Case study:

Fatima Fertilizers Corporation Limited-Repaying the Loan

It was beginning of August 2016, Aamer Malik, Manager of Finance Department at Fatima Fertilizers Corporation Limited was asked by the board of governors to present some recommendations for financing the repayment of loan which was due in month of October 2016. The loan was received from a commercial bank to fund some projects and acquisitions which were parts of expansion plan for FFCL to deal with growing competition in fertilizer industry. The amount of loan to be repaid was Rs. 10500 million and FFCL was in no position to pay such amount in short span of time. Aamer was tasked to find out the possible solutions to meet the loan repayment amount through either by issuance a financial instrument like Sukuk or by issuing new shares. It was a huge responsibility for Aamer. He had to evaluate all the options before putting forward a right solution in front of the board.

FFCL

Fatima Fertilizer Company Limited (FFCL) was incorporated on December 24, 2003, as a joint venture between two major business groups in Pakistan namely, Fatima Group and Arif Habib Group, with its head office located in Lahore, Pakistan. The Company is listed on Pakistan Stock Exchange. Fatima Fertilizer Company Limited is involved in the manufacturing and marketing of fertilizers. The fertilizer complex is a fully integrated production facility producing mix fertilizer products, occupying 947 acres of land located at Mukhtar Garh, Sadiqabad, and District Rahim Yar khan. The Complex has dedicated gas allocation of 110 MMCFD from Mari Gas Field and has 56 MW captive power plants in addition to off-sites and utilities. Commercial production commenced on July 01, 2011. The Complex had initially an annual design capacity of 500,000 Metric Tons of Urea, 420,000 Metric Tons of Calcium Ammonium Nitrate (CAN) and 360,000 Metric Tons of Nitro Phosphate (NP). Product and Services of FFCL are presented in Exhibit 1.

Its Vision is to be a world class manufacturer of fertilizer and ancillary products, with a focus on safety, quality and positive contribution to national economic growth and development. Mission is to be the preferred fertilizer Company for farmers, business associates and suppliers by providing quality products and services. Company believes in the Corporate Values i.e. Integrity, Innovation, Teamwork, Health, Safety, Environment& CSR, Customer Focus and Excellence. Company value its people as its greatest resource by creating value for all stakeholders through continuing excellence in our operational efficiencies, strategic planning and a robust implementation plan for driving our market position. It is achieved by focusing on our sustainable competitive advantage. It considers appropriate investments in people, infrastructure and diversification of its product line as major drivers behind corporate sustainability in the ever changing market. Focus is to drive land productivity through balanced fertilizer application.

Industry

Traditionally, Pakistan's fertilizer production capacity is over 6 million tons per year, little over the national demand. Over the past years, this sector has been facing several challenges due to insufficient gas supplies, high gas tariffs and heavy taxation. As the present government focus on strengthening the agricultural and fertilizer sectors - a special "Kissan Package" was announced to benefit farmers and support the agricultural sector by providing subsidies on fertilizers, along with soft loans to small farmers. The FBR has also announced a big reduction in sales tax on fertilizers, bringing it down from 17% to only 5%. Moreover, the government is also working towards ensuring gas availability and large-scale LNG imports whereby all urea manufacturers are able to optimize their productivity to meet the local demand.

Responding to the government's support and incentives, the fertilizer sector in Pakistan had already paid over Rs 109 billion as Gas Infrastructure Development Cess (GIDC), till October, 2016. It had emerged as the highest contributor to GIDC, among all industrial sectors across the country. It is expected that improved farm-economics will lead to a substantial rise in domestic urea sales - driven by lower prices, gas-subsidy and tax-reduction in the local market. The industry faced cash flow problem due to unnecessary delays in payment of subsidy besides incurring financial cost. The fertilizer market usually also gets distorted due to delays in government's decisions on prices or other critical aspects. The unexpected changes in prices make it extremely difficult for farmers to make decisions and optimize their harvest. If the government continues its support to fertilizer sector, an opportunity will emerge through which Pakistan will once again become the exporter of locally produced urea to earn substantial amounts of foreign exchange for the country. Currently BMA research suggest an increase of 17% month-on-month in international urea prices, due to higher coal prices; however, the high cost of production in Pakistan does not make it an economical of proposition for export. The government will have to offer incentives to allow export of piled up urea inventory, which was estimated to be at 900,000 at the close of 2016.

The key players in Pakistan's fertilizer industry spend generously on improving the healthcare and educational facilities in many deprived regions. They install renewable power projects to reduce the energy crisis and provide relief during major calamities or disasters in the country. They have always followed traditions of good-governance and transparency, while paying all their taxes prudently as they absorb the substantial part of taxes or GIDC levied on the industry, thus helping to revive the poor farming community. They have played a key role in reducing imports to save precious foreign exchange and improving food security in the country.

Projects and Acquisitions

In past decade, Fatima group launched some projects, acquisition and took stake in some companies for the expansion of its operations like in 2011, group invested in FFC Energy Limited (FFCEL), Pakistans first wind power generation project. In 2012, did Inauguration of FFC Energy Limited, Inauguration of new state of the art HO Building in Rawalpindi. In 2013, Acquisition of 100% equity stake in Fatima Fresh and Freeze Limited (FFF), a pioneer Individually Quick Freeze (IQF) fruits and vegetables project. Also acquired 43.15% equity stake in Askari Bank Limited (AKBL) representing the Companys first ever venture into the financial sector. In 2015, FFCL received award of setting up of a Fertilizer Project by the Government of Tanzania and execution of a Joint Venture Agreement by FFC, and its international consortium members, with the Tanzania Petroleum Development Corporation (TPDC). The Company has acquired entire share capital of Fatimafert Limited (FF) (formerly DH Fertilizers Limited) and Buber Sher (Pvt) Limited (BSPL) against purchase price of Rs 2,020.634 million and PKRs. 0.01 million respectively. The price of 100% shares of FL has been valued as total of:

1. Differential between the agreed enterprise value of FF (PKRs. 6,600 million) and the total long term loans of PKRs. 4,607 million.

2. Excess of current assets over current liabilities of FF as at June 30, 2015 determined to be PKRs. 28.134 millions.

The control of DH Fertilizers Limited was transferred to the Company on July 01, 2015. The Company has invested 858,056 fully paid ordinary shares of PKRs. 100 each of Multan Real Estate Company (Pvt) Limited (MREC). The investment represents 39.5% of the total issued, subscribed and paid up share capital of MREC. The main business of MREC is establishing and designing housing and commercial schemes, to carry on business of civil engineers for construction of private and governmental buildings and infrastructure and provision of labor and building material. This Investment is measured at cost as the associated company has not yet started its commercial operations and the breakup value for the purpose of equity method is not significantly different from cost.

Because of these projects, acquisitions and expansions, FFCL took loan of PKRs. 10,500 million in that period and this had to be repaid PKRs. 10,500 million amount by 30 October, 2016. So, Aamer Malik, Manager Finance Department, FFCL was supposed to prepare some options to repay this huge amount. First thing came in Aamers mind was to solve this matter by issuing an Islamic Finance instrument i.e Sukuk

Sukuk

Aamer was thinking that FFCL should issue an Ijarah Sukuk to meet the loan. Sukuk will be backed by complete Ammonia Plant including civil, construction, installation works and other allied accessories located at Mukhtar Garh, Sadiqabad, Distt. Rahum Yar Khan. Assets value is Rs. 15.47 billion. The rental payment will comprise of Fixed (principal) and Variable (profit) components. Rentals will be payable semi-annually. Rate of return will be as follows:

Base Rate (5-year floating rate @ 6 month KIBOR (ask side)) plus 1.10% per annum (subject to a floor of 3% per annum and a cap of 25% per annum).

Aamer was focusing on this option because of recent growth of Islamic Finance industry in Pakistan. (See Exhibit 2 for more information about Islamic Finance in Pakistan.) Sukuk emergence has been the most important development in capital market in recent years by Islamic scholars, which alters the traditional means of doing investment and financing. Finance products Sukuk are asset backed securities, whose terms are comply with shariah were made in an intention to create similar revenues streams to those with conventional fixed income instruments for-example bonds. Sukuk represent the ownership in tangible real asset which give the legal right of ownership, using the asset, selling and enjoying the fruits on profit and services which is not debt instruments or represent the debt obligation to issuer.

There are five major differences between sukuk and traditional bonds. First the sukuk owners hold the ownership of an asset and bond indicate the debt obligation. Second shariah compliant asset are used to secure the sukuk and bond are backed with products or services which are against Islam. Third difference is the price of sukuk is derived from the value of an assets and bond priced as per credit rating provided by rating agencies. Forth sukuk value increase or decrease according to the value underlying assets and bond value changes as per the current market interest rate. Fifth difference is when owner of sukuk sells the certificate than he or she is actually selling ownership from the asset backing those sukuk and selling the bond means selling the debt.

In the Islamic Market, the most common funding arrangement and products include: Ijarah sales and lease structure, musharkah a joint-venture equity investment and murabaha a form trade finance.

Ijarah Sukuk work for-example if a manufacturer requires funds to purchase equipment to extend manufacturing plant, it will than issue Sukuk which purchased by financial institutions and individual investors. From the proceeds of Sukuk, the required equipment is purchased by issuer and leased to the manufacturer. During the period of lease, the manufacturer will pay rent which use as income stream for the Sukuk certificate owners. After the lease period is over, the new contract will made to purchase assets and use sales proceeds to redeem sukuk holder investments.

Murabaha Sukuk is a special kind of sale where the seller of the asset explicitly tells the cost and sale it to the buyer by including some profit. In this A bank for-example make a contract of sale with client, on contact the bank buys a underlying asset from a client at market price then again sells the same item back to client in installments by adding predetermine profit margin, which consider as fee is charged to execute the transaction which is permissible in Islamic laws and not considered as Riba or interest.

In Arabic Musharkah means sharing and as per Islamic finance it means joint venture formed to conduct business on which all partners will share the loss according to the investment and profit will be distributed as per specified ratios. Monthly or yearly installments are set on amortization bases and pass on to the client during the specified contract.

Equity

Another option was to issue shares of Rs 10500 million @110 per share, which meant that total number of shares would be around 95 million. Aamer was worried whether FFCL will be able to afford such an increase in shares. Over the past 4 years, FFCL maintained share capital of Rs. 12722 (see Exhibit 3). This might discourage current investors of FFCL. Aamer estimated the cost of equity to be at 8%. There was a huge uncertainty whether equity is better option than the Sukuk issuance. Aamer needed to understand the cost and benefit of both options so that he could come up with better recommendation for the board meeting.

Decision

Aamer was also aware about the Revenue Reserves that FFCL held in the year 2015. The total value of the revenue reserve was Rs. 15893 million. He thought that FFCL could use this money to pay off its loans. But these reserves were held as special accounts for future needs. FFCL needed this money for funding its projects in coming years and keep running its operations smoothly with such reserves. Aamer then thought board might not allow consuming these reserves so that such amount is saved for later usage. Right now he had to make a decision whether FFCL should go for either Sukuk issuance or equity.

Questions: 1. What are the main reasons behind the loans to be paid by FFCL?

2. Explain what a Sukuk is and how it is structured in general?

3. Whether FFCL should opt for Sukuk? Describe the pros and cons of this option?

4. An alternative to Sukuk is Equity. Explain why should FFCL go with Equity or why not?

5. Can there be any other options through which FFCL can repay its Loan?