The whole corporate world has been surprised by the purchase price in the recently concluded deal for the buyout of the Pak Saudi Fertilizer Ltd (PSFL) by the Fauji fertilizer Company (FFC), which has now been confirmed by the Cabinet Committee on Privatization.

The price paid by the FFC for acquiring the PSFL is higher than any estimate given by analysts across the investment banking and corporate research industry. It is also far higher than the next closest bid given by any of the other competitors. Herein a closer look has been taken at the various possible causes behind the high price paid by the FFC for the PSFL.

The PSFL transaction is the first major privatization deal after a long time. The deal was concluded at a price of Rs 135.63 per share for 54 million shares of the PSFL (total Rs 7.324 billion), offered by the FFC. Most analysts expected the successful bid to be in the range of Rs100-110 per share. The other bids were Rs66.7 per share by the Engro Chemicals and Rs70 per share by the Dawood Hercules, both local urea producers in the private sector. The first thing coming to mind is what was there in the PSFL that the FFC saw but the other bidders did not? Was it a matter of creating corporate synergies that are generally considered important in the manufacturing industry, or was it a case of over-estimating the fair value of a company? Or did the FFC want to capture a market share that would place it comfortably above the rest of the competitors? Though the effects of this acquisition on the FFC’s balance sheet would be visible over a period of time, the initial analysis reveals the following facts:

The difference between the assets and liabilities (net assets) of the PSFL (as per accounts for the year 2000) is Rs606 million. As against this, a price of Rs7.324 billion has been paid. Whatever the long-term benefits to the FFC, it immediately has to arrange funds to pay for the deal. Lets take a look at how this amount of Rs7.324 billion may be arranged.

As per the latest published accounts, the FFC has approximately Rs5.85 billion in cash and short-term investments and around Rs2.45 billion in marketable long-term investments. The aggregate amount under these heads comes to Rs8.3 billion. Assuming that 50 per cent of this cash and investments can be liquidated (so as to keep a reasonable amount for the working capital needs), the total available amount comes to approximately Rs 4.15 billion. If these short and long-term investments are attracting an average interest rate of 11 per cent this would mean an amount of approximately Rs456 million foregone in terms of interest income.

Since the FFC has 256 million outstanding shares, the amount of interest forgone per share would be at a rate of Rs 1.78 per share. The remaining amount of Rs3.224 billion (Rs 7.324 billion — Rs 4.1 billion is being raised as a debt. Assuming the cost of debt to be in the vicinity of 14 per cent per annum for the next 5-6 years, an annual expenditure on this account can be estimated at near about Rs 451 million. This would mean additional financial charges at the rate of Rs 1.76 per share. The effect on reduction in earnings per share thus comes to Rs 3.54 per share (Rs 1.78 + Rs 1.76=Rs 3.54 share).

It is pertinent to note that the financial costs to the FFC don’t end here. The FFC has already made a commitment to its sister concern, the Fauji Jordan Fertilizer Company (FJFC) to provide it with financial assistance of Rs3 billion. It is not known at present what the schedule of recovery for this financial assistance would be. But one can be sure that recovery on this account from the FJFC would not start soon. The FFC would most probably have to raise this amount from banks and financial institutions, rather than to raise equity, as raising equity is a lengthy process and the sponsors may not have the financial resources for such large equity injections.

Borrowing, therefore, seems to be inevitable, as large amounts of funds have to be paid on account of the PSFL acquisition as well. Again assuming an interest rate of 14% per cent per annum, the amount comes at Rs 420 million per year. This financial burden would mean an erosion in the per share earnings to the tune of Rs 1.64 per share. The overall financial effect of this transaction thus comes to a reduction in the profits by about Rs 5.18 per share (Rs 3.54+ Rs 1.64 - Rs 5.18 per share). These figures may only change depending upon any permission or provision of the Privatization Commission (PC) to allow repayment in easy instalments, which again is highly unlikely.

On the earnings side and benefits to the FFC from the acquisition of the PSFL, the main advantage would be in terms of reduced selling and distribution expenses. For 1,460,000 tons of annual fertilizer production, the FFC incurs an expenditure of about Rs 838 million (calculated on the basis of half yearly selling and distribution costs for the latest year, at Rs 419 million) for the selling and distribution expenses.

This means an expenditure of Rs 598.6 per ton. The PSFL produced 565,000 tons of fertilizer for the latest year. If the same ratio of expenditure and production is assumed for PSFL, the total selling and distribution expenses for the PSFL should be near about Rs 338.2 million. It is our assumption that savings on this account, for the PSFL would be not more than 70 per cent of the existing expenditure. Thus saving on this account to the FFC after acquiring the PSFL would be no more than Rs 236.7 million. On a per share basis this means a saving of Rs 0.92 per share for the FFC.

By acquiring the PSFL, the FFC tends to gain a formidable position in the market. Already the FFC is the largest producer of Urea fertilizer in the country. By adding PSFL’s production capacity, FFC stands to command more than 65 per cent of the total market share. But being a deregulated sector, it is highly unlikely that the FFC would come into any position to manipulate the prices in beyond a certain limit because, prices, if increased beyond a certain limit, would result in an influx of imports.

Both the FFC and the PSFL run highly efficient plants and have a production capacity in excess of their installed capacities. It is therefore unlikely that there would be any significant increase in their production from this point onwards. With the country having nearly achieved the international standard level of fertilizer usage per area of cultivated land, any increase in demand for Urea is also unlikely. More so, the shortage of irrigation water may actually result in lower fertilizer demand.

The FFC may tend to gain some financial advantage over its competitors by increasing its share in the import of fertilizer, specially the DAP fertilizer which is imported. Gaining through the sale of additional imports of fertilizer is actually possible because of the better marketing, selling and distribution channels obtained by acquiring the PSFL. Even though the primary purpose of a fertilizer manufacturing plant is not trading the FFC is expected to dominate the market of imported fertilizer, also making use of the channels of the FJFC to cater to the requirements of imported DAP fertilizer. Savings on this account may be anywhere near Rs 50 million (as can also be seen in a rising trend the head of ‘other income’ in the latest half yearly accounts). This would mean a per share saving of about Rs 0.2 per share. The total estimated impact of the acquisition of the PSFL by the FFC thus comes to a reduction in the profits by about Rs 4.06 per share (Rs 5.18 — (Rs 0.92 + Rs 0.2 per share).

The only plausible justification in favour of the FFC management is that bids given by potential buyers are inherently risky and they are unaware of the bids being given by other parties. That is why due diligence is carried out to arrive at a certain price level. But due diligence of course, is also dependent upon several non-quantifiable factors like personal judgment and intuition. Hence it remains susceptible to errors of judgment.

Cheers must have been sent across the PC boardroom after the FFC-PSFL deal. What holds in spare for the shareholders of FFC, only time will tell. The management of the FFC is busy defending its acquisition and the price paid for the PSFL, insisting that significant corporate synergies would in fact be achieved from this acquisition. on the one side, the investment analysts are giving their divergent views and on the other side the employees of the PSFL are complaining that they were never allowed to put up their own bid. For this one deal it seems that the only winner is the PC.