Decoding the IMF Program

Transcription

1 Decoding the IMF Program Choose Cautiously; Choose Wisely Friday September 6, 2013 IMF facilities availed since 1988 Facility Date of Amount Amount SDRbn Arrangement Agreed Drawn SBA Nov 24, ECF Dec 06, SBA Nov 29, ECF Oct 20, EFF Oct 20, SBA Dec 13, ECF Feb 22, EFF Feb 22, SBA Sep 16, SAF Dec 28, SBA Dec 28, SBA: Standby Arrangement ECF: Extended Credit Facility EFF: Extended Fund Facility SAF: Structural Adjustment Facility Research Analysts Furqan Punjani Muhammad Affan Ismail Farid Aliani Zoya Ahmed Pakistan has finally entered into IMF s Extended Fund Facility (EFF) program of USD6.6bn (4.39bn DSR or 425% of country s allocated quota) with an initial disbursement of USD544mn. To, recall this would be Pakistan s 3rd EFF program in the history while on the whole Pakistan has availed the IMF facilities 11 times since 1988 to meet current account and currency crisis the latest program having expired in Sep11. Like previous programs, the inflows are contingent upon economic and monetary targets to be reviewed quarterly over the next three years. Though the reform agenda was widely known especially the power sector reforms which were also covered in the recently released Energy Policy 2013, the latest Memorandum on Economic & Financial Policies already met (discussed below) if the government sticks to the plan, we should expect a firm grip on fiscal management, lower inflation levels and a complete over haul of power sector enough to pace the economic growth by the time program concludes. We opt to highlight few important details from the memorandum agreed with IMF and its impact on local economic variables and sectors respectively. Fiscal Management: No deep pockets As agreed with IMF, by the end of the third fiscal year (FY17) the government would reduce the fiscal deficit to 3.5% of GDP by means of: 1) Increasing the tax rates (as seen in Budget FY14) and tax base by bringing grey economy into the tax net (through targeting bank accounts) which would cumulatively have an impact of ~0.75% of GDP or PKR175bn in FY14 and onwards, 2) Reducing the untargeted subsidies. This would be done by increasing power tariffs by another 26% in FY15 and 20% in FY16 (our estimates) over and above the recently increased power tariffs (50% for industrial units in Aug13 to be followed by another 30% for domestic users using 200 or more units). This would further reduce the quantum of circular debt by approx. PKR95bn and PKR70bn in successive years. 3) Increasing the existing gas tariffs (currently USD4.7/mmbtu for industries) by imposing additional levy by the year end, though subject to the court decision on GIDC issue. Through this levy, the government intends to increase its collection by 0.4% of GDP or PKR95bn. 4) Removing the concessionary grants by successive SROs from second year and onwards. 5) Streamlining the salary costs of government employees which would positively impact state managed and privately managed public enterprises. To mention, the government in last 5 years have increased minimum wages by a cumulative 66% negatively impacting especially export oriented businesses. 6) Provincial surpluses. Though provinces have principally agreed to curb down their expenditures in line with the federation, the government intends to open up the discussion with the provinces over a new NFC system to adjust the terms of fiscal decentralization. 7) Shifting government s focus away from short term borrowing through Tbills to long term PIBs. Though this wouldn t change the borrowing balances, the long tenure would help government to finance its capex projects with greater liberty compared to current maturity risk. All being said, the government intends to increase the size of PIB market which stands at 19% of total government paper borrowing of PKR6,521bn. or sell the securities mentioned.11 1

2 Probable Govt. Entities to be privatized Gas Distribution 1 Sui Southern 2 Sui Northern Banks 3 Sindh Bank 4 Bank of Punjab 5 Bank of Khyber 6 NBP Petroleum 7 PSO 8 POL 9 PPL 10 PARCO 11 Mari Petroleum 12 National Refinery Miscellaneous 13 Pakistan Railways 14 PTV 15 Radio Pakistan 16 Pakistan National Shipping 17 NESPAK 18 Pakistan Postal Service 19 PIA 20 Pakistan Steel Mills Electric Supply 21 Sukkur Electric 22 NTDC 23 Hyderabad Electric 24 HUBCO 25 LESCO 26 KANUPP 27 Faisalabad Electric 28 Gujranwala Electric 29 Islamabad Electric 30 KAPCO 31 Multan Electric 32 Peshawar Electric 33 Quetta Electric 34 Tribal Electric Source: BMA Research 8) Considerable attention on privatization as government has indicated total of 65 entities to be either privatized or be managed by private entrepreneurs (as the case with PTC and KESC). The report indicates privatization structure of PIA, Pakistan Railways and Pakistan Steel Mills by Jun14. With power and gas tariff hikes on the cards, the immediate risk to inflation cannot be thrown out, however lower accumulation of circular debt would indeed free up much of the fiscal space and would help revive the industry s utilization. However, the impact of tariff hikes would be widely different on industries depending upon their pricing power and demand/supply dynamics. Moreover with stiff fiscal position in FY14, the government would have to reduce the allocation to public sector development projects (as shown by their indication of slowing PSDP spending down till 9MFY14 to have a fair idea of fiscal deficit). Thus, a major uptick in the economic growth especially with dried up private investment seems unreasonable. Inflation will not be a focus doesn t necessarily mean status quo The agreed terms with IMF indicates the government s prime focus would be towards rebuilding the foreign exchange reserves, staying away from open market operations and refraining from directly lending to the government. The memorandum also indicates to: 1) Maintain price stability but inflation reduction will not be under key focus at least for the first year 2) Tight monetary policy in second and third year once exchange rate pressure eases to ensure the real interest rates, bringing the inflation down to the range of 6% 7% 3) Strengthen competiveness over time through PKR depreciation and 4) Limitation on net domestic asset Unlike previous programs IMF has agreed to not to focus on inflation levels in the first year, however we believe this doesn t mean that SBP will not follow inflation. We expect the discount rates to increase by 50bps in the upcoming monetary policy as: Restriction on direct borrowing from SBP will leave no option to the government except to head back to commercial banks, which have so far refrained to lend in expectation of an uptick in policy rates (indicated by latest M2 numbers and last few auctions where offer to borrowing ratio has gone down drastically). Thus this limitation will lead SBP to increase the discount rates to unlock the flows from commercial banks. CPI will head back north in the next three months on the back of increase in power tariffs (30% expected in the next month) and higher costing imports after 5% depreciation of PKR FYTD. Further PKR depreciation and higher oil prices would certainly pull up the imported inflation levels in 2HFY14 We understand not focusing on the inflation means not keeping high enough real rates as seen in the previous programs and thus this makes a strong case for a 50bps increase in the next MPS. Moreover, curbing down the forex operation would mean higher PKR depreciation in years to come and hence this should also be followed keenly. We believe the businesses having positive correlation with PKR depreciation should be given more attention in times to come. or sell the securities mentioned.22 2

3 Pakistan: Quantitative Performance Criteria and Indicative Targets for FY2013/14 (In PKR bn, at program exchange rates, unless otherwise specified) FY2012/13 end June end Sep FY2013/14 end Dec end Mar Act. Program Performance Criteria Floor on net international reserves of the SBP (USD mn) 2,437 2,499 2, Ceiling on net domestic assets of the SBP (stock, billions of Pakistani rupees) 2,402 2,377 2,532 2,354 Ceiling on overall budget deficit (cumulative, excluding grants, PKR bn) 2, ,209 Ceiling on SBP's stock of net foreign currency swaps/forward position (USD mn) 2,255 2,255 2,005 2,005 Ceiling on net government borrowing from the SBP (including provincial governments, stock, billions of Pakistani rupees) 2,168 2,690 2,560 2,390 Continuous Performance Criterion Accumulation of external public payment arrears by the general government (continuous) Indicative Targets Cumulative floor on Targeted Cash Transfers Spending (BISP) (PKR bn) Source: IMF Banks Capital MCR CAR CAR PKR mn SCBPL 38,716 M 14% M BOP 22,288 M 8% NM NBP 18,500 M 16% M SILK 18,097 M 6% NM NIB 13,808 M 13% M BAFL 13,492 M 13% M KASB 12,923 M 1% NM UBL 12,242 M 15% M HBL 12,123 M 16% M HMB 10,478 M 15% M ABL 10,410 M 16% M MCB 10,118 M 22% M BAHL 10,104 M 16% M MEBL 10,027 M 14% M FABL 9,274 NM 11% M SNBL 9,021 NM 12% M BOK 9,001 NM 25% M JSBL 8,610 NM 16% M AKBL 8,131 NM 12% M SAMBA 6,731 NM 44% M DIB 6,715 NM 19% M BURJ 5,862 NM 23% M ALBARAKA 5,801 NM 11% M BIPL 5,280 NM 15% M SUMMIT 4,709 NM 4% NM M: Meeting NM: Not Meeting Financial Sector: Well managed but can be managed even better Well capitalized in hard times where global banks were collapsing, the document has endorsed the banking system as well managed largely. However, out of 34 banks operating in Pakistan, four small banks that fail to meet the CAR ratio requirements have attracted attention. One of them, a state owned bank (Bank of Punjab, we believe) will have to meet the CAR requirement by the end of 2014, according to the agreement with the IMF. Recently being recapitalized, the bank has posted profits and we believe the bank will meet the target by itself. Out of the three banks that fall below the CAR requirement, SBP has highlighted some specific solutions such as mergers and acquisitions, capital raising plan through preference share issuance and share subscription by some foreign investors to meet the same and thus may not catch much of the attention going forward. Energy Sector: Memorandum imitating the Power Policy 2013 The power reforms explained in the memorandum are no more than an imitation of the National Energy Policy announced by the government in Aug13. The government has proposed the following steps targeting the entire power value chain including generation, distribution and transmission areas: Generation: Pursuing efficiency aggressively To improve productivity and use fuel provision effectively: 1) The inefficient Gencos will be either privatized or leased out to private sector in order to revamp the inefficient machines and introduce better and credible management to tackle administrative issues. 2) The efficiency levels of all the power plants would be continuously re evaluated based on their heating rates 3) Fuel storage and delivery facilities will be leased to Pakistan State Oil (PSO) by end Dec13 in order to minimize losses in fuel delivery to GENCOs. or sell the securities mentioned.33 3

4 4) Signing of performance contracts with GENCOs, PSO and fuel transporters across the power value chain 5) In the longer term, the government intends to shift the generation mix from expensive FO generation (~PKR17/kwh) onto cheaper sources such as hydel, coal (PKR10/kwh), wind and solar 6) In this regard, NEPRA has come up with an upfront tariff for coal power plants further incentivizing private investment in the sector 7) Many run of the river projects are also in the pipeline that can add up to another 2,000 3,000 MW of electricity in the system. Transmission: Automating the systems Pakistan loses almost 25% of its electricity generation on account of electricity theft and T&D losses. The government intends to tackle the transmission issues by: Performance contracts to be signed with NTDC to ensure that losses remain within the allowed range of NEPRA (2.5%). In addition to this, to optimize effective transmission, various software, hardware Distribution: Curtailing T&D losses On the distribution front, the government looks forward to: Introducing smart meters at all feeders that will help reduce the T&D losses (currently at 25%) and resultantly lower the electricity theft amounting to PKR140bn. Developing an online monitoring system for electricity distribution from feeders and transformers to recognize areas where collections are low thereby increasing loadshedding in those areas. Also, The said proposition would be beneficial for all the distribution companies especially KESC whose profits tend to increase by PKR4,236mn from 1% decline in T&D losses. Tariff Rationalization: Need of the hour The most important and much needed action to solve the liquidity concern of the power sector and thus increase generation was to rationalize electricity tariff and reduce subsidies. Importantly, the government has decided to provide subsidies to domestic users utilizing 200 units or less only and plans to phase out subsidies over a period of three years. In this regard, the government has increased tariff (up 35% 55%) for commercial and industrial units from August whereas tariff for domestic consumers would be raised in October). This step would be positive for the entire power sector that has suffered immensely on account of 1) lower generation due to inability to procure fuel and 2) increased working capital requirements because of stuck up cash. The table below explains the amount of tariff increase needed in order to achieve the subsidy target set for different phases. Phase wise subsidy elimination Phase 1 Phase 2 Phase 3 FY13 FY14 FY15 Subsidy as % of GDP 0.75% 0.40% 0.30% Probable tariff increase (PKR/kwh) Source: BMA Research or sell the securities mentioned.44 4

5 Structural changes Poor governance and politics have also played their role in hampering the growth in power sector. To bring all the concerned ministries on board and improve coordination amongst them, a Coordination Council will be created between Ministry of Water and Power, Ministry of Finance, Planning Commission and provincial members. Most importantly, the policy looks to reform the structural and regulatory aspects of NEPRA whose inability to notify tariff increases on time causes huge losses to the power companies. Pakistan: Prior Actions and Structural Benchmarks under Extended Fund facility Time Frame Item Measure (by End of Period) Prior Actions (implemented before Board consideration of the program) 1 Net purchase of $125 million by the SBP in the foreign exchange sopt market between July 1 to Aug days prior to the Board meeting 2 Develop and approve a three year plan by the Government for phasing out Tariff Differential Subsidies (TDS), and implement the first step by: (i) the notification of new tariffs for FY2012/13; (ii) increasing the weighted average tariffs by 50 percent on industrial, commercial, bulk, and AJ&K consumers electricity consumption; 5 days prior to the Board meeting and (iii) announcing a reduction of the subsidy on second group of consumers (as defined in the TMU) through increasing the weighted average notified tariffs by 30 percent that will be in effect from October 1st, Implement a series of fiscal adjustment measures (including those in the 2013/14 budget) totaling 5 days prior to the Board meeting 2 percent of GDP on an annualized basis. 4 Impose a balanced budget requirement on provinces and agree with provinces to save additional 5 days prior to the Board meeting revenues generated by the program. 5 Issue 10 thousand notices based on large potential fiscal liabilities. 5 days prior to the Board meeting Structural Benchmarks Fiscal sector 1 Develop and launch initiatives to enhance revenue administration for sales tax, excises, and customs end December 2013 similar to that prepared for income tax. 2 Announce a rationalization plan for gas prices which will involve a levy to generate 0.4 percent of GDP end December 2013 fiscal savings by end December Monetary sector 3 Enact the amendments to the SBP law to give SBP autonomy in its pursuit of price stability as its primary end March 2014 objective, while strengthening its governance and internal control framework, in line with Fund staff advice. Financial sector 4 Prepare detailed plans to achieve compliance of all banks that fall below minimum capital adequacy, end December 2013 including specific actions, end dates, and contingency arrangements. Also detail a plan for recapitalization, consolidation or liquidation of 9 banks that fall below the minimum capital requirement but not CAR. 5 Enact the Deposit Protection Fund Act, in line with Fund staff advice end September Enact the Securities Bill, in line with Fund staff advice. end December 2014 Structural Policies 7 Develop and approve PSE reform strategy for thirty firms among the 65 PSEs approved for end September 2013 privatization by the Council of Common Interest (CCI). 8 Hire a professional audit firm to conduct a technical and financial audit of the system to identify the stock end November 2013 and flow of payables at all levels of the energy sector (including Power Sector Holding Company Limited). 9 Make Central Power Purchasing Agency (CPPA) operational by separating it from the National Transmission and Despatch Company (NTDC), hire key staff, issue CPPA rules and guidelines, and initiate end December 2013 the payment and settlement system. 10 Enact the amendments to the Pakistan Penal Code 1860 and the Code of Criminal Procedures end December Privatize 26 percent of PIA's shares to strategic investors. end June 2014 Source: IMF or sell the securities mentioned.55 5

6 Pakistan Equities Theme: Cements, Textiles, Power, E&P and Fertilizers With government already meeting the pre conditions of the IMF, we opt to highlight the impacts on specific sectors if the plan moves through. Apart from the sectors covered in this report, we would advice investors to focus on sector which are hedged against or benefits from PKR depreciation, have strong pricing power, strong earnings growth despite having been impacted by PKR deprecation, strong local demand and above all having an ability to pass on the power and gas tariff hikes. Power: Macro Indicators + Structural Reforms; all turning positive The power sector reform agenda, if implemented in its true spirit will have a multiplier effect on the economy as a whole and particularly power sector. The power companies have suffered a great deal due to the non payment of dues by the government in the form of lower generation and higher borrowings to meet working capital requirements. Things are going to take a turn for the good now. Steps to eliminate tariff subsides, reduce electricity theft, decentralization of regulatory bodies, reduction in time period for determination of base tariff by NEPRA will all lead towards better liquidity and improved cash position for the sector making room for further increase in the dividend payouts. We maintain a bullish stance on power sector on account of PKR depreciation (PKR110/USD in FY14E), circular debt reduction and better cash flows paving way for increase in payouts going forward. Valuation Summary FY14E EPS FY14E DPS Div Yield Total Return TP HUBCO % 10% 70 KAPCO % 19% 67 NPL % 27% 36 NCPL % 27% 37 Source: BMA Research Cements: Price consensus key to sustain margins in the face of rising tariffs While the recent combination of power and gas tariff hikes in very different quantum has already dented consensus at All Pakistan Cement Manufacturers Association (APCMA), we highlight that the same consensus needs to be strongly in place to weather the storm of continued increase in these costs during FY14 FY16. To review, post 56% hike in power tariff and merely 17% rise in gas prices in Aug13, larger cement players with gas based captive power generation face much less negative earnings impact than their smaller completely electricity grid based counterparts. Our estimates of required cement price increase to maintain margins post Aug13 tariff hikes are: BMA Cement Universe: Required price hike to pas on tariff increase Electricity Mix Price Hike (PKR/bag) ACPL KESC/WHR 26 DGKC WAPDA/WHR/Captive 13 FCCL WAPDA 32 LUCK Captive/WHR 6 MLCF WAPDA/WHR/Captive 17 Source: BMA Research or sell the securities mentioned.66 6

7 Additional ~46% cumulative rise in power tariff during the next two fiscals may bring further negative vibes for the sector profitability. Having said, we believe that imminent hefty levy on gas usage by Dec13 ultimately implies that it is in both larger and smaller players interest to maintain price discipline and gradually pass on the full scale impact from these cost pressures. For the same reason we have no concerns on cement prices and margins front and maintain BUY on current attractive valuations. Another point to ponder is the government s intent to minimize capital expenditures envisaged in Budget FY14 during the first nine months. This bodes negative on cement demand front and we may have to revisit our annual domestic dispatches assumption based on 1QFY13 sales performance. To recall, BMA projects domestic dispatches to grow by 6% this year. Our favorite pick in the sector is DG Khan Cement (DGKC), based on 1) over 100% capacity utilization, declining finance costs, robust and growing dividend income from portfolio and last but not the least a hedge against rising electricity charges. At our Jun14 TP of PKR108/sh, DGKC offers upside of a whopping 40% from last close BUY! Fertilizer: Gas cost on the up + global urea freefall = subdued outlook Gas price rationalization implies removal of feed gas subsidy for the fertilizer sector. Also, fuel gas rates are set to rise inline with the tariff and levies imposed on the industrial sector as a whole. This, together with free fall in global urea market shrinking local urea s discount to international prices to as low as 20% (global urea prices down by 24% during FY13), spell troubles for the sector s pricing power. Already we have seen the manufacturers hesitant to pass on complete impact of gas cost increases in the face of cautious demand. To quantify, every PKR100/mmbtu rise in feed gas costs (currently at PKR320/mmbtu including cess) requires urea price hike of PKR130 PKR145/bag for the local players to maintain margins, whereas the same increase in fuelstock rates (currently at PKR623/mmbtu) implies urea price increase of PKR26 32/bag. We maintain that either 1) any removal of feed gas subsidy is bound to be accompanied by direct subsidy to the farmer or 2) the feed gas subsidy will stay as the political cost of this step to the ruling party would be substantial. Having said, purely urea manufacturers will still face gradual erosion in margins due to continued increase in fuel gas costs and currently toppish urea prices. While we don t see much upside potential in Fauji Fertilizer Company (FFC) based on stable to declining margin outlook, we recommend a convincing BUY on Engro Corporation (ENGRO) on the back of various upcoming triggers. Engro Fertilizer will continue to receive additional 60mmcfd of gas diverted from Guddu power plant in Aug13 till Sep13 atleast, with possibility of further extension. This should reflect positively in ENGRO s 3Q results. To recall, annualized impact of this gas supply clocks in at an enormous PKR11.3/sh for FY14. ENGRO will also stand to benefit from their fertilizer subsidiary s IPO slated for 2HCY13. Another long term upside trigger in initiation of LNG imports from Qatar, which presents potential for sustainable tolling income for the company s chemical handling business. Even without incorporating these factors, the company is trading at 22% discount to our Dec13 TP of PKR187/sh BUY! Textiles: A short term pain to translate into long term gains The government has indicated to impose an additional levy on consumption of natural gas by Dec13 to increase tax revenue. This coupled with further hike in power tariff (estimated to increase by further 26%) to reduce the subsidy burden will bode negative for the sector. Among our Textile Universe, NML and NCL will be primarily exposed to gas price hike or sell the securities mentioned.77 7

8 given in house gas based power generation capability while the impact of increase in electricity tariff (on National grid) will be nominal. As per our estimate, every PKR100/mmbtu hike in tariff on natural gas may result in annualized downside impact of 6% 8% on our NML and NCL earnings estimates. While the same gas tariff increase for captive power plants may result in an erosion of 3% and 7% (on annualized basis) in earnings of NML and NCL respectively. Furthermore, NCL plans to outsource 13 14MW additional in electricity from WAPDA to cater its upcoming capacity expansion program. We believe, the incoming power supply from WAPDA will reduce reliance on alternate fuels (being priced at ~28% higher rate than normal tariff) previously used for power generation. However, we believe the positive outcome of reformist policies i.e. 1) improvement in energy supply post materialization of power sector reforms, 2) trade policy liberalization measures (MFN status + EU GSP plus benefits) and 3) favorable policies for manufacturing sector to support GDP growth will outweigh the negative impact of aforementioned variables. The consistent supply of gas and electricity will not only reduce reliance on expensive alternate fuels but will also improve operational capacity of the companies. This will allow them to reap the full benefits of upcoming GSP plus status which coupled with PKR depreciation will further strengthen margins. NML remain our top pick in textile sector with a total return of 36% at our TP of PKR122/sh. NCL follows with a total return of 34% based on our TP of PKR76/sh Oil & Gas: Expanding resources; time to chip in As the focus has largely remained on downsizing the allocated subsidy amount, the document has also presented a comprehensive framework for implementing energy sector reforms aimed at curing the disease of circular debt. Exploration and Production sector being positioned at top of energy chain will also witness significant improvement in cash flow generation which will improve payouts and most importantly timely execution and completion of key development and exploration projects. The government will also undertake privatization of state owned entities already approved by the CCI, which may again bring OGDC and PPL under limelight. Though not highlighted categorically, the government may end up issuing long awaited exchangeable bonds of OGDC given favorable yields on Pakistani bonds amid improving foreign investors confidence post general elections. Whereas newsflows related to much anticipated secondary offering of PPL may again resurface and that too at attractive rates given bolstering index levels and healthy earnings prospects of PPL. In order to overcome the aggravating gas crisis, the government has also committed to continue offering lucrative well head gas prices to boost indigenous gas production. Inline with Petroleum Policy 2012, higher gas prices will also be offered on surplus gas production from existing fields through semi annual gas price revisions. We believe, PPL to emerge as the prime beneficiary with heavy arsenal of gas heavy fields and exploration licenses. OGDC will follow with much concentration being tilted towards development of existing fields while upside may emerge from success at ongoing drilling ventures. The steep undervaluation of POL during recent market correction (despite robust fundamentals) coupled with an attractive yield of 12% compel us to re iterate our BUY call on the stock. With 16%, 16% and 33% total return, we maintain our BUY stance on OGDC, PPL and POL with 1) rising oil prices and 2) upcoming volumetric additions being the major earning growth drivers. or sell the securities mentioned.88 8