Fertilizer Sector

Industry Analysis

[CREDIT MODULE]
Presented to: Mr. M.A. Hijazi
Presented by Zain Bin Ishaq

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Fertilizer Industry
The Pakistan fertilizer sector lead most of the ills afflicting the economy at present including the
risks of economic downturn, high inflation/interest rates and dependence on direct GoP
subsidy. The country still remains a net importer of urea and DAP, providing the sector with
enviable pricing power, further enhanced by the inelastic demand for urea.

Fertilizer consumption in Pakistan has grown steadily with annual consumption growth rate of
3.4% over the last 19 years (FY91-FY09). Despite being a developing nation, fertilizer
consumption in Pakistan has remained high. Per capita consumption is above the average level
for Asia as well as the global average. In terms of application per hectare of arable land,
Pakistan ranks 15th in the world. The sustained growth in fertilizer demand in Pakistan could be
explained by desire for higher yields among a rising population and high amounts of subsidy
particularly on urea (feed gas subsidy). Compared to other industries, the fertilizer industry
enjoys greater backing due to the strategic nature of the product as fertilizer application has a
direct relation with crop yields, and thus helps in achieving food sustainability.

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Pricing Power
Profit of the listed fertilizer sector that comprises of FFC, FFBL, ENGRO, and DAWH has grown at
an annual rate of 18% during the last seven years to PKR16.7bn by CY08. Urea is the primary
product of three of the four companies in the sector, and with the country being a net importer
of both urea and DAP, the sector enjoys considerable pricing power, that is reflected in the
profitability growth.

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The following graph shows the market shares of the major players of the fertilizer sector.

Fertilizer Sector ROE

Thanks to strong urea pricing power, fertilizer sector net margins have been considerably
higher than KSE ex-financials. Despite the low asset turnover (fertilizer plants are capital
intensive) and leverage, it is the superior net margins that have helped fertilizers’ ROE to

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continually outpace that of KSE ex-financials. While these days it seems a fad to regulate
industries that are perceived to be over pricing/cartelizing sugar and cement), fertilizer sector is
unique with demand still overwhelming supply, strategic nature of product, and domestic urea
selling at discount to international urea. Additionally, strong parent group backing (Fauji
Foundation for FFC and FFBL, and Dawood group for ENGRO and DAWH) further enhance the
industry’s bargaining power with the regulators.

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Porter's Five Competitive Forces
Rivalry amongst firms (low)
a. Generic nature of product.
b. Small number of competitors. Major shareholding of the 4 big fertilizer players is controlled by two
groups, Fauji Foundation (FFC & FFBL) and Dawood Group (ENGRO and DAWH).
c. Demand exceeding supply.
Threat of new entrants (low)
a. Biggest barrier to entry is the availability of natural gas (raw material), which is in short supply.
b. Capital intensive industry.
Bargaining power of suppliers (medium to low)
a. Industry gets preference over others when it comes to supply of gas due to its strategic nature.
b. Backward integration by FFBL via PMP reduces phos acid supply volatility.
c. Low number of competitors.
d. Gas rationing during winters results in disruption in supply.
Threat of substitutes (low)
a. Organic fertilizers are nearest substitute, which are produced on micro scale.
b. Alternatives such as bio-char are still in their infancy stages.
Bargaining power of consumers (low)
a. Generic product with low degree of differentiation.
b. Low rivalry amongst firms.
c. Urea is a necessity, w/o which farmer risks suffering serious crop yield penalties.

UREA
Urea Consumption
Urea consumption is expected to cross 6mn tpa by CY09. Urea sales growth momentum has
been strong over the last two years with offtake rising by 11.5% Y/Y in CY08 and increase by
10% Y/Y in CY09. At present the country remains a net importer of urea, but with
commissioning of Fatima Fertilizer (0.5mn tpa, by end CY09) and Engro’s new urea plant
(1.3mtpa, expected by Jul 10), the country will have slightly excess urea capacity.

In the long term, urea sales are expected to grow at an annual rate of 3.5%, similar to the 10-yr
CAGR of 3.4% for the CY99-08 period. Upside risks to the demand growth assumption could

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come from successful, large scale application of the fertilizer intensive cotton, in addition to
increased area under cultivation brought about by construction of more dams and efficient
water utilization techniques.

Supply Demand scenario

Present industry urea capacity stands at 4.6mn tons compared with an annual demand of ~6mn
tons, with the gap being filled by imports. The commissioning of Fatima Fertilizer (expected by
end-CY09) and ENGRO’s new urea plant (Jul 10), a total of 1.8mn tpa (0.5mn tpa for Fatima and
1.3mntpa for ENGRO) capacity will be added to the system, taking total capacity to 6.4mn tons,
by the end of CY10, a token surplus of 173k tons. While the average industry capacity utilization
has averaged around 110% over the last four years, largely due to utilization levels in excess of
120% for FFC (45% of current industry capacity), utilization levels are expected to drop to near
100% during CY10-11 and gradually improve to 110% going forward.

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In FFC’s CY08 annual report, it was mentioned that the company was planning to undertake
BMR at its Plant I (Goth Machhi), bringing total urea capacity to 160% of nameplate. This would
effectively add 417k tons incremental urea capacity. In case it does decide to go ahead with the
expansion and assuming the additional capacity to come online by CY11, total industry capacity
would increase to 6.8mn tons, bringing excess capacity to 441k tons @100% industry utilization.

Global urea outlook: Significant oversupply by 2013

The following graph depicts the global urea consumption levels.

Global urea capacity is expected to grow at an annual rate of 5% over the next 5 years to
210mn tons, compared to annual demand growth of 3%, resulting in overcapacity of 11.1mn
tons by 2013. However, South Asia region will continue to have large supply deficits.

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Domestic urea prices vs. international
Domestic urea has traded at a historical discount of 18% to international urea. Factors
contributing to this discount are:
i) Lower gas prices, particularly feed stock
ii) PKR depreciation, making imported urea dearer
Domestic urea was selling at premium to international prices during 2001-02, where
international prices averaged ~US$103/ton, but have since been trading at discount, which had
peaked in Jul 08 to 77% (US$624/ton) at the peak of the commodity super cycle. Urea prices
have subsequently crashed, coming down from US$815/ton to the current US$250/ton, with
spread reducing to 26%.

Province wise urea breakup

Fertilizer consumption is concentrated in the agriculture intensive provinces of Sindh and
Punjab which cumulatively account for approximately 90% of total urea offtake. Over the last
five years (CY04-08) total urea offtake has increased at an average rate of 3.8% while for Punjab
and Sindh the growth rate has been 4.4% and 3.5%, respectively.

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DAP
Volatile dynamics
Compared to stable-natured urea, DAP demand and price dynamics exhibit a lot more volatility.
Domestic prices follow international prices, as the country meets ~55-60% of the demand
through imports, while FFBL is the sole DAP producer in the country (total capacity of 670k tpa).
Compared to urea, there is better soil retention of DAP, which further adds to the fluctuation in
demand.

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Demand drivers for DAP are:
i) GoP direct subsidy,
ii) Wheat support price, and
iii) Differential between DAP and urea prices. Greater the differential, more likely is the farmer
to substitute DAP with urea.

In CY08, average DAP prices surged 114% Y/Y to PKR2,955/bag, while the DAP/urea price ratio,
which can be also interpreted as the number of urea bags available for the price of a bag of DAP
jumped to 4.3x compared with 2.2x in CY07. Resultantly, DAP offtake dropped by 44% Y/Y to a
multi-year low of 775k tons.

Spectacular rise and fall of DAP

Major raw materials for DAP are ammonia and phosphoric acid (phos acid). While natural gas is
the basic raw material for ammonia, phos rock and sulphur are the core ingredients of phos
acid. Riding high on the soft commodity boom, DAP prices peaked in Aug 08 to near
US$1,200/ton as pursuit for higher crop yields kept demand sentiment positive. The pull of
biofuels was never greater as crude oil prices neared the US$150/bbl mark making biofuels an
attractive proposition. Thus food crops were in direct competition with fuel crops, and with
land being a constant, the only way to increase production was via higher yields, resulting in
greater demand for DAP. However as commodities, particularly oil crashed so did DAP prices,

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crashing to US$270/ton by Jun 09. Only recently have DAP prices started recovering with
current prices at US$320/ton.

Phos acid raw materials share a high correlation with DAP prices. Like other commodities,
sulphur prices also peaked to US$800/ton by Jul 08. Relative to other commodities, movement
in sulphur prices has been amplified, as prices have fallen by a massive 96% from peak levels to
the current price of US$30/ton.

Compared to sulphur, fall in phos rock prices has been gradual, which despite the global
commodity disturbance during 2H08, exhibited downward stickiness. The historic differential
between phos rock and sulphur prices has averaged just US$7/ton, which at present is around
US$60/ton, implying further possible decline in phos rock prices.

Domestic DAP prices trade at a premium to international

Domestic DAP prices in Pakistan have been trading at an average premium of 35% to
international DAP. There are two major factors contributing to this premium which include:
i) Transportation charges
ii) Importer margins, which arrive accounting for distribution expenses and other costs like bank
charges (LC costs) etc.
At present, domestic DAP is selling at US$491/ton compared to international price of
US$320/ton, a premium of US$159/ton or 53%.

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FFC
FFC has been one of safest growth plays at the KSE with average earnings growth of 13% over
the last 5 years (CY04-08) along with an impressive average payout of 103%.

Stable product demand = steady earnings growth

With FFC expected to sell whatever it produces, earnings are forecast to grow at an annual
growth rate of 4% over the CY09-15 period, besides we expect FFC to maintain an average
payout of 97% over this period. High product demand has also translated into a highly favorable
cash conversion cycle, which is expected to peak in CY09. Surplus urea capacity following
Fatima and Engro’s expansion is expected to last till only CY11, thus, urea pricing power would
be further augmented as rising demand weakens supply, brightening the long term growth
prospects for FFC.

Operating margins above peers

Compared to peers FFBL and ENGRO, FFC has consistently outscored both in terms of gross and
EBITDA margins, while its Selling & Administration cost/ton also remains the lowest.
Factors contributing towards the higher margins include
i) higher composition of own-manufactured ‘Sona urea’ in sales mix, which has higher
margin than imported fertilizer and DAP which relatively drags down ENGRO and
FFBL margins,
ii) lowest Selling and Administration (S&A) expense/ton of fertilizer sold, as the
company benefits from strong product demand, plant location being in proximity to
market, and economies of scale as it has the biggest distribution network in the
country.

Capacity Utilization
FFC’s operational metrics have been impressive with capacity utilization averaging 120% over
last five years. Utilization for the MM (Mirpur Mathelo) plant has averaged 119%, while that of
GM (Goth Machhi) has averaged 122% over the CY04-08 period.

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Imported DAP to fuel growth
FFC is expected to restart active participation in the DAP market after a lull of nearly two years.
Average DAP market share of FFC remained at 15% for the CY04-07 period.

Core profitability drivers’ assumptions

FFC core profitability drivers include:
i) urea price increase

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 ii) gas price changes, and
iii) capacity utilization

Diversification to augment growth

Compared to ENGRO, FFC has followed a passive growth strategy, with long term investments
largely in Fauji group of companies (FFBL and FCCL).

Option A: Wind power project

FFC is currently in the process of evaluating a wind power project of 50MW at Jhimpir, Sindh. As
per FFC’s CY08 annual report, total cost of the project is estimated at US$130mn.

Option B: Goth Machhi expansion

The company also has plans for 417k tpa expansion at its Goth Machhi (GM) plant, that would
increase FFC’s annual capacity to 2.3mn tons. Expansion is expected to come online in CY11, a
time where the industry will already have over capacity. According to Investment & Finance
Securities Limited’s assumption, only slight surplus of 20k tons existed by CY11, the addition of
GM expansion would increase surplus to 441k tons, which would extend till CY15 assuming that
the industry operates at 105-110% utilization.

FFBL
Annual earnings for FFBL have depicted a steady progression, with earnings growing at a 5-year
CAGR of 12% over CY04-08 period. However, earnings momentum has remained highly skewed
towards 4Q, the peak quarter for DAP offtake. Compared to the sector, FFBL’s business model is
exposed to fluctuations in international phos acid and DAP prices, as it imports phos acid and
domestic DAP prices follow the international price trend. Other variables like GoP subsidy on
DAP as well as sharp currency depreciation have added to the earnings fluctuations. Earnings
volatility is also reflected in FFBL’s share price which has the highest beta amongst the listed
fertilizer sector.

Major competitive advantages

FFC has the largest fertilizer distribution network in the country and forms the distribution arm
of FFBL. This presents a competitive advantage for FFBL’s ‘Sona DAP’ over imported DAP. On an
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average, around 74% of FFBL’s DAP sales are in the province of Punjab. Being the sole producer
of DAP also gives the company pricing power over importers, which is also depicted by the
premium over which domestic DAP has historically been sold to international DAP, while the
prices of its major raw material; phos acid are set on an international basis. Lastly, proximity to
port in addition to superior product (granular urea) provides FFBL with an attractive
opportunity to export urea in the coming surplus years.

PMP venture, adding to FFBL outlook

Pakistan Maroc Phosphore (PMP) is a joint venture between OCP Morocco and the Fauji group,
in which FFBL has 25% shareholding. PMP is involved in the manufacturing of phosphoric acid
and is located in Morocco. In brief, business model of the company includes the purchase of
phos rock and sulphur for the manufacturing of phos acid, which is then exported to Pakistan.
The company has capacity in excess of the current FFBL requirement, providing further export
opportunities.

Benefits expected to accrue from the PMP venture are:

i) Uniform supply of phos acid
ii) Provides hedge against sharp rise in phos acid prices, as higher prices may squeeze FFBL PMs
but would improve PMP profits

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iii) Ease in de-bottlenecking of FFBL DAP capacity of upto 100k tpa, as PMP has spare capacity of
~50k tons

Potential drawbacks of PMP:

i) Non integrated manufacturer making it vulnerable to raw material price fluctuations
ii) Sharp PKR depreciation to amplify losses

Actual figures for 2009, Business Recorder Thursday October 28

The use of all types of fertilizer is expected to decline by 2.7 percent during the RABI season
(only). Last year’s (2009) total fertilizer consumption stood at 4.116 million tons.

Main reason behind the lower demand for urea fertilizer was said to be inundation of a large
agricultural area with floodwater and farmers’ inability to purchase fertilizers due to high prices
of the phosphate fertilizer prevailing in both domestic and international market for last six
months.

Country will require 3,180,000 tons of urea, 765 tons of DAP, 45,000 tons of other phosphoric
fertilizer (TSP/MAP) and 13 thousand tons of Potash fertilizer.

Punjab’s total fertilizer demand will be around 2,993,000 tons during the season.
Sindh will require 520,000 tons of urea, 150,000 tons of DAP, 15,000 tons of other phosphoric
fertilizer and 5,000 tons of Potash.

KPK’s urea deman will be 190,000 tons, DAP 25,000 tons.

Balochistan will need 90,000 tons and 15,000 tons of DAP.

The estimated supply-demand situation will begin with an opening inventory of 458,000 tons of
urea.

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Domestic production is estimated to be around 3.159 million tons thus total availability of the
urea will be 3.617 million tons. The off-take for RABI season is estimated to be around 3.180
million tons. DAP domestic production will be 300,000 tons.

Cotton was damaged on about 1.7198 million acres mostly in Sindh and Punjab. Cotton
production will remain 11.411 million bales from remaining 6.0359 million acres against set
target of 14 million bales.

Initial paddy production target was at 5.949 million tons but estimates revealed that about
2.395 million tons crop was damaged.

Target for sugarcane crop was set at 54.834 million tons but floods damaged about 10.418
million tons and thus expected crop was 44.42 million tons.

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