Zuari Industries: Buy

The change-over to a nutrient based subsidy system, a shift to cash subsidy payments and signs of the Government loosening its grip on prices have lifted the company's prospects.



After prolonged uncertainty, the policy environment for fertiliser producers has turned more friendly in the last two years. Makers of phosphatic and complex fertilisers, in particular, have seen their prospects get a boost from the change-over to a nutrient based subsidy (NBS) system in April 2010, a shift to cash subsidy payments and, recently, signs of the government loosening its iron grip on selling prices.

These developments empower players to capitalise on the yawning gap between the requirement and domestic availability of these fertilisers. While Coromandel Fertilisers remains the preferred option for investors to play this opportunity, Zuari Industries (Rs.677), trading at a modest price-earnings multiple of about eight times its FY-11 consolidated per share earnings (Rs 84) is a dark horse. Investors with some appetite for risk can add it to their portfolio.

Phosphate focus

Zuari Industries owns capacities to produce about 4 lakh tonnes per annum (tpa) of urea and 8 lakh tpa of di-ammonium phosphate (DAP) and various grades of complex fertilisers, apart from holding small interests in other agri-inputs such as seeds, micronutrients and pesticides.

With manufacturing facilities in Goa, Zuari's products are marketed under the brand Jai Kisaan in the key markets of Maharashtra, Karnataka, Andhra Pradesh and Tamil Nadu. Zuari also holds a 50 per cent stake in Zuari Maroc Phosphates, a joint venture which controls 80 per cent of Paradeep Phosphates. The latter, with a 12 lakh tpa capacity, is a leading player in the complex and phosphatic fertiliser market.

Strong demand

Demand has posed no problem for Indian fertiliser makers in the last few years, despite vagaries of the monsoon. Very limited additions to fertiliser capacity in recent years, even as demand has soared on rising crop prices, has opened up a large deficit in the market. About 20 per cent of India's nitrogen requirement and 40 per cent of the requirement of phosphatic fertilisers was met by imports in 2010-11.

Thus, it was strong volume growth that helped Zuari Industries expand its consolidated sales at a 20 per cent compounded annual rate in the last four years (Rs 7,600 crore in 2010-11).

Profit margins in the business have so far been held in check by wild swings in prices of imported inputs (naphtha/gas, phosphoric acid, sulphur and ammonia), even as selling prices remained capped by policy.

Both in the case of urea and phosphatic fertilisers, producers sell well below their cost of production, with the difference reimbursed by way of a subsidy.

The burgeoning deficit has, however, forced the government to reconsider its concession scheme for phosphatic fertilisers with a new Nutrient Based Subsidy system (NBS) ushered in 2010.

Under NBS, the cost of production is computed on prevailing global benchmarks for key inputs (nitrogen, phosphate and potassium). Instead of the government notifying ad-hoc concession rates and selling prices for each product, producers are now reimbursed a flat per-tonne subsidy.

The NBS has removed the ad-hocism and uncertainty that made for difficult planning and volatile profits for phosphatic producers. It has allowed them a free hand in deciding and customising their product mix.

The policy regime has received a further fillip last week, with government removing the cap on selling prices of complex and phosphatic fertilisers.

Prospects

The relaxation in informal pricing controls may allow producers such as Zuari Industries (and its step down subsidiary Paradeep Phosphates) to take measured price increases on their phosphatic portfolio starting this year, to compensate for recent spikes in input costs. Zuari Industries closed 2010-11, the first year of NBS-based subsidy with a 23 per cent increase in its consolidated sales, a 22 per cent increase in operating profits and nearly flat net profits.

Over the medium term, expanded capacity, a more varied product mix and easier pass-through of costs may allow the company to improve its profit margins from the current single-digit levels.

Prospects for Zuari's urea business remain more uncertain, owing to the company using naphtha — a high cost feedstock — as the primary input. While a decontrol of urea will expose Zuari to competitive pressures, this policy shift appears unlikely as long as domestic gas availability remains inadequate. Zuari has already made the requisite changes to its plants and inked supply contracts with GAIL, to allow the changeover to gas. A ramp-up of gas supply, either domestically or through imports of Liquified Natural Gas, can expand margins and brighten prospects for this business.

In addition to this, the company is investing in a 13 lakh tpa urea plant at Belgaum, which is expected to source gas from the proposed Dhabol-Bangalore pipeline. From an investment perspective, the company has traditionally been low on disclosures.

However, the recent restructuring of the K. K Birla group assets, resulting in several companies including Zuari Industries, Paradeep Phosphates and Texmaco being clubbed under the banner of the Adventz group, may lead to greater focus.

The shelving of the merger of Gobind Sugars and the decision to vest group holdings in a subsidiary, Zuari Holdings, which is to be demerged later, are a pointer to a greater focus on the core business. Shareholders are likely to receive shares to compensate for the proposed demerger.

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