Why companies are allowed to subsist in this manner is a question that begets an answer
If one wants to get a lowdown on National Fertilizer, look no further than the ten year financial highlights that have been appended to the annual report. It is a total giveaway. It reveals a company which has been in limbo for the last ten years. The many years of sloth have exacted its toll on its vitals. But for the fact that fertilizer companies are ensured a fair return on capital employed, this company would have gone down the tubes.
As the name suggests it makes its living primarily by manufacturing and selling chemical fertilizers - Urea, at its four units based at Nangal, Panipat, Bathinda and Vijaipur. In an effort to garner a few additional nickels to lubricate its top-line and bottom-line, the company also makes do by selling bio-fertilizers, imported muriate of potash, seeds and a few agricultural commodities. It will in future also sell imported NPK (nitrogen/phosphorus/ potash) fertilizers in an effort to add some spice to the languishing top-line. It is also a PSU undertaking, with the promoter group, or the government of India, holding 97.6% of the outstanding equity, with the balance 2.4% in non -governmental hands. What sort of a shareholding pattern is this anyways? But given its financials it is some wonder that any sane individual would want to be a stake holder of this company. PSU companies, it would appear, are also exempt from the provisions of secondary market listing guidelines or some such.
A silver lining
The only silver lining it would appear is that after a Rip Van Winkle existence this past decade, the management has suddenly wised up to the need to modernise and expand - in one go. This would call for a massive infusion of capital, and given its cash flow it is plainly beyond its capacity to do so on its own. But apparently the company has also been able to cook up some magic mantra to get the capex flowing so far. The company is revamping its fuel oil based plants to natural gas at a capital cost of Rs 41 bn. It is simultaneously expanding the capacity of its ammonia and urea plants at two of its units at a cost of Rs 6.5 bn. That is a lot of capex spending on the anvil. Following the expansion, the urea capacity of the two plants will increase to 2.1 m tonnes from 1.7 m tonnes. The beneficial impact on the top-line and bottom-line through a change in the feedstock and at considerable cost at that is difficult to comprehend - but obviously it is cost effective or some such.
What the financials have to say
Suffice to add that what the brief financials have to say is very revealing. In the last ten years the capacity to manufacture urea appears not to have changed in any direction. That is to say it produced 3.2 m tons in 2001-02, production rising to 3.4 m tons in 2004-05, fell to 3.3 m tons in 2007-08, and recording a production of 3.4 m tons in 2010-11. The increase and decrease is accounted for by the oscillating percentage capacity utilisation during this period. The highest capacity utilisation was in 2004-05. Interestingly enough, the directors' report also adds that it is not economically viable to hike production beyond 100% in fuel oil based plants in terms of the pricing policy of urea. But in eight of the ten years the production averaged over 100% of capacity - albeit marginally! Given this learned deduction that producing at over 100% capacity levels is counterproductive to the company's health, why then has the company gone about doing precisely what they should not be doing in the first place? Is there a screw loose somewhere perhaps? The other obvious question is how fertilizer companies across the board are able to produce in excess of the installed capacity that they have created. Is one to understand that the installed capacity per- se is understated, or that the suppliers of capital goods give efficiency norms which are guarded, or that they are gold plating the capacity of the plant which enables them to show capacity usage in excess of the stated capacities? Something has got to give.
Besides this anomaly there are a lot of loose ends within the system. The gross rupee sales have grown at a fairly steady clip from Rs 29.5 bn in 2001-02 to Rs 58 bn in 2010-11, barring a few minor aberrations that is. But the net rupee sales - excluding the subsidy that is laboured to Rs 18.7 bn from Rs 15.3 bn over the same period. That is to say the subsidy element in the gross sales bloated to Rs 39 bn from Rs 14.2 bn. In other words the company's cash flow is primarily decided by the timing of the subsidy payments made by the central government. With all other statutory expenses well under control, the gross profit before interest, depreciation and taxes showed only some minor variations, and very unappetising to boot. The interest and depreciation were but minor irritants. Interest charges because the subsidies were apparently received in time, and also because there was precious little capex spend in the last ten years. It may be noted that the net fixed assets fell to Rs 6 bn in 2010-11 from Rs 13.4 bn in 2001-02. The debt however oscillated from a high of Rs 8.2 bn in 2001-02 to a low of Rs 600 m in 2004-05 before settling at Rs 6.1 bn in 2010-11. This appears to be a factor of the time lag in receipt of the subsidy. Declining depreciation charges are due to zero spending on gross block accretion and also due to the natural attrition of the gross block over the ten year period. The year-end gross fixed assets in 2001-02 stood at Rs 27 bn while the year end figure in 2010-11 was Rs 29.3 bn. The net fixed assets however slid dangerously to Rs 6 bn from Rs 13.4 bn over the ten year period. The company must however be complemented for reducing its employee strength from 5,751 nos in 2001-02 to 4,596 nos in 2010-11.
Cash flow generation at the mercy of the Govt
Though the company ratcheted up a turnover of Rs 58 bn in 2010-11 and managed a post tax profit of Rs 1.4 bn, the fact of the matter is that it registered a negative cash flow from operations to the tune of Rs 2.9 bn against a positive cash flow of Rs 1.6 bn previously. This was basically due to a ludicrous situation. It was unable to encash its credit sales. As a matter of fact the trade debtors at year end at Rs 16 bn were substantially higher than the trade debtor dues of Rs 9.2 bn previously-which probably infers that the government delayed loosening its purse strings. Inspite of a higher leeway from trade creditors, the company's cash flow from operations was still in the red. This anomaly could also largely explain the increase in debt to Rs 6.1 bn from Rs 4 bn previously. With sharply higher demands on capital asset spending, as it is now embarking on gross block expansion, the company was hard put to make ends meet. The saviour came in the form of the rather large opening bank balance of Rs 6.9 bn which was able to tide over the 'credit crunch'. It will of course be very interesting to see how the company bank rolls its capex in the current year. Issue of additional equity appears to be a no brainer as the government, the key shareholder, has no dosh to spare and any additional issue of capital to its non promoter shareholders is also likely to fall by the way-side. That leaves only internal generation of funds on the one hand and a resort to additional debt on the other to fund any capex.
How the fertilizer industry functions
Borrowing moneys for fixed asset expenditure by fertilizer companies is no issue as the price paid to the manufacturer for the fertilizer (urea) sold is based on the retention pricing scheme (RPS). This scheme was introduced in 1977 by the central government following the steep hike in the price of crude oil and in the fertilizer feedstock-naphtha. The idea then conceived was to provide fertilizers to farmers throughout the country at a fair and uniform price, as also to provide a reasonable return on investment to the producers. The selling price of the fertilizer-read urea-and the retention price are fixed by the government. (The RPS for phosphatic, potassic and other complex fertilizers was removed by the government in various stages). The difference between the higher retention price paid to the producer and the lower selling price paid by the farmers is then paid as a subsidy to the producer by the government. The retention price paid to the producer is based on variable and fixed costs (conversion costs, selling costs, interest on debt, depreciation, capacity utilisation and so on) incurred by the producer, and a 12% return on capital employed. Thus, the retention price per producer is different and unique. The retention price is also dependent on the feedstock used - naphtha, fuel oil gas or coal. However there are minimum capacity utilisation norms (90%) which are also factored in. Conversely it also follows that the higher the capacity utilisation, the higher the return on capital employed.
Hence for National Fertilizers it is a win-win situation both for its changeover of feedstock plans, and in the expansion programme of its ammonia and urea plants. But the point to note here is the mindboggling amount of dosh that the company has to put down just to convert the manufacture of urea from one feedstock to another. Needless to add some of the expenditure will also go towards modernising its production facilities. This will also facilitate the need for the government to pay a bloated subsidy to the company once the new plant goes on stream, as the capital costs will now accelerate through the roof. And so long as the company is producing at 90% capacity levels, the producer is considered an efficient user of capital. The person who ultimately foots these costs is the tax payer.
Is it any wonder then that fertilizer shares have no takers in the market? In sum total there is really very little to commend in this share, save the fact that the floating stock is severely limited, and even small volumes of trade could lead to severe price fluctuations.
Disclosure: I do not hold any shares in this company, either directly, or under any non discretionary portfolio management scheme
This column Cool Hand Luke is written by Luke Verghese. Luke has been a business journalist, financial analyst and knowledge management head with a professional experience of more than 20 years. An avid watcher of the stock market, he has written extensively on stock market trends. His articles have featured in Business Standard, Financial Express and Fortune India amongst others. He has also been the Deputy Editor, Fortune India and the Financial Editor of The Business and Political Observer.