Fauji Fertilizer wants to be the only Fauji Fertilizer company. How will the chips fall going forward?

On the face of it, it might seem a little strange. Fauji Fertilizer Company (FFC) is looking to take over Fauji Fertilizer Bin Qasim (FFBL). The former is a grand old company set up in 1978 that has become one of the leading fertiliser manufacturers in the country. It is owned by the Fauji Foundation, which is as old (and by some measures older) than Pakistan itself. The latter is also a fertiliser company owned by the Fauji Foundation founded in 1993. It is an independent entity owned by the Fauji Foundation and Fauji Fertilizer. 

Fauji Fertiliser actually played the leading role in setting up the Bin Qasim plant. The plant was planned and executed to cater to increasing demand. Fauji Fertilizer started with a production capacity of 570,000 metric tons which has steadily increased to 3.4 million metric tons where it stands now. Currently, the company holds around 49.88% of Bin Qasim and is the major shareholder. The point of not acquiring it entirely was to keep it a separate entity that can be listed individually on the stock exchange where investors can buy a stake in the company and its profits which are exclusive to the profitability of the parent company. The advantage to Fauji is that it is able to generate funds for the plant by issuing equity shares in the company.

That original decision seems to have changed. There is a move to merge Bin Qasim completely into the parent company. What would Fauji Fertilizer gain from this move and what will the investors in Bin Qasim get in exchange for it? Profit tries to parse through the intricacies of this deal.  

Fauji Fertilizer

The history of Fauji Fertilizer starts in 1978 when the company was incorporated as a joint venture between Fauji Foundation and Haldor Topsoe of Denmark. The culmination of this venture was the setting up of the first plant in Sadiqabad in 1982. The annual capacity of the plant was around 570,000 metric tons initially which was increased to 695,000 metric tons. The primary goal of the company was to produce urea to be used by the farmers of the country. 

As the company saw expanding demand, it set up its second plant and commissioned the Fauji Fertilizer Bin Qasim plant in 1993 with the cooperation of international and national institutions. In 2000, the company also took over Pak Saudi Fertilizers Limited situated in Mathelo after it was privatised by the Government of Pakistan. The company is currently involved in the production of various types of fertiliser to cater to the local market. The company is considered the largest fertiliser marketing company in the country and boasts production of 3.4 million metric tons on an annual basis including production carried out by Bin Qasim plant.

Bin Qasim by itself has also been a successful company on its own. The company started with an initial capacity of 551,000 metric tons of urea and 445,500 metric tons of DAP. Recent results show that the company crossed the Rs 200 billion mark in terms of revenues and earned Rs 33 billion in terms of gross profit alone in 2023. The company has 56% of the market share in terms of DAP sales.

The merger being announced

In its board meeting held on 19th of July, Fauji Fertilizer announced that the board had granted an approval to evaluate the amalgamation of Bin Qasim into Fauji Fertilizer based on a scheme of arrangement. The actual breakdown and the numbers were not shared as the board had only approved the idea of the merger. At this point, the company is considering the due diligence to be carried out in order to formalise this deal. The rationale behind this move is to allow for synergies which will add value to the combined company once the amalgamation is carried out. It can be expected that the deal will unlock additional value for Fauji Fertilizer which will be accrued to the shareholders of the company. 

Both these companies are part of the Fauji Foundation group and Fauji Fertilizer already owns 49.88% of Bin Qasim due to its initial investment in the project back in 1993. 

The board of Bin Qasim has also agreed to the decision and has stated that they are looking forward to the scheme of arrangement that will be designed in order to finalise this proposal. Based on the performance of the company, it can be expected that the scheme of arrangement that is announced is beneficial to the investors who currently hold the shares of Bin Qasim. An amalgamation would mean that Fauji Fertilizer would own 100% of Bin Qasim and investors who currently hold the shares of Bin Qasim will get an equivalent shareholding in Fauji Fertilizer. But what can be considered equivalent?

Based on a simple back of the napkin calculation, it can be seen that the market price of Fauji Fertilizer is around Rs 167 per share while for Bin Qasim it is around Rs 42.5. A rough calculation would mean that for an investor who holds 100 shares of Bin Qasim, he will get 25.5 shares of Fauji Fertilizer. The swap ratio of 3.92 shares of Bin Qasim will be converted to 1 share of Fauji Fertilizer. It does seem like a good proxy but such an estimate is based on market prices of the two companies currently. 

The Securities and Exchange Commission of Pakistan (SECP) dictates that in any such transaction, fair value has to be determined which can be an average of four distinct methods of valuation. By taking four different methods, all aspects can be seen of the two companies and a more holistic approach can be implemented rather than using only one method. The methods that have to be used are net worth method, market value method, discounted cash flows and comparable transaction method. The simple calculation done earlier only encompasses the market value approach. To evaluate this transaction, at least three methods need to be applied and weighted accordingly.

In order to see the mechanics of this transaction, it is important to note another transaction that was carried out in the recent past. Askari Cement Limited was merged with Fauji Cement Limited just a few years back. In that case, the swap ratio for the two companies was based on discounted cash flow, net worth and market approach. Based on this, the auditors determined that 5 shares of Fauji Cement would be swapped in exchange for 1 share of Askari Cement.

The swap ratio was determined and announced within a month of the announcement being made by the board but the process took a painstaking seven months, as regulatory approvals were required from Competition Commission of Pakistan (CCP) and had to be sanctioned by the High Court.

The proposal being made here will also be expected to go through the same process as two companies are merging horizontally. In the face of this, there can be an expectation that it can hinder the market share and monopoly that the amalgamated company will have in the market. There are checks and balances that are placed along the way where first CCP will scrutinise the deal to make sure that the market is not being disadvantaged by the bigger company. The last step is to get the approval of the High Court in order to make sure that the swap ratio that has been determined by the auditors is fair for the shareholders. If they do feel that they are being exploited, they can approach the SECP who will step in to get a more amicable deal for the shareholders.

The valuation being carried out

Due to a lack of comparable transactions being carried out, three approaches will be used in order to determine the swap ratio that might be suggested. The final authority on the actual swap ratio lies with independent evaluators who will carry out their own valuation which will subsequently be approved by the boards of the two companies.

According to the market valuation, Fauji Fertilizer is valued at Rs 253, which is a sum of the parts of the major components being carried out. Around 61% of this value is derived from the fertilizer business of the company while 39% is attributable to the portfolio of companies that it owns. In terms of the same valuation of Bin Qasim, it is valued at around Rs 75 per share which is made up of 62% from its core operations while the rest is from its portfolio companies. Based on the market values, the swap ratio that should be used comes to around 3.36.

In terms of income or net worth approach, it can be seen that the valuation of Fauji Fertilizer comes to Rs 271 per share which is primarily based on its fertilizer business. Similarly, Bin Qasim gives a value of Rs 74.5 per share. Based on these two values, the swap ratio comes to around 3.59.

Lastly, when the breakup value is considered, it gives a book value of Rs 121 for Fauji Fertilizer based on its assets and liability while it is Rs 37 for Bin Qasim. This yields a swap ratio of 3.26 shares. This gives a band of swap ratios ranging from 3.26 to 3.59 with an average value of 3.39.

The situation after the merger is carried out

In order to understand the benefit that will be enjoyed by Fauji Fertilizer after the proposal is accepted, we can consider the latest annual accounts and combine the results of the two companies into one. This will provide a basic guideline to understand how the combined company would have performed if the deal had been carried out before the year ended in December of 2023. The combined results will also be compared to the results of some of the other companies producing fertiliser in order to provide some context to the scale and performance of the new entity in comparison to the industry. The standalone accounts of Fauji Fertilizer will be considered for this analysis as the consolidated accounts will have some earnings and profits from Bin Qasim as the company has a large equity investment in Bin Qasim.

The total assets of the new entity will stand at Rs 370 billion compared to Rs 231 billion of assets held by Fatima Fertilizer and Rs 161 billion held by Engro Fertilizer. One of the major issues that Fauji Fertilizer faces is the fact that more than half of its liabilities is made up of trade and other payables making up Rs 107 billion out of Rs 139 billion. Bin Qasim is also impacted by similar issues as half of its liabilities constitute this. In order to improve the efficiency of the company, one area that needs to be addressed is to cut down on these payables in order to make the new company more efficient going forward. Being a bigger player in the market, the company will be able to enjoy favourable credit terms accordingly.

In terms of combined revenues, the merged company would see revenues of around Rs 353 billion which is 1.5 times more than Fatima or Engro clocking in at Rs 233 billion and Rs 224 billion respectively. In terms of gross profit, the number would be around Rs 97 billion before any efficiencies and cost reductions are taken into account. Fatima and Engro both were able to earn Rs 72 billion for the same period. The result of any cost reductions will only be seen once the merger goes through and the company carries out its operations accordingly. Still, as a minimum threshold, the company can at least expect this amount of revenues and profits as a conservative measure.

The new Fauji Fertilizer will also see a profit before taxation of Rs 68 billion where its closest competitors earned just below Rs 50 billion in the last financial year. It is evident that in terms of revenues and profitability, the new company will see better results owing to economies of scale and better cost management. As duplication of roles will be eliminated, there may also be layers of the organisation chart which will be removed which will further add to the cost benefits of the merger. Lastly, the new organisation would also be able to get better credit terms from banks going forward which will also lower its finance cost.

As already mentioned, Bin Qasim already has 56% market share in the DAP fertiliser market. Once this deal is carried out, it can be expected that the new company will have 43% of the market share in the urea market and 60% combined market share in the DAP market. This can be a point of contention that can be raised by CCP as the new company will have a larger market share and could impede on the competition in the industry. Assurances will have to be given by Fauji that they will not be involved in price gouging and that they will not start to exploit the market share they have in order to maximise its profits.

Things are already looking good for Fauji

While the details of this deal are being hashed out, the half year results for Fauji Fertilizer and Bin Qasim have been announced and they show that both companies are performing on an upwards trajectory. 

Fauji Fertilizer saw its sales increase by 60% compared to the half year performance of last year valuing at Rs 116 billion. The company enjoys a lower rate on its gas provision which means that it is able to maintain a higher gross profit margin. The company retained Rs 48 billion in gross profits compared to Rs 31 billion last year. Due to rising finance costs, distribution costs and other expenses, the operating profits did not grow by the same amount as sales. The company earned operating profits of Rs 29 billion compared to Rs 19 billion a year before. 

One of the biggest increases was seen in the other income generated by the company. Other income was around Rs 6 billion last year which increased to Rs 16 billion this period. The end result of this was that the company recorded net profits of Rs 26 billion which was double than what it earned last year. Seeing such amazing results, the company also gave out ite biggest interim dividend of Rs 10 per share. 

In terms of the performance of Bin Qasim, sales of the company increased by 50% which was due to higher productivity carried out owing to better gas supply and availability. This was translated into better gross profits where the company earned Rs 20 billion this period compared to Rs 6.6 billion in the year. Even though expenses doubled, the company was still able to earn Rs 15 billion in terms of its operating profit which was only Rs 4 billion for the same period of six months last year.

Due to record high interest rates and rupee depreciation, the company saw finance costs of Rs 5.3 billion and exchange losses of Rs 4.6 billion. This year, however, the company was able to cut down finance costs by nearly 60% with better working capital management coming in at around Rs 2 billion. Similarly, as the currency was stable during this period, the exchange losses decreased to Rs 0.2 billion. The company has also made some short term investments which has meant that other income earned by the company has increased from Rs 3.4 billion last year to Rs 8.7 billion this year. This has helped dampen the impact of increase the company has seen in terms of its other expenses which have increased from Rs 92 million to Rs 1.5 billion this year.

The net result of this has been the fact that a loss before tax of Rs 3 billion last year for the same six month period to Rs 19 billion this year. After taxation, the net profit earned by the company this year was Rs 10.6 billion which had been a loss of Rs 5 billion last year. 

One caveat that needs to be placed here is that gas is the major raw material used in the manufacturing of fertiliser and the gas pricing policy of the country has been haphazard in the past. What this has meant is that Fauji was able to see much lower cost of production compared to some of its competitors. This led to higher gross margins for the company. Recently, the gas pricing policy is being shifted on a weighted average cost of gas (WACOG) basis which will place a uniform gas price on the industry. Fauji will be a company that will be adversely impacted due to the upward revision in its cost. Fauji is looking to consolidate its position and some of the benefits of the merger will dampen the impact of this policy decision. 

Based on the merger going forward, it can be seen that the new company will have better results going into the future as the sum of parts will perform better in the long term.