Equity Analysis /

Pakistan Fertilizer and Agri: GST to be passed on, remain Overweight

  • IMF has recommended Pakistani authorities to rationalize GST on fertilizer and tractors to 17%

  • We believe that producers will likely to pass on GST impact on end users amid better pricing power and farm economics

  • While an increase in GST may reduce tractor sales, a possible subsidy may negate any negative impact on profitability

Intermarket Securities
7 February 2022

As per the Article IV Consultations report, IMF has recommended Pakistani authorities to rationalize GST on fertilizer and tractors to 17% from 2% and 5% at present, respectively. At the same time, the government has agreed to formulate a mechanism to increase GST on these items in the FY23 Budget but will try to offset the price impact with subsidies for farmers. Recall that the removal of tax exemptions on these two items was expected in the recently passed Mini Budget but did not come through.

Fertilizer Sector 

In the present scenario, producers are selling Urea at a price of PKR1,732/bag to dealers, who are in turn selling it to farmers for PKR2,500-2,800 per bag. The premium arose before the release of Mini Budget in November, when there were rumors that the government would increase GST from 2% to 17% and that gas prices are set for an increase as well (typically passed on). These speculations led to an artificial Urea shortage in the market, and hence fertilizer has been selling at a large premium ever since.

Therefore, we believe that an increase in GST on Urea will eradicate the premium in retail Urea prices; and, given the presently robust demand (thanks to elevated commodity prices and better farm economics) fertilizer producers will easily pass on the tax impact. Note that farmers are already paying the high price of Urea. Below are possible increases in prices of various fertilizers, if the government increases the GST on them to 17%.

DAP prices in Pakistan are already at their all-time high levels. Producers will try to pass on the full impact, but it will eventually hurt DAP demand. We saw such demand destruction in CY21 (prices rose 62% yoy leading to 13% yoy lower sales). But going forward, we expect that international Urea and DAP prices will come down from present levels as global demand – specifically in China – will slow down, leading to more exports out of China in the coming months. Therefore, in that scenario, it will be easy for the domestic industry to pass on the increase in taxes, in our view.

To mitigate the elevated cost of fertilizer products, the government has already proposed a plan to the IMF and may launch another subsidy plan to minimize the cost of farmers. To recall, subsidy on fertilizer products is not new; it was in place previously between December 2015 and March 2018. The maximum subsidy was given on DAP, of PKR500/bag (c.15% of the average price at the time).

But this subsidy mechanism is widely disliked by the sector, majorly because of delays in receiving the subsidy from the government. Given past subsidy is not yet settled, the launch of a new subsidy will exacerbate working capital issues for the industry, straining cash flows and possibly future payouts as well, in our view. Refer to the table below for the outstanding subsidy receivable of each company.

Apart from GST rationalization, another increase in consumer gas prices is also on the cards. Presently feed and fuel gas prices are PKR302/mmbtu and PKR1,023/mmbtu, respectively. A PKR50/mmbtu in feed and fuel gas will increase the cost by c.PKR65/bag. This is, however, also likely to be passed on to farmers, in our view.

Going forward, we believe that increase in GST on the fertilizer sector especially for Urea will easily be passed on by the domestic players and it will eventually erode the premium that dealers are presently charging from end users. Therefore, we maintain our Overweight stance on the sector and our top picks will remain FFC with a TP of PKR140/sh and Buy on EFERT with a TP of PKR95/sh.

Tractor Sector

Since FY17, the government has placed a GST of 5% on tractors, in order to improve mechanization in farming and elevate crop yields. The special rate was also continued in the recently approved Mini-Budget. However, as mentioned above, GST on tractors may be hiked to 17% in the upcoming FY23 budget. We highlight that historically GST increase has been a big negative for the sector. Sales nosedived c.30% yoy when GST was last increased in 2014. Having said that, a subsidy of the same amount – worth about PKR12bn on nearly 60,000 tractor sales estimated for FY23f – will offset the negative price impact and moderate the decline in sales, in our view.

As in case of Fertilizer producers, for both tractor producers, MTL and AGTL, the GST hike and potential delays in receipt of subsidy will lead to greater working capital requirements (increase in refunds from the government, which already stood at a combined c.PKR8.5bn by end-Sep 2021), in our view, with a slight impact on earnings. However, a net increase in prices (if subsidy of a lower amount is given) will dampen our demand growth (lower than 5% estimated for FY23), earnings and dividends.

Due to the importance of the sector, a handsome subsidy is highly plausible, in our view. We therefore remain Overweight on the Tractor sector, preferring MTL (TP of PKR1,200/sh) as our top pick.