· We maintain our “over-weight” stance on the fertilizer sector due to its stable demand dynamics, attractive dividend yield and reasonable pass-on ability.
· The upcoming gas tariff hike of 42% and 82% for feed and fuel gas will increase the cost, however we believe that the manufacturers have decent pricing power given the significant discount between local and international urea prices.
· In federal budget FY23, GoP exempted the fertilizer sector from sales tax which stopped the pileup of sales tax refunds on manufacturers’ books, however this has resulted in an increase in their cost.
· Heavy rains and flooding, especially in Sindh and Baluchistan have wreaked havoc in the region. As per initial reports, many standing crops have been destroyed by the natural calamity. This might result in a period of slowdown in fertilizer offtakes, however we expect offtakes to normalize in next few months.
Lately, news of the deregulation of fertilizer sector is making rounds. Deregulation of the sector will increase the cost of fertilizer for farmers and will result in higher profits for manufacturers but this deregulation will also expose the fertilizer companies to the movements in international commodity prices.
· Our top picks from the sector are FFC (TP: PkR124/sh, offering total return of ~37%) and EFERT (TP: PkR95/sh, offering total return of ~35%).
Flood to hit fertilizer offtake in near term: The recent floods have wreaked havoc in the country affecting millions of people and damaging infrastructure. In addition, the flood has caused heavy damage to Kharif crops, especially cotton and rice. Furthermore, the floods might also result in delays in sowing of Rabi crops. As per our channel checks, standing crops of cotton and different fruits & vegetables have been severely impacted by the floods. According to the chairman of the Pakistan Cotton Ginners Association, around 40%-45% of the cotton crop has been damaged by the recent floods. Furthermore, the indirect impact of these floods in the form of loss of soil nutrients will also hurt the sector. This could potentially hurt soil quality and will impact crop yields. However, once flood water recedes, we might see a jump in fertilizer offtakes as farmers try to replenish nutrients in flood hit areas. We believe that, fertilizer demand is also expected to take a hit in the near term due to floods, where DAP sales have already started to paint a gloomy picture. To note, DAP offtake is already down by ~18%YoY in 7MCY22, amid record high prices. On urea front, we expect demand to take a hit in 3QCY22 but is expected to normalize in coming months like we witnessed in 2010. During the floods of 2010, which hit the country in July, urea sales were lower by ~41%, 35%, and 15% against the 12 month moving average in Aug, Sep and October, respectively.
However, sales witnessed a decent recovery in Nov and Dec increasing by 64% and 22% against the 12 month moving average, respectively. One thing to note here is the difference between the 2010 and current floods, the 2010 flood was river-flood caused by heavy rains resulting in higher water levels. However, the impact of 2022 monsoon rain is far more widespread and will take more time to recede, thus, affecting the fertility of land along with lower area availability for next crop season.
Gas tariff hike, likely to be passed on: ECC approved increase in gas tariff across the board, which is still awaiting a final nod from federal cabinet which has been pending for ~2 months. The proposed increase in gas tariff for fertilizer manufacturers will take feed gas price from PkR302/mmbtu to PkR430/mmbtu, up by ~42%, while fuel gas will increase to PkR1,857/mmbtu from PkR1,023/mmtbu, up by ~82%. If passed on fully, the said increase in gas tariff will increase per bag cost of urea production by PkR420/340/170/380 for FFC/EFERT/FFBL/FATIMA, respectively. Local urea price stands at ~PkR2,250/bag which might see a jump of ~PkR400/bag post increase in gas tariff, taking final price of urea to PkR2,650/bag. Urea manufacturers boast decent pricing power in current scenario given the stable demand dynamics of the product and significant gap between local & international urea price. However, recent flooding in the country will restrict price pass on in the near term. To note, we have assumed price hike of PkR350/bag for CY23 and a minimal increase going forward in our models.
Deregulation of sector: Fertilizer companies have been advocating for deregulation of the sector for quite some time now and the work on the new fertilizer policy is underway. Key points of the proposed fertilizer policy are uniform gas rate for all manufacturers, deregulation of urea price, quota-based export mechanism, favorable policies to allow debottlenecking of current facilities etc. Deregulation will result in removal of subsidy on gas resulting in higher cost for manufacturers, however, fertilizer companies will then sell urea at import parity prices. This will increase cost for farmers and effective subsidy mechanism will be needed for transparent disbursement of the subsidy. On the flip side, this will not only increase the profitability of fertilizer companies, but also result in higher tax collection for the Gov’t. However, this will expose the industry to swings in international commodity prices.
Investment thesis: Fertilizer manufacturers operate in a stable business environment as demand for urea remains firm despite headwinds on economic front. The companies have decent ability to pass on cost side pressure as demand for urea is inelastic and significant gap between local and international urea price further strengthens the case. Recent flooding might hurt offtakes in near term, however, we expect demand to pick up once the rehabilitation process starts. We continue our liking for the sector due to stable dynamics of fertilizer industry, reasonable pass on ability and attractive dividend yield, where EFERT and FFC are our top picks. Key risks to our investment thesis are i) Lower than estimated fertilizer offtake, ii) Inability to fully pass on gas tariff hike, iii) Unfavorable decision on GIDC front, v) Poor agronomics, and v) Abrupt regulatory changes.
Courtesy – AKD Research