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Aarati Krishnan

Fortunes linked to harvest in subsidies

SHAREHOLDERS can retain the Chambal Fertilisers stock. At the current price of Rs 30, the stock trades at about eight times its trailing 12-month earnings of about Rs 4. The company's earnings growth could be in double digits in the near term, due to the widening supply deficit in urea and the firm freight rates that would bolster shipping business, now to be integrated with the company. However, there are a couple of uncertainties over the long-term prospects for Chambal Fertilisers.

With a significant portion of its urea production now based on naphtha feedstock, the company's cost structure is less competitive compared to other gas-based players. A switch to natural gas and its pricing would play a key role in determining the company's competitiveness over the long term.

The impending restructuring in the group, which will see the merger of India Steamship Company with Chambal Fertilisers, could lead to equity dilution in the near term. As a marginal player in the shipping business with an aging fleet, the long-term prospects for this business are uncertain.

Chambal Fertilisers operates facilities for 4,600 tonnes per day of urea at Gadepan on the HBJ pipeline. Over the past year, with the offtake of fertilisers surging on the back of the good monsoon in 2003, the supply gap for urea has widened. With imports becoming expensive on price surges, domestic producers have had strong volume growth.

Chambal Fertilisers, with its strong presence in the northern and western regions, reported a strong sales growth of 14 per cent in 2003-04 and 22 per cent in the first nine months of 2004-05. Profit growth before exceptional items was more modest at 3 per cent and 18 per cent respectively.

Higher volumes and savings in interest costs, following the replacement of high-cost debt, have helped profit growth in even an environment of spiralling variable costs. In the near term, with domestic output of urea falling short of requirements, strong volume growth could continue to push up profits.

Though feedstock prices are holding firm, the company could continue to pass on the higher cost incidence to the government through the subsidy bill. The higher allocation towards urea subsidies in the latest Budget also points to a policy status quo at least for a year.

But, eventually, urea producers are expected to move to a new subsidy regime where their realisations will be linked to import parity prices.

To compete at import parity prices, producers such as Chambal will have to substitute naphtha with natural gas from domestic sources or imported liquified natural gas. Gas finds by the Reliance group and ONGC do offer some optimism on this score. But talks between the fertiliser companies and the oil majors on the supply and pricing of LNG have as yet yielded no concrete results. Chambal's earnings prospects over the long term depend heavily on the successful negotiation of gas supplies at reasonable prices.

Also of concern is a history of investments in unrelated ventures and group companies. Chambal Fertilisers is now involved in a restructuring exercise to merge India Steamship Company with itself. The merger, with the share swap ratio at 11:20, could lead to a marginal dilution (up to 6 per cent) of Chambal's equity base.

A buoyant freight market has helped India Steamship, earlier a loss-making company, report a turnaround over the past couple of years. Favourable market conditions could continue to bolster this company's earnings over the next couple of years.

However, with a fleet consisting of just two single-hull tankers of considerable vintage, the company appears unlikely to emerge as a player of note in the shipping market over the long term. If the business is to be revived, it may call for substantial capital investments from Chambal Fertilisers.

The Chambal Fertilisers stock now trades at a discount to such players as Tata Chemicals and Indo Gulf. The low valuation and the reasonable dividend yield of over 4 per cent reduce the downside risk attached to the stock.

Investors can watch out for a couple of positive triggers, before they accumulate the stock. For one, the successful commencement of LNG or gas supplies to Chambal will reduce significantly its costs and place it in a position to compete in a decontrolled regime.

Second, any consolidation exercise involving the three fertiliser companies in the K. K. Birla group — Zuari Industries, Chambal Fertilisers and Paradeep Phosphates — would help unlock value for investors in each of these stocks.

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