How to do Business Analysis of Fertilizer

Companies
 Published: 21-Aug-22
Modified: 21-Aug-22
1. Increasing regulations and tightening subsidy support
2. Other factors influencing the business performance of fertilizer companies
3. Summary
The current article aims to highlight the key aspects of the business of fertilizer
companies. After reading this article, an investor would understand the factors
that impact the business of fertilizer companies and the characteristics that
differentiate a fundamentally strong fertilizer company from a weak one.

Types of fertilizers

Fertilizers are classified based on the key nutrient that they contain: Nitrogenous
(N), Phosphoric (P) and Potassic (K).

There are simple fertilizers, which primarily contain one nutrient like Urea
(nitrogenous), Single Super Phosphate (SSP, phosphoric) and Muriate of Potash
(MoP, potassic). In addition, there are complex fertilizers, which contain more
than one nutrient like diammonium phosphate (DAP) and nitrogen, phosphorous
and potassium (NPK).

From the perspective of understanding the industry, an investor may simply

classify them into two groups. First is Nitrogenous fertilizers of which Urea is the
most prominent and the second is Phosphoric & Potassic (P&K) fertilizers
because these two groups of fertilizers have slightly different dynamics within the
fertilizer industry.
Urea is the most used fertilizer constituting about 55% of total fertilizer
consumption.

Ratings criteria for the fertiliser industry by CRISIL, February 2018, page 3:

urea accounts for more than half (~55%) of the fertiliser consumption in India
Let us now understand the business environment under which the fertilizer
companies operate.

Increasing regulations and tightening subsidy support

The first aspect of the fertilizer industry that an investor should know about is
regulations and subsidies. In fact, it seems that there is no existence of fertilizer
industry without govt. support and control. Govt. influences every aspect of the
industry including demand, supply, distribution, pricing, and supply of raw
materials.

The primary reason for such high govt. control is that fertilizers are sold to
farmers at a significant discount to their actual market price. Urea is sold at a
discount of about 70%-80% and Phosphoric & Potassic (P&K) fertilizers are sold
at a discount of about 30%. This discount is reimbursed by the govt. to fertilizer
companies in the form of subsidies.

Rating methodology – fertilisers by ICRA, March 2022, page 3:

Urea: Subsidy as % of total realization = ~70-80%

P&K: Subsidy as % of total realization = ~30%
The huge amount of subsidy provided by the govt. for providing fertilizers at a
cheaper price to farmers distorts the whole fertilizer market.

Govt. provides such a high amount of subsidy on fertilizer with two primary
objectives. The first is to ensure food supply to the population at a cheaper price
and the second is to increase the income in the hands of the farmers who are
also a large politically important segment.

Every kilogram of fertilizer, which is produced puts a monetary burden on the

govt. finances; therefore, govt. influences every aspect of the industry including
supply of raw material, sale, distribution, operating efficiency etc.
India has been a large consumer of fertilizers where almost always demand has
exceeded supply. In addition, increased consumption of fertilizers has also
increased the subsidy burden on the govt. Therefore, govt. has implemented
different regulations for the fertilizer industry at different times based on its vision
and objectives in this field like increasing production and reducing subsidy
burden.

In 1977, Retention Price Scheme (RPS) was introduced for the fertilizer industry,
which was aimed at increasing fertilizer production within the country. Therefore,
govt. promoted investments in the industry with an assured return to the entire
fertilizer industry.

Rating Criteria for the fertiliser industry by CRISIL, February 2021, page 13:
Introduced in 1977, the RPS, with the objective of achieving self-sufficiency and
providing adequate returns to fertiliser companies, has been primarily
responsible for the growth in domestic fertiliser capacity and production.
As fertilizers were sold at a discount/subsidised price to farmers; therefore, as
the production of fertilizers increased, the subsidy burden on the govt. also
increased. As a result, govt. gradually removed fertilizers from the RPS scheme.
P&K fertilizers were taken out of RPS in 1992 and Urea was taken out in 2003.

Rating Criteria for the fertiliser industry by CRISIL, February 2021, page 13:

The commissioning of large capacities, persuaded by the promise of assured

returns under RPS, and a marginal rise in farm-gate prices compared with
production costs, however, resulted in a ballooning subsidy burden.

Phosphatic and potassic fertiliser makers were governed by the Retention Price
Scheme (RPS) till  1992, and urea players till March 2003.
Later on govt. kept bringing different regulations with the twin objective of
increasing fertilizer production in the country and controlling its subsidy burden.

Further advised reading: How to analyse New Companies in Unknown

Industries?

a) P&K fertilizers:

For P&K fertilizers, the govt. almost freed the retail prices and introduced
nutrient-based subsidy (NBS), which provided these fertilizer companies with a
fixed amount of subsidy while leaving retail prices to fluctuate in line with import
parity prices.

Rating Criteria for the fertiliser industry by CRISIL, February 2021, page 13:

While retail prices of urea continue to be regulated, prices of non-urea fertilisers

were deregulated in April 2010.

Currently, non-urea fertilisers are governed by the nutrient based subsidy

(NBS) scheme, introduced in 2010, wherein the subsidy component is
fixed and domestic prices are allowed to vary in line with international prices.
Therefore, with NBS, the govt. could put a limit on the subsidy that it would
provide on the sale of P&K fertilizers. However, it could not free the retail price of
Urea because it is the most used fertilizer and has a very high component of
subsidy in its realization. Therefore, unlike P&K, where the subsidy amount is
fixed and the retail price is variable, for Urea, the strategy has been to fix the
retail price and let the subsidy amount be variable.

Rating Criteria for the fertiliser industry by CRISIL, February 2021, page 14:

Essentially, extant regulations fix the retail price of urea and subsidy is

dependent on cost of production (which in turn would have commodity linkages).

b) Urea:

In the urea segment, the policy guarantees a minimum return on investment by

fertilizer companies. Therefore, the aim of the govt. has been to force the
companies to reduce their operating/production costs so that the govt. has to pay
them a lower subsidy amount for the guaranteed return (a return on equity of
12%).

Rating methodology – fertilizer companies by CARE, May 2020, page 1:

Urea is a controlled fertilizer and is sold at a statutorily notified uniform sale

price. This price is lower than the cost of production and the difference
is reimbursed as subsidy to manufacturers by the government, enabling the
manufacturers to earn a reasonable return.
Rating methodology – fertilisers by ICRA, December 2016, page 3:

This is to ensure, in principle, that a normative return (post tax 12% Return on
Equity or RoE) on fixed costs  is earned by the urea players.
In addition, to reduce the imports and promote domestic production of urea, the
govt. incentivizes domestic urea companies to produce even more than their
reassessed capacity (RAC) by assuring to buy it at a predetermined pricing
framework till the time such purchase price for the govt. does not exceed the
import parity price.

Rating methodology – fertilisers by ICRA, December 2016, page 3:

As per the NUP-2015, units producing more than its re-assessed capacity will be
entitled to get their respective variable cost and ~Rs. 2,300/MT…subject to
a cap of the import parity price plus a weighted average of other incidental
charges (transportation and handling charges, etc.), which the GoI incurs on
imported urea on its own account (~$25/MT).
Therefore, after urea was taken out of RPS in 2003, govt. implemented multiple
stages of the new price scheme (NPS) and in 2015, it implemented New Urea
Policy-2015 (NUP). This scheme has aimed to reduce the subsidy per unit of
urea sold.

The key strategy behind these regulations has been to force/incentivize the
fertilizer companies to be more efficient and then take benefit of resultant savings
to reduce the subsidy amount on Urea production.

Rating Criteria for the fertiliser industry by CRISIL, February 2021, page 14:

Urea pricing is governed under the new pricing scheme (NPS) from April 1,

2003…Pre-set energy consumption norms were specified…and capital costs
were also reassessed. These resulted in a decline in industry profitability during
the period.

In May 2015, the government announced the New Urea Policy-2015 (NUP-

2015)…with the objective of maximising indigenous urea production, promoting
energy efficiency in urea production by changing the prescribed energy norms
and rationalising subsidy burden on the government by mopping up energy
savings by the industry.
Fertilizer production is an energy and capital-intensive process; therefore, govt.
primarily focuses on the energy efficiency of urea companies to reduce its
subsidy costs.

Rating methodology – fertilizer companies by CARE, May 2020, page 1:

Fertilizer production is an energy and capital intensive process

Previously, different urea manufacturing units used different raw materials to
make urea like naphtha, coal, natural gas etc. To improve the production
process, govt. mandated the use of natural gas for urea units.

Rating methodology – fertilizer companies by CARE, May 2020, page 5:

Government policies in the recent past have encouraged the use of gas as
feedstock for the manufacture of urea.
As India started producing natural gas domestically, it was priced cheaper than
imported gas. As a result, companies that could get a large supply of domestic
gas were in a beneficial position due to the lower cost of production than those
companies using imported regasified liquid natural gas (RLNG).

To provide a levelling field to all the urea producers, the govt. introduced a gas
pooling mechanism and made the energy costs uniform across all urea
producers irrespective of the fact whether they used cheaper domestic gas or
costlier imported regasified liquid natural gas (RLNG). As a result, now, all the
urea producers who are linked to the national gas grid get uniform gas pricing.

Rating methodology – fertilisers by ICRA, March 2022, pages 6-7:

The GoI implemented gas pooling, for all the fertiliser units connected to the
natural gas pipeline network, in July 2015 resulting in levelized gas cost for the
entire fertiliser sector. For players which were earlier operating using domestic
gas only witnessed an increase in their cost of production while players using R-
LNG witnessed a decline in their cost of production
In addition, the govt. classified urea producers into groups based on their energy
efficiency. As almost all the producers use the same production processes;
therefore, the energy efficiency primarily depends upon the vintage/age of the
plant. Older plants using old processes are less efficient than newer plants using
new processes.

Rating methodology – fertilisers by ICRA, March 2022, page 6:

Energy consumption is a function of the vintage of the unit, process

technology adopted, and maintenance practices followed. With very few process
technology suppliers to choose from, the process technology differentiation has
mainly been determined by the plant vintage.
The Govt. has classified Urea producers into three groups based on energy
efficiency (primarily vintage-based) and has set fixed energy norms for each
group.

Rating methodology – fertilisers by ICRA, March 2022, page 7:

all the urea units are classified under three categories with normative norm of
5.5 Gcal/MT, 6.0 Gcal/MT and 6.5 Gcal/MT
Govt. provides a fixed reimbursement to companies in each of these groups.
Therefore, those companies, which are more energy efficient within their group
earn higher profitability and those that are energy inefficient, earn lower
profitability.

Rating methodology – fertilizer companies by CARE, May 2020, page 2:

The companies whose energy efficiency is inferior to the pre-set energy norms

of its respective group under NUP 2015 would have lower profitability on
account of lower subsidy entitlement.
As the govt. has specified fixed payments based on energy consumption
benchmarks, all the companies try to be more energy efficient to increase their
profitability. However, as the energy efficiency of many companies in the group
increases, the govt. further tightens the energy consumption benchmarks and
reduces the subsidy outgo.

Rating methodology – fertilisers by ICRA, March 2022, page 7:

GoI has been progressively tightening the normative energy norms for the urea
industry over the years. The tightening of the energy norms results in lower
subsidy outgo for the GoI and improvement in the energy efficiency of the urea
industry.
Moreover, the govt. has been cutting down the subsidy burden even in the cases
where companies have been producing urea more than their reassessed
capacity (RAC).

Originally, the companies producing more than RAC received their variable cost
+ ₹2,300 per MT and incidental charges. However, in recent times, it has been
reduced to variable cost + ₹1,635 per MT and incidental charges.

Rating methodology – fertilisers by ICRA, March 2022, page 5:

As per the NUP-2015, units producing more than their re-assessed capacity are

entitled to get their respective variable cost and ~Rs. 1635/MT…subject to a cap
on the import parity price plus a weighted average of other incidental charges
As the retail price of urea is much less than the cost of production; therefore,
there were instances of urea meant for farmers finding its way into factories as a
raw material for producing other goods. This pilferage meant that the subsidy did
not reach the intended beneficiary. As a result, the govt. started neem coating of
urea, which made it unsuitable for industrial use.

Rating Criteria for the fertiliser industry by CRISIL, February 2018, page 3:

The proportion of urea in overall fertiliser consumption is expected to come down

on account of government policies such as neem coating of urea (which
improves absorption in to soil and prevents its diversion to
other chemical industries by making it unfit for non-fertilising use),
Therefore, from the above discussion, an investor would notice that in both the
segments, urea as well as P&K fertilizers, the govt regulations are high due to
significant subsidy contribution and in both the segments, the govt. aims to cut its
subsidy burden, which reduces the profitability of fertilizer companies.

In P&K, under a nutrient-based subsidy scheme, the govt. has already fixed its
subsidy burden whereas letting the companies change the retail price in line with
changing costs of production whereas in the urea segment, the govt. still decides
the retail price and reimburses money to urea producers to ensure that they earn
a reasonable return on their investment. However, over time, the govt. is forcing
urea manufacturers to be more efficient and is using these efficiencies to reduce
its subsidy burden.

Further advised reading: How to do Business Analysis of a Company

With this background in the fertilizer industry, let us understand the key business
dynamics under which fertilizer companies operate.

Other factors influencing the business performance of fertilizer

companies

1) Very low pricing power:

As the price of fertilizers directly affects the farmers and their income; therefore,
govt. has hardly given fertilizer producers any power to earn large profits.

In the case of urea, the govt. directly controls the retail price (farm-gate price)
and gives the companies subsidy that determines their return on investment.
Therefore, as discussed earlier, the only way for urea companies to increase
their profitability is to be more efficient in their production. Moreover, as the urea
industry becomes more efficient, the govt. reduces the subsidy payments, which
in turn puts a check on the profitability of urea manufacturers.

In fact, for urea manufacturing units the govt. has determined a range of returns
on equity that companies can earn. If there are profits higher than this range,
then govt. updates the policy and takes the benefits away.

Rating methodology – fertilisers by ICRA, March 2022, page 5:

GoI introduced the New Urea Investment Policy-2012 (NIP-2012) which assured
a floor and ceiling of post-tax RoE of 12% and 20% respectively through the
policy measures.
In the case of phosphoric and potassic (P&K) fertilizers, even though the prices
were freed/deregulated in 2010; still, govt. interferes in the retail prices by
controlling the selling price of fertilizers by public sector fertilizer producers. This,
in turn, forces the private players to match the price offered by public sector
companies.

Rating methodology – fertilisers by ICRA, October 2019, page 7:

Government intervention in the pricing decisions for a supposedly deregulated

P&K market is a credit negative for the industry…For example, in July 2016, the
Fertiliser Ministry, announced its decision to reduce the retail prices for P&K
fertilisers, cutting prices through the public sector undertakings (PSUs)
and suggested that the private players follow suit. Due to these price cuts,
players suffered  inventory  losses as the high inventory in the system (with
companies, distributors, dealer and retailer) aligned with the reduced prices.
Even otherwise, despite deregulating the P&K prices, the govt. wants to ensure
that P&K fertilizer producers charges prices within a reasonable range. To
ensure it, govt. regularly audits their input costs.

Rating methodology – fertilisers by ICRA, March 2022, page 1:

P&K segment was partially decontrolled during 2010, following which the players
have been able to freely price such decontrolled fertilisers as per their cost
structure and the demand-supply dynamics. However, the GoI still  monitors  the
reasonableness of the retail prices by auditing the input costs.
The control of govt. on the profitability of fertilizer companies is so much that in
the past when some fertilizer companies earned outsized returns due to usage of
domestic gas, then govt. stopped their subsidy payments and is looking for
recovery of “undue benefits”.

Rating methodology – fertilizer companies by CARE, May 2020, page 8:

In some fertilizer units, the Government of India (GoI)…has issued office

memorandum for recovery of ‘undue benefits’ accrued with use of domestic gas
for production of P&K fertilizers and chemicals. GoI has withheld subsidy in such
disputed matters.
Therefore, fertilizer producers are not able to charge customers as per their will.
The govt. continues to influence the pricing of fertilizers either directly or
indirectly. Therefore, fertilizer companies have very low pricing power.

To increase profitability, fertilizer companies sell nonregulated products like

seeds and agrochemicals (pesticides) in their outlets.
Rating methodology – fertilisers by ICRA, March 2022, page 12:

Companies can offer unregulated farm inputs like seeds, agrochemicals etc.

along with fertilisers which enables them to realise higher profits.
Players attempt to increase their profitability by providing other value-added
products like customized fertilizers suited to local soil health.

Rating methodology – fertilizer companies by CARE, May 2020, page 6:

Companies offering customized fertilizers based on the type of soil and crop are

expected to gain competitive advantage with increased focus on soil health
report by the government.
Due to the commoditised nature of fertilizer products, companies attempt to
differentiate themselves by branding and offering other farm-related services,
which build some competitive advantage by trying to generate some brand
loyalty.

Rating methodology – fertilizer companies by CARE, May 2020, page 7:

Additionally, though the fertilizer business may be a commodity business,

product differentiation, branding and provision of farm support services are
expected to gain greater importance.
Advised reading: How to do Financial Analysis of a Company
2) High capital intensity:

Operations of fertilizer companies require high capital investment in both,

working capital as well as fixed capital.

The primary reason for high working capital is that receivables from the govt. in
the form of subsidy for a major part of cash inflow for the companies and these
subsidy payments are usually delayed.
The key reason for delays in subsidy payments is overall inadequate subsidy
budgets. In addition, the problem intensifies especially during the second half of
the year when the annual subsidy budget is exhausted.

Rating methodology – fertilizer companies by CARE, May 2020, page 8:

Delays have been observed in subsidy payment to fertilizer companies on

account of inadequate subsidy budget. The shortfall in subsidy budget usually
affects the cash flow position of companies in second half of the financial
year when the subsidy budget gets exhausted and thus companies have
to resort to short-term borrowing to fund extended subsidy receivables.
Recently, the initiation of direct benefit transfer (DBT) by the govt. has added to
the problem of delays in the recovery of subsidy.

Previously, companies became eligible for a subsidy when the fertilizer was
produced and dispatched from the factory. However, now, under DBT, they
become eligible for subsidy only after the fertilizer is purchased by the farmer.
Therefore, the period between the dispatch of the fertilizer from the factory and
the purchase by the farmer i.e. the duration spent by the fertilizer in the entire
distribution channel is added to the estimation of subsidy entitlement, which
increases the working capital requirements of the companies.

Rating methodology – fertilizer companies by CARE, May 2020, page 4:

The government has rolled out direct benefit transfer (DBT) for subsidy payment
from February 2018 where in the subsidy would be transferred to the
manufacturers after the fertilizer is sold to the farmer which is expected
to increase the working capital intensity of the companies as under the earlier
regime subsidy was largely linked to the point of dispatch, and under DBT, it is
linked to the point of retail sales
The working capital intensity of urea producers is higher because subsidy forms
a higher portion (70%-80%) of total realization than 30% of total realization for
P&K fertilizers.

Rating methodology – fertilizer companies by CARE, May 2020, page 4:

The urea manufacturing plants have higher working capital intensity than other

decontrolled fertilizers since subsidy comprises higher portion of the sales price
for urea.
Nevertheless, companies get working capital borrowing from banks against
subsidy receivables at low-interest rates because these are receivables from
govt and in effect have a sovereign guarantee.

Rating methodology – fertilizer companies by CARE, May 2020, page 9:

Currently, the lending institutions have been funding subsidy receivables up to

240 to 360 days due its sovereign nature
Still, delays in the recovery of subsidy receivables add to the costs of the
company due to increased interest costs.

Further advised reading: Receivable Days: A Complete Guide

In FY2021, govt. cleared all the pending subsidy dues of fertilizer companies.
However, it remains to be seen whether going ahead, companies will get prompt
payments of subsidy receivables from govt.

Rating methodology – fertilisers by ICRA, March 2022, page 4:

by the end of FY2021 the GoI cleared the subsidy backlog that had built-up over
the years
In addition to delays in subsidy payments, the fluctuations in the fertilizer demand
due to uncertainty in monsoon performance also increase the working capital
burden on the companies due to higher inventory requirements.

Rating methodology – fertilizer companies by CARE, May 2020, page 7

This leads to higher fertilizer sales during the normal monsoon period while low
sales during drought or low rainfall period. During the period of low rainfall, the
fertilizer companies may be impacted in terms of increased channel
inventory which may also impact its working capital borrowings and can also
lead to increase in discounts and larger credit period to increase sales.
Therefore, most fertilizer companies have a high working capital debt on their
books.

In the terms of the requirement for fixed capital also, the intensity of the fertilizer
industry is high. Plants for the production of urea and DAP need a large amount
of capital.

Rating methodology – fertilisers by ICRA, March 2022, page 1:

urea and DAP plants are characterised by high capital intensity, while the NPK
complexes and SSP plants are relatively less capital intensive.
In addition, due to consistent pressure from the govt. on fertilizer companies to
improve their operating efficiencies, they need to consistently make investments
in more energy and cost-efficient equipment leading to consistent capital
requirements.

Rating methodology – fertilisers by ICRA, March 2022, page 7:

GoI has been progressively tightening the normative energy norms for the urea
industry over the years. The tightening of the energy norms results in lower
subsidy outgo for the GoI and improvement in the energy efficiency of the urea
industry. However, to meet the lower energy norms, urea units have to incur
capital investments
Therefore, fertilizer companies need to invest a large amount of money in the
business both in the fixed capital as well as working capital.

Further advised reading: Asset Turnover Ratio: A Complete Guide for

Investors
Going ahead, an investor should keep a watch on the govt. policies about
changes in the DBT. If the policy changes to direct transfer of subsidy to the
accounts of a farmer like LPG, indicating that farmers purchase fertilizers by
paying the full price to companies, then the subsidy receivables will decline
sharply for companies releasing the money stuck in working capital.

3) Operating/cost efficiency is the key:

India is a fertilizer deficit country; therefore, almost all the fertilizer companies are
assured of the sale of whatever amount they produce. However, there is intense
pressure on the companies to perform as efficiently as possible.

In the case of urea, as govt provides the key raw material, natural gas to all the
companies at a uniform price via a gas pooling mechanism; therefore, govt.
provides a fixed reimbursement of their costs by grouping the companies into
three groups based on energy efficiency.

Within a group, a company is going to get a fixed reimbursement of variable

costs irrespective of its actual operating efficiency. If a company is more cost-
efficient, then it will earn a high profit whereas if a company is poor in cost-
efficiency, then it may not earn any profit or become unviable.

Rating methodology – fertilisers by ICRA, March 2022, page 6:

The feedstock cost for all the domestic urea players, which have gas pipeline
connectivity, is uniform and is a pass-through to the GoI up to the normative
energy norm. Profitability gets negatively impacted for the urea units
having energy consumption higher than the normative energy norm
while positively impacted  for urea units with energy consumption below
normative energy norms
In the case of phosphoric & potassic (P&K) fertilizers, the retail prices are
deregulated (market-determined) and the subsidy component is fixed. Therefore,
companies, which are cost-efficient earn a higher profit.

Rating methodology – fertilizer companies by CARE, May 2020, page 3:

NBS regime has changed the structure from fixed MRP and variable subsidy
to fixed subsidy and variable MRP. As a result, control over raw material
prices such as phosphoric acid, rock phosphate, ammonia, sulphur and MOP
and energy efficiency in conversion to finished goods is important to
drive profitability.

3.1) Competition from imports:

For urea manufacturers, govt provides assurance of purchasing fertilizers only up

to the reassessed capacity (RAC) of a unit. The govt. would purchase any
production beyond RAC only if it costs cheaper than the imports.
Rating methodology – fertilisers by ICRA, March 2022, page 5:

While the urea production up to the re-assessed capacity (RAC) has an assured
offtake under the urea policy, the profitability on the urea production beyond the
RAC is a function of the prevailing international prices and the cost structure of
the urea unit.
Therefore, urea companies have to become more cost-efficient than imports,
especially during periods of commodity price increases when it might become
cheaper for the govt. to import urea than procure it from domestic companies
producing above RAC.

Rating methodology – fertilisers by ICRA, March 2022, pages 5-6:

The energy consumption of the urea units also determines the competitiveness

of production beyond the re-assessed capacity against imported urea. Lower the
energy consumption, the higher is the competitiveness against imports

Effectively, the GoI is encouraging the domestic manufacture of urea until the

time its subsidy outflow does not exceed its opportunity cost of importing urea.
As P&K fertilizers are deregulated; therefore, whenever domestic market prices
increase beyond imports, many traders and importers emerge as competitors as
they can import P&K fertilizers from abroad and sell them profitably at the market
price in the domestic market because for the subsidy, govt. treats both imported
and domestically produced fertilizers as the same.

Rating methodology – fertilizer companies by CARE, May 2020, page 5:

The subsidy on imported fertilizers is similar to the subsidy on domestically

produced fertilizers. Thus, the phosphatic fertilizer manufacturers have to
efficiently control their cost of production since the imported fertilizers can be
cheaper than the domestically manufactured fertilizers with easy access to
lower-cost raw materials and higher plant efficiencies. Some de-controlled
fertilizers also have the risk of becoming unviable if their IPP is cheaper than the
price of domestically manufactured fertilizer.
Therefore, imports, if cheaper than domestically produced fertilizers, affect the
profitability of Indian fertilizer companies both in urea as well as P&K segments.

Further advised reading: Operating Performance Analysis: A Simple &

Complete Guide
4) Large-sized operations and economies of scale help:

Large fertilizer plants gain cost efficiency from multiple aspects like operating
leverage where the fixed costs of the plant are spread across a large volume and
in turn, reduce the per-unit production costs.

Rating methodology – fertilisers by ICRA, March 2022, page 14:

While subsidy under NPS is expected to be progressively tightened, players with

low energy consumption levels, competitive cost structure and economies of
scale are expected to fare better in the long term.
A large scale of operations brings in other benefits as well like a higher
bargaining power over their suppliers, which brings in cost savings in raw
material procurement.

Rating methodology – fertilisers by ICRA, December 2016, page 5:

In case of P&K players, however, players with large requirement for raw

materials have relatively better bargaining power and can save on some costs.
Large companies are also able to enter into long-term contracts for raw materials
with suppliers, which is essential in the case of phosphoric fertilizers where most
of the raw material is imported.

Rating methodology – fertilisers by ICRA, March 2022, page 15:

In the case of phosphatic fertilisers, the degree of import dependence is

high with most raw materials such as phosphoric acid, rock phosphate, muriate
of potash, sulphur and ammonia being imported…In such a scenario, players
with assured long-term supply of raw materials at stable prices or with domestic
facilities for phosphatic fertilisers tend to have stronger credit risk profiles.
In the case of potassic fertilizers, most of the finished products are imported
because India has very little domestic production of potassic fertilizers. In such
cases also, large-scale importers/traders benefit as they can get a better price
from their suppliers.

Rating methodology – fertilizer companies by CARE, May 2020, page 1:

Potassic fertilizers are not produced in India and the entire requirement of the
same is imported.
Even in the case of Urea, fertilizer manufacturers face a shortage of key raw
materials like natural gas. Therefore, large-sized companies find it comparatively
easier to have long-term supply tie-ups.

Rating methodology – fertilizer companies by CARE, May 2020, page 5:

Fertilizer units in the country today are faced with gas shortages and under such
circumstances, CARE reviews the ability of the company to have long-term tie-
ups for its gas requirements at competitive rates.
Large-sized companies also benefit as their operations are spread over many
geographies, which protects them from adverse agro-climatic events like a failed
monsoon because the possibility of monsoon failure in all the geographies in one
year is low.

Rating Criteria for the fertiliser industry by CRISIL, February 2021, page 15:

players that cater to a larger number of states would be relatively better placed

as they would be less susceptible to uneven monsoon.
Rating methodology – fertilizer companies by CARE, May 2020, page 7:

Fertilizer companies with large and well-established distribution network would

also be less susceptible to the regional demand-supply fluctuations.

5) Other cost efficiency measures:

Being an energy-intensive industry, most of the time, energy costs gain the
maximum importance in determining cost efficiencies of fertilizer companies
However, other aspects of cost efficiency are also important like locational
advantages of plants, backward integration etc.

5.1) Locational advantages:

Fertilizer plants, which are located close to their customers are at an advantage
because the transportation cost of finished fertilizers is higher than its raw
materials. However, P&K plants, where imports are an important source of raw
material/ready potassic fertilizers are established near the coast.

Rating methodology – fertilizer companies by CARE, May 2020, page 6:

The location of the units near major consumer markets augurs well as the cost
of transporting the raw material is lower than that of the finished goods. An
exception to it is the P&K fertilizer units which are usually located in
coastal regions.

5.2) Backward integration:

Efficiency improving measures like backward integration are very important for
phosphoric fertilizers, which face a shortage of some raw materials even at
global levels.

Rating methodology – fertilisers by ICRA, March 2022, page 7:

Of the raw materials/ intermediates, phosphoric acid and rock phosphate are in

short supply in the global market and hence durable tie-ups with producers in
overseas countries could be a source of competitive advantage for the units
Therefore, if any company is either able to secure supplies of phosphoric acid or
is able to backwards integrate into the production of phosphoric acid from rock
phosphate, then it gets a competitive advantage.

Rating methodology – fertilisers by ICRA, March 2022, page 8:

ICRA also favourably factors in backward integration in the manufacturing of

phosphoric acid and sulphuric acid. Since rock phosphate, which is a key raw
material for manufacturing phosphoric acid, is available more easily compared to
phosphoric acid, which has limited international suppliers, it enables the entity to
produce phosphoric acid and achieve cost advantage over imported phosphoric
acid.

5.3) Flexible manufacturing plants:

In addition, companies with flexible manufacturing plants that can use easily
switch between the basic raw material and intermediate products for making
fertilizers are at an advantage because they can choose the most cost-effective
starting material based on the prevailing pricing scenario.

Rating Criteria for the fertiliser industry by CRISIL, February 2021, page 15:
Additionally, players with flexible manufacturing facilities that enable them to
shift between sourcing of intermediates and basic raw materials, depending on
the cost economics, are usually able to minimise cost increases.
Therefore, whether it is nitrogenous (urea) or P&K fertilizers, staying cost
competitive is essential and companies must attempt to be as cost-efficient as
possible to remain competitive. In fact, in the case of urea producers, in light of
assured offtake and subsidies, any poor performance is always due to poor cost
efficiency.

Rating methodology – fertilizer companies by CARE, May 2020, page 5:

The under-performance of the units would largely be a derivative of higher

energy consumption than the normative parameters, lower capacity
utilization and non-approval of any fixed cost by the regulator.
Further advised reading: 3 Simple Ways to Assess “Margin of Safety”: The
Cornerstone of Stock Investing

6) Risks:

The fertilizer industry is currently facing risks from different aspects. Let us
understand some of them.

6.1) Volatile raw material prices and forex risks:

Raw material prices of all the fertilizers be it urea or P&K are imported whether
directly or indirectly. P&K fertilizers are directly dependent on imports for their
raw material whereas, for urea plants, the key raw material like natural gas is
influenced by the international price of crude oil.

Rating methodology – fertilisers by ICRA, March 2022, page 7:

The key raw materials, for manufacturing of complex fertilisers e.g. ammonia,

phosphoric acid, rock phosphate, muriate of potash, sulphur, are largely
imported. Although some players manufacture phosphoric acid and ammonia to
meet their requirements partially while sulphur is available indigenously as well
from oil refineries, the raw material to produce these products is also largely
imported leading to indirect import dependence
As a result, the raw material prices of fertilizer companies are impacted by both
the commodity cycles and foreign exchange (forex) movements and are volatile.

In the case of nitrogenous fertilizers (urea), the forex changes, as well as raw
material price changes, are a pass-through to the govt. under variable costs.
However, in the case of P&K fertilizers, as the amount of subsidy is fixed, any
increase in raw material costs hurts their profit margins.

Rating methodology – fertilisers by ICRA, March 2022, page 7:

Urea players are protected from foreign currency fluctuations due to the pass-

through nature of the subsidy regime although it does impact the working capital
requirements. However, P&K players are exposed to the currency risk as almost
entire raw material is imported and in situations of steep currency depreciations,
the industry may find it difficult to pass on the currency impact to the farmers.
For urea plants, any increase in raw material costs is a pass-through to the govt.
as it increases the amount of subsidy entitlement. However, subsidy recovery is
usually delayed; therefore, it increases the working capital burden on the
companies to fund the subsidy receivables by borrowings and increases the
interest costs.

Rating methodology – fertilizer companies by CARE, May 2020, pages 8-9:

For urea units in circumstances where the feedstock prices are on an

increasing trend, the working capital intensity stretches due to fixed farm gate
price inducing pressure on liquidity, gearing and interest burden.
In the case of P&K fertilizers, any increase in raw material costs, apart from
hurting their profitability directly also intensifies the competition from imports. This
is because any attempt by P&K fertilizer companies to increase prices to recover
higher costs makes imported fertilizers cheaper. As a result, as discussed earlier,
many importers and traders launch their products in the market at a cheaper
price.

As a result, especially in the case of P&K fertilizers, large raw-material-storage

facilities and efficient handling operations become a key competitive advantage.

Rating Criteria for the fertiliser industry by CRISIL, February 2021, page 15:
The raw material handling facilities of the players and ability to store these are
other key operating efficiency determinants, given that raw materials are
imported and their prices are volatile.
Further advised reading: Credit Rating Reports: A Complete Guide for Stock
Investors

6.2) Environmental risks and organic farming:

Manufacturing of urea is an environmentally sensitive process because of the

usage of a large amount of natural gas, which is a petrochemical.

As an alternative, govt. is planning to mandate the usage of green hydrogen for

manufacturing urea; however, it would require additional investments by an
already capital-intensive business.

Rating methodology – fertilisers by ICRA, March 2022, page 11:

Fertiliser manufacturing, particularly urea, has a significant carbon

footprint as natural gas is the key raw material…With the GoI exploring the
passing of a mandate for the procurement of green hydrogen by refineries and
fertiliser plants
Excessive usage of fertilizers also has an impact on soil health, which in
association with growing awareness against using the chemical for producing
food is giving growing acceptance of organic foods, which are grown without the
usage of pesticides and fertilizers.

Currently, such foods are costly because the production yields of organic farming
are lower. However, as newer innovations lead to improvements in the yields of
organic food, which would reduce their premium pricing, they will gain more
acceptance. It might have an impact on the demand for fertilizers by farmers.

Rating methodology – fertilisers by ICRA, March 2022, page 12:

Changing consumer preference towards use of organically-grown

products wherein no chemical fertilisers are used could pose a social risk for
fertiliser demand.

6.3) Sharp regulatory changes with excesses and reversals:

Like any highly regulated segment, the fertilizer industry is prone to regulatory
flip-flops. Many times, regulations may turn out to be conducive to the industry
and as a result, may not benefit the industry. Whereas the subsequent changes
may lead to too much incentive that the govt. has to roll back the measures.

The fertilizer industry has seen such reversals multiple times in the past and it
may see it in the future as well.

In the past when govt introduced Retention Price Scheme (RPS) in 1977 to
increase fertilizer production to achieve self-sufficiency in the country, then the
subsidy burden increased so much that it had to move P&K fertilizers out of it in
1992 to reduce the subsidy outgo.

Thereafter, the prices of P&K fertilizers increased. However, urea was still under
RPS making its price much cheaper than P&K fertilizers. As a result, farmers
used too much urea and it created a nutritional imbalance.

Rating Criteria for the fertiliser industry by CRISIL, February 2021, page 13:

In the early to mid-1990s, demand for phosphatic fertilisers was considerably

impacted following the decontrol (1992) and flip-flops in government policies,
resulting in highly decontrolled farm gate prices as against urea, which was then
governed by RPS and was, therefore, subsidised. High phosphatic fertiliser
prices distorted the consumption patterns in the country in favour of nitrogenous
fertilisers, thereby creating a nutrient imbalance.
The use of urea by the farmers had exceeded too much from the advised
benchmarks.

Rating Criteria for the fertiliser industry by CRISIL, February 2018, page 3:

The ideal nutrient composition, too, favours nitrogen, and hence, urea. The
perfect NPK ratio of soil stands at 4:2:1. However, due to indiscriminate urea
use, this ratio stood at 6.9:2.7:1 in fiscal 2016
Once the govt. started focusing on reducing the subsidies, then it could not timely
revise its investment guidelines for the sector. Therefore, for a very long time, no
new urea manufacturing capacity came up in the country, which led to a very
sharp increase in imports of urea to meet the continuously increasing demand.

Rating Criteria for the fertiliser industry by CRISIL, February 2021, page 14:
On account of unfavourable investment policies, capacity additions were
absent in the urea segment – leading to a surge in urea import (from 0.5 million
tonne [MT] in fiscal 2000 to 6.9 MT in fiscal 2008).
Rating methodology – fertilisers by ICRA, March 2022, page 5:

domestic urea industry did not witness any capacity additions in the past two
decades
Therefore, the govt. revised its investment policy for the urea segment; however,
the first policy in 2008 proved insufficient and did not get a good response. As a
result, the govt. revised it in 2012 and this time, gave so many incentives that the
investment proposal received could create an oversupply of urea in the country.
Now, the govt. had to cut down on the incentives especially, the clause for an
assured offtake of production.

Rating Criteria for the fertiliser industry by CRISIL, February 2021, page 14:

The government introduced the urea investment policy in 2008, which

saw muted response as no assurance was provided for gas prices and returns
were not linked to gas costs. This was addressed in the updated policy in 2012,
which linked realisations to costs and assured minimum return on networth of
12% to the companies. This policy led to a rush of applications, which would
have resulted in overcapacity in the industry. Consequently, the policy was
modified to remove the assured offtake clause.
Now, due to the removal of the assured offtake clause, the new urea plants are
seeing sales risk because their production costs are anticipated to be higher than
imports.

Rating methodology – fertilisers by ICRA, March 2022, page 5:

new urea plants being set up under New Urea Investment Policy-2012: these
plants are exposed to offtake risk  as well, given that the GoI replaced the
assured offtake clause in the NIP-2012. Since the cost of procurement from
these plants will be higher than the imported urea, these plants are exposed to
the off-take risk.
Therefore, an investor would appreciate that like any other highly regulated
sector, the fertilizer industry is also exposed to the risks of regulations and
incentives moving towards excesses in each direction like a pendulum. It has
happened in the past and may happen in the future as well. Therefore, an
investor should be cautious of these risks while assessing fertilizer companies.
 Summary
Fertilizers are a very essential product to ensure food security as well as farm
income. Therefore, govt. attempts to provide them below their cost price to
farmers. It results in a huge subsidy outflow from the govt. to fertilizer
manufacturers. As a result, the govt. control fertilizer industry heavily by
regulations controlling almost all aspects like retail prices, raw material prices,
operating efficiencies, production incentives etc.

India is a fertilizer deficit country and almost the entire domestic production of
fertilizers is consumed. However, the companies cannot take undue benefits
from this assured demand. Govt. influences how much return these companies
can make and if companies start making large profits, then govt. takes away
these benefits by reducing the subsidy amount.

In essence, the aim of govt. regulations is to increase fertilizer production in India

and control its subsidy burden. As a result, over the years, the industry has been
under continuous pressure to improve efficiencies and in turn, help govt. in
reducing its subsidy burden.

Fertilizer companies do not have any independent pricing power. Govt.

influences retail prices either directly (urea) or indirectly (P&K fertilizers).
Companies have to resort to selling nonregulated items like seeds, and
pesticides (agrochemicals) in their outlets to increase profitability.

The pressure on the companies to improve efficiency is immense because govt.

frequently keeps tightening the efficiency norms, which in turn, reduces the
profitability of inefficient firms. It requires fertilizer companies to invest money in
more efficient equipment in an already capital-intensive industry.

Even though govt. promises subsidy payments to ensure a reasonable return to

fertilizer companies; however, subsidy payments are usually delayed putting
pressure on their working capital. However, banks are ready to provide funding
for these receivables considering that they have a sovereign guarantee.

Fertilizer companies compete with each other on operating efficiency because

govt. has made their input costs almost uniform by measures like gas pooling.
More cost-efficient companies earn more profits than inefficient companies.
Various efficiency measures like economies of scale, better raw material
procurement, long-term sourcing contracts, backward integration, better storage
and handling capacities, large distribution channel, geographic diversity, flexible
manufacturing, locational advantages etc. are especially important for fertilizer
companies.

Competition for operating efficiency is not limited to domestic producers. If

imports are more cost-efficient, then all fertilizer companies be it P&K or urea,
suffer. Govt. buys urea above reassessed capacity only if it costs lower than
imported urea. In P&K fertilizers, as imports become cheaper than domestic
prices, traders and imports start selling products at a cheaper price. Therefore,
attempts to control raw material prices and forex risks are important.

Due to rising environmental awareness, the fertilizer industry faces risks from
growing acceptance of organic food as well as a transition from natural gas to
green hydrogen. Nevertheless, one of the biggest risks faced by the industry is
regulatory flip-flops where frequently incentives and harsh measures go to
extremes.

Therefore, an investor should keep in mind these multiple aspects for fertilizer
companies to understand the true picture of their business position.

 Continuously increasing regulatory environment with tightening

subsidies
 Very low pricing power
 The utmost importance of cost efficiencies in business operations
 Benefits of large size and economies of scale
 Risk of volatile raw material prices and forex fluctuations
 Risks from green movements, organic foods
 Regulatory flip-flops
We believe that if an investor analyses any fertilizer company by considering the
above parameters, then she would be able to assess its business properly.

Dr Vijay Malik

P.S.