Company Report

ENGRO Corporation (ENGRO)

Last Price
PKR 119.99

September 05, 2011

Free Float
177 mn

Target Price
PKR 256

Upside
113%

Market Cap
PKR 47.2 bn

Shares Outstanding
393 mn

Avg. daily volume

1.9 mn

Comments: Syed Muhammad Kamran, ACCA Senior Research Analyst Farrukh Karim Khan, CFA Head of Research
Email; research@nextcapital.com.pk

Executive Summary
We initiate coverage on ENGRO, with a 5 star Next Capital ranking. The stock offers a 113% upside to our target price of PKR 256. ENGROs share price has fallen by 42% since its March 2011 high of PKR 206. Investors are spooked about the impact that gas load-shedding on the new plant would have on earnings and debt servicing capabilities. Given the uncertainty about gas load-shedding, we have built two scenarios; a base case and a bad case. Our calculations indicate that the recent investor pessimism over the gas load-shedding issue has been over-done. We estimate that even if gas load shedding continues at a high level (the bad case scenario), ENGRO offers an 81% upside to investors. Table 1: ENGRO Target price sensitivity matrix
Primary urea margin - existing plant

In terms of debt servicing, ENGROs EBITDA to debt servicing remains above 1 during our forecast period, which indicates that their leverage will remain manageable. The issue of gas load-shedding can and should be resolved. Pakistan enjoys a competitive advantage in producing urea, and diverting gas from power to fertilizer will be beneficial. In addition, ENGRO has a water-tight gas supply agreement with sovereign guarantees in place. Flouting such an agreement for any length of time would send a very adverse signal to potential investors in the country. Fertilizer remains the biggest component of ENGROs value, contributing 69% to the target price. EPS contribution of fertilizer is projected to be PKR 13.6 and PKR 15.6 in FY11 and FY12 respectively. Engro Foods (EFOODS) is an evolving success story. Based on a conservative valuation, EFOODS contributes 14% to ENGROs target price. The main source of revenue and profits is expected to be the dairy segment. Value of other businesses (Eximp, PowerGen, Vopak, and Polymer) contributes 17% to ENGROs target price. ENGRO is one of the biggest success stories of corporate Pakistan. Its share price, having come of dramatically over the last few months, provides an attractive investment opportunity. Figure 2: Shareholding Pattern as of Dec 10

54%
Gas factor new plant

60% 318 256 290

63%
KIBOR

100% 80%

275 211 345

252 211 180

14% 13%

No. of days production - new plant

Source: Next Capital Research

Earnings decline due to gas load-shedding will be cushioned by raising of urea prices. We expect ENGRO to post an EPS of PKR 23.2 and PKR 27.3 in FY11 and FY12 respectively. Figure 1: Relative Price Performance.
250%

188%

ENGRO

KSE-100

37.1%
125%

38.1%

63%

8.8% 4.7%
0%

3.5% 1.7% 6.1%

Sep-10

Feb-10

Jul-10

Apr-10

Feb-11

Aug-09

Nov-10

Apr-11

May-10

Aug-11

Jan-11

Dec-09

Jun-11

Oct-09

Source: Next Capital Research

Dawood Hercules NIT Others

Central Insurance Public sector co.

Patek (pvt) Ltd. Financial Institutions

Source: Next Capital Research

ENGRO Corporation {ENGRO} |

ENGROs Fate: The Throne or the Gallows?

In a speech delivered in 2009, Asad Umar ended by quoting a famous verse. There are only two destinations for freedom-loving people. Either the throne or the gallows. Those words seem prescient; the investment community today cannot seem to determine the fate of the company he manages. But depending on who you speak to, its either the throne or the gallows! Since April 2011, ENGROs share price has taken a severe hammering, having fallen by more than 40% and significantly underperforming the market and peers. The share price decline owes largely to investor concerns about the frequent gas shutdowns that are hampering production from ENGROs new fertilizer plant. Investors are concerned about two issues; earnings and debt servicing capabilities. Amidst the doom and gloom, it is easy to lose perspective. ENGRO remains one of the biggest success stories of corporate Pakistan, and is likely to become the countrys pre-eminent multi-national in the years to come. In ambition, strategy and execution, ENGRO has no equal in corporate Pakistan. Most of its businesses, including fertilizers, foods, and power have strong underlying business economics based on the needs of the Pakistani economy. The perceived chink in its armor from an investors perspective is the high amount of leverage it carries, which makes it susceptible to exogenous shocks like the current unplanned gas load-shedding. From ENGROs perspective, the high level of debt is justifiable because they are operating in stable businesses with strong cash flows. To put the leveraging in perspective, ENGROs decision to undertake the urea expansion was based on key assumptions like availability of gas through a water tight sovereign guarantee agreement, incentivized gas rates as prescribed in the 2001 Fertilizer Policy, and favorable demand-supply dynamics. These factors led the company to take the aggressive route of financing this investment with a Debt-Equity Ratio of 75:25. Although the fate of ENGROs share price in the shortterm is hard to determine, investors with a medium to long-term horizon have the opportunity to buy a slice of Pakistans best-run company at a marked down price. Before delving into the numbers and target prices debate, our advice is simple; Carpe Diem (seize the day).

Strong Upside Even if Gas LoadShedding Persist

We initiate coverage on ENGRO Corporation (ENGRO) with a 5 star ranking. The stock offers a 113% upside to our December 2011 target price of PKR 256. A Sum-Of-The-Parts (SOTP) valuation has been used for ENGRO, which we believe is appropriate given its conglomerate structure. The primary value drivers are the fertilizer, food, trading and power operations. We have applied a 20% conglomerate discount to the SOTP value of the group. Table 2: ENGROs SOTP Valuation
ENGRO Corporation SOTP Valuation Fertilizer Foods Eximp Powergen Qadirpur Polymer Vopak SOTP Value per hare Conglomerate Discount @ 20% ENGRO Fair Value per Share
Source: Next Capital Research

PKR per share Method of Valuation 222 Free Cash Flow model 44 Free Cash Flow model 25 Dividend discount model 14 Dividend discount model 7 Market Value 8 Dividend discount model

320
64

256

With uncertainty regarding the gas issue persisting, we have built two scenarios; a base case and a bad case for gas load-shedding. The Base Case Scenario- Assumptions 1. Gas load-shedding at Engros new plant to be contained to 75 days per year, with a gas factor of 80% Urea margins (on existing plant) to be maintained at 60% levels. This translates into a urea price of PKR 1,037 per bag (ex-GST) in FY12.

2.

The Bad Case Scenario- Assumptions 1. 2. Gas load-shedding at Engros new plant at 50% (180 days) per year with a gas factor of 80%. Urea margins to be maintained at current levels to compensate for lost production. This translates into a urea price of PKR 1,121 per bag (ex-GST) in FY12.

Our analysis indicates that the pessimism surrounding ENGRO has been overdone, with regards to both earnings and debt servicing. The target price in the case of the base case and the bad case offer an

ENGRO Corporation {ENGRO} |

upside of 113% and 76% respectively. The base case target price is PKR 256 and the bad case target price is PKR 211 per share.

Figure 3: EBITDA to Debt Servicing

2.5 2.0

Earnings Decline to be Cushioned by Higher Prices

Earnings forecasts for the base case and the bad case are shown in Table 3. Based on FY12 projected EPS, ENGRO is currently trading at a PE of just above 5x using the base case and 4x using the bad case. Although fertilizer earnings are adversely impacted by the lost production in the bad case scenario, the impact is cushioned through increased urea prices. Local urea producers continue to enjoy pricing power as international urea prices are currently 104% higher than local prices. ENGRO has demonstrated that pricing power in recent months by raising urea prices significantly in response to excessive gas load-shedding. Table 3: Earnings Projections for ENGRO
(PKR mn) Fertilizer Foods Eximp Power Vopak Others TOTAL EPS 2011 2012 Base Bad Base Bad 5,336 4,286 6,153 4,563 690 690 994 994 1,590 1,590 1,765 1,765 1,330 1,330 1,233 1,233 544 544 571 571 (350) (350) 9,140 8,089 10,717 9,127 23.2 20.6 27.2 23.2 2013 Base Bad 8,647 6,715 1,834 1,834 1,730 1,730 1,139 1,139 600 600 13,949 12,017 35.5 30.6

2.0

1.8 1.5 1.2 1.2 1.0 1.2 1.2 1.3 1.3

(x times)

1.5

1.0

0.5 2011 2012 Bad Case 2013 2014 2015

Base Case

Source: Next Capital Research

Secondly, we have included principal repayments in debt servicing calculations. However, as has been the case in many corporate restructurings recently, banks are more than willing to roll-over/extend maturities as long as interest payments are being made. If push comes to shove, debt restructuring can be done with the banks. Thus, whilst ENGRO will be walking a tight rope in managing its debt servicing obligations over the next couple of years if gas shortages persist, the company has options at its disposal to manage its liquidity requirements.

Source: Next Capital Research

Gas Issue Can and Should Be Resolved

Although ENGRO can ride out the storm, resolution of the gas curtailment issue is important from the perspective of the overall economy. The country is facing a gas shortage of around 20-25%, but the SNGPL network faces an even higher shortage of up to 40%. Gas load shedding in the fertilizer sector started in April 2010 when the government decided to divert gas supplies to power plants in order to reduce electricity load shedding. The fertilizer plants on the SNGP network, including ENGROs new plant, Dawood Hercules, Pak Arab and Pak American are bearing the brunt of the gas loadshedding, with production hampered significantly.

Debt Servicing: Walking a Tight Rope but Manageable

One of the major concerns spooking investors at the moment is the high level of debt that Engro carries. ENGRO has PKR 18 bn and PKR 17 bn of debt servicing in FY12 and FY13 respectively (including principal and interest repayments). Whilst those numbers sound scary, we believe it appropriate to approximate debt servicing capacity with EBITDA. And as Figure 3 highlights, ENGROs EBITDA to Debt Servicing remain above 1, even in the bad case scenario. Therefore, we are confident that even if gas outages continue at current levels, ENGRO will manage to service its debt obligations in the coming years. A couple of qualitative factors regarding the issue of leverage are worth bearing in mind. Firstly, ENGRO has the ability to raise additional funding through the balance sheets of ENGRO Corporation and other subsidiaries, which it is currently doing through the Rupiya certificates.

ENGRO Corporation {ENGRO} |

Figure 4: Gas Load-Shedding and the Impact on Stock prices

140%

105%
05 April: Gas supply cut off to new plant due to pipeline fault 21 April: Gas supply restored 17 May: Gas supply suspended 03 June: ENGRO returns belowminimum load gas to SNGPL

70%

24 June: ENGRO announces COD of new plant 20 June: Plant starts full-scale production on 80 MMCFD
16-Jun-11 23-Jun-11 30-Jun-11

28 July: Gas supply restored at 80 MMCFD 14 July: Gas supply suspended, ENGRO increase urea prices by PKR 125/bag
7-Jul-11 14-Jul-11 21-Jul-11

35%

27 April: SHC gives 14 April: ENGRO interim order for increase urea price gas supply by PKR 60/bag maintenance
31-Mar-11 5-May-11 7-Apr-11 12-May-11 14-Apr-11 21-Apr-11 28-Apr-11

19 May: ENGRO files contempt of Court notice against SNGPL

19-May-11 26-May-11 2-Jun-11 9-Jun-11

01 August: Govt. deciding to end unplanned loadshedding

4-Aug-11 11-Aug-11 18-Aug-11 28-Jul-11

0%

Source: KSE, Company news, Next Capital Research

ENGRO

FFC

FFBL

FATIMA

KSE100

With competing uses for gas, the gas allocation should not be done through a random nows-your-turn policy, but on the basis of economic value. Currently, the fertilizer sector offers a higher economic value for gas consumed in comparison to the power sector.

Table 4: Pakistan Enjoys a Competitive Advantage in Producing Urea

Annual Power generation capacity on 100 MMCFD (kWh) Plant availability factor Plant load factor Annual power generation (kWh) Latest Adjusted Fuel Cost per unit - Gas (PKR per kWh)* Latest Adjusted Fuel Cost per unit - FO (PKR per kWh)** Annual Fuel Cost - Gas (PKR mn) Annual Fuel Cost - FO (PKR mn) Additional Cost to the economy (PKR mn) 4,818,000,000 90% 70% 3,035,340,000 2.5158 12.881 7,636 39,098 31,462

(a) (b) (c) (a)X(b) (a)X(c)

ENGRO's annual urea production capacity - new plant (tons) Import parity price - Current (US$ per ton) Landed Cost of imported urea (PKR mn) Cost of urea in case of ENGRO's full production (PKR mn)*** Additional Cost to the economy (PKR mn) Net Savings to the economy in case of full gas allocation to ENGRO (PKR mn)
* Revised tariff of Saif Power Limited ** Revised tariff of Atlas Power Limited ***Assumption of a normalized urea selling price of PKR 900 per bag
Source: NEPRA, Company Sources, Next Capital Research

(d) (e) (d)X(e) (f)

1,300,000 561.23 63,110 23,400 39,710

8,248

ENGRO Corporation {ENGRO} |

In Table 4 below, we calculate that the overall savings of allocating 100 mmfcd of gas from the power to the fertilizer sector is PKR 8.2 bn. Whilst the additional cost of importing 1.3 mn tons of urea as compared to local production is PKR 39.7bn, the additional cost of importing High Speed Furnace Oil (HSFO) for power generation as compared to gas based power generation is PKR 31.4 bn. This amounts to a saving of PKR 8.2 bn if 100mmcf is allocated to producing urea instead of power. We believe that the government will eventually prioritize gas to the fertilizer sector, because Pakistan has a competitive advantage in producing urea.

EPS projections for the fertilizer business are shown in Figure 5. Fertilizer earnings are lower in the bad case scenario because we believe that ENGROs pricing power in the urea market has limits. Urea prices at substantially higher (than current levels) are likely to begin destructing demand. Therefore, earnings are reduced in the bad case scenario as compared to the base case scenario. Figure 5: EPS Projections for ENGRO Fertilizer
30.0 22.0 15.6 10.9 11.7 17.2 27.6 21.5

22.5

(PKR)

Fertilizer Value Hinges on Gas Supply

Despite diversifying into other businesses, fertilizer continues to be the mainstay of ENGROs earnings and valuation. Our base case fertilizer valuation for ENGRO is PKR 222 per share, based on plant load shedding of 75 days per year and a gas factor of 80%. In this scenario, fertilizers contribution to ENGROs target price is 69%. The bad case fertilizer valuation is PKR 166 per share, based on 180 days of gas loadshedding per year, and a gas factor of 80%. Whilst we have used the base case value to determine our target price, investors who are more conservative about gas supply can use the bad case valuation as the benchmark. Table 5: ENGRO Fertilizers Valuation
Key Valuation Assumptions
Risk Free Rate Equity Risk Premium Cost of Equity Cost of Debt Target Debt to Equity Tax Rate Long term growth rate WACC

15.0

13.6

7.5

0.0 2011E 2012F Fertilizer (Base Case) 2013F Fertilizer (Bad Case) 2014F

Source: Next Capital Research

Table 6 shows a comparison of revenue and primary margins between ENGROs new and old plants. The important point to highlight is that owing to higher efficiency and lower gas prices, ENGROs new plant margins are significantly superior to that of the old one. Table 6: New Plant Has Better Margins
(PKR mn) Revenue - Existing - New Primary margin - Existing - New 2010A 19,018 56% N/A 2011E 21,780 11,003 58% 87% 2012F 23,408 17,904 60% 85% 2013F 27,728 20,679 59% 85% 2014F 30,910 23,911 58% 86%

14% 6% 20% 15% 50:50 35% 1% 15% (PKR mn)

105,960 50,787 156,746 (69,494)

Source: Next Capital Research

EFoods An Evolving Success Story

EFOODS is an evolving success story. Having made major inroads in the dairy and ice-cream segments within its first few years of operations, EFOODS plans an aggressive PKR 41 bn capex in the next five years to invest in existing and new businesses. In its initial phase, the company has rightly focused on building brands and capturing market share. However, since 2010, EFOODS bottom-line has turned green, and we expect the companys contribution to ENGROs earnings to increase in the coming years.

Valuation
Sum of PV of FCFF (Forecast period) PV of Terminal Value Enterprise Value Net Borrowing Equity Value ENGRO's share of Value (@ 100%) Fertilizer's contribution to ENGRO's SOTP Valuation*
*based on ENGRO's no. of shares
Source: Next Capital Research

87,253 87,253 222

ENGRO Corporation {ENGRO} |

Figure 6: EPS Contribution of EFOODS

2014F 2013F 2012F 2011E 2010A 0.5 2.5 5.0 (PKR) 2010A 2011E 2012F 2013F 2014F 7.5 10.0 1.9 2.8 5.2 8.7

Dairy Segment existing business: The company has planned a massive PKR 12 bn capex in its existing dairy segment during the next five years (2011-2015). We expect that bulk of this expenditure would be incurred to enhance production capacities of UHT milk processing, powdered milk, juices and nectars and brand development of juices and nectars and powdered tea whitener. Dairy Segment new business: In order to complete its coverage of the dairy spectrum, the company is planning to extend its reach to the most lucrative powdered milk sub-segments of infant nutrition and Growing Up Milk Powder (GUMP) where currently Nestle Pakistan dominates the market. In addition, the company also plans to enter the chilled dairy niche (e.g. fruit yogurt) where currently Nestle Pakistan controls the majority of the market. The capex earmarked for these projects is PKR 10 bn during the next five years. Ice cream Segment: The company plans to incur a capex of PKR 4 bn in its ice cream segment during the next five years with major emphasis on consolidating its position as the no. 2 player, brand development and extension of outreach to all major cities of Pakistan. Rice Segment: Perceiving substantial opportunities in this segment, Foods has planned a massive PKR 14 bn capex for this segment during the next five years which would mainly be directed to the expansion of processing and storage capacity of the plant along with other civil works. We expect that this capex would result in a multi-fold increase in the rice plants processing capacity from the existing 28 k tons to 158 k tons by 2015. Figure 7: EFOODS Capex (2011-2015) by Segment

Source: Next Capital Research

We value EFOODS at PKR 44 per share of ENGRO, contributing 14% to ENGROs target price A three-stage DCF valuation has been used to capture the impact of the high capex phase (FY11-FY15), followed by a high growth phase (FY16-FY20), and the eventual maturity phase. Free cash flows are projected to be negative till 2014 due to the companys aggressive capex plans. However, from 2015 onwards, capex is reduced, and cash flows become significantly positive. Table 7: EFOODS Valuation
Key Valuation Assumptions Risk Free Rate Equity Risk Premium Cost of Equity Cost of Debt Target Debt to Equity Tax Rate Long term growth rate Additional growth rate (High-growth period) WACC Valuation Sum of PV of FCFF (Forecast period) Sum of PV of FCFF (High-growth period) PV of Terminal Value Enterprise Value Net Borrowing Equity Value ENGRO's share of Value (@ 90%) Foods' contribution to ENGRO's SOTP Valuation*
*based on ENGRO's no. of shares
Source: Next Capital Research

14% 6% 20% 15% 47:53 35% 3% 7% 15% (PKR mn) (7,667) 12,426 19,889 24,647 (5,380) 19,267 17,340 44

13,568

11,793

974 4,482 10,323

Dairy - Existing

Dairy - New

Ice cream

Farm

Rice

Source: Investors Presentation, Next Capital Research

Ambitious Long Term Strategy Multiple Frontiers in Sight EFOODS has enjoyed unprecedented early success, and the future looks even brighter as the company looks to expand both geographically and product-wise.

Dairy segment Promising Prospects Whilst EFOODS in totality has no clear cut peer group in Pakistan, in terms of its dairy operations, Nestle Pakistan is a good benchmark, being a market leader in milk and juices. Nestls operating performance has been nothing short of sensational, with

ENGRO Corporation {ENGRO} |

average ROEs over the last decade of 62%. Sales and PAT have grown have a 10 year CAGR of 20% and 27% respectively. Apart from the strong growth, worth highlighting is the stability in Nestle Pakistans operating profit margin, as can be seen in Table 8. This indicates that business economics of the market leader in the dairy segment are very attractive. Table 8: Nestle Pakistans Sensational Performance
NESTLE PAKSITAN (PKR mn) Revenue Operating profit Operating profit margin PAT ROE FY06 22,031 2,640 12.0% 1,363 62.0% FY07 28,235 3,511 12.4% 1,805 54.4% FY08 34,184 4,105 12.0% 1,553 36.5% FY09 41,156 5,575 13.5% 3,005 68.2% FY10 51,487 6,858 13.3% 4,113 82.2%

However, we have been conservative in our revenue and earnings projections for EFOODS ice-cream segment, considering that the overall market size is currently not that large, and margins are also moderate. Table 11 shows our revenue and profit forecasts for the ice-cream segment. Revenues are expected to grow through the next few years, although profitability is expected from 2013. Table 11: EFOODS Ice-Cream Segment
PKR mn Revenue Profit After Tax Net Margin Capex
Source: Next Capital Research

Source: NESTLE Annual Accounts, Next Capital Research

We are confident that EFOODs will also enjoy high ROEs in its dairy business as it matures. It has already become the market leader in UHT milk (current market share of 40%+), and plans to follow Nestle in the full range of dairy products. Table 9 shows revenue and profit forecasts for the dairy segment of EFOODS. Over the next four years (FY11-FY15), revenue and PAT are projected to grow at a CAGR of 29% and 43% respectively. Table 9: EFOODS Dairy Segment
PKR mn Revenue Profit After Tax Net Margin Capex 2011 2012 2013 2014 2015 26,518 35,368 45,938 58,858 74,088 1,106 1,271 1,873 2,834 4,619 4% 4% 4% 5% 6% 3,337 6,647 5,769 4,818 1,545

2011 2,633 (132) -5% 1,091

2012 3,718 (78) -2% 1,025

2013 4,949 64 1% 751

2014 6,647 366 6% 808

2015 8,918 788 9% 807

Rice segment expansion mantra all the way The rice segment of Foods is managed by ENGRO Foods Supply Chain (Pvt) Limited (EFSL), a subsidiary of Foods, which was created as a specialized supply chain company to focus on one of the most critical elements of the overall value chain. EFSL has set up a rice processing plant in Muridke with an initial rice processing capacity of 28 k tons. The processed rice from the plant is being sold (at market prices) to ENGRO Eximp for export to premium customers in regional markets and beyond. Pakistan currently lies at the heart of world rice consumption with two of the worlds top three rice importers i.e. Philippines and Iran situated in proximity. The company is focused on Basmati rice and targets high-value commercial customers in the region. In 2010, the first order of 5,000 tons was dispatched to customers in Middle East. With its competitive advantage in terms of strategic location and economies of scale in terms of logistics, we foresee the rice segment to make better contributions towards Foods overall profitability in comparison to the ice cream segment despite much lower sales. With exception of a loss in 2011 and 2012, we expect increasingly positive bottomline for the rice segment during the next five years. Table 12: EFOODS Rice Segment
PKR mn Revenue Profit After Tax Net Margin Capex
Source: Next Capital Research

Source: Next Capital Research

Ice cream segment More of a Mixed Bag In the ice-cream segment, ULEVERs Walls is the closest benchmark to EFOODS. However, the historical profitability of Walls is not as impressive as that of the dairy segment of Nestle. As shown in table 10, Walls operating margins are neither as stable nor as high as Nestles. Table 10: Walls Pakistans Financial Performance
WALLS Pakistan (PKR mn) Revenue Operating profit Operating profit margin FY06 2,852 512 17.9% FY07 3,074 179 5.8% FY08 3,824 (13) -0.3% FY09 4,163 277 6.6% FY10 5,548 269 4.9%

Source: ULEVER Annual Accounts, Next Capital Research

EFOODS, however, appears quite sanguine about the prospects of the ice-cream business, which is evident by their focus on developing the Omore brand and the expansive capex plans. Since launch in 2009, Omore has already captured a 17% market share.

2011 640 (224) -35% 2,263

2012 1,451 (50) -3% 2,420

2013 2,185 183 8% 1,860

2014 3,011 286 10% 3,310

2015 4,214 784 19% 3,715

ENGRO Corporation {ENGRO} |

Eximp Expertise

Leveraging

the

Figure 9: Engro Eximp Revenue and Profit Projections

35,000 26,250 17,500 8,750 2011 2012 Fertilizer sales 2013 Rice sales 2014 Profit 2015

3,000 2,250 1,500 750 -

As a wholly owned subsidiary of ENGRO, Eximp imports and sells fertilizers such as DAP, MAP, MOP, SOP and micro-nutrients like Zinc Sulphate. In addition, Eximp has also established a fast growing rice trading business. The company will procure finished rice from EFSL and export it to premium business-to-business customers all over the world. According to the internal arrangements, Eximp used to sell its fertilizer imports (upon arrival) to Engro Fertilizer at prevailing local prices which kept Eximp immune to any unfavorable price movements in the domestic fertilizer market. During the last three years, Eximps EPS has averaged PKR 4.6 (based on ENGROs shares) with an average dividend payout of 88%. Figure 8: Engro Eximps EPS and DPS History
7.0 5.6 5.3 5.6 4.4 3.7 3.5 3.6 2.8

Source: Next Capital Research

We have used the Dividend Discount Model (DDM) to value Eximp because of consistently high dividend payout history of the company. Our key valuation assumptions include Cost of Equity at 20% and terminal growth rate of 0%. The value of Eximp based on ENGROs shares outstanding is PKR 25 per share. Table 13: Engro Eximp Valuation
Valuation
Sum of PV of Dividends PV of Terminal Value Equity Value ENGRO's share of Value (@ 100%)

(PKR mn)
4,737 4,941

9,678 9,678 25

(PKR)

1.8

0.0 2008 2009 Earnings Dividends 2010

Eximp's contribution to ENGRO's SOTP Valuation*

*based on ENGRO's no. of shares
Source: Next Capital Research

Source: Annual Accounts, Next Capital Research

As the largest importers of phosphates in Pakistan with a demand-supply gap in excess of 50%, the future of Eximp is largely tied to the performance of its DAP business. After group restructuring, Eximps immunity to unfavorable local price movements has diminished because of removal of the imported fertilizer business from Engro Fertilizers ambit. Thus, Eximp will bear price risk in the future. For the rice segment, after a negligible level of sales in 2010, the rice segment of Eximp is expected to increase sales in 2011 and would gain sizeable traction during next five years. We have assumed trading margins of 7% for Eximp, which are significantly lower than what they earned in the last 3 years. However, we have been conservative due to the change in ENGROs internal pricing structure and the addition of the rice business, where margins are less certain at the moment.

Powergen Stable Cash Flows Coupled with Efficiency Gains

ENGRO Powergen (EPL) is a 95% owned subsidiary of ENGRO and has set up a 220 MW gas fired power plant near Qadirpur. The power plant utilizes low base permeate gas from Qadirpur gas field which was previously not being utilized. Like other Independent Power Projects commissioned under the 2002 Power Policy, the 25-year tariff structure of the project implies a guaranteed US$ equity return of 15% above all costs of generation (including debt servicing). The plant achieved its COD at the end of March 2010 and has been successfully operating since with near maximum operational availability. Like other new IPPs, ENGRO Power Gen earnings are being significantly boasted by efficiency gains/lower O&M charges. We forecast that these gains will continue to augment the bottom-line for the next three years, albeit at lower levels.

ENGRO Corporation {ENGRO} |

Figure 10: Engro Power Gen EPS Projections

4.0 3.6 2.8

3.3

3.0

3.0

2.8

2.0

As the only company in Pakistan providing storage and handling solutions for products of this nature, the business economics of ENGRO Vopak are very attractive. In the backdrop of continuous growth in the chemical and petrochemical industry of Pakistan, the demand for Vopaks services has remained above par with revenue components of the company denominated in US$. Figure 11: Engro Vopak EPS and DPS

(PKR)

1.0

0.0 2010A 2011E 2012F 2013F 2014F 4.0

Source: Next Capital Research

Given the low risk and stable cash flow stream and the expectation of a high dividend payout, we have used DDM to value EPL. Key valuation assumptions include Cost of Equity at 20%. ENGROs shareholding in the company is valued at PKR 14 per share. Table 14: Engro Power Gen Valuation
Valuation
Sum of PV of Dividends (remaining life) Equity Value ENGRO's share of Value (@ 95%) EPL's contribution to ENGRO's SOTP Valuation*
*based on ENGRO's no. of shares
Source: Next Capital Research

3.0 2.8 2.8 2.9

3.1

(PKR)

2.0

2.3

1.0

0.0 2009A 2010A 2011E Earnings 2012F Dividend 2013F

(PKR mn)
5,680

Source: Next Capital Research

5,680 5,396 14

Vopak has a history of maintaining almost a 100% dividend payout and we have taken this assumption going forward in our DDM based valuation. Key valuation assumptions include cost of equity at 20% and a terminal growth rate of 0%. Engro Vopak contributes PKR 8 per share to ENGROs SOTP value. Table 16: Engro Vopak Valuation
Valuation
Sum of PV of Dividends PV of Terminal Value Equity Value ENGRO's share of Value (@ 50%) Vopak's contribution to ENGRO's SOTP Valuation*
*based on ENGRO's no. of shares
Source: Next Capital Research

Vopak Icing on the Cake

The first of its kind in Pakistan in liquid bulk logistics, ENGRO Vopak (Vopak) is a joint venture between Royal Vopak of Netherlands and ENGRO. The company was formed for setting up an integrated liquid chemical terminal and storage farm and was granted exclusive rights to handle and store all liquid chemicals and gaseous liquid chemicals entering the Port Qasim area for 30 years by the Port Qasim Authority. Vopaks terminal currently handles several products of divergent nature like, Paraxylene, Acetic acid, VCM, Ehtylene, MEG, Phos acid and LPG. The companys major customer is Lotte Pakistan PTA (LOTPTA) for Paraxylene and Acetic Acid, followed by Fauji Fertilizer Bin Qasim (FFBL) for Phos acid. Table 15: Engro Vopak Customers
Products Paraxylene Acetic acid VCM Ethylene MEG-Tank Storage Phos acid LPG
Source: Next Capital Research

(PKR mn)
4,188 2,418

6,605 3,303 8

Polymer riling operational issues

through

Customers LOTPTA LOTPTA EPolymer EPolymer PET Resin producers FFBL LPG marketing companies

ENGRO Polymer (Polymer) is the sole manufacturer of PVC Resin in Pakistan with an annual capacity of 150 k tons. As part of a recent expansion, the company now has an integrated facility with the capability to manufacture EDC, VCM, Chlorine and Caustic Soda in addition to PVC Resin. Pricing policy of the companys main segment i.e. PVC Resin is governed by international prices and its main raw material i.e. Ethylene (used for production of EDC and VCM) is also imported which exposes the

ENGRO Corporation {ENGRO} |

companys primary margins and profitability to trends in the international markets. Prior to undergoing the expansion and integration project, Polymer had a history of regular profitability. However, unfavorable price movements have led to a deterioration of the bottom-line in the last two years. Figure 12: Engro Polymer: From Green to Red
15,000 600

11,250

200

(PKR mn)

7,500

-200

3,750

-600

0 2006 2007 Revenue 2008 2009 Profit/(Loss) 2010

-1,000

Source: Next Capital Research

The uncertainty on the performance of the integrated operations still exists and only a demonstrated performance for an extended period of time and its translation into profits would revive the investors confidence in the company. Considering this uncertainty, we have valued Polymer at its current market price which gives a contribution of PKR 7 per share to ENGROs SOTP based value. Table 17: Engro Polymer Valuation
Valuation
Current Market price (PKR per share) Equity Value ENGRO's share of Value (@ 56%) EPQL's contribution to ENGRO's SOTP Valuation*
*based on ENGRO's no. of shares
Source: Next Capital Research

(PKR mn)
8

5,195 2,919 7

Invest for the Long Haul

The recent price correction in ENGRO is a window of opportunity for long-term investors to acquire shareholding at extremely attractive valuations. ENGROs business economics remain strong, its management is best in class, and the price is attractive. Those who are able to invest amid the current doom and gloom are likely to be well rewarded as the ENGRO juggernaut goes from strength to strength in the future.

(PKR mn)

10

ENGRO Corporation {ENGRO} |

ENGRO Corporation (ENGRO)
Current Price Dividend Yield (FY10) Current PE Current Dividend Yield Current P/B Market Cap (PKR mn) 1 Yr Avrg daily Val (PKR mn) Oustanding shares (mn) 1Yr High Price 1Yr Low Price Free Float (%) Free Float (mn) 120.0 ENGRO 11.4 1.9% 2.0 47,217 366.2 393 205.8 111.9 45% 177.0 300
ENGRO KSE100

250 200 150 100 50

365 D a y -11% 16% 13%
FY02

T o ta l Retu rn ENGRO KSE100 KSE30

FY98

7 D a ys 2% 2% 1%
FY99

30 D a y -16% -9% -9%

FY00

90 D a y -39% -10% -11%

FY01

Apr-08

Apr-09

Apr-10

Feb-08

Feb-09

Feb-10

Feb-11

Apr-11
3.1 3.0

Jun-08

Jun-09

Jun-10

Mar-07

Dec-07

Dec-08

Dec-09

Aug-07

Aug-08

Aug-09

Aug-10

Dec-10

Oct-07

Oct-08

Oct-09

Oct-10

Jun-11

Jul-07

FY03

May-07

FY04

FY05

FY06

FY07

FY08

FY09

FY10**

Valuation

6.0 1.9 8.0 10.8% 8,986 10,881 118.3 44.7 8,366 3,226 2,230 105 123 405 1,807 319 1,488 3.78 8,087 2,796 469 1,653 3,470 1,008 4,616 101 11.7 973 (1,905) (78) (1,010) 0.0% 38.6% 26.7% 21.6% 17.6% 17.8% 0.0% 0.0% CAG RS Sales Gross profit Operating profit Net profit C/F from operat Dividends Book value

11.7 2.5 6.0 6.8% 12,218 17,459 141.5 69.7 8,628 3,364 1,980 142 106 674 1,342 294 1,048 2.66 8,287 2,800 256 1,923 2,908 1,209 4,939 121 12.6 2,057 (435) (1,184) 437 3.1% 39.0% 22.9% 15.6% 21.9% 12.1% 21.9% 9.5%

8.9 1.9 7.5 9.8% 9,975 9,599 127.5 49.5 8,394 2,935 1,914 219 99 684 1,350 224 1,126 2.86 8,457 3,106 659 1,694 3,071 1,209 5,219 121 13.3 1,634 (503) (757) 374 -2.7% 35.0% 22.8% 16.1% 16.6% 13.4% 22.2% 9.9% 1 yr 165% 192% 140% 63% -102% 0% 14%

8.3 1.7 9.8 13.0% 8,816 7,919 83.3 42.6 8,220 2,742 1,736 199 98 646 1,191 127 1,064 2.71 8,413 4,010 752 2,575 2,992 1,390 5,240 139 13.3 1,323 (333) (1,030) (40) -2.1% 33.4% 21.1% 14.5% 10.7% 12.9% 20.3% 8.9% 3 yr 51% 60% 54% 27% -145% 59% -17%

9.0 1.9 9.2 11.3% 10,146 14,086 94.9 50.3 10,893 3,550 2,327 231 147 576 1,836 703 1,133 2.88 8,875 5,408 804 4,098 3,322 1,390 5,330 139 13.6 1,757 (491) (533) 733 32.5% 32.6% 21.4% 16.9% 38.3% 10.4% 21.4% 8.5% 5 yr 34% 39% 35% 23% -163% 32% -10%

9.2 2.5 1.0 9.7% 14,263 15,621 102.6 77.1 12,173 3,863 2,534 392 231 372 2,323 766 1,557 3.96 8,640 4,225 1,295 2,371 3,236 1,529 5,664 153 14.4 1,846 (128) (1,408) 310 11.7% 31.7% 20.8% 19.1% 33.0% 12.8% 28.3% 11.5% 10 yr 26% 22% 21% 20% n.a -5% 0%

10 3 2 8.6% 16,730 21,765 133 89 12,798 3,269 2,233 558 190 286 2,315 704 1,611 4.10 8,583 4,603 1,617 1,683 2,580 1,529 6,586 153 16.7 998 28 (816) 210 5.1% 25.5% 17.4% 18.1% 30.4% 12.6% 26.3% 12.4%

9.6 3.0 1.5 8.3% 22,201 27,682 179 108 18,276 3,912 2,641 1,145 287 280 3,220 900 2,319 5.90 9,100 5,012 2,211 710 2,890 1,529 7,376 153 18.8 1,380 (227) (2,177) (1,024) 42.8% 21.4% 14.5% 17.6% 28.0% 12.7% 33.2% 17.0% P/E

13.9 3.8 1.5 4.9% 35,293 32,715 239 156 17,602 4,237 2,756 1,339 287 363 3,445 897 2,547 6.48 10,296 5,684 2,042 2,406 1,800 1,682 9,370 168 23.8 1,380 (689) (1,238) (547) -3.7% 24.1% 15.7% 19.6% 26.0% 14.5% 30.4% 16.9%

15.1 3.1 1.5 3.1% 47,548 56,588 297 170 23,183 4,920 3,279 1,831 339 535 4,236 1,081 3,155 8.02 21,759 16,397 11,133 1,319 15,423 1,935 15,482 193 39.4 1,542 (10,367) 15,863 7,038 31.7% 21.2% 14.1% 18.3% 25.5% 13.6% 25.4% 11.7%

12.5 2.5 6.0 2.8% 53,047 20,540 374 96 23,317 6,197 4,539 2,754 580 1,509 5,205 964 4,240 10.78 45,123 12,042 6,043 2,611 27,757 2,128 21,054 213 53.5 (117) (20,797) 13,187 (7,727) 0.6% 26.6% 19.5% 22.3% 18.5% 18.2% 23.2% 8.9%

10.6 1.6 6.0 4.3% 41,886 54,635 187 96 30,172 6,931 4,986 1,973 424 1,321 5,215 1,258 3,957 10.06 82,961 10,749 4,353 2,392 58,565 2,979 26,888 298 68.4 6,089 (36,218) 34,296 4,167 29.4% 23.0% 16.5% 17.3% 24.1% 13.1% 16.5% 5.2%

9.4 1.8 6.0 3.3% 60,320 63,519 213 166 79,976 20,274 11,984 897 958 4,201 8,277 1,836 6,441 16.38 131,082 33,696 (4,055) 5,716 89,171 3,277 34,115 328 86.7 (142) (19,741) 16,624 (3,259) 165.1% 25.3% 15.0% 10.3% 22.2% 8.1% 21.1% 5.0% P/B

Price/earnings (year avg) Price /book (year avg) Dividend per share Dividend yield Market cap (year avg) Market cap (year end) Share price (High) Share price (Low) Pro fi t & Lo s s Sales Gross profit Operating profit Other Income Other Expenses Financial Charges Profit before tax Tax Profit after tax EPS (Besed on curr paid up) B a l a n ce Sh eet Fixed assets Current assets Working capital Short-term debt Long-term debt Paid up capital Shareholders equity Shares outstanding BVPS (Based on current paid up) Ca s h Fl o w s Cash flow from operations Cash flow from investing Cash Flow from financing Net change in cash Ra ti o s Sales growth GP margin Operating profit margin PBT margin Tax rate NP margin ROE ROA

FY10** FY09 FY08 FY07 FY06

9.4 10.6 12.5 15.1 13.9 9.6 10 9.2 9.0 8.3 8.9 11.7 6.0

FY10** FY09 FY08 FY07 FY06 FY05 FY04 FY03 FY02 FY01 FY00 FY99 FY98

1.8 1.6 2.5

3.8

Sa l es FY09 FY10 FY11 PAT PKR mn FY09 FY10 FY11 E q u i ty PKR mn FY09 FY10 FY11

Q1 5,733 16,859 21,848 Q1 695 1,805 2,042 Q1 20,469 26,989 35,749

Q2 4,974 16,865 24,236 Q2 349 1,392 1,274 Q2 25,609 31,942 38,271

Q3 10,143 19,845 Q3 1,556 861 Q3 26,043 32,260 -

Q4 9,321 26,407 Q4 1,358 2,383 Q4 26,888 34,115 -

Fu l l yea r 30,172 79,976 46,084 Fu l l yea r 3,957 6,441 3,316 Fu l l yea r 26,888 34,115 -

FY05 FY04 FY03 FY02 FY01 FY00 FY99 FY98

3 2.5 1.9 1.7 1.9 2.5 1.9

* n.a = Not Available * N/A = Not Applicable ** Consolidated figures

Aug-11

Jan-07

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ENGRO Corporation {ENGRO} |

Next Capitals Star Ranking Methodology: Next Capital assigns a star ranking to stocks under coverage. Rankings range from a maximum of 5 star to a minimum of 1 star, based upon the upside potential that a stock offers. Ranking changes can occur due to price movement, or a change in the target price. 5 star Target price offers > 25% upside 4 star Target price offers > 15% and < 25% upside 3 star Target price offers > 0% and <15% upside Target price offers > 0% and < 15% downside 2 star 1 star Target price offers > 15% downside The primary advantage of the star ranking is that it allows our clients to ascertain our batting average in equity research. Often, sell side research analysts trumpet their successful ideas, and fail to mention their failures. Using the star rankings, our research team will be held accountable for all calls made, good and bad. With ranking updates provided on a regular basis, our clients will have an objective framework through which they can determine the calls we got right, and how many we didnt. An added advantage of the star rankings is that a change in ranking due to a significant move in price (without any change in the underlying fundamentals), will help our clients make considered buy and sell decisions.

Equity Research
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Ext 106

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