The Pakistan Credit Rating Agency Limited RIS K MAT RIX … · Pakistan produces some 4% of the...

SECTOR STUDY The Pakistan Credit Rating Agency Limited

RIS K MAT RIX

HIGHL IG HT S

FY10 P KR

Total Credit ~150bln NPL Ratio n.a. Investment (last 3 yrs) 127bln Subsidy (3yr average) 18bln

Listed Companies 5

SECT OR TRE ND S

Major expansions online Around 1.8mln ton urea capacity added to the system

GST implemented on Fertilizers Prices gone up third time in one year

Improved Margins Price hikes have contributed positively to the sector with margins going up

Supply deficit to continue Despite expansion, shortages to be met by imports

NPLs emerging from single entity

2007 2008 2009 2010

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Fertilizer-Turnover & Margins

Turnover Gross Margin NP Margin

FERTILIZER SECTOR - 2011 ➔ Agriculture (excluding livestock) accounts for approximately

10% of the GDP. The foremost mean to increase agricultural

productivity is by the use of balanced fertilization (Nitrogenous,

Phosphatic & Potasssic). Pakistan produces ~4% of world urea

(Nitrogenous) output, all consumed locally (FY10: 5.1mln; FY09:

4.9mln) while larger portion of Phosphatic fertilizer (DAP) is

imported. In recent times, industry has experienced around USD 2bln

of investment, taking total number of players to nine. Fertilizer

sector's association with larger agrarian economy places it in a strong

strategic position. The sector enjoys preferential treatment from GoP,

primarily in the form of subsidized natural gas - the key raw material

in urea production – and price subsidy for phosphatic fertilizers.

KEY RISKS

➔ Natural Gas Availability: Natural gas production has remained

flat () in the last__ years in Pakistan, while demand is high. Despite

having high priority access to supply of natural gas (Natural Gas &

Management Policy 2005), fertilizer sector is facing upto 20% gas

curtailment resulting in lower capacity utilization. This has neutralized

the impact of enhanced capacities which came online during the year

and the supply deficit is likely to continue.

➔ Total demand of all fertilizers stood at 8.9MT against the supply

of 6.7MT during FY10. The price of urea went up by ~48% in one years'

time on back of gas curtailment and GST implementation (currently at

a discount of ~40% to the international prices). However, the demand

for urea is highly inelastic and price change is expected to have limited

impact on demand. However, phosphatic fertilizer – DAP – being price

sensitive, would experience decline in its offtake. In the past, GoP has

provided subsidies for phosphatic fertilizers whenever prices have

escalated beyond farmer community's reach. Hence, fertilizer demand

would be dependent upon GoPs action in the current situation.

CREDIT EXPECTATIONS

➔ Owing to the capital intensive nature of the sector, the recent

expansions by large players has pushed the average financial leverage

for the sector to a significant level (~7% of total private sector lending).

The short term borrowings are a function of imported fertilizer

quantum, which varies within entities. The leveraging levels for

growing entities are as high as 70:30 (debt to equity).

➔ The quality of credit is good based on the ability of business to

generate strong and stable margins(~42%). The cash nature of the

business requires lesser working capital credit. The sector serviced

~PKR 22bln interest during the year. PACRA has used due care in preparation of this document. Our information has been obtained from sources we consider to be reliable but its accuracy or completeness is not guaranteed. PACRA shall owe no liability whatsoever to any loss or damage caused by or resulting from any error in such information. None of the information in this document may be copied or otherwise reproduced, stored or disseminated in whole or in part in any form or by any means whatsoever by any person without PACRA’s written consent. Our reports and ratings constitute opinions, not recommendations to buy or to sell.

Tel: 92 (42) 35869504 Fax: 92 (042) 35830425 www.pacra.com

The Pakistan Credit Rating Agency Limited SECTOR STUDY

1. PROFILE

Strategically important – association with agrarian economy

Largely based on natural gas as a raw material

Enjoys preferential treatment from GoP – subsidized gas rates

1.1 The agriculture sector is the backbone of Pakistan’s economy. It accounts for approximately 10%1 of the GDP (excluding livestock) and provides employment to almost 45%2 of the country’s total work force. Moreover, agriculture and agro-based products are the largest source of foreign exchange earnings for the country. Agriculture sector registered a sharp recovery in FY09 and grew by 4% as against the preceding year’s growth of 1%. However, continuing with the high volatility trend, the sector posted only 2% growth in FY10. Supply of cultivable land in Pakistan is relatively inelastic and the land is highly deficient in nutrients resulting in low yields. Therefore, the foremost means to increase agricultural productivity is by the use of fertilizers. Subsidy on imported phosphatic and potassic fertilizers, good wheat production and attractive agricultural support prices, were the key factors behind significant 15% growth seen in fertilizer offtake in FY10. The focus of the government on agriculture as an engine of growth and the rapidly increasing demand for agricultural produce place the fertilizer industry in a strategic position.

1.2 Product Classification: Fertilizer products are divided into the following classifications (1) Nitrogenous fertilizers, (2) Phosphatic Fertilizers, (3) Pottasic Fertilizers and (4) Complex Fertilizers. However, in terms of final products, urea and di-ammonium phosphate (DAP) are the most standardized products traded worldwide. Category Products Composition

Nitrogenous Urea 46.65%N 26.64%O 20%C 6.71%H CAN 27%N 6%CaO 4%MgO AS* 21%N 24%S

Phosphatic DAP 18%N 46%P MAP* 11%N 52%P (most common) TSP* 46%P (rock phosphate) SSP* 16%P 19-25%Ca Free Acid 3.5-4.5%

Pottasic SOP* 50%K 18%S MOP* 60%K 3.5% Sodium

Complex NP* 12%N 52%P NPK* Various combinations of N P & K

* Unlike Urea and DAP, these are not standardized products and are available in various combinations of chemical compounds.

Urea comprises over 70% of the fertilizer demand in Pakistan followed by DAP (~17%). The availability of natural gas – a major raw material – allows local production of Urea and DAP. However the demand outspaces the production and the shortfall is met by imports. Wheat being the largest crop of Pakistan takes up almost

1 Economic Survey 2009-2010 2 Federal Bureau of Statistics

FERTILIZER

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2005

-06

2006

-07

2007

-08

2008

-09

2009

-10


47% of the total cultivated land, while it accounts for 50% of the fertilizer consumption. The use of fertilizers among different crops in Pakistan is depicted in the graph. 1.3 Historical Review: Organized research into fertilizer technology began in the early seventeenth century. As scientific chemical theories developed, the chemical needs of plants were discovered, which led to improved fertilizer compositions. The chemical fertilizer industry could be said to have its beginnings with a patent issued to Sir John Lawes – British agricultural chemist (1814–1900) – which outlined a method for producing a form of phosphate that was an effective fertilizer. The synthetic fertilizer industry experienced significant growth after the First World War, when facilities that had produced ammonia and synthetic nitrates for explosives were converted into nitrogen-based fertilizers plants. The global fertilizer industry produces some 170 million tonnes of fertilizer nutrients annually. These are used in every corner of the globe to support agricultural production. There is no substitute for the nutrients absorbed by crops. As a major source of these, fertilizers therefore represent an essential ingredient in the drive towards world food security3.

1.3.1 A sharp shift in actual consumers of fertilizer has also occurred over the period in view. From 12:88 ratio (developing : developed nations consumption) in early 1960's the mix has now become 65:35. Almost a parallel shift has also occurred in fertilizer production in which close to 70% of the world's fertilizer is produced in developing countries as against about 40% in the early 1960s. Interestingly, over a third of the world's total production is in just two countries namely China and India. Hence, production

Ur

ea

(MT

)

6,000,000

5,000,000

4,000,000

3,000,000

2,000,000

1,000,000

0

Urea Production (Pakistan)

of fertilizers has become concentrated in countries, who are also the major users. Pakistan produces some 4% of the world urea.

1.4 Global Context: After the worst recession since World War II, the global economy is recovering. According to the International Monetary Fund (IMF), world

3 International Fertilizer Industry Association (IFA)

FERTILIZER of 26May 2011 www.pacra.com


output is seen as firmly rebounding in 2010 (+4.8%), driven by robust growth in emerging and developing economies. However, the recovery remains fragile, mostly because of high unemployment, low consumer confidence, reduced household incomes, and high public debt in many of the advanced economies. As a consequence, economic growth is expected to be +3.5% in 2011. These forecasts face certain downside risks, at least until the required reforms are completed. However, IMF estimates that these risks are appreciably lower than a year ago. With the economic recovery, prices of most commodities, including oil, minerals and agricultural commodities, have remained firm or have strengthened in 2010 and 2011. After a sharp contraction in 2009, international trade recovered in 2010 and could further increase in 2011. The weak US dollar strongly affects the profitability of farming in countries with strong currencies while providing opportunities to the farmers in countries with weaker currencies. Resultantly, Farmers in strong currency countries are more reluctant to invest in fertilizers. 1.4.1 Global Fertilizer Demand: After a sharp drop in 2008/09 due to the financial and economic downturn, world fertilizer consumption started to recover in 2009/10. Aggregate consumption in 2009/10 is estimated to be up by 5.2% to 163.7 Mt nutrients. This is still 4.2 Mt below the record in 2007/08 of 167.9 Mt. Nitrogenous (N) fertilizer demand is estimated to have fully recovered (+4.1%) to 102.6 Mt N, which is 2.1 Mt above the previous record. Phosphatic (P) fertilizer demand strongly rebounded (+11.5%) to 37.5 Mt (P2O5), but remained 0.9 Mt below its record of two years earlier. Pottassic (K) fertilizer demand remained stable and depressed at 23.5 Mt (K2O), which is 5.4 Mt below its previous record. Demand is estimated to have increased in all the regions but Latin America and Oceania. The largest changes in volumes occurred in North America (+2.8 Mt), South Asia (+2.5 Mt), East Asia (+1.2 Mt), and Western and Central Europe (+1.1 Mt).

Supported by attractive agricultural commodity prices in the second half of 2010, total world fertilizer demand is forecast to rise firmly in 2010/11 by 4.7% to 171.4 Mt. N demand would increase by 1.6% and is projected to reach a new record at 104.2 Mt. P demand is expected to fully recover (+6.0%) to a new high at 39.8 Mt. K demand should strongly rebound (+16.3%) at 27.4 Mt, but would remain 1.6 Mt below the record of three years earlier. Total fertilizer demand is forecasted to rise in all the regions but Eastern Europe, Central Asia and West Asia. The largest increases in volume are seen in East Asia (+3.1 Mt), North America (+1.5 Mt), Latin America (+1.3 Mt) and South Asia (+1.2 Mt).

Forecasts of 2011/12 are still very speculative. They will be greatly influenced by the evolution of agricultural commodity prices, which are likely to be highly volatile in 2011. Aggregate demand is forecasted to be up by 3.8% to 177.9 Mt. 1.4.2 Global Fertilizer Supply: Global fertilizer demand in 2010 has been robust and widespread, driven by a strong rebound in traditional markets where nutrient application was depressed in 2009 (Latin America, North America, Oceania and West Europe) and a sustained level of consumption in emerging markets. The recovery in demand has been stronger than anticipated and has provided support for an increase in domestic sales and global trade.



Global total nutrient production in 2010 has converged with world consumption, marking a significant 11% rebound over 2009. Production has increased in all nutrient segments, but potash has registered the largest gain. Ammonia production has increased by 4%, while urea output has expanded marginally. Phosphate rock production and that of phosphoric acid have grown in parallel, at the same rate of 10% over 2009. Potash production has increased by 57% over 2009, fully recovering from the depressed conditions existing since mid-2008.

Globally, the fertilizer industry has operated at 82% of installed capacity in 2010, compared with 74% in 2009. While this indicates a rebound, it does not yet signal the emergence of a potential shortfall in supply compared with 2007.

1.4.3 Global Demand/Supply - Urea: Global urea production in 2010 is estimated at 149 Mt product, representing a marginal 1% increase over 2009. The international urea trade is estimated at 38.5 Mt, a 6% increase over 2009. Imports have increased in most regions, notably Latin America, North America and Oceania. Worldwide, close to 25 urea projects will provide new capacity in 2010 and 2011. IFA estimates that global urea capacity will be close to 181 Mt in 2010 and 190 Mt in 2011. China alone would contribute 46% of the annual capacity increases. Taking into account a maximum operating rate of 87% of installed nameplate capacity, it is estimated that world urea supply will increase from 157 Mt in 2010 to 164.2 Mt in 2011. The global urea supply/demand balance shows an increase in the potential surplus by the second half of 2011, reaching 8.8 Mt product by the end of the year. Overall, the potential surplus would represent less than 5% of supply when idled plants are taken into account. Additional capacity in 2011 would add substantial tonnage of exports, with at least 3 Mt of urea by the end of 2011, equating to 9% of current global trade. The supply deficit nature of industry would not allow any negative impact on the prices.

1.5 Pakistan's Fertilizer Industry: Pakistan’s first Nitrogenous fertilizer plant, Pak American Fertilizers Limited (now Agritech Limited), was commissioned in 1958 to produce 50,000 metric tons per annum of ammonium sulphate based on indigenous coal and gypsum as raw materials. This was a public entity. Although, Mari Gas Field was discovered in 1956 by the Esso Eastern Pakistan Ltd. with the appraisal of 3 wells, the field was left undeveloped for lack of a suitable market till 1965-1966. Esso proposed the establishment of a urea plant in Dharki, a small remote area near Mari gas fields, due to the suitability of this gas for urea fertilizer production. Esso Pakistan Fertilizer Company Limited (now Engro Corporation Limited) started commercial urea production in 1968. 1.5.1 Production Process: The production process of fertilizers is depicted in the following figure.



The most recent offtakes of all fertilizers in Pakistan are depicted in the graph below:

80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%

1HFY11

Urea CAN AS DAP MAP TSP SSP SOP MOP NP NPK

FY10 FY09

All Fertilizer Offtake in Pakistan Nitrogenous Phosphatic Pottasic Complex

Urea CAN AS DAP MAP TSP SSP SOP MOP NP NPK Offtake FY09 73% 4% 0% 14% 0% 0% 2% 0% 0% 5% 1% Offtake FY10 72% 4% 0% 17% 1% 0% 0% 0% 0% 0% 0% Offtake 1HFY11 66% 5% 0% 21% 7% 2% 24% 4% 0% 4% 9%

Source :NFDC

1.5.2 Major players: Currently there are 9 players in the fertilizer industry in Pakistan out of which 3 major players contribute ~80% to the industry (based on FY10 urea production capacity). Six players are in the production and marketing of urea and other fertilizers while two players specialize in the production of Single Super Phosphate (SSP) fertilizer only. Fauji Fertilizer Bin Qasim is the sole producer of DAP in Pakistan. Out of 18 plants in Pakistan, 11 are in Punjab, 6 in Sindh and 1 in Khyber Pakhtunkhwa (KP).



Product Location Province Manufactured

1 Fauji Fertilizer Company Limited (FFC) Plant -I Plant -II Plant -III

2 Fauji Fertilizer Bin Qasim Limited (FFBL) Plant-I Plant-II

3 Engro Fertilizers Limited (EFL) Plant-I Plant-II Plant-III

4 Dawood Hercules Chemicals Limited (DAWH) 5 Pak Arab Fertilizers Limited (PFL)

Plant-I Plant-II Plant-III

6 Fatima Fertilizers Company Limited Plant-I Plant-II Plant-III

Agritech Limited (formerly Pak American7 Fertilizers Limited) 8 Hazara Phosphate Fertilizers Limited (HPFL)

Goth Machhi, RYK Goth Machhi, RYK Mirpur Mathelo, Ghotki

Bin Qasim, Karachi Bin Qasim, Karachi

Daharki Bin Qasim, Karachi Daharki Sheikhupura

MultanMultanMultan

Iskanderabad, Mianwali Haripur

9 Lyallpur Chemicals & Fertilizers Limited (LCFL) Jaranwala

Punjab Urea Punjab Urea Sindh Urea

Sindh UreaSindh DAP

Sindh Urea Sindh NPK Sindh Urea Punjab Urea

Punjab Urea Punjab NP Punjab CAN

Punjab Urea Punjab CAN Punjab NPK

Punjab Urea KP SSP

Punjab SSP

FFC is currently the leader in the fertilizer industry with approximately 46% market share (urea). In the past, the fertilizer industry has not been able to meet the local demand. This has encouraged firms to increase their capacities. In this regard, the largest expansion plan carried out by Engro Fertilizers Limited which is expected to announce COD in 2Q10; increasing its capacity by 1,300 Mt per annum. Fatima Fertilizer has undertaken a major fertilizer project with urea capacity of 500,000 tons per annum began production in 1HFY11. Meanwhile, a minor urea revamp is also underway in Agritech Limited. The fertilizer industry may experience excess supply, albeit limited, once the expansion projects are complete and gas is fully restored to all fertilizer plants.

UreaProduction 2,500,000

46% 32% 35%

22%

12% 10% 8% 9% 8% 7%

2% 1% 8%

50%

45%

2,000,000 40%

35%

1,500,000 30%

25%

1,000,000 20%

15%

500,000 10%

5%

- 0%

FFC FFBL EFL DAWH PakArab Fatima Agritech

CurrentCapacity ExpandedCapacity

1.1 1.6 Strategic Importance: Urea, being the most desired fertilizer, formed 71% of the total use of fertilizers in Pakistan in FY10. Urea is produced from Ammonia, production of which is entirely dependent upon the use of natural gas as a raw

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material. Pakistan, being blessed with indigenous natural gas reserve, has a significant portion allocated to fertilizer sector. The fertilizer industry is highly dependent upon the policy decisions by the government on the supply of gas. Lately, constrained supply of gas and its diversion to power plants has brought curtailment in gas supply for fertilizer sector. 1.7 Gas Availability: Pakistan’s available gas reserves are around 28 Trillion Cubic Feet (TCF) and the current annual consumption is 1.3 TCF4. Although these gas reserves, if tapped, could last for another 20 years at the current consumption rate, lately supply has lagged behind consumption because extraction from current fields is stagnant and no new fields have been discovered. In this regard, natural gas production increased nominally from 4,002mcfpd (million cubic feet per day) in FY09 to 4,063mcfpd (1.5% increase) to FY10. Meanwhile, the massive oil import bill and volatile international oil prices have forced the government to place greater emphasis on promoting the development of indigenous energy resources. Consequently, the government has been encouraging the industrial sector and power plants to shift from oil to gas, and the bulk of increased gas production has been diverted to this sector in recent years. As a result, Pakistan’s final energy consumption by source has witnessed a rise in gas’s share from 36% in FY05 to 44% in FY10. The fertilizer sector is the second largest consumer of gas (~670mmcfd) after the power sector (~2000mmcfd). Gas is used as fuel (fuelstock) and as the principal raw material (feedstock) in the production of fertilizers. Feedstock accounts for three-fourth of the total gas consumption of the industry. However, the recent energy crises have forced the sector to face upto 20% gas curtailment despite having high priority access to supply of natural gas according to the Natural Gas & Management Policy 2005.

1.8 Regulatory Structure: Fertilizer sector has always held its strategic importance in Pakistan. The early industrial players were public limited companies and government was able to exercise its pricing policy directly with the objective to keep it affordable for the farmers, helping the agricultural sector. The fertilizer sector falls under the purview of Ministry of Food, Agriculture, and Livestock (MINFAL). MINFAL is mainly responsible for policy formulation, economic coordination and planning in respect of food grain, agricultural & livestock. It also includes procurement of food grains, fertilizer, import price stabilization of agriculture produce, international liaison, economic studies for framing agricultural policies, fishing and fisheries beyond territorial waters and animal quarantine5.

1.9 Sector Development: In the last decade, all the public sector fertilizer plants have been privatized by GoP while the private sector companies are also adding manufacturing facilities. This has been possible due to incentives provided by the Ministry of Commerce & Industry through its Fertilizer Policy 2001. The highlight of the policy was the grant of extra gas subsidy upto 10 years. This was lower than the subsidized rates for the feedstock provided to the sector, available for setting up a new fertilizer manufacturing facility by the private sector. The subsidized rates are available to the manufacturers who sign the General Sales Agreement (GSA) with gas providers. The purpose was to keep up with the growing need of fertilizers in the country. GoP provided average ~PKR 18bln in subsidy to the sector in the past three years.

4 Pakistan Energy Yearbook 2010 5 http://www.minfal.gov.pk/


http://www.minfal.gov.pk/


2. GOVERNANCE

Governed by two Ministries

Special incentives for the sector through Fertilizer Policy 2001

NFDC – Fertilizer Research & Development

2.1 It is useful to examine the nature of governance system prevailing in the industry in order to assess the feasibility and efficacy of an industry towards achieving sustainable development. Fertilizer sector contributes directly to the agriculture of Pakistan and the first ministry to look after the welfare of agriculture was formed right after the partition in 1947 – Ministry of Food, Agriculture and Health. Raja Ghazanfar Ali Khan Khokhar , a leading member of the All India Muslim League and a trusted lieutenant of Muhammad Ali Jinnah, was appointed as its first minister. Today, fertilizer sector comes under the scope of two ministries, i) Ministry of Food, Agriculture & Livestock (MINFAL) and Ministry of Industries & Production (MOIP). The Federal Minister, appointed by the Prime Minister, is the functional head and is assisted by the Parliamentary Secretary. The position remains subject to political shifts. The sitting minister for MINFAL is Mir Israrullah Khan Zehri (graduate in agricultural studies – UK) while Mr. Shafqat Hussain Naghmi is the Secretary of MINFAL. The current minister for MOIP is Chaudhary Pervaiz Elahi (Diploma in Industrial Management – UK) and Mr. Aziz Ahmed Bilour is the Secretary to the Ministry.

2.1.1 MINFAL: The Ministry is mainly responsible for policy formulation, economic coordination and planning in respect of food grain, Agricultural & Livestock. Major functions include procurement of food grains, fertilizer, import price stabilization of agriculture produce, international liaison, economic studies for framing agricultural policies, fishing and fisheries beyond territorial waters, animal quarantine. It has eight attached departments, five autonomous bodies and one corporation (PASSCO – Pakistan Agriculture Storage and Services Corporation).



Functions: Functions of MINFAL are summarized in the table below:

Ministry Functions

Ministry of 1.Economic Co-ordination and planning in respect of food. Food, 2. Keeping a watch over the food supplies (including storage) position in the

Agriculture country. & Livestock 3. Procurement of food grains, including sugar:-

a) from abroad;b) for Federal requirement;c) for Inter-provincial supplies;d) for export and storage at ports. 4. Import and export control on food grains and foodstuffs. 5. Inspection, grading analyses of food grains and foodstuffs and maintenanceof standards of quality for import and export.Note:- Inspection, handling, storage and shipment of rice for export is theconcern of Commerce Division 6. Preparation of basic plan for bulk allocation of food grains and foodstuffs7. Price stabilization by fixing procurement and issue prices includingkeeping a watch over the price of food grains and foodstuffs imported fromabroad or required for export and those required for inter-Provincial supplies. 8. Collection of statistics regarding production, consumption , prices, importsand exports of food grains. 9. Food and Agricultural Organization of the United Nations in respect offood.10. Co-ordination of work relating to aid/assistance being received from aid-giving agencies in respect of food sector.11. Economic, Planning and policy-making in respect of agriculture.12. Agricultural Research Council; Agricultural commodities research.13. Food and agriculture organization of the United Nations in respect ofagriculture.14. Co-ordination of work relating to aid/assistance being received from aid-giving agencies in respect of agriculture sector. 15. Plant protection:-a) standardization and import of pesticides;b) aerial spray;c) plant quarantine; and d) locust control in its international aspect and maintenance of locust warningorganization.16. Economic studies for framing agriculture policy.17. Farm management research for planning, project formulating andevaluation.18. Seed testing and seed certification ; crops forecast and estimation; cropinsurance.19. Collection and complication of agriculture statistics. 20. Marketing intelligence.21. Grading of agricultural commodities other than food grains, for exports.22. Agricultural commodity research (marketing research and laboratoryresearch for laying down national grades).23. Soil survey, comprehensive inventory of the soil resource of the countryand their proper utilization. 24. Standardization and import of fertilizers for meeting Provincialrequirements25. Introduction of special crops like jute, tea, olive etc. 26. Standardization of agricultural machinery.27. Under-developed Areas :-a) Identification of Under-developed Areas.b) Identification of the fields in which an area is under developed.c) Measures necessary to remove the causes of under-development indifferent areas.28. Administrative control of the PASSCO. 29. Sugar Board.31. Socio-economic studies for framing agricultural research policies.



32. Agricultural commodities research; Federal Agricultural ResearchOrganizations (expecting Pakistan Central Cotton Committee and Soil SurveyDepartment).33. Coordination of aid/assistance from international aid-giving agencies andFAO in respect of agricultural research, including manpower training forresearch.34. Research for the introduction of improved germ plasm, both of plant andanimal origin 35. Research coordination in respect of livestock production , livestockdiseases and marine fisheries.36. Collection of statistics on agriculture research.37. High level manpower training for agricultural research..38. Inter-provincial coordination and coordination between the center and theprovinces in respect of agricultural research, including training of high levelagriculture scientist. 39. National policies, planning and economic co-ordination in respect of -i) Live stock including dairy, poultry and fisheries;ii) Animal disease control. 40. i) Co-ordination of foreign aid and technical assistance in the livestocksector and related fields;ii) Liaison with international agencies especially Food and AgricultureOrganization of the United Nations in the field of livestock.41. Development and co-ordination of livestock and poultry complexes withbilateral assistance.42. Statistics regarding livestock, poultry and fisheries.43. Price stabilization measures.44. Animal protection:i) Vigilance and measures for prevention of extension from one Province toanother of infectious or contagious diseases affecting animals;ii) Animal quarantine and inspection.45. Veterinary drugs, vaccines and animal feed additives. i) Import and Export. ii) Procurement from abroad for Federal requirements and for inter-provincialsupplies. 46. Livestock, poultry and livestock products;i) Market intelligence.ii) Import and export. iii) Laying down national grades;iv) Project formulation and evaluation.47. Standardization of dairy, poultry and meat processing machinery.48. Livestock insurance.

2.1.2 MOIP: Ministry of Industries (MOI) was established in early 1950s to act as a policy formulating agency and a focal point for promotion and expansion of industrial sector of the country. It was also entrusted to supervise the activities of Pakistan Industrial Development Corporation, which had the charter to develop the sectors where the private investor was not willing to invest. The concept of Public Sector emerged under Economic Reform Order (ERO) of January 1972, when major nationalization of industrial sector took place. Accordingly, the Government set up a new ministry namely Ministry of Production to supervise the affairs of newly nationalized Public Industrial Sector. In October 1993, both the Ministries were merged into one, as Ministry of Industries & Production (MOI&P).

Ministry Functions

Ministry of AS PER RULES OF BUSINESS 1973 AND AMENDED IN 1999 , Industries THE FUNCTIONS OF INDUSTRIES & PRODUCTION DIVISION

& ARE AS UNDER: Production

• National industrial planning and coordination.



Ministry Functions

• Industrial Policy.

• Employment of foreign personnel in commercial and industrial enterprises.

• Federal agencies and institutions for: a. Promoting industrial productivity; b. Promotion of special studies in the industrial fields; and c. Testing industrial products.

• Keeping a watch, from the national angle, over general price trends and supply position of essential commodities; price and distribution control over items to be distributed by statutory orders between the Provinces.

• Administration of the Essential Commodities Control Order, 1971, and related laws including price and distribution controls.

• Explosives (excluding the administration of Explosive Substances Act) and safety measures under the Petroleum Act and Rules made there-under.

• Designs and inventions including patenting thereof.

• Prescription and review of criteria for assessment of spare parts and raw materials for industries.

• Administration of Boilers Act.

• Development of Industries (Federal control) (Repeal) Ordinance, 1979.

• Economic Reforms (Protection of Industries) Regulation, 1972.

• Transfer of Managed Establishment Order, 1978.

• All matters relating to State Industrial Enterprises, especially, in basic and heavy industries, namely:-

• State Engineering Corporation, Islamabad

• Pakistan Automobile Corporation, Karachi

• National Fertilizers Corporation, Lahore

• Pakistan Steel Mills Corporation, Karachi

• Pakistan Industrial Development Corporation, Karachi

• Any other industrial enterprises assigned to the Division.

2.2 Pakistan Fertilizer Policy 2001 :Fertilizer Policy was announced with effect from 1st July 2001. The Policy was fixed for ten years with an estimated investment of USD 1.2bln in this sector for ten years. The policy has already entered its tenth year and a new policy is awaited. Basic objective of this Policy was a) to bring in new investment in this sector; b) provision of fertilizers to farmers at reasonable prices; c) to ensure optimal price and supply of gas; d) and to keep fertilizer prices 20% below the import prices.

It was estimated that Pakistan will need additional 2 million tons of fertilizers for local consumption in 10 years when the production stood at 4.2 million tons while consumption was 4.4 million tons in 2001.

As a result of this policy, the fertilizer industry experienced significant growth during the 10 year tenor. The green field projects as well as BMR activities in the sector attracted over USD 2bln investment in the sector with additional nameplate capacity of over 2 million tons. However, the rarionalisation of gas subsidy to the sector as envisioned in the Policy has not materilized.



Policy Highlights

The Policy had three parts : 1) Existing Fertilizer Plants, 2) New Fertilizer Plants and 3) Existing Plants Planning for expansion and BMR. The Highlights of the policy were as follows:

• Gas subsidy on Fertilizer will end in next five years.

• Pakistan offers gas to the new Plants at USD 0.70 as compared with USD 0.77 in many countries.

• Window for obtaining permission for new plants will be open for 4 Years only.

• For expansion in the existing Plants the gas prices will be the same for feed stock for five years.

• Second hand Plants will be allowed for import for the manufacture of fertilizer.

• Privatization of Gas Companies will have no effect on gas price to new plants as these will be catered from Mari Gas Field.

• Duty free import of rock Phosphate to Phosphatic Fertilizer manufacture and duty-free import of raw material to NPK fertilizer producers.

FertilizerPolicy 2001 • Guaranteed minimum price of DAP at USD 250 per tone.

• New investors would enjoy 10% discount on determined prices of Gas for a period of 13 years from the date of Gas Supply Agreement (GSA), in dollar terms.

• The Import of Plant, machinery and equipment not manufactured locally is allowed against customs duty of 10%.

• The charge of catalyst, chemicals lubricants and spares for the first two year operations would also be exempted from all taxes and levies.

• All the fertilizer producers, domestic and foreign, public and private would be treated equally in commercial, fiscal, corporate and contractual matters.

• To encourage local production, 10 percent duty on NPK imports would apply for a period of 5 years only, from the date of commencement of production.

• Selling price of fertilizer shall remain deregulated.

• Tax relief : Initial Depreciation Allowance (IDA) @50% of machinery & equipment cost

2.3 NFDC: The National Fertilizer Development Centre (NFDC) was set up by the Government of Pakistan (Planning and Development Division) in December 1977. After a brief period of aid from the United Nations Development Programme (UNDP) it has been assisted by the Food and Agriculture Organization (FAO) of the United Nations with Trust Funds from Norway (NORAD) upto May 1981, and from the Netherlands upto December 1997.

NFDC is a multidisciplinary research and development organization at the federal level that integrates disciplines such as economic planning, pricing and subsidies, privatization and deregulation, production and imports, marketing and credit, agronomy and soil science, research, extension and training.

In co-operation with the various federal and provincial institutions, NFDC studies all fertilizer-related problems from the supply source to the farmers' fields, with a view to helping in the formulation of Government policies and their implementation and to give support to other institutions.



The current broad objectives of NFDC are:

• To provide objective and comprehensive advice to all levels of Government, to the fertilizer industry and to other parties as may be relevant, on all matters related in any way to the fertilizer sector of Pakistan and its relations with the international fertilizer community.

• To conduct research studies on physical and economic returns on fertilizer use to farmers, impact of input prices on crop output, deregulation/privatization of fertilizer in order to facilitate policy decisions.

• To conduct fertilizer use surveys at farm level to monitor fertilizer use by crops, impact on crop productivity, crop responses to fertilizers and problems faced by farmers. Natonal

Fertilizer • To monitor the status of all aspects of fertilizer use development: Development production, imports, consumption, prices and evaluate situation

Centre (NFDC) critically for the information and action by the concerned organizations, so that timely actions can be taken to effect improvement.

• To promote efficient, balanced and environmental friendly integrated use of plant nutrients for sustainable agricultural growth.

• To help upgrade the capability of fertilizer research, extension and marketing personnel in the transfer of fertilizer technology.

• To provide a neutral common platform to resolve contentious issues in fertilizer sector.

• To launch new initiatives in soil fertility and plant nutrition management.

Organization Objectives

2.4 Entity governance structures: The ownership structures in the sector is dominated by prominent corporate groups of the country. This is translated into the better governance practices followed throughout. The sector is continuing to improve its governance with entities having foreign members on their boards. The entities are also active in imparting adequate information, fulfilling corporate social responsibilities and maintaining suffcient health and safety standards.

2.5 MINFAL safeguards the interests of the farmer community while MOIP is responsible for the well being of the industries. Hence, a slight conflict of interest exists for fertilizer sector. However, this has not caused any significant problem to date. The gas allocation related issues are moved in by the ministries to the Economic Coordination Committee (ECC), which takes the final decision considering the energy requisites of the country. 3.1 Fertilizer Industry is a capital intensive industry which requires huge initial

3. OWNERSHIP capital outflow. Plant setup costs are high and the process takes 3-5 years to Capital Intensive complete. To develop current idea about the costs involved, Engro is at an advanced

Industry stage of setting up a 1.3mln MT urea plant at a cost of USD 1,050mln. Considering Instituitional the huge costs, approximately USD 850mln has been arranged through local and

Holding Structure foreign debt while USD 300mln was injected as equity from the sponsors. 3.2 The industry experienced significant growth during the past 10 years. The fresh Owned by large allocation of gas for fertilizer plants in this period attracted over USD 2bln groups investment in the sector. After the completion of privatization process in 2006, there are currently 9 fertilizer companies of which 5 are listed on stock exchange. The following graphs provide YoY status of the paid up capital, market capitalization of listed fertilizer companies and their respective share in Karachi Stock Exchange.



2006 2007 2008 2009 2010

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

0.0%

1.5%

3.0%

4.5%

6.0%

7.5%

9.0%

10.5%

12.0%

Market Capitalization

Fertilizer Industry Capitalization % of total KSE Capitalization

PK

R(m

ln)

2006 2007 2008 2009 2010

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

Paidup Capital

Paidup Capital % of total paidup capital on KSE

PK

R(m

ln)

3.3 The presence of private investors in Pakistani corporates normally implies that the majority of companies would be owned by individuals or family owned institutions. However, in the fertilizer sector, the ownership structure has evolved from individual holdings and there is concentration towards institutional/group holding structures. The fertilizer industry is owned by large financial groups of Pakistan including Dawoods, Fauji Foundation, and recently Fatima Group and Arif Habib Group. Hence the level of commitment from the sponsors have been fairly high. The sponsoring groups financial strength has enabled them to inject as well as attract capital to fertilizer industry. The move from individual to group holding structure has largely mitigated the succesion risk in ownereship. A brief profile and ownership structure of the major fertilizer players of Pakistan is discussed below.

3.3.1 A) Fauji Fertilizer Company Limited (FFC), incorporated in 1978, commenced full commercial production in 1982 as a urea manufacturing, purchasing and marketing company in Pakistan. Listed on all three bourses of the country, FFC has two production facilities: one located at Goth Machi, District Rahim Yar Khan and the other in Mirpur Mathelo, District Ghotki. FFC is currently the largest urea manufacturing facility of Pakistan comprising three ammonia/urea plants with a combined design capacity of ~2mln MT per annum.

B) Fauji Foundation (FF) holds the majority shareholding in FFC. FF, established as a charitable trust in 1954 and operating on a completely self-sustaining basis, channels approximately 80% of the dividends from commercial ventures into social protection programs. The Foundation provides services in the areas of healthcare, education, technical and vocational training. The commercial ventures include entities operating in fertilizer, cement, power generation, oil and gas, food, financial and security services. Established entities like FFC, Fauji Fertilizer Bin Qasim Limited, Fauji Cement Company Limited, Mari Gas Company Limited and Fauji Cereals are part of the group. FF holds combined assets of over USD 2bln.

3.3.2 A) Fauji Fertilizer Bin Qasim Limited (FFBL), incorporated in 1994,



commenced full commercial production in 2000 as a granular urea and Di-Ammonium Phosphate (DAP) fertilizers manufacturing, purchasing and marketing company in Pakistan. It is listed on all three bourses of the country with the manufacturing complex located in Eastern Zone of Bin Qasim, Karachi. The current design capacity is 551,000 MT per annum for urea and 670,000 MT per annum for DAP.

B) Fauji Fertilizer Company Limited (FFC) and Fauji Foundation (FF) hold the majority shareholding in FFBL. Both FFC and FFBL market their products under one umbrella brand, Sona, which has wide recognition among the farmers’ community.

3.3.3 A) Dawood Hercules Chemicals Limited (DHCL) was incorporated in 1968 as a joint venture between Dawood Group and Hercules Incorporation, USA. The company, listed on Karachi and Lahore Stock Exchanges, is engaged in the business of manufacturing Urea. DHCL was the first private sector venture in Pakistan (in fertilizer industry). DHCL’s urea production capacity is 445,500 MT per annum.

B) Dawood group (DG) has majority shareholding in DHCL (through group companies and individuals). DG is primarily engaged in the business of fertilizer, textiles, insurance, IT, and power. The journey of the group started in 1949 with the foundation of first group company - Lawrencepur Woollen & Textile Mills. With the passage of time, apart from DHCL, some other group concerns – Dawood Cotton Mills Limited, Burewala Textile Mills Limited, Central Insurance Company, Dawood Foundation, and Dilon Limited were also founded. In 2004, all the textile companies of the DG were merged in a single entity – Dawood Lawrencepur Limited. During the same year, the group acquired majority stake in Inbox Business Technologies (Pvt.) Ltd, an information technology firm. The group also runs a small brokerage house by the name of Elixir Securities Pakistan (Pvt.) Limited. Meanwhile, the DG, through DHCL, also has a strategic investment in Sui Northern Gas Pipelines Limited.

3.3.4 A) Following demerger of fertilizer operations as on January 1, 2010 from Engro Corporation Limited (formerly Engro Chemical Pakistan Limited) to Engro Fertilizer Limited (EFL), EFL began its fertilizer manufacturing operations as a new entity. EFL, currently the second largest producer of urea in the country, is in the business of manufacturing and marketing of fertilizers. EFL markets urea under the brand name of Engro Urea, MAP under the brand name of Zorawar, NPK under Zarkhez and DAP as Engro DAP. EFL’s urea plant, with a capacity of 975,000tons per annum, is located at Dharki, whereas NPK plant is situated at Port Qasim.

B) EFL is a wholly owned subsidiary of Engro Corporation Limited – ECL while Dawood Group holds a majority stake in ECL through direct and indirect shareholding. As a part of demerger, Engro Corporation is now the holding company for all strategic investments including fertilizer operations. Other business interests include Engro Eximp Limited, Engro Foods Limited, Engro PowerGen Limited and Engro Vopak Terminal Limited.

3.3.5 A) Fatima Fertilizer Company Limited, incorporated in December 2003 as a non-listed public company, is at significantly advanced stage of setting up a fertilizer complex at Mukhtar Garh, Sadiqabad, Rahim Yar Khan to produce Urea, Calcium Ammonium Nitrate (CAN), Nitro Phosphate (NP) and Nitro Phosphate Potash (NPK). The company was listed on all three bourses of the country in Mar10. The nameplate production capacity of the fertilizer complex would be 1.58mln tons per annum.

Fatima Group (FG) and Arif Habib Group (AHG) acquired Pakarab Fertilizers Limited (PFL), the associate company of Fatima Fertilizer, in 2005 from the government of Pakistan at a total cost of USD 250mln. PFL, with its plant located in Multan,



manufactures nitrogenous (Urea and CAN) and complex (NP) fertilizers with a nameplate capacity of 846,900 tons per annum. It is currently the only producer of CAN (450,000 tons per annum) in Pakistan.

B) FG and AHG own Fatima Fertilizer through PFL and their direct shareholding in the company. FG includes Fazal Group (FaG) as well. Late Mr. Sheikh Fazal-ur-Rehman, the predecessor of the Fatima Group, started his journey in 1936 by setting up a vegetable oil and ghee unit. His son, Mr. Sheikh Ahmad Mukhtar, played a leading role in establishing Fatima Group. FG is now one of the leading corporate groups in Pakistan with interests in sugar, textiles, fertilizer and foreign trade. Two of group’s entities, Fazal Cloth Mills Limited and Reliance Weaving Mills Limited, are listed on Karachi and Lahore Stock Exchanges. The group has close to seven decades of experience in textile business with over 50 years of experience of dealing in export markets such as the USA, Japan, Hong Kong and various European countries. Other group entities include Fatima Sugar Mills Limited, Reliance Cotton (Pvt.) Limited, Reliance Commodities (Pvt.) Limited and Pakarab Fertilizers Limited.

Ownership Summary Company Majority Stake Listing status Dawood Hercules Chemicals Limited Dawood Group Listed Engro Fertilizers Limited Dawood Group Not Listed Fauji Fertilizer company Limited Fauji Foundation Listed Fauji Fertilizer Bin Qasim Limited Fauji Foundation Listed

Fatima Fertilizer Company Limited Fatima Group/Arif Habib Group Listed

Pakarab Fertilizers Limited Fatima Group/Arif Habib Group Not Listed

Agritech Limited (formerly Pak American Fertilizers Limited) Azgard9/JS Listed Hazara Phosphate Fertilizers Limited Azgard9/JS Not listed

Lyallpur Chemicals & Fertilizers Limited Al Hamd Chemicals Not listed

4. MANAGEMENT, SYSTEMS & CONTROL

Experienced professionals

Renowned consultants for project management

Integrated MIS implemented in large companies

4.1 Management & Control: Fertilizer industry in Pakistan is mostly populated with chemical engineers with degrees from local universities. Nevertheless, the top management of fertilizer companies constitutes people holding foreign degrees and having working experience abroad. The individuals working in a fertilizer company are classified as management and non-management staff members. The term management staff refers to individuals who are actively involved in managerial activities, mostly based in head offices situated in major cities and a few on the plant site. All others are termed as non-management staff members. Being a very specialized sector, the turnover is very low in the industry. For instance, people in the top management of fertilizer companies have been associated with their firm for 20 or more years in majority cases.

The industry is dominated by few players, the top 3 firms comprise ~80% of the system share. These top firms maintain an effective control environment with clear reporting lines and well defined policies and procedures. The review and accountability function runs through the entire organizational structure. To maintain proper monitoring and thorough oversight of strategic investments, these firms have established effective MIS. These characteristics have set precedents in the industry and the new entrants are in process of matching these standards.

Fertilizer companies have a very simplistic organogram with departments divided into functional areas such as 1) Manufacturing, 2) Finance & Admin , 3) Human Resource, 4) Marketing & 5) IT. Apart from manufacturing based on plant-site, all departments are usually located at the head offices in large cities.

4.2 Production: The business model of fertilizer companies is not a complicated one. It is a sellers' market and the core management function is to ensure the smooth flow



of production and distribution. Hence an efficient logistic system in place ensures ready delivery of the product. On the other hand, the only raw material critical for production is supply of gas. Hence the other requisite strength in fertilizer industry's human resource is their political connections, which ensure stability on the production side.

Owing to the capital intensive nature of plants, some fertilizer plants in Pakistan are second-hand relocated from Europe. Even during the relocation process, the de-assembling and assembling require a lot of new parts to be used until the plant is commissioned. Hence, a lot of international consultants, constructors, and technical advisers are involved in the setup process. The production process is a simple one, hence once the plant is commissioned and has no apparent technical problems, it is able to produce a salable product even during the trial run.

4.3 Maintenance & BMR: The plants are periodically maintained under annual turnarounds being carried out by local engineers. Regular maintenance and timely BMRs improve efficiency levels enabling them to consume lesser energy while maintaining optimal output. The plants require replacement of parts over time which are imported.

4.4 New Plants: Pakistan experienced major expansions in fertilizer sector during the last decade due to the favorable government policies. During this period there was one new plant erected (Engro), there were plants relocated to Pakistan (Fatima Fertilizers) and Balancing, Modernizing and Revamping (BMR) activities carried out (FFC, FFBL, Dawood and Agritech). Hence, different set of skilled labour was required during this period.

In the recent expansionary phase of fertilizer industry, project management is one of the key areas developed at the top management level. The people chosen for this responsibility are in the industry for over 15 years and have ample experience of successfully conducting BMR activities. The industry was able to attract workforce from specialized chemical industry into fertilizers specially in the area of project management. Pay-levels in the industry are at par with other major industries but human resource retention becomes difficult in competition with fertilizer & chemical industry in the middle east.

Unlike some industries, such as textile, fertilizer sector is not directly managed by Self Regulatory Organizations (SRO). The industry falls directly under the purview of Ministry of Food, Agriculture and Livestock (Minfal). The decisions on the allocation of gas to the firms is decided by the Economic Coordination Committee (ECC).

4.4 Technology: The industry has been engaging leading international contractors and suppliers, which have significant experience in their respective fields. These include Sojitz Corporation – a leading chemical fertilizer producer in Southeast Asia and reputed suppliers and technology licensors such as Kellog, Kawasaki and Stamicarbon – repute in setting up new or refurbished plants. Kellog is a technology-based engineering service provider specializing in ammonia plants, Kawasaki specializes in project management services, whereas Stamicarbon – specializing in licensing of urea – has provided license to 220 projects and has a global share of approximately 70%. China National Chemical Engineering Corporation, a large corporation directly administered by the State Council of China, has been responsible for establishing the plants and have expertise for civil and mechanical completions. General Electric, a renowned name, is a provider of power plants and known for the overhauling of the used fertilizer plants. Descon Engineering – a multi-dimensional engineering, construction and manufacturing company operating in Pakistan and the Middle East – has also been involved in projects for fertilizer industry.

Independent consultants such as Shaw Consultants (for technical reviews and monitoring), Miller Consulting Services (for risk assessment and insurance cover), and Haidermota & Company (for legal advisory and counseling services) have also been the feature of the industry for upcoming plants.



4.5 MIS: The industry realizes the importance of efficient use of information systems in entity resource planning. An ERP integrates all the modules in manufacturing (including purchasing, inventory and order management) , financial management, human resource planning under one umbrella. For this purpose, two ERP systems are being used in the industry, 1) SAP ERP and 2) Oracle 12. Both systems are very efficient and capable of generating real time reports to facilitate day to day operations and also aid in long term strategy formulation.

5. BUSINESS RISK 5.1 Pakistan is an agrarian economy where more than 70% of its population is Stable demand directly or indirectly employed

Gro

wth

(%)

Growth Trend Strong Margins by this segment. Similarly, the

performance of this 50% segment

2004 2005 2006 2007 2008 2009 2010

Gas supply risk also translates into a spiraling 40%

and prominent impact on thecountry’s overall economicperformance. However,productivity of the farmingsector continues to remain lowdue to the prevalence ofinefficient farming practices,lack of technical know-how anddepletion of nutrients in thesoil. Nevertheless, the strategicimportance of the sectortowards ensuring ruralemployment and food securityof the country forces the

30%

20%

10%

0%

-10%

-20%

-30%

-40%

Year

Agriculture Urea DAP

government to support the sector. Thus, the domestic governments help farmers in the form of increasing crop support prices, raising market accessibility, improving water reservoirs and distribution system, developing infrastructure and emphasizing the need for credit to the agriculture sector by encouraging banks and DFIs to come forward. Since efficiency in balancing soil nutrients is always considered as the initial and the most vital factor for the output of any crop, fertilizer consumption in Pakistan is witnessing a persistent growth during last few decades. Currently, Pakistan is amongst the top fertilizer consumers of the world with offtake of approx 8mn tons for 2008/09 (almost 5% of the total world consumption as reported in the IFA Annual Conference 2009).

5.2 Strategic Importance: The importance of Agriculture in Pakistan raises the significance of fertilizer as the major farm input. The Government has taken several significant steps to boost agricultural production over the last five years. In this regard, GoP has kept the prices of phosphatic fertilizers affordable for the farmers not allowing them to go beyond certain limit by providing subsidies.

5.3 Market Structure: Fertilizer industry falls under Urea Market Share (Current) an oligopolistic market 8%

structure with two players –

12%

2%

10% Fauji and Engro Fertilizers – combined holding over 75% of the market share. This 46%

allows the major players in the market to have power to

22%

determine urea prices. The market share of all players at present and after the expansionary activities are

FFC FFBL Engro Dawood Pakarab Agritech depicted in the pie charts.



5.4 Competition: Engro and Fauji Fertilizers, being the largest players in the industry, set the urea market prices while others players follow. Since the fertilizer companies have gas available to them at subsidized rates, the final price of the product is reviewed by GoP. Pakistan still suffers from production deficit in fertilizers, therefore the element of competition does not dominate pricing. All the players are able

Urea Market Share (post expansion)7%

8%

32% 1%

8%

9%

35%

FFC FFBL Engro Dawood Pakarab Fatima Agritech

to sell everything they produce. The final price of urea in Pakistan works out to be ~40% cheaper than the international urea price, thus ruling out any possibility of international competition.

5.5 Barriers to entry: The biggest barrier to the entry in fertilizer sector is the limited availability of gas. In early 2000s, GoP initiated the drive to rely more on indigenous energy resource and distributed additional gas contracts to the existing firms for expansion and to the new entrants, interested in setting up fertilizer plants. Additional gas subsidies were also provided under Fertilizer Policy 2001 to encourage fertilizer production. Players like Engro opted for an additional plant setup and other players also took up minor expansionary projects. Meanwhile, Fatima Fertilizer was the new entrant in the market. However, by late 2000s, the gas demand had increased significantly on the back of increased uses of gas in commercial and industrial activities. The major contributors were transportation and power segments, which moved to gas from oil. In the current scenario, there has to be gas load shedding to manage the gas supply to all the sectors. Fertilizer, though having the priority allocation of gas (Natural Gas & Management Policy 2005), faced gas curtailment (upto 20%) for the first time in 2010 as gas was diverted to the power plants. This limited gas supply has become another barrier to entry for the fertilizer sector. GoP is making efforts to improve the situation through imports from Iran and Turkmenistan to bridge the demand-supply gap. Secondly, the other vital barrier in entering fertilizer industry is the capital intensive nature of the business. According to the latest estimates, a million ton urea producing plant requires a billion dollar investment. Therefore, this sector provides investment opportunities to only the large groups with financial muscle.

5.6 Urea Demand-Supply Gap:Urea consumption comprisesmore than 70% of the totalfertilizer use in Pakistan andhence using the term fertilizer,most commonly, refers to urea.The demand for urea has grown~160% over the past twodecades. The local productionhas not been able to meet thedemand and the difference hasbeen bridged through imports.During last two decades, Therehave been only a few years

Tons

Urea Analyses7,000,000

6,000,000

5,000,000

4,000,000

3,000,000

2,000,000

1,000,000

0 (1994-1995 & between 2001- 2005-06 2006-07 2007-08 2008-09 2009-10 2004) where the domestic Years supply has exceeded the local Production Offtake Imports demand. On average, ~10%



demand per year is met through imports. The average production and offtake growth occurred at almost the same rate (~5%) which meant the demand-supply gap never declined. In fact, in last two years, urea imports have increased (FY09: 878k tons; FY10: 1,523k tons).With new capacities coming online (Engro & Fatima), Pakistan could have urea surplus (~300k tons) for at least a couple of years (2011-2013). However, the continuing gas curtailment, resulting in lower capacity utilization, have neutralized the impact of additional capacity. This implies that demand (6300k tons) would out pace supply unless there is significant expansion in the sector. The other critical factor is sufficient supply of natural gas.

Demand – Supply Position for past two decades

Period Production Offtake Surplus/(Deficit) Imports Surplus/(Deficit) 1989-90 2,108,865 2,524,000 (415,135) 371,000 (44,135) 1990-91 2,050,278 2,553,000 (502,722) 541,000 38,278 1991-92 1,902,296 2,553,000 (650,704) 570,000 (80,704) 1992-93 2,306,110 2,849,000 (542,890) 525,000 (17,890) 1993-94 3,103,854 2,978,000 125,854 206,000 331,854 1994-95 3,000,313 3,152,000 (151,687) 0 (151,687) 1995-96 3,258,046 3,648,000 (389,954) 389,000 (954) 1996-97 3,258,135 3,643,000 (384,865) 704,000 319,135 1997-98 3,284,168 3,802,000 (517,832) 264,000 (253,832) 1998-99 3,550,457 3,887,000 (336,543) 574,000 237,457 1999-00 3,968,151 3,999,000 (30,849) 114,000 83,151 2000-01 3,983,257 4,047,000 (63,743) 86,000 22,257 2001-02 4,259,829 4,185,000 74,829 0 74,829 2002-03 4,407,462 4,262,000 145,462 0 145,462 2003-04 4,434,834 4,637,000 (202,166) 0 (202,166) 2004-05 4,610,672 5,120,000 (509,328) 307,000 (202,328) 2005-06 4,803,870 5,405,000 (601,130) 825,000 223,870 2006-07 4,731,732 4,678,000 53,732 281,000 334,732 2007-08 4,925,132 5,579,000 (653,868) 181,000 (472,868) 2008-09 4,920,730 5,766,000 (845,270) 878,000 32,730 2009-10 5,152,610 6,545,000 (1,392,390) 1,523,000 130,610

5.7 Derived Demand: The demand for fertilizer is often linked to the agricultural growth in the country. In the past 50 years the growth of agriculture sector has ranged between 3%-5% for each decade. However, during the past 7 years the trend has been very mixed. The agricultural growth went as high as 6.5% in 2004-2005 and as low as 1% in 2007-2008. This variation is not reflected in urea offtake, which shows a growth of 10% in 2004-2005 and 19% in 2007-2008. As a general perception, an increase in fertilizer offtake should reflect directly in agricultural growth, whereas, the statistics suggest that the the application of fertilizers has been growing at a steady pace. This is peculiar but a justifiable answer is that at the time of the application of fertilizer, farmers are not aware of the outcome of the final crop. Hence fertilizer consumption may show growth but attributes like bad weather can wipe out the crops. A more clearer relation of agriculture and fertilizer use is evident in the preceding years. The application of fertilizer per hectare of arable land in Pakistan is at 184kg/ha, which is 28 percent higher than the global average. Other variables such as farmer awareness, farmer income and depletion of nutrients in the soil also play vital role in computing fertilizer demand.

5.8 Farmer Awareness: Fertilizer companies have become very active in recent years with the objective to educate farmer on the most effective and efficient usage of fertilizer. These efforts materialize through the setting up of camps by the fertilizer companies in the rural areas to conduct soil testing. This enables the companies to recommend correct proportion of fertilizer use for the farmland. Fertilizer recommendations are based on two factors: i) nutrient requirement of a crop and ii) fertility level of the soil. Hence, increased awareness contributes to the demand for fertilizers.

5.9 Farmer Income: Income generated in a given year determines the purchasing power of the farmer effectively in the following year. Though some effect is captured



in the same year since the farmers raise credit to finance their seed procurement with the hope of generating higher income. This was evident in the year 2008 when the support price for wheat, a major crop, was raised to PKR 950/50kg. The results were visible in the 2009-2010 fertilizer offtake, which grew by 13.5%.

5.10 Nutrients Depletion: Crop need 16 different nutrient elements for their growth. With the introduction of high yielding crops (BT cotton) and increased cropping intensity, soils are becoming deficient in these nutrient elements. So to make the deficiency of nutrients, farmers have to apply more chemical fertilizers. A genetically modified crop consume 50%-100% more fertilizer. Therefore, to maintain the nutrients in the soil, fertilizer application has to increase every year.

5.11 Nature of Product: Fertilizer, in nature, is equivalent to a consumer item used everyday (food). The way food is important for the humans when they are hungry, fertilizer application is required for the crops whenever they need nutrition intake. The fertilizer application varies like humans where some crops require more intake whereas others consume less.

5.12 Demand Elasticity: The demand for fertilizer is highly inelastic where a small change in price does not corresponds to a very large fall in demand. Its a basic necessity for the crops and has to be consumed on periodic basis. There may be a switching effect within the fertilizer products in response to the price of various products but overall fertilizer demand is not affected.

5.13 Diversification: Fertilizer sector has only one avenue to sell its product, which is agriculture. However, the strategic importance of agriculture is very high and it ensures a very stable demand for fertilizer in the country. The product is available in different combinations of Nitrogen, Phosphate and Potash.

5.14 Demand & Supply: In 2010, the urea demand, which witnessed a mixed growth trend during the last few years, increased sharply by 13.7% to 6.5mln tons. This coincided with short revival in the agriculture sector. Not only did the major crops of the country (wheat, rice, cotton, sugarcane) perform well in terms of yield, they also fetched better pricing in the domestic and international market.

In the past, the fertilizer industry has not been able to meet the local demand. This supply-demand gap has encouraged firms to increase their capacities. In this regard, the largest expansion plan is being carried out by Engro Fertilizers Limited, which is expected to come online by end of 2010. This will increase its capacity by 1,300,000 MT per annum. Fatima Fertilizer Company Limited is undertaking a major fertilizer project with urea capacity of 500,000 tons per annum expected to achieve commercial production of urea soon. Meanwhile, FFC has BMR plans to expand its capacity by 158,000 tons per annum and a minor urea revamp is also underway in Agritech Limited. The fertilizer industry will have excess supply, though limited, once the expansion projects are complete and may have to export the surplus production. Nevertheless, since the GoP has decided to curtail the gas supply to fertilizer industry in order to support the power sector, the industry may continue to have a deficit position, met through imports. The local production registered a growth of 4.7% in 2010 on YoY basis.

(000 tons) All Fertilizer

1Q11 FY10 FY09 FY08

Products Offtake 1,703,033 8,966,253 7,873,882 7,641,000 Production 1,804,224 6,735,387 6,376,716 6,050,300

Urea Offtake 1,154,000 6,545,365 5,756,963 5,579,000 Production 1,312,000 5,152,610 4,920,730 4,925,000

DAP Offtake 355,000 1,535,519 1,090,247 1,088,000 Production 164,000 625,889 533,734 356,000

Source: National Fertilizer Development Centre (NFDC)


July

09

Aug0

9

Sep0

9

Oct09

Nov09

Dec09

Jan1

0

Feb1

0

Mar10

April1

0

May10

June

10

Jul-1

0

Aug-

10

Sep-

10

00/9991

10/0002

20/1002

40-3002

50-4002

60-5002

70-6002

90-8002

01-9002

)M9(11-0102


During FY10, DAP sales picked up after having couple of dry years on the back of higher phosphate prices. Increased awareness among farmers about the benefits of balanced fertilization and the low base effect contributed to ~41% growth in DAP offtake in FY10 returning close to peak FY07 offtake levels (1.6mln tons). DAP offtake in 1HFY10 contributed 79% to the total offtake for the year. The demand went southwards during the later period owing to the rising trend in DAP prices. The country produced 17% more DAP in FY10 on YoY basis, attributed to no turnaround this year.

During July10, Pakistan faced worst floods affecting almost all provinces of the country. The flood impacted several agricultural fields and along with capital losses to the standing crops, eroded distribution channels for the manufacturing industries. Among other sectors, fertilizer production also suffered including one instance where the gas pipeline from Mari Gas fields was chocked because of rain water causing supply disruption lasting ~5 consecutive days. Fertilizer offtake remained slow in the beginning of FY11 owing to a) submerged agricultural lands and b) the weakened financial strength of the farmers. The World Bank and Asian Development Bank in their joint Damage and Needs Assessment have assessed ~USD 5bln losses to the agriculture and livestock of the country during the devastating floods in the country. However, fertilizer offtake is expected to experience Fertilizer Offtake recovery, going forward, 1,000,000

in the wake of upcoming 900,000

Rabi season. 800,000

Demand for phosphatic 700,000

and potassic fertilizers, 600,000

required for balanced 500,000

fertilization, has been met 400,000

mainly through imports. 300,000

The high cost of imported 200,000

raw material for non- 100,000

nitrogenous fertilizers and 0

vulnerability tointernational scenario

Urea DAP provides limited attractionfor domestic producers to venture into the production of these fertilizers. Fatima’s new fertilizer complex will produce CAN (410k tons), NP (363k tons) and NPK (330k tons) along with Urea. FFBL remains the only DAP producing facility in Pakistan which met ~40% of local demand of DAP during FY10. Engro Fertilizer also has a small facility for manufacturing NPK.

5.15 Prices Urea prices have almost doubled in the last couple of years after following arelatively stabletrend in thepreceding years. Theprices rose mainlyon the back ofincrease in gasprices and otheroperating expensesin the wake ofpersistent inflation.However, the urea prices in Pakistan still remain at ~40% discount to the

PR

0b

)a

gg

5(K

K

4,000

3,500

3,000

2,500

2,000

1,500

1,000

500

0

Fertilizer Price Trend

international market Urea DAP



0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

due to the subsidy provided in form of feedstock to the local producers. Since most of the local consumption of DAP is fed by imports, its prices have been changing in line with the international market dynamics. Given the past history, GoP comes forward to provide subsidy on DAP when the prices of DAP go beyond a certain level – a level at which demand of DAP is normally strangled.

With rising imports, the government has to bear the major cost of the imported product, which is procured at international market prices and sold to the final consumer at subsidized rates. The current import urea price is ~USD 380/ton (fob), whereas current domestic urea price is ~USD 270/Ton. The prices of local urea are, therefore, expected to remain firm and margins are likely to remain stable. The international DAP price is around USD 600/ton (fob) whereas it is sold in the domestic market at ~USD 850/ton6. GoP provided averaging around PKR 18bln as subsidy to the sector in last three years. The trend in prices of urea and DAP is illustrated in the chart.

5.16 Performance: The year 2010 has been a mixed year for the fertilizer sector interms of its performance. The fertilizer industry, having very stable demand drivers,had a good start to the year.The urea prices were raisedupto PKR 100 per 50kg bag Fertilizer-Turnover & Margins on the back of the gas curtailment announcement 160,000

from GoP in the first quarter, 140,000

which contributed positively 120,000

to the margins in the industry. 100,000

The actual gas curtailment 80,000 came in the second quarter but 60,000 since the industry had already 40,000 incorporated the effect in their 20,000 prices, the large players were 0 able to maintain their margins. 2007 2008 2009 2010 Unfortunately the small players had to suffer because

Turnover Gross Margin NP Margin of a) their inability to charge higher prices b) coupled with their geographical location which received comparatively more gas load shedding due to the proximity with most of the power plants in the country. The gas curtailment was lesser than expected for large players and they reduced their prices upto PKR 25 per 50 kg urea bag in Aug10. Recently, the prices have crossed PKR 1100/50kg urea bag after further gas curtailment to the sector and implementation of 17% GST on fertilizers.

5.17 Profitability: Major players in the industry reported healthy growth in their toplines during the year 2010 on the back of increased fertilizer prices. The gross margins in the industry remained ~42% on average which converted into an average bottom line of ~21% of sales in the same period. With the stability of demand, the margins are expected to remain unchanged. The performance of major players in the industry pertaining to 2010 are depicted in the following table.

Debt servicing for the period ending Dec 30,2010

Fauji Fertilizers FFBL Engro Fertilizers Dawood Hercules Pak Arab Fertilizers

Sales (mlns) 44,874 43,257 19,018 8,715 18,248 Gross Profit (mlns) 19,563 13,463 8,910 3,501 9,197 Finance Cost (mlns) 1,086 934 1,292 909 3,590 Other Income (mlns) 3,153 1,153 120 1,189 1,408 Net Profit (mlns) 11,028 6,514 3,729 2,148 3,232 EPS 16.3 7.0 3.5 17.9 7.2 Gross Margin 44% 31% 47% 40% 50% Net Margin 25% 15% 20% 25% 18%

6 freight and distribution charges are estimated to range between USD 80-100 per ton. The prices are after incorporating 17% GST



5.18 Supply Risk: The industry is facing high supply risk in the recent times. Since the demand for gas has increased and its utilization is spread to new avenues such as power sector, the fertilizer industry faced gas load shedding upto 20% for the first time in 2010. The industry, having the top priority on the right to utilize gas, lost to the power sector facing the worst crises in Pakistan. The situation is unlikely to improve in the short run based on the rising demand for gas until GoP find new supply line for the gas. In this regard, project is underway to purchase gas from Iran and Turkmenistan but by the time it is available, the gas demand in the country would have already exhausted the new addition to the supply line. An alternative solution may exist in the form of importing LNG and using it as a raw material rather than natural gas. However, the issues of allocation of LNG/natural gas between the major sectors (Power, Fertilizer & domestic segment) has no easy solution as the cost differential between the two is high and the margins of the sector switched to LNG will be greatly impacted. A further concern may arise on account of limited foreign exchange available for import of LNG – most of which is tied up in the procurement of oil for energy, transport and large scale industries.

Gas curtailment impact on Urea demand deficit (000) tons CY11 CY12 CY13 CY14 a) Urea Demand 6,338 6,559 6,789 7,027

CY15 7,273

Without Gas Curtailment b) Production 6,822 6,822 6,822 6,822 Surplus/(Deficit) (c-a) 484 263 33 (205)

6,822 (451)

With Gas Curtailment c) Production 5,782 5,933 5,933 5,933 Surplus/(Deficit) (c-a) (556) (626) (856) (1,094)

5,933 (1,340)

6. FINANCIAL RISK

High debt-to-equity driven from expansions in capacities

Moderate to Strong debt coverages

Sufficient access to capital

5.19 Investment Risk: The returns on the investments in the industry are quite stable from the point where the costs have been incurred and the fertilizer plants are up and running. However, the delays and cost overruns during the construction of the plants pose significant risk. Among the listed securities, fertilizer industry is currently one of the top picks and it is attracting a lot of foreign investment.

6.1 Capital Structure: Fertilizer industry has experienced expansion activities in the last decade post the incentives given under Fertilizer Policy 2001. These activities required significant capital investments and along with equity injections by the sponsors, major mode of financing was debt. This brought changes to the capital structures in the industry which moved from moderately high to highly leveraged industry. The high capital intensity of the industry also contributed to a quantum of high debt.

The largest investment activity was carried out in Engro Fertilizers Limited to build a new urea producing capacity of 1.3mln tons per year. The initial project cost was estimated at USD 1bln with the debt to equity ratio of 60:40. At Jun10, Engro stands at debt to equity ratio of 71:29. Likewise FFBL also went under BMR. This coupled with the low DAP demand in 2008, pushed the debt-to-equity levels of 71%. FFC is currently moderately leveraged but will have to raise more debt if its proposal to acquire Agritech goes forward. The financial leverages in the major players in the industry are shown in the table.

Financial Leverage

2008 2009 2010 Fauji Fertilizers

2008 FFBL 2009 2010 2008 2009 2010

Engro Fertilizers 2008 2009 2010

Dawood Hercules

Debt 9,235 12,446 11,218 25,229 13,599 10,398 29,563 59,592 73,781 6,372 7,499 5,749 Equity 12,285 Debt to Equity 43%

13,082 49%

15,448 42%

10,486 71%

10,660 56%

12,210 46%

21,053 58%

26,888 69%

13,639 84%

17,383 27%

17,855 30%

19,544 23%



6.2 Debt servicing: With the interest rates rising and large companies in growth stage, the finance cost has been increasing. The finance costs of the major players accounts for 8% of their turnover, on average. The net interest coverage varies between 1 to 28 times with firms experiencing expansion averaging around 3 times due to high finance cost associated with debt funded capex. The statistics advocate the strong business dynamics sufficiently meet the costs associated with high leveraging prevalent in the sector.

Debt servicing for the period ending Dec 30,2010

Fauji Fertilizers FFBL Engro Fertilizers Dawood Hercules Pak Arab Fertilizers

Sales (mlns) 44,874 43,257 19,018 8,715 18,248 Finance Cost (mlns) 1,086 934 1,292 909 3,590

Finance Cost % of Sales 2% 2% 7% 10% 20% Net Interest Cover 28.3 21.1 4.4 3.5 1.4

6.3 Cash Flows & Working Capital Requirements: Owing to the demand supply dynamics, the industry sells fertilizer mostly on cash basis resulting in healthy cashflows. This is reflected in form of low receivable amounts on the books of the entities in the industry. However, short term borrowings are a direct function of working capital requirements in the industry. In most cases, the entity's reliance on imported fertilizer determines the magnitude of working capital requirements for an entity. The cash nature of the business ensures adequate liquidity in hand at all times for the manufacturers. Further the cost of maintaining finished goods inventory, which may vary based on seasonal demand trends, is also borne by the distribution channel. The liability of the manufacturer is thus limited to financing raw material inventories, sufficiently reducing working capital requirements.

6.4 Access to Capital: The low business risk of fertilizer sector places it in a very comfortable position to raise capital as and when required. Fertilizer industry has a total debt of ~PKR 150bln (~4% of total lending) and pays ~PKR 22bln as a cost to service this debt. With the gross margins between 40%-45% in the industry, the entities have a sound record of servicing their debts. The debt has been majorly in form of bank loans and TFCs issues.

The other avenue has been the access through capital markets. All the major players are listed on stock exchange and access capital, often through IPOs. The players have received good response from local and international investors based on their good track record of paying out dividends as well as providing capital gain to the investors. During the year 2010, Agritech Limited and Fatima Fertilizer completed their IPOs while Engro Fertilizers Limited is expected to carry out its IPO in 2H11.

In Jan11, Engro successfully raised medium term debt (PKR 4,000mln @ fixed rate of 14.5%) from the retail segment of investors through first of its kind TFCs (Engro Rupiah). This is the first time that a corporate is tapping the retail sector directly. This helped Engro to raise capital at lower cost while increasing its investor base. The brand name of Engro coupled with low business risk associated with the fertilizer sector aided the uptake of the instrument by the general public. The strong marketing campaign made a significant contribution towards raising awareness of the debt-market and its oppurtunities amongst the general public. Engro, based on posituve response, is in process of launching another instrument with similar characteristics during 2011.


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