ECONOMY OF PAKISTAN: AN OVERVIEW

Pakistan was one of the few developing countries that had achieved an average growth
rate of over 5 percent over a four decade period ending 1988-89. Consequently, the
incidence of poverty had declined from 40 percent to 18 percent by the end of the 1980s.
The overall picture that emerges from a dispassionate examination of these indicators is
that of a country having made significant economic achievements but a disappointing
record of social development. The salient features of Pakistan’s economic history are:

 Pakistan is self sufficient in most food production.

 Per capita incomes have expanded more than six-fold in US Dollar terms.
 Pakistan has emerged as one of the leading and successful producers of Cotton
and cotton textiles.
Pakistan has developed a highly diversified base of manufactured products for domestic
and world markets. Physical infrastructure network has expanded with a vast network of
gas, power, roads and highways, ports and telecommunication facilities. These
achievements in income, consumption, agriculture and industrial production are
extremely impressive and have lifted millions of people out of poverty levels. But these
do pale into insignificance when looked against the missed opportunities. The largest
setback to the country has been the neglect of human development. Had adult literacy
rate been close to 100 instead of close to 50 today, it is my estimate that the per capita
income would have reached at least US$1200 instead of US$640. Pakistan’s
manufactured exports in the 1960s were higher than those of Malaysia, Thailand,
Philippines and Indonesia. Had investment in educating the population and upgrading the
training, skills and health of the labor force been up to the level of East Asian Countries
and a policy of openness to world market would have been maintained without any break,
Pakistan’s exports would have been at least US$100 billion instead of paltry US$13-14
billion. Had the population growth rate been reduced from 3 percent to 2 percent, the
problems of congestion and shortages in the level of infrastructure and social services
would have been avoided, the poor would have obtained better access to education and
health and the incidence of poverty would have been much lower than what it is today.
But as if this neglect of human development was not enough, the country slacked in the
1990s and began to slip in growth, exports, revenues, and development spending and got
entrapped into external and domestic indebtedness. This was due to both fundamental
structural and institutional problems as well as to poor governance and frequent changes
in political regimes. With short life spans, succeeding governments were hesitant, if not
outright unwilling to take tough and unpopular economic decisions to set the economy
right. Moreover, the average lifespan of two to three years was clearly inadequate for
implementing meaningful policy or institutional changes. The external environment had
also become unfavorable after the event of May 1998, when Pakistan conducted its first
nuclear test. The aftermath of this test led to further economic isolation of Pakistan and a
considerable erosion of confidence by domestic and non-resident Pakistanis. Economic
sanctions were imposed against Pakistan by the western governments. By the late 1990s
Pakistan had entered almost a critical state of paralysis and stagnation in its economy
particularly in its external sector. There was a significant drop in workers’ remittances,
export growth was negative, IMF programme and World Bank assistance were
suspended, bilateral donors had terminated their aid while debt payments due were in far
excess of the liquid foreign exchange resources the country possessed. Pakistan was
almost at the brink of default on its external payments. Economic growth was anemic,
debt ratios were alarmingly high, and the incidence of poverty had once again risen to 32
percent. It was at this stage that the military government under General Pervez Musharraf
assumed power in October 1999. The initial period was devoted by the economic team of
the new government in managing the crisis and making sure that the country avoided
default. A comprehensive programme of reform was designed and implemented with
vigour and pursued in earnest, so as to put the economy on the path of recovery and
revival. The military government did not face the same constraints and compulsions as
the politically elected governments. It was therefore better suited to take unpopular
decisions such as imposing general sales tax, raising prices of petroleum, utilities and
removing subsidies so badly needed to bring about fiscal discipline and reduce the debt
burden. The IMF and the World Bank were invited to enter into negotiations on new
stand-by and structural adjustment programmes.
Although the canvas of reform in Pakistan was vast and corrective action required on a
number of fronts, there was a conscious effort to focus on achieving macroeconomic
stability, on certain key priority structural reforms and improving economic governance.
The structural reforms included privatization, financial sector restructuring, trade
liberalization, picking up pace towards deregulation of the economy and generally
moving towards a market-led economic regime. A stand-by IMF programme was put in
place in November 2000, which was successfully implemented followed by a three-year
Poverty Reduction and Growth Facility (PRGF), which was successfully completed in
December 2004. It is a matter of pride that Pakistan decided not to draw down the last
two tranches although it was eligible to do so. The IMF has also decided that Pakistan
will not be subject to the usual post-program monitoring due to its good economic
standing. Pakistan’s economic turnaround during the last five years is even more
impressive because the country was faced with a critical and fragile regional and
domestic environment with constant threats to security (a result of playing key role as a
frontline state in the war against terrorism) a prolonged and severe drought, tensions with
India and high oil prices.

Gas Marketing Sector of Pakistan

Natural gas in Pakistan has been strictly an internal fuel historically, grown out of oil
exploration and development efforts. It is one of the cheapest and most efficient energy
sources for Pakistan, surpassing oil as country’s leading energy fuel in 2002. In FY09, it
contributed 48.3% to serve the energy needs of Pakistan’s 160.97mn population.
Pakistan’s first gas distribution pipeline was laid in 1955 in the city of Karachi. Natural
gas became available through gas distribution system to industrial, commercial and
domestic consumers of Karachi in October 1955.
Sui Northern Gas Pipelines Limited (SNGPL) and Sui Southern Gas Company Limited
(SSGC) are the two major companies of the country which are involved in transmission
and distribution of natural gas throughout the country. SNGPL supplies gas to consumers
in the northern part of the country. Its franchised areas include two of the four provinces
of Pakistan - Punjab and Frontier. SSGC is responsible for the southern part of the
country and supplies gas to customers in the remaining two provinces of Sindh and
Balochistan.

Gas distribution system can be classified into three categories: a) Supply Mains Pipelines,
b) Distribution Mains Pipelines, and c) Service Pipelines. Gas supply mains pipelines
represent relatively high or medium gas pressure and large-diameter gas pipes are just
like major roads in a city. Gas distribution mains consist of low-pressure interconnected
pipeline networks which carry natural gas from supply mains to points adjacent to
consumer premises. Natural gas runs from the distribution main to the consumers’ gas
meter through a service pipeline. The gas distribution system is comprised of varying
pipe seizes ranging from ¾-inch to 42 inches in diameter with steel and polythene
material.

Return formula for Sui Twins: Internationally, regulated return of utility companies is
designed so as to keep the companies motivated toward serving more consumers.
Following suit, return of gas distribution companies was decided as part of a covenant of
ADB loan. With the repayment of ADB loan under whose covenants the gas companies
were guaranteed a fixed return, rumors of return formula modification became stronger
day by day with some expecting a change to an equity based return formula while others
counting on interest rate based return formula for the sui twins. However, no such
development has ever materialized and both companies still calculate their return based
on the same formula.

Regulated return calculation under current formula: As per the Provisions of OGRA,
Sui twins earn a fixed (17% for SSGC, 17.5% for SNGP) annual return before tax on the
net average operating fixed assets (net of deferred credit) for the year, excluding financial
and other non operating charges and non operating income. The determination of annual
required return in reviewed by OGRA under the terms of the license for transmission,
distribution and sale of natural gas, targets and parameters set by OGRA. This means that
the only factors that determine the bottom line for these two gas distribution companies
are the net average operating fixed assets, average deferred credit, non operating charges
and non operating income. Any disallowances (like UFG losses) determined by OGRA
are then deducted from the return formula to arrive at earnings before interest and tax for
these companies.

Unaccounted for Gas (UFG): The net volume difference of gas purchase and sale after
adjusting internal consumption in the company’s operations is termed as Unaccounted for
Gas (UFG). The term UFG is used for units, which are not billed (due to theft) or lost
during the transmission of gas to the consumers.
Gas marketing companies are facing considerable difficulty in maintaining past
momentum of UFG losses reduction due to inefficient T&D systems and seasonal
increase gas theft in areas which are difficult to monitor as well as increasing gas theft
and pilferage culture owing to higher gas prices,. Moreover, constant shift from bulk
sales (where UFGs are minimal) towards retail sales has also led to increase in UFGs. In
addition to that, considering that gas marketing companies are expanding into more theft
prone areas (northern areas, Balochistan and Interior Sindh), controlling UFGs seems to
be an uphill task for Sui twins. Balochistan’s share in total gas sales in 5% while it
contributes 25% to the total UFG losses.

According to a OGRA’s decision on 24th September 2010 with regard to petition filed by
SSGC, SSGC’s UFG benchmark has been increased from 5.5% to 7% for FY10.
Iran-Pakistan gas pipeline: A bridge too far

Ever since an agreement on IP pipeline was signed, vibes have been in circulation about
IP pipeline and its positive impact on Sui twins. Given that modalities of the aforesaid
project have not been finalized yet, it is too early to incorporate any impact on gas
distribution companies. However since gas distribution companies will be distributing the
gas received via IP-pipeline, controlling UFGs might get more important considering that
cost of gas or IP Gas Pipe-line will be considerably higher. The project cost is estimated
at $1.25bn (within Pakistan boundaries) with debt equity composition of 70:30. The
target date for completion is 2013 and the pipeline is expected to deliver 750mmcfd gas.
The pricing of IP Gas Pipe-line has been settled at 80% of Japanese Crude Cocktail
(JCC). This pricing arrangement seems very expensive. For crude price of $70/barrel,
local gas fields under Petroleum Policy 2001 in Zone – 1 (Zone-1 is the most attractive
zone in terms of pricing) are priced at $3/mmbtu, whereas the recently announced
Petroleum Policy 2009 offers $4.62/mmbtu. This is in sharp contrast to $9.82/mmbtu
price applicable for IP gas pipeline at crude price of $70/barrel. Moreover, there is no cap
on crude prices so the cost of gas from IP pipe line can potentially be several times the
cost of gas under Petroleum Policy 2009. One possible solution can be to supply the gas
received to bulk consumers where the UFGs are nil.
Company Overview :
SSGC is primarily involved in operations and maintenance of gas transmission pipelines
(iii) gas compression facilities and gas distribution pipelines. It purchases natural gas
from 5 different sources and sells this gas to its customers in Sindh and Balochistan.
SSGC manufactures gas meters for domestic and commercial consumers under a
licensing arrangement with Schlumberger of France since 1976. SSGC was established in
1989 as a result of the merger of two gas companies - Sui Gas Transmission Company
Limited (SGTC) and Southern Gas Company Limited (SGC). SGTC was formed in 1954
with primary responsibility of purification of gas at Sui Field and to transmit the sweet
gas to the consumer centre in the southern part of the country. Two distribution
companies established in 1955 were responsible for the distribution of gas to consumers
in Karachi and in towns en-route to the transmission pipeline between Sui and Karachi.
These two distribution companies were first merged in 1985 to form SGC and later in
1989, SGC and SGTC were merged together to form SSGC.
Shareholding Pattern: Being the holder of more than 60 per cent shares, government
nominates/appoints most of the directors. About 10per cent shares are held by individuals
and foreign shareholders and remaining 24 per cent by companies and institutions.

Transmission and distribution network: SSGCL transmission system extends from Sui
in Balochistan to Karachi in Sindh comprising over 3,200 KM of high pressure pipeline
ranging from 12 - 24" in diameter. The distribution activities covering over 1200 towns in
the Sindh and Balochistan are organized through its regional offices. An average of about
357,129 million cubic feet (MMCFD) gas was sold in 2006-2007 to over 1.9 million
industrial, commercial and domestic consumers in these regions through a distribution
network of over 29,832 Km. The company also owns and operates the only gas meter
manufacturing plant in the country, having an annual production capacity of over 550,150
meters.

Return Formula for SSGC: Under the provisions of World Bank loan 3252-PAK, the
company is required to earn an annual return of not less than 17% per annum on the value
of its average fixed assets in operation (net of deferred credit), before corporate income
taxes, interest and other charges on debt and after excluding interest, dividends and other
non operating income. In order to bring down unaccounted for gas (UFG) losses to
international standards, OGRA (Oil and gas regulatory authority) introduced UFG
benchmarks in 2004. UFG losses above those benchmarks are deducted from the formula
return.
SSGC is engaged in the business of transmission and distribution of natural gas in Sindh
and Balochistan. It is also involved in construction contracts for laying of pipelines, sale
of gas condensate and also owns and operates the only gas meter manufacturing plant in
the country, having an annual production capacity of over 550,150 meters.

SSGCL transmission system comprises over 3,200km of high pressure pipeline ranging
from 12 – 24 inches in diameter. The distribution activities cover over 1200 towns in
Sindh and Balochistan through a distribution network of over 29,832km.

Fundamentals Analysis
Event
 • Sui Southern (SSGC) has underperformed broad market for couple of years due to
increase in UFG losses and financial charges of the company. However,
subsequent to OGRA’s decision to increase the UFG targets and allow higher non
operating income, SSGC PA is set to outperform broad market driven by
significant positive impact on earnings

• We revise our target price for SSGC PA from PKR12.2/share to PKR42.2/share

after incorporating the regulatory changes in our model. Along with a dividend
yield of 18%, the stock offers 53% upside to our June 11 target price of
PKR42.2/share. We upgrade SSGC from Underperform to Outperform.

Impact

• UFG benchmark raised to 7%: SSGC had requested OGRA to increase the
UFG benchmark from existing 5.5% in FY10 to 7.5% for three years with the
condition that disallowance should not be more than 20% of profit before tax.
OGRA, in its 24th September decision, has decided to increase the UFG target
from 5.5% to 7% for FY10. UFG targets for next year will be determined on year
on year basis by taking into account the circumstances prevailing at the relevant
time.

• JJVL royalty to be treated at non operating income: SSGC had requested

OGRA to include JJVL royalty in its non operating income since it is not a
regulated activity and does not require a license from OGRA. OGRA has allowed
SSGC to classify royalty income from JJVL as non-operating income in its 24th
September decision. Royalty income from JJVL is expected to be around
PKR2.57bn, resulting into positive after tax impact of PKR2.49/share on SSGC’s
FY10 earnings. Considering that gas volumes are gradually declining from Badin
field, we expect royalty income from JJVL to decline going forward.

• Gas condensate, meter manufacturing profit and late payment surcharge to

be treated as non operating income: OGRA, in its 24th sep decision, has
allowed SSGC to treat its late payment surcharge as non operating income. Late
payment surcharge is expected to be around PKR1.0bn during FY10 which
translates into an after tax impact of PKR1.00/share. OGRA has also allowed
SSGC to include income from gas condensate as non operating income. Income
from gas condensate is expected to be around PKR370mn during FY10 (after tax
per share impact of PKR0.36). Moreover, OGRA has finally accepted to include
the profit from meter manufacturing plant in non operating income for SSGC.
Income from Meter manufacturing plant is expected to be around PKR75mn
(after tax impact of 0.07/share) during FY10.

Earnings Revision
 • Earnings revised upwards to reflect change in fundamentals of company

Target Price and Price catalyst

• June-11 price target: Rs42.2/share on Justified P/B and relative P/E methodology.

• Catalyst: Relaxation in UFG benchmark and higher non operating income allowed
by regulator.

Action and recommendation

TP revised from PKR12.2 to PKR42.2: Due to significant change in fundamentals, we
have raised our target price for SSGC to PKR42.2/share. Buy!

Important factors to determine the bottom line

Operating fixed assets: In order to support its operations, SSGC has appropriate
infrastructural facilities spread over the two provinces of the country. SSGC's major
infrastructure components comprising of gas transmission/distribution pipelines and
compressor stations. SSGC is expected to build its operating fixed assets to PKR38bn by
end of FY10.
Deferred credit: Deferred credit is deducted from operating fixed assets to arrive at net
operating assets to calculate return of 17% for SSGC. Deferred credit has increased by
average 25% per annum since FY06 for SSGC. Owing to higher leverage and insufficient
funds, SSGC’s reliance on deferred credit has increased from 10% of fixed assets in
FY06 to 13% in FY10.

Net operating assets: Net operating assets are calculated by subtracting average deferred
credit from average operating fixed assets. Though operating assets increased by
average16% per annum during FY06-09 period, net operating assets increased by average
15% per annum during the same period owing to higher (average 25% per annum)
increase in deferred credit. Since SSGC earns 17% on average net operation assets, the
return has been rising in line with the increase in net operating assets.
Non operating income for calculation of formula
return
As discussed earlier, income from non operating sources is added in return on net
operating assets to arrive at formula return for SSGC. Previously SSGC was only allowed
to classify limited heads from income from financial assets to be included in non
operating income. However, after the decisions taken by OGRA on 24th September 2010,
following incomes will also be treated as non operating income FY10 onwards for SSGC:

a) Royalty from Jamshoro Joint Venture Limited (JJVL): SSGC receives royalty
from JJVL for making Badin gas available at its Liquefied petroleum Gas (LPG)
extraction plant at Hyderabad. SSGC had requested OGRA to include JJVL royalty in its
non operating income since it is not a regulated activity and does not require a license
from OGRA. Moreover, since the royalty income from JJVL is received without any
incremental investment (pipeline from Badin was not specially laid to supply gas to
JJVL), SSGC petitioned that it should be treated as non-operating income. OGRA has
allowed SSGC to classify royalty income from JJVL as non-operating income in its 24th
September decision. Royalty income from JJVL is expected to be around PKR2.57bn,
resulting into positive after tax impact of PKR2.49/share on SSGC’s FY10 earnings.
Considering that gas volumes are gradually declining from Badin field, we expect royalty
income from JJVL to decline going forward.

b) Late Payment Surcharge: Late payment surcharge is a non-regulated income as it is

an interest income being financial compensation for delayed payment of gas dues by
defaulting consumers. Since delayed payment by consumers result in cash flow problems
requiring the company to borrow additional funds to offset shortfall in cash flow, SSGC
asked OGRA to treat it as non operating income to offset the impact of incremental
borrowing. Considering this factor, OGRA, in its 24th Sep decision, has allowed SSGC
to treat its late payment surcharge as non operating income. Late payment surcharge is
expected to be around PKR1.0bn during FY10 which translates into an after tax impact of
PKR1.00/share.

c) Sale of Gas Condensate: Sale of gas Condensate was treated as a part of operating
income. SSGC urged OGRA to reclassify it as non operating income considering that
condensate is classified as crude oil under the provisions of OGRA ordinance. Keeping in
view that gas condensate cannot be classified as natural gas; OGRA has allowed SSGC to
include income from gas condensate as non operating income. Income from gas
condensate is expected to be around PKR370mn during FY10 (after tax per share impact
of PKR0.36).

d) Meter Manufacturing Profit: SSGC's domestic meter manufacturing plant is located

in Karachi. It produced 650,460 meters during FY09 as compared to 513,245 meters
during FY08, translating into a growth of 20% YoY. SSGC has been pushing OGRA to
include meter manufacturing profit in its non operating income considering that it is a
non-core business activity. OGRA has finally accepted to include the profit from meter
manufacturing plant in non operating income for SSGC. Income from Meter
manufacturing plant is expected to be around PKR75mn (after tax impact of 0.07/share)
during FY10. Going forward we expect income from meter manufacturing plant to
increase in line with increase in consumer base.
UFG target for SSGC relaxed from 5.0% to 7% for FY10

Positive regulatory development results in lower

UFG Losses
Since the inception of UFG benchmarks by OGRA, SSGC has been unable to keep the
UFG losses within the specified limits. SSGC has paid disallowances of around
PKR6.0bn during FY04-09 period which has reduced the effective return from 17% in
FY03 to less than 6% in FY09. UFG losses, which amounted to average 22% of regulated
return during FY05-FY08 period, ballooned to 48% of regulated return in FY09 owing to
tighter UFG benchmarks, increase in cost of gas and SSGC’s inability to control UFG
losses. Owing to aforesaid reasons, UFG losses increased from only PKR762mn in FY08
to PKR2.8mn (EPS impact of 2.97) in FY09.
Recent positive development: SSGC had requested OGRA to increase the UFG
benchmark from existing 5.0% in FY10 to 7.5% for three years with the condition that
disallowance should not be more than 20% of profit before tax. Moreover, SSGC has
urged the regulator to determine UFG benchmarks every year considering factors like
size and age of network, rise in gas sale prices, change in sale mix, law & order situation,
uneconomic expansion etc. OGRA, in its 24th September decision, has decided to increase
the UFG target from 5.0% to 7% for FY10. UFG targets for next years will be determined
on year on year basis by taking into account the circumstance prevailing at the relevant
time.
Regulated Return based on formula
SSGC’s regulated return is expected to increase significantly by 50% YoY from
PKR8.1bn in FY09 to PKR12.1bn in FY10 primarily on back on increase in non
operating income after OGRA’s decision to allow SSGC to treat aforesaid items as non-
operating income.

Use of leverage to finance CAPEX to increase financial charges

SSGC has been financing a sizable portion of its CAPEX through debt financing which
has increased the gearing of this company. SSGC’s financial charges are expected to
grow to PKR5.1bn in FY10 (up 16% YoY) primarily due to higher long term debt, higher
short term financing (owing to cash flow problems) and delayed payment of gas bills.
While we foresee gradual improvement in company’s performance due to higher non
operating income and relaxation in UFG benchmark, its positive earnings impact will be
constrained by higher financial charges during the year.

Circular debt: Owing to circular debt and rising cash crunch, SSGC’s receivables and
payables have surged as the utility is facing a cash crunch due to delays in collection of
payments from KESC. Historically, SSGC faced 1-2 months delay in collection cash
from KESC, whereas now the delay has stretched to nearly 5 months. Coupled with low
receivables turnover ratio, the company has delayed payments to the gas suppliers.
However, the severity of this circular debt situation is mitigated in the short term as the
payables account is surging more than the receivables, which to an extent is providing
cushion to the company’s cash position. We believe the company does not have ample
room to leverage as evident from its 9MFY10 total debt to equity ratio of 66:34. It is
worth noting that a similar situation arose in 1998-99 when GoP had to intervene to bail
out KESC from its cash flow crisis.

Valuation: Target PKR42.2

We have valued the stock using Justified P/B and relative P/E based methodology
because of the return formula structure of the company. For Justified P/B, we have used a
risk free rate of 13% and equity risk premium of 6%, leading to discount rate of 19% in
our model. We have assumed a terminal growth rate of 7% and return on equity of 35.8%
for SSGC to arrive at a fair value of PKR40.1/share. For P/E based methodology, we
have used average EPS of PKR6.34 for FY10-12 period and price multiple of 7.0x (based
on historical multiples) to reach at a fair value to PRK44.38/share. Assigning 50% weight
to each method, our June-11 target price for SSGC PA comes to be PKR42.23/share.

The stock at current price offers an upside of 53.3% to our June 2011 target price of
PKR42.2/share. The stock offers 18.2% dividend yield in FY10 which is expected to
improve to 21.8% in FY12. Buy!
Key risks
Circular debt getting out of control: Though the government is working seriously to
settle the circular debt issue, we feel that circular debt is one of the biggest risks currently
being faced by gas distribution companies. The government will have to raise the power
tariff substantially if it is to completely eliminate circular debt. Increase in the quantum
of circular debt will affect the cash flows of SSGC and may lead to reduction in
dividends.

Regulatory risk for UFG Benchmarks: Though OGRA has raised its UFG benchmark
this year but UFG benchmark for next year will be determined by OGRA subsequently.
Any decline in UFG target from 7.0% can hurt SSGC’s bottom line and poses as
significant regulatory risk for the company.

Change in non operating income calculation: Though our discussion with SSGC
management show that OGRA will not alter the non operating income calculation again
but if OGRA changes the non operating income calculation, SSGC would take a hit on
bottom line.

High interest rate scenario: Since the existing formula does not account for cost of
capital (interest charges on debt + cost of equity), incremental value addition of
additional capex is inversely proportional to the interest rates. This can also be verified
by historical inverse relation between SSGC’s PBV ratio and local short term interest
rates. The stock has always underperformed broad market in high interest rate scenario.
Reference:
http://ssgc.com.pk/

http://www.kse.com.pk/

SSGC Annual Report

http://www.fs.com.pk

http://www.google.com.pk

http://khistocks.com/