The Hindu Business Line : Urea: As props fall only the robust will stand

IT WAS to be a challenging year for companies producing urea, as they came out of the protective cocoon of the retention pricing system and took their first steps towards a free market regime (see accompanying piece). But the financials for the first nine months of 2003-04 show that the transition impacted differently the players.

Some players have shown a robust improvement in their profitability in the period. But others have added a fresh coat of red ink to their bottomline. A good monsoon, coupled with cost-cutting efforts, appears to have made the transition relatively painless for companies such as Tata Chemicals, Indo Gulf Fertilisers, RCF and GNFC in 2003-04.

Time for caution

Reflecting the improving business climate, fertiliser stocks have participated actively in the recent stock market rally, after being shunned by investors for several years. But after the sharp run-up in stock prices, it may be time for investors in urea company stocks to turn cautious.

For one, the impact of the 2003 monsoon may, at best, spill over to the next couple of quarters. Whether sales and earnings growth are sustained after that will depend on the next monsoon. And, as the industry progresses to the next stage of the group-pricing regime, subsidies are likely to be trimmed further.

A shakeout appears to be imminent, as the props that have sustained high-cost producers in the first stage of the group-pricing regime are gradually removed (see accompanying piece).

Widening gulf

The transition to the group-pricing regime has created a big gulf in financial performance among players in the urea sector. For the first nine months of 2003-04, GNFC reported a 50 per cent jump in its net profits, and a 10 per cent growth in sales revenues. RCF has managed a turnaround, notching up net profits of Rs 101 crore, against losses of the same magnitude last year. Both Tata Chemicals and Indo Gulf Fertilisers, despite moderate sales growth, have managed double-digit growth in their net profits. All of these companies operate gas or fuel-oil-based urea plants and their costs compare favourably with others in their group.

In contrast, for this period, the profitability of Madras Fertilisers, Duncans Industries and National Fertilisers' deteriorated. These players derive a significant portion of their revenues from naphtha-based units, which makes for a relatively high cost structure. How these units fare in the second stage of group pricing will rely to a large extent, on whether they are able to switch to more cost-effective feedstock such as LNG.

Cost-cutting exercises

Going forward, as subsidies are snipped further under the group-pricing regime, the differences between high- and low-cost units are likely to become starker. Some of the private players have already initiated belt-tightening measures, such as savings in energy usage, better procurement systems and better inventory management, to make up for the lower realisations.

Tata Chemicals, for instance, has tweaked its production processes to bring down its energy consumption from around 5.7 g.calories/tonne a couple of years ago, to 5.2 g.cal/t in 2003-04, making it the most energy-efficient domestic producer. Players have also streamlined inventories by "re-phasing" sales to coincide with the marketing season.

Both Indo Gulf and Tata Chemicals operated with minimal pipeline inventories this year. Lower pipeline stocks have made for better marketing discipline this year, with practices such as dealer rebating largely absent, despite an intensely competitive marketplace.

The "re-phasing" of sales is likely to result in larger blips in the financial performance of companies from quarter to quarter.

A freer hand on marketing

The Government has also set the ball rolling on a phased relaxation of the marketing and distribution controls on urea. Earlier, the quantum of urea marketed by a player in each State was parcelled out through ECA (Essential Commodities Act) allocations.

But in the 2003 kharif season, producers were allowed to sell up to 25 per cent of their output outside of the ECA allocations; this rose to 50 per cent in the ongoing rabi season. By next year, players are expected to have a free hand on marketing and distribution. This change would benefit players whose units are located in close proximity to deficit regions such as the East and South, as that would save on freight costs.

Bracing up for a free market

In preparation for a free marketing regime, players have been putting an additional effort into brand building and improving their distribution reach. Tata Chemicals plans to use the extensive distribution network of the Tata Kisan Kendras (TKKs) to vend a range of farm inputs under one roof. The TKKs will also provide advisory and service inputs to farmers.

Indo Gulf Fertilisers has also rolled out distribution initiatives such as an incentive system for dealers and new marketing counters at the mandi level to improve its reach in its core markets. In an attempt at differentiating its product, it has brought out "Shaktiman" urea in 25-kg bags (the industry norm is bags of 50 kg).

Immediate outlook

The urea offtake in the kharif season (April-September 2003) rose by about 7 per cent. This is reasonable, especially after the stagnation witnessed over the past four years. There has been a sharp spike in sales in markets such as Uttar Pradesh, West Bengal, Punjab and Haryana, but offtake has been less robust in some of the southern States, such as Karnataka and parts of Tamil Nadu. This is expected to be partly made up in the ongoing rabi season, which will reflect in the January-March financials.

The firming up of farm product prices on the back of the drawdown in stocks and global trends are also likely to increase farm incomes. This may ensure that the impact of the good monsoon of 2003 spills over to the next two quarters. But given that players are set to enter the most challenging phase of the group pricing system from April 2004, only select players may continue to post robust earnings growth.

There are also a couple of other near-term concerns for urea producers. One, with commodity prices on an upswing, gas, power and fuel costs are rising at a time when the industry is striving desperately to adjust to lower realisations. Second, there is still some uncertainty about the availability of LNG as supplementing feedstock at reasonable prices (see interview). Though the long-term picture on domestic gas availability has improved, it would be some time before the necessary infrastructure comes up for tapping these sources. In the meantime, gas availability continues to be erratic and inadequate to service existing capacities.

Improving business climate

Over the long term, though, the policy environment is likely to pan out in favour of the low-cost gas-based producers who have shown themselves able to survive the group-pricing regime. After years of uncertainty, the business fundamentals for urea have brightened significantly over the past year on the following counts:

Though the group-pricing regime is a difficult phase, it does chart out a clear roadmap on the policy environment, which today is certainly less hazy than it was a couple of years back.

The new subsidy regime is expected to knock out high-cost capacities, putting the efficient players in a better position to service the widening demand-supply gap. The ongoing PSU divestment could also put additional capacities in the hands of the private players and enhance economies of scale.

In an unexpected bonanza, the feedstock situation has also improved dramatically. After grappling for years with a chronic shortage of natural gas, a series of gas finds in the Indian sub-continent, promise to improve domestic availability of natural gas. Gas is the lowest cost feedstock for urea.

With Petronet LNG receiving its first shipment of LNG earlier this month, the infrastructure for import of LNG, an alternative feedstock, is also falling into place.

With global urea prices firming up unexpectedly, the industry has also been handed a reprieve from facing up to competition from cheap imports. After hovering at $90-110 for some time, global urea prices have firmed up to $170-180 over the past year.

Prices are likely to hold firm over the next few months as winter demand in markets such as the US peaks and holds up gas prices. Import parity prices for urea are, at present, in the Rs 8,000 per tonne range — a level at which gas-based units should easily be able to compete with imports.

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