Elixir Securities Limited – Elixir Insight

Karachi, October 16, 2017 (PPI-OT): Engro Fertilizers Limited – Re-initiating with PT of PKR 66/share; TR of 20%

We re-initiate coverage on EFERT with a BUY call driven by our Jun-18 PT of PKR66/share offering a capital upside of 10% along-with dividend yield of 10%.

With overall fertilizer sector dynamics likely to remain dull, dividend yield emerges as the only attractive investment driver where we expect the company to maintain its payout ratio of 90% as working capital eases due to reducing Urea inventory and gradual release of subsidy. Moreover accrual of ~PKR1bn pa in GIDC, which is being withheld by the company, should also allow EFERT to pay out DPS of PKR6.0 and PKR6.25 in 2017 and 2018, respectively.

Over medium term, we expect the government to allow annual Urea export quota of ~300Ktons to the industry in order to i) ease their cash cycle emanating from delays in subsidy disbursement, ii) continued supply overhang and iii) pressures on External Accounts.

We have incorporated EFERT’s exports at 93Ktons at USD245-225/ton until industry demand-supply situation normalizes; note that every 45KTons of exports add PKR0.12/share to the bottom line of the company.

While we see modest improvement in Urea dynamics, we estimate the company’s profitability to stay flat over 2017-20, whereas revenue is projected to post a meagre CAGR of 4.4% over 2016-2021. We expect local Urea prices (dealer transfer prices) to remain at current levels of PKR1,360/bag in 2018 and gradually improve to 1,380/bag in 2019.

Re-Initiate Coverage with PT of PKR66/share: We reinitiate coverage on Engro Fertilizers Company Limited (EFERT) with a BUY call, driven by our Jun-18 PT of PKR66/share offering a capital upside of 10% from its last close. We estimate the company’s profitability to stay flat over 2017-20, with our 2017E and 2018F EPS estimates standing PKR6.6 and PKR6.9, respectively. We however eye near term improvement in urea dynamics on the back of i) seasonal growth in overall Urea demand, ii) relatively better pricing and, iii) reduction in industry’s inventory levels owing to exclusion of LNG players and availability of unutilized exports quota.

Over medium term, we expect government to allow annual exports quota of ~300Ktons to the industry in order to i) ease their cash cycle emanating from delays in subsidy disbursement, ii) continued supply overhang and iii) pressures on External Accounts. On DAP’s front, changes in tax regime are expected to hamper earnings growth.

Eyeing flattish profitability and industry’s Urea supply overhang persisting up till 2023, our BUY call on EFERT largely emanates from attractive dividend yield of 10.1%/10.4% for 2017E/2018F.

Sturdy Pricing Supported by Taming Inventory levels: Industry’s Urea inventory has witnessed a significant improvement in last 16months, easing to ~0.8mnT (as at Sep-17) from its highs of 1.7mnT (as of May-16) which was primarily attributable to heavy subsidy by GoP, allowing offtakes to register TTM growth of 20%YoY to 6.1mnTpa (compared to historical average annual growth of 2% over the past 9 years).

Further icing on the cake came from i) sudden contraction of supply by LNG players owing to hike in international Oil prices and, ii) upbeat utilization of export quota (~366Ktons dispatched and on Port by Sep end) which enabled manufacturers to pass on additional burden of decline in cash subsidy by GoP through FY18 budget.

Given the seasonal nature of demand, retail prices are likely to remain stable in 4Q. We expect Urea demand to exceed supply by 90-100KTons over 4Q2017, which coupled with materialization of export quotas, should result in ending inventory of ~650KTons (close to Jan-16 levels) for the industry. While this should allow stability in Urea prices over 2018, gradual built of inventory from 1Q2018 onwards should still keep retail prices under the GoP set cap of PKR1,400/bag.

Making a Case for Exports: It is pertinent to note that despite Urea inventory is nearing its minimal levels, over-supply situation in 2018 would again lead to inventory accumulation in the industry. As per our calculations, average monthly production on 495KTons (Ex of LNG players) and sales of 476Ktons will lead to excess of inventory of ~0.9mnT by the end of 2018 – far above strategically required level of 0.4mnT. Thus we expect fertilizer sector to demand annual export allowance of at least 300Ktons over 2018-22 which should help them ease their cash cycle, where delays in subsidy disbursements by GoP have already forced manufacturers’ to rely on short term borrowings. We believe this will also help the government’s efforts to tame the widening Current Account deficit, as the sector can contribute USD75mn to country’s exports.

For EFERT, we have incorporated 93Ktons of exports at USD245-225/ton in the medium term, till industry demand-supply situation normalizes; note that every 45KTons of exports adds PKR 0.12/share to the bottom-line.

Revenue to Depict Modest Growth: Despite improving industry dynamics, we expect EFERT’s revenue to post a meagre CAGR of 4.4% over 2016-2021, and depict only a slight accretion of 2% to PKR81bn in 2018. The primary reason behind flattish revenues in 2018 is decline in export sales which will be offset by improving domestic market situation. We expect local Urea prices (Dealer Transfer Price) to remain at current levels of PKR1,360/bag in 2018 and gradually improve to PKR1,380/bag in 2019.

On the positive side, however, waning production from LNG players should allow EFERT to gradually grow its market share by 45bps to 31%, which we expect to continue into 2018 and 2019 and stabilize at 30.5% in the long run.

Profitability to be Dented by DAP Sales: Over the last 10 years, domestic DAP demand has witnessed a major volumetric accretion; growing at a 10 year CAGR of ~4% to clock in at 2.2mnTpa in 2016. This growth primarily emanated from i) increasing demand for Sugarcane and Wheat crops which require relatively higher DAP application and, ii) lower DAP prices which incentivize local farmers to gradually move towards the optimal mix. However owing to over-supply situation in sugar crop, going forward we expect DAP demand to depict slower run rate of 1% pa. With Fauji Fertilizer Bin Qasim (FFBL), the sole DAP producer in Pakistan, operating at over 110% of its capacity, we expect additional demand to continue to benefit bulk importers. In this backdrop, EFERT has gained the most in terms of volumes as it holds largest market share of 40% in total imported off-takes (our long term market share assumption is 38%).

While the company has been gaining ground on volumetric DAP offtakes, margins are expected to come off owing to the recent change in tax regime from Normal Tax Regime to Final Tax Regime (FTR), imposed through Budget FY17-18. The measure is expected to reduce EFERT’s trading margins from 10-11% to 4.5% (as per our calculation) as 5.5% tax on import stage is relatively higher than 30% corporate tax on profitability.

Dividend Payout Likely to Sustain: With overall fertilizer sector dynamics likely to remain dull, dividend yield emerges as the only attractive investment driver behind EFERT. We believe that current payout ratio of 90% is sustainable as working capital is likely to ease on the back of i) reduction in Urea inventory and ii) gradual subsidy disbursement. Moreover, EFERT has so far been accruing the entire Gas Infrastructure Development Cess (GIDC) on the variable gas allocated through Petroleum Policy; however since the company contends that the additional cess on the allocation is unfair, it has so far withheld PKR1.7bn as payables. We estimate that until the issue is resolved, it will generate an additional amount of PKR1bn (PKR0.75/sh). This, combined with management’s intention to finance its majority of Capex though debt, should allow EFERT to pay out DPS of PKR6.0 and PKR6.25 in 2017 and 2018, respectively – translating into respective 2017E and 2018F dividend yields of 10.1% and 10.4%.

Risks:

Supply additions from LNG players from 2018 can hamper pricing assumptions.

Substantial decline in export prices making it unviable to export and/or government not agreeing to additional export quotas going into 2018 and beyond.

More than expected increase in gas prices.

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