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Aarati Krishnan

DESPITE a robust growth in fertiliser offtake, urea producers such as Indo Gulf, Chambal Fertilisers and RCF (Rashtriya Chemicals and Fertilisers) have reported higher sales, but stagnating profits from their operations in the just-concluded fiscal. Producers, especially the efficient ones, appear to be hamstrung by a delay in progression to a decontrolled regime. Given the lack of clarity on the policy front and the prospects of lower sales growth in 2005-06, investors in these stocks, especially those who favour an active approach, can use any uptrend in prices to pare exposures.

Re-entry can be contemplated on concrete signs of a change in the demand outlook or policy announcements. Due to their modest valuation levels (of 8-10 times their trailing earnings), there may be limited downside risk to these stocks. However, the lack of traction in earnings may lead to these stocks under-performing the markets over the current fiscal.

2004-05: Strong sales, but lower profitability

In 2004-05, the demand for urea was at its most robust in recent years, as fertiliser sales benefited from the lag effect of 2003-04's good monsoon and the improved storage position in the reservoirs. Since domestic urea production was short of domestic demand, producers such as Indo Gulf ramped up capacity utilisation and beefed up their market infrastructure to register strong sales growth. The robust growth in sales helped companies maintain their operating profits (on urea operations), at the previous year's levels. This mitigated the impact of the escalation in material costs and the trimming of subsidy, on profits.

Demand outlook less bright

On the demand front, the outlook for 2005-06 is not as bright, on account of two factors. For one, the growth in fertiliser sales could slow down, as the lag effect of 2003's good monsoon wears off. While the 2003 monsoon was exceptionally good in terms of quantum and spatial spread of rainfall, the 2004 monsoon saw deficient rainfall in the key fertiliser-consuming belts.

Given the lingering effects of last year's deficient monsoon and the uncertain prospects for this one on account of the El Nino phenomenon, the demand growth this year is likely to be lower than in 2004-05. Another factor that could reduce sales growth for domestic producers is the commencement of urea imports into India from the joint venture — Oman India Fertilizer Company — in mid-2005.

The latter has a supply arrangement with the Indian Government, under which it has undertaken to supply up to 16 lakh tonnes of urea at fixed prices, for a 15-year period.

These imports will help substantially bridge the domestic shortfall between demand (about 215 lakh tonnes) and domestic production (about 205 lakh tonnes).

The contracted prices are lower than the prevailing international prices.

With an additional source of supply opening up, domestic producers may have less scope to ramp up utilisation levels or expand through capacity addition in the near term.

Efficient producers will win over long term

This does not materially alter the long-term prospects for low cost urea producers such as Indo Gulf or RCF. In a decontrolled scenario, these producers would still be best-placed to cater to domestic requirements, given their low cost structure, that can help them compete effectively with imports.

With several new gas finds set to improve domestic availability of feedstock and the infrastructure for import of LNG also in the take-off stage, glitches in input availability could be sorted out in the near future.

Policy hiatus

Long-term prospects are bright, but policy hiatus a cause for concern.

However, the hiatus on the policy front is proving to be tough. Under the current group-pricing regime, which is a transitional phase, subsidies have been trimmed for low-cost producers, even as units with a higher cost structure enjoy favourable treatment, as `outlier' units in their group.

Under a completely decontrolled scenario, the `outliers' may not survive, allowing greater scope for efficient producers to ramp up their sales. Players have been investing in their production and marketing infrastructure, in preparation for a decontrolled scenario.

However, the progression to the next stage of decontrol is making slow progress. The date for distribution decontrol, which was to take effect in April 2005, has recently been pushed back. A new committee has also been appointed to examine the case for decontrol. The report is expected in June 2005, though the proposals are likely to take effect only from April 2006.

De-bottlenecking and expansion proposals from companies have also been pending government clearance for quite some time now.

Considering these factors, investors in Indo Gulf should watch for a policy announcement on the progression to a decontrolled regime as this would provide a trigger to stock price. This would be the preferred exposure in the urea sector, given its low capital costs and pre-dominantly gas-based facilities.

Chambal Fertilisers and RCF face the additional challenge of switching a substantial portion of their production from high-cost naphtha to alternate feedstock such as natural gas or LNG. Investors can pare exposures and look for signs of a switchover before re-entering these stocks.

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