Ideal conditions providing unparalleled yields

• Fertilizer Universe's earnings/dividend is expected to rise by 58%/39% in CY24. The fertilizer industry will experience a notable surge in profits due to several increases in output prices and the probable lack of adverse effects from deferred taxes. The attractiveness of core business dynamics is sustained by strong demand and competitive pricing from global marketplaces. Businesses are attempting to offset the uncertain future of gas supplies by making timely capital expenditures in that area. Last but not least, the present trading multiple discount to their historical near-term levels increases comfort in a setting where the economic outlook is strengthening.

• In terms of company, EFERT, FFC, and FFBL will have YoY increases in EPS of 41%, 55%, and 218%, respectively, to PKR 27.5/36.1/10.9 in CY24. The industry's reputation for having a high dividend yield will be maintained with the support of higher earnings. Given the increased capital investment needed for gas pressure enhancement facilities, PKR 26.0/21.5/4.0 per share in dividend payout for EFERT/FFC/FFBL is anticipated for CY24E, which translates into yields greater than those on PIBs. Consequently, the industry offers solid returns to investors looking for comparatively secure investment opportunities.
  

Nutrient Demand

According to the Punjab-based Soil Fertility Research Institute, the amount of nitrogen needed for one acre of various crop kinds is displayed in the table above. These calculations show that the total nitrogen needed for just eight major crops is 3.1 MTPA, or 6.7 MTPA of urea. The P2O5 requirement is 1.6 MTPA as well.

Due to price discounts, historical offtake levels indicate that farmers typically substitute N for P2O5. Thus, according to NFDC, average P2O5 demand stayed at 1.4 MTPA over the previous two years, whereas average nitrogen demand stayed at 3.8 MTPA. The remaining 0.7 MTPA of nitrogen requirement is supplied by phosphatic fertilizers with trace amounts of nitrogen (DAP, NP) or other fertilizers with low nitrogen content (CAN, AS).

Given this context, we believe that even with higher fertilizer costs, urea demand will remain relatively stable, with fertilizer making up less than 25% of a farmer's total expenses. Therefore, a single digit increase in prices will result in an overall cost increase that can be offset by higher crop prices.

Urea sales KTPA

Even without taking importer margin into account, local (EFERT) urea is still selling at a 26% discount to imported parity, notwithstanding recent drops in importer urea pricing. As a result, even though it is happening less frequently, the commodity is still vulnerable to cross-border smuggling. But at the current local urea costs, this smuggling becomes unfeasible if international urea prices drop to USD300/Ton.

Cross-border smuggling worries have not yet been allayed

Price distortion in the market for urea

Over the past two years, fertilizer manufacturers' gas prices have varied dramatically. Fertilizer policy gas pricing is applicable to the three FFC plants and the base plant of Fatima Fertilizer. Each plant receives specific communication from the Mari network regarding this policy. Because of this, even while other firms saw an increase in gas expenses during the first three quarters of CY23, their gas rates remained the same.

Gas for FFBL was previously supplied at system gas rate, ENVEN from EFERT at a concessionary rate of USD 0.7/MMBTU, and PPKR1,239/MMBTU for RLNG-based facilities. The government equalized the gas supply tariffs to FFBL and EFERT's ENVEN, which were formerly based on RLNG, on February 24. The gas rates for the other six plants, on the other hand, are the same since they receive their supplies straight from Mari rather than through the Sui network's infrastructure. The contracts for those facilities' gas supply expire in June 2024.

The ministries of industries, finance, commerce, planning, energy, power, and food security were represented on the committee that the ECC established in CY23 to discuss the cost and distribution of gas to the fertilizer sector. As a result, the ministry of petroleum's proposal to raise tariffs may be carried out provided that new contracts are signed before June 2024.

The present variation in urea costs across manufacturers has increased to PKR1,720/bag as a result of this disparity in gas pricing. Because granular and prilled urea differ, this range has generally been around PKR100/bag prior to CY22. Farmers have suffered from fluctuations in urea pricing since they purchase urea at rates that are nearly always in line with the industry's highest MRP. According to our informal conversations with several dealers, the market price of pelleted urea for farmers now ranges between PKR 4,900 to PKR 5,300 per bag depending on the location, while the price of granular urea is between PKR 5,500 and PKR 5,700 per bag.

Pressure enhancement facility to ensure food security of the country

FFC/EFERT/FATIMA is constructing compressors to maintain gas pressure at Mari HRL. Capital investment for the project is anticipated to be between USD250-USD300 million, with FFC/EFERT/FATIMA accounting for 47.7%, 33.9%, and 18.4%, respectively. Phase 1 is scheduled to be completed. By the conclusion of CY24, while phase 2 has also started with acquisition of compressors will be completed during CY25. Dispatches from the MARI field are predicted to plateau in the year following the completion of HRL phase X development project. This capital investment will maintain strong gas pressure for a longer period, ensuring the country's food security.

Sector trading at attractive future earnings

The ability of the sector to pass-on any increase in costing to end users by the virtue of it selling at steep discount to landed parity has enabled it to maintain a robust future earnings profile. For the ongoing quarter, companies will have to book higher gas cost since start of February, however, this slight hit on earnings due to retrospective gas tariff hike is one-off in nature. Note that FFC’s gas pricing remained unchanged. Moreover, it will book higher other income in 1QCY24 due to dividend flow from power subsidiaries and associates (AKBL, FFBL). Future earnings and dividend yield remain robust as shown below.

Due to its capacity to sell at a significant discount to landed parity, the sector is able to pass on cost increases to end users, which has allowed it to sustain a strong profitability profile going forward. For the current quarter, businesses must make larger reservations.

gas prices have been rising since the beginning of February, although this little impact on profits from the retroactive gas tariff increase is just temporary. Take note that FFC's gas prices haven't changed. Additionally, because of the dividend flow from Power subsidiaries and associates (FFBL, AKBL), it will book greater other income in 1QCY24.

As demonstrated below, projected earnings and dividend yield are still strong.

FFC's profitability is predicted to increase due to increased urea pricing at the beginning of CY24, leading to higher margins and strong demand. resulting from a robust farm economy. Thar Energy Limited's expected dividend of PKR1.5bn will boost profitability beginning in CY25 and increasing over time. The company has one of the highest dividend yields (17.7%) among KSE-100 companies. Our December-24 price estimate of PKR152.3/sh represents a 25.1% potential upside for the company. Dividend yield raises total return potential to 42.8%. The company is currently trading at a 52% discount to its previous 10 year projected P/E multiple of 7.1x. Even a minor re-rating might lead to significant price appreciation.

Fujia fertilizer~ FFC - BUY

Pricing power will outweigh any cost pressure:

FFC is the industry leader in urea sales, with strong pricing power. Currently, FFC is charged PKR580/1580 for feed/fuel gas, exclusive of sales tax, because the latest gas price hike notification excluded manufacturers who take gas directly from the MARI network. As a result, unlike competitors, FFC did not raise the price of urea and is now selling it to EFERT at a discount of PKR882 per bag.

According to recent news, the IMF has proposed removing all fertilizer subsidies. We have considered increasing input costs in line with industry peers starting July 24th, as the gas supply agreement is extended on new conditions. We assume that FFC will enhance retention by PKR1190/bag with a bigger dealer margin, while FED will take MRP at PKR 5130. The increase in output prices will outweigh the negative impact of higher gas costs, resulting in virtually unchanged profitability.

As of the end of fiscal year 2019, FFC had PKR64 billion in GIDC due. In August 2020, the Supreme Court issued an order. In November 2020, a review petition requested payment in 48 monthly installments, instead than the original 24 monthly payments. The matter is still in adjudication, and the firm has not paid any payment. We have assumed full payment in CY25 since we expect the Pakistani government will pursue the matter due to fiscal constraints.

The company's cash and short-term investments in December'23 totaled PKR96bn, indicating sufficient financial resources to pay off the liability. This repayment will reduce revenue from financial assets from CY25 onward. Our expected income from this stream is PKR 19.5/13.6/4.5 bn in CY24/25/26, with after-tax income per share of PKR 9.3/6.5/2.2.This payment may reduce the company's readiness to pay dividends slightly. We assume an 80% payout ratio after subtracting the capital investment for the pressure enhancement facility.

Our predicted dividend yield is 17.7%, which is attractive. FFC has one of the highest dividend yields among the KSE-100 index companies.

Moreover, whenever the capital currently deployed in fixed income instruments is used for payment of GIDC, the company will become more attractive for sharia compliant investors.

GIDC payment will slightly strain payout capability:

Associates and subsidiaries will help to buffer profitability.

We have anticipated that Thar Energy Limited will pay dividends of PKR1.1 billion beginning in CY25. We assume AKBL would continue to pay an annual dividend of PKR2.5/sh going forward. These inflows are expected to provide PKR 4.1/6.5 bn in dividend income for CY 24/25.

Foundation Wind Energy 1 & 2 will increase consolidated earnings by about PKR 4.1/2.2 per share in CY24/CY25, as debt repayments are completed during the current year.

In CY23, the company recorded a loss allowance of PKR2.9 billion on subsidy receivables, reducing net profitability by PKR1.4 per share. In CY24, we anticipate a loss allowance of PKR1.24 billion on subsidy receivable from the Government of Pakistan, ensuring 100% coverage.Furthermore, management may consider reducing equity stake in Fauji Fresh N Freeze (FFF). The current carrying value of FFC's investment is PKR4.23 billion, while our estimations suggest a net book value of roughly PKR1.1 billion.

We estimate that the company may incur an impairment charge of PKR3.1 billion in CY24. The two charges will reduce CY24 profits by PKR2.1/sh. However, these costs should not continue in CY25 unless FFC converts the PKR1.8bn lines of credit recently given to Fauji Fresh and Freeze into equity, which would further damage them.

Trading at a discount to its historical multiple

Other expenses may stay high throughout the fiscal year 24.

FFC has traded at an average forward price-to-earnings ratio of 7.1 over the last decade. The current trading multiple of 3.4 represents a 52% discount to its historical average. Even with partial rerating, the company can still yield tremendous potential.

We used discounted free cash flows to value the company at a cost of equity of 23%. We recommend buying the stock at our target price of PKR152.3/sh on December 24th, which represents a 25.1% increase from the previous closing. The potential dividend yield of 17.7% results in a total upside of 42.8%.

Upside Risks

• Further Delay in GIDC dues payment

• Better operating performance of Fauji Fresh n Freeze leading to no impairment

• Higher than expected decline in interest rate

• Resolution of power sector circular debt issues
  

Downside Risks

• Restraint on urea price hike under pressure from government Higher than assumed

• increase in KIBOR Further sharp decline in international urea pric