The Analyst TheAnalyst Word Word

Monday, August 22, 2011

EngroCorp.

ENGRO CORPORATION LIMITED: FINANCIAL COSTS JUST BEING MANAGED

In 1957, an Esso/Mobil joint venture discovered the Mari Gas field near Dharki, Sindh. Esso proposed the establishment of a urea plant in that area and in 1965, Esso Pakistan Fertilizer Company Limited was established, with 75% of the shares owned by Esso and 25% by the general public. Following the international Esso takeover by Exxon, diversification, a management buyout, and a demerger scheme, the company exists today as Engro Corporation Limited (ECL). Engro is an acronym for Energy for Growth. However, lately the stock of the company has been anything but growing and has taken a massive beating with the price plummeting ~42% since the start of the year. To put this in perspective, the benchmark KSE-100 index has declined ~9% in the same period, whereas other peer fertilizer stocks have witnessed substantial upticks (FFC: ~23% YTD, FATIMA: 41%). While Engro can be thought of as a diversified conglomerate, fertilizer operations remain at its core thus far; contributing 64% towards the companys consolidated bottom-line. Accordingly, the issues plaguing the fertilizer business are central to the performance of Engro as well. Based on fears circling around gas curtailment and a burgeoning debt burden, the company has ended up on the negative side of investors 93 times out of the 162 trading days that have concluded this year.
1H2011 ANALYST BRIEFING KEY TAKEAWAYS:

Revenue
(PKRmln) 1H2011 1H2010
YoY% 29% 43% 17% 88% 48% 5% 7% 37%

PAT
1H2011 1H2010
YoY% 8% N.M N.M 97% 68% 8% N.M 0.5%

EngroFertilizerLimited EngroFoodsLimited EngroPolymer EngroPowergen EngroEximp EngroVopak Avanceon EngroCorp(Consolidated)

12,146 13,652 8,031 3,781 7,631 1,014 705 46,084

9,415 9,529 6,854 2,007 5,161 1,072 757 33,724

2,175 217 (195) 745 314 478 (65) 3,381

2,012 (180) (449) 379 973 518 (94) 3,397

The issue of gas availability for the fertilizer expansion project is the key problem faced by the company. According to the management, urea off-take has witnessed a decline of 10% YoY and is estimated at 2.7mln MT Vs. 3.00mln MT seen during 1H2010. This comes on the back of 7% YoY decline in production on account of continued gas curtailment, as well as a negative incidence of decreased imports. They further add that the new plant Enven 1.3 produced 139k MT only as it remained shut down for ~113 days in 1Q2011. However, they are quick to indicate that there has been an improvement in the same mainly due to (1) enhanced awareness of the economic impact posed by continuing gas shortage, and (2) enhanced gas supply during 2Q11. As a result, the plant was shut for only 14 days during the second quarter. Talking solely in context to the business profile of fertilizers, with a decline in gas supply, the growth in revenues for the fertilizer business has come about vis--vis several urea price hikes initiated by the company to prevent a drag on its earnings. Given that the end of June landed price of imported urea of approximately PKR 2,950 per bag is significantly lower than the domestic price of PKR 1,235 per bag, urea as a product has enjoyed relatively inelastic demand and so the room for price hikes has been there. Going forward, the management expects gas supply to cease by August 28 as the annual turnaround for the Qadirpur gas field is due, which would result in 20 - 30 days gas outage. Following this, winter load shedding in early December can also come into play. In this regard, we expect that further price hikes systematically spread via ~PKR 100/ bag ranges to be on the cards. Windfall gains for this would naturally befall on other fertilizer manufacturers as they have done so in the recent past.

The Analyst Word

EngroCorp.

Meanwhile, the foods business registered its first half yearly period of profitability. Revenues saw a 43% jump led by the dairy and juice segments. Foods has certainly emerged as the star investment of Engro in the recent past being the largest revenue earner for the company as its products have aggressively established their standing in the segments in which they are offered. Robust market positioning in the UHT market segment is reflected by Olpers share rising 2ppt QoQ to 41% led by ~20% YoY growth in UHT volume. Meanwhile, the company has also launched premium ice-cream products while making an entry into the lower-than-UHT milk segment targeting loose milk consumers. Given the track record of strategy employed, reasonable performance in terms of gaining market share can be expected, however, consumer response still remains to be seen. Other businesses for Engro which ended in the positive include the Energy and Terminal Services business. Meanwhile, the Chemicals business continues to see red incurring a loss to the tune of PKR 195mln for the 1H2011. This loss is mainly on account of troubled Vinyl Chloride Monomer (VCM) operations, which increases reliance on expensive VCM imports, thus eating in into company margins. Although the loss incidence has decreased YoY, achieving stable operations still need further efforts and attention by the management. Strong business dynamics which have driven the 37% jump in consolidated revenues of the company are one thing, but they count for little if they do not translate appropriately into the bottom-line of an entity; large debt levels continue to raise eyebrows and concerns from the perspective of the investor. Engro, with borrowings crossing PKR 110bln, has a leverage ratio of ~74%, presenting no more room to borrow considering senior lender debt covenants (max leveraging allowed: 75%). In their analyst briefing, the management shed light on higher financial cost, which went up by 92% YoY during 2Q CY11. It is this financial cost which is proving to be a significant burden on the companys profitability, which largely remained stagnant relative to the healthy growth in revenues. However, it is pertinent to mention that the 1H2011 results recently announced include interest capitalization upto April 30, 2011 only for the new expansion plant, beyond which they have been expensed out although the plant achieved its COD ~6 days prior to the period end. According to the management, work on core activities concluded on April 30th after which ancillary portions of the plant accounted for the delay in COD announcement. The added interest expense resulted in an after tax impact of PKR 844mln, which if added back to the bottomline and assuming amortization to start from the following period, would have resulted in an increase in profits of ~24%. In light of the true picture of business dynamics, we expect Engros debt burden to be manageable given the strong operating performance of the companys subsidiaries. We take comfort from the PKR 2/share dividend announced which is some respite for a fragile and frail stock that cash flow generation remains adequate. For this to continue, the smooth running of the new 1.3mln urea plant, maintaining a certain amount of production, is critical, which in turn is a function of gas availability. As per cash flow estimates, only 6 month running is required to meet 2012s debt service payments. Even in the case of gas falling short, the ability to raise prices to cover expenses remains an advantage. In addition, the performance of Engro Foods and Engro Energy seems to be heartening as both companies have continued their trend towards healthy profitability. However, given the sheer quantum of leveraging in the companys capital structure, it is rational to anticipate a gradual tapering off of debt levels rather than a one-time significant reduction. We identify three Critical levels as debt servicing milestones the fertilizer business would be looking to achieve (pointed in the graph). We remain confident that these levels can be achieved given no more deterioration in an already depleted operating environment. Unfortunately, the same optimism cannot be shared for the scrip as investors will become increasingly wary unless their fear of the debt burden is removed once and for all. Fundamentally, the company remains strong as indicated by analyst expectations for the fair value of the stock to hover around the PKR 220 region. But the growth plans which have been put into motion will take their time to materialize and so the road to recovery is expected to be slow paced. Engro is clearly undervalued; however, it is important to wait for price stabilization before assuming a long position.
Aahyan Mumtaz 0300 843 7700 fcraresearch@gmail.com

STOCK CALL: HOLD

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