 th

September decision. Royalty income from JJVL is expected to be around PKR2.57bn, resulting into positive after tax impact of PKR2.49/share on SSGC’s FY10 earnings. Considering that gas volumes are gradually declining from Badin field, we expect royalty income from JJVL to decline going forward.

b) Late Payment Surcharge: Late payment surcharge is a non-regulated income as it is an interest income being financial compensation for delayed payment of gas dues by defaulting consumers. Since delayed payment by consumers result in cash flow problems requiring the company to borrow additional funds to offset shortfall in cash flow, SSGC asked OGRA to treat it as non operating income to offset the impact of incremental borrowing. Considering this factor, OGRA, in its 24th Sep decision, has allowed SSGC

to treat its late payment surcharge as non operating income. Late payment surcharge is expected to be around PKR1.0bn during FY10 which translates into an after tax impact of PKR1.00/share.

c) Sale of Gas Condensate: Sale of gas Condensate was treated as a part of operating income. SSGC urged OGRA to reclassify it as non operating income considering that condensate is classified as crude oil under the provisions of OGRA ordinance. Keeping in view that gas condensate cannot be classified as natural gas; OGRA has allowed SSGC to include income from gas condensate as non operating income. Income from gas condensate is expected to be around PKR370mn during FY10 (after tax per share impact of PKR0.36).

d) Meter Manufacturing Profit: SSGC's domestic meter manufacturing plant is located in Karachi. It produced 650,460 meters during FY09 as compared to 513,245 meters during FY08, translating into a growth of 20% YoY. SSGC has been pushing OGRA to include meter manufacturing profit in its non operating income considering that it is a non-core business activity. OGRA has finally accepted to include the profit from meter manufacturing plant in non operating income for SSGC. Income from Meter manufacturing plant is expected to be around PKR75mn (after tax impact of 0.07/share) during FY10. Going forward we expect income from meter manufacturing plant to increase in line with increase in consumer base.

UFG target for SSGC relaxed from 5.0% to 7% for FY10

Positive regulatory development results in lower UFG LossesSince the inception of UFG benchmarks by OGRA, SSGC has been unable to keep the UFG losses within the specified limits. SSGC has paid disallowances of around PKR6.0bn during FY04-09 period which has reduced the effective return from 17% in FY03 to less than 6% in FY09. UFG losses, which amounted to average 22% of regulated return during FY05-FY08 period, ballooned to 48% of regulated return in FY09 owing to tighter UFG benchmarks, increase in cost of gas and SSGC’s inability to control UFG losses. Owing to aforesaid reasons, UFG losses increased from only PKR762mn in FY08 to PKR2.8mn (EPS impact of 2.97) in FY09.Recent positive development: SSGC had requested OGRA to increase the UFG benchmark from existing 5.0% in FY10 to 7.5% for three years with the condition that disallowance should not be more than 20% of profit before tax. Moreover, SSGC has urged the regulator to determine UFG benchmarks every year considering factors like size and age of network, rise in gas sale prices, change in sale mix, law & order situation, uneconomic expansion etc. OGRA, in its 24th September decision, has decided to increase the UFG target from 5.0% to 7% for FY10. UFG targets for next years will be determined on year on year basis by taking into account the circumstance prevailing at the relevant time.

Regulated Return based on formulaSSGC’s regulated return is expected to increase significantly by 50% YoY from PKR8.1bn in FY09 to PKR12.1bn in FY10 primarily on back on increase in non operating income after OGRA’s decision to allow SSGC to treat aforesaid items as non-operating income.

Use of leverage to finance CAPEX to increase financial chargesSSGC has been financing a sizable portion of its CAPEX through debt financing which has increased the gearing of this company. SSGC’s financial charges are expected to grow to PKR5.1bn in FY10 (up 16% YoY) primarily due to higher long term debt, higher short term financing (owing to cash flow problems) and delayed payment of gas bills. While we foresee gradual improvement in company’s performance due to higher non operating income and relaxation in UFG benchmark, its positive earnings impact will be constrained by higher financial charges during the year.

Circular debt: Owing to circular debt and rising cash crunch, SSGC’s receivables and payables have surged as the utility is facing a cash crunch due to delays in collection of payments from KESC. Historically, SSGC faced 1-2 months delay in collection cash from KESC, whereas now the delay has stretched to nearly 5 months. Coupled with low receivables turnover ratio, the company has delayed payments to the gas suppliers. However, the severity of this circular debt situation is mitigated in the short term as the payables account is surging more than the receivables, which to an extent is providing cushion to the company’s cash position. We believe the company does not have ample room to leverage as evident from its 9MFY10 total debt to equity ratio of 66:34. It is

worth noting that a similar situation arose in 1998-99 when GoP had to intervene to bail out KESC from its cash flow crisis.

Valuation: Target PKR42.2

We have valued the stock using Justified P/B and relative P/E based methodology because of the return formula structure of the company. For Justified P/B, we have used a risk free rate of 13% and equity risk premium of 6%, leading to discount rate of 19% in our model. We have assumed a terminal growth rate of 7% and return on equity of 35.8% for SSGC to arrive at a fair value of PKR40.1/share. For P/E based methodology, we have used average EPS of PKR6.34 for FY10-12 period and price multiple of 7.0x (based on historical multiples) to reach at a fair value to PRK44.38/share. Assigning 50% weight to each method, our June-11 target price for SSGC PA comes to be PKR42.23/share.

The stock at current price offers an upside of 53.3% to our June 2011 target price of PKR42.2/share. The stock offers 18.2% dividend yield in FY10 which is expected to improve to 21.8% in FY12. Buy!

Key risks

Circular debt getting out of control: Though the government is working seriously to settle the circular debt issue, we feel that circular debt is one of the biggest risks currently being faced by gas distribution companies. The government will have to raise the power tariff substantially if it is to completely eliminate circular debt. Increase in the quantum of circular debt will affect the cash flows of SSGC and may lead to reduction in dividends.

Regulatory risk for UFG Benchmarks: Though OGRA has raised its UFG benchmark this year but UFG benchmark for next year will be determined by OGRA subsequently. Any decline in UFG target from 7.0% can hurt SSGC’s bottom line and poses as significant regulatory risk for the company.

Change in non operating income calculation: Though our discussion with SSGC management show that OGRA will not alter the non operating income calculation again but if OGRA changes the non operating income calculation, SSGC would take a hit on bottom line.

High interest rate scenario: Since the existing formula does not account for cost of capital (interest charges on debt + cost of equity), incremental value addition of additional capex is inversely proportional to the interest rates. This can also be verified by historical inverse relation between SSGC’s PBV ratio and local short term interest rates. The stock has always underperformed broad market in high interest rate scenario.

Reference:

http://ssgc.com.pk/

http://www.kse.com.pk/

SSGC Annual Report

http://www.fs.com.pk

http://www.google.com.pk

http://khistocks.com/