Global Outlook

Share prices of Indian sugar companies have gone up but still the risk-reward ratio is not in favour of investors

Contributed by Nirmal Bang

By Nirmal Bang

Off late sugar companies and their share prices have been in the limelight. Stocks of most sugar companies have gone up significantly in the recent past in the hope of favourable developments in the industry.

Briefly, world’s two largest sugar producers namely Brazil and India are expected to have lowered their production this year and the coming year. The impact is already seen on the global sugar prices. Indian sugar prices are inching higher and making multi-year highs.

According to estimates, the world sugar production was about 154.2 million tonnes in 2008-09 as against the consumption of 164.6 million tonnes, leading to a deficit of 10.3 million tonnes. In India also, the situation was bleak as sugar production deficit reached about 7 million tonnes. No wonder sugar prices are trading at multi-year highs of about Rs 45 per kg.

Considering high sugar prices, companies are expected to post bumper profits and report significant jumps in earnings that lead to re-rating of these companies’ stocks. In many of these cases, companies will be making profits in the range of about Rs 10 per kg to Rs 15 per kg of sugar sold in the market, which is significantly high for companies which do not make more than Rs 2 per kg to Rs 5 per kg of profits even in the peak of the cycle.

WHAT IS CHANGING?

The rationale behind such a development is simple. Higher prices mean higher profits and earnings lead to soaring share prices of these companies. Earnings of most of these companies are very sensitive to sugar prices. For instance, in many cases every 1% change in sugar prices leads to 2% to 5% increase in the earnings or EPS of these companies.

Consider what will happen to these companies when in the last one year alone sugar prices went up by over 110%. No wonder now as new estimates suggest most of these companies will post at least 2 to 3 times or a 200% to 300% jump in net profits.

Typically a sugar industry cycle is estimated to be of about 6 years to 7 years. Under this period, the industry travels all the way from boom to bust. In the boom time as prospects improve, the share prices of most of these companies trade at their historical peaks.

Take the current scenario which started from 2006. During 2006 and 2007, the industry was struggling with a surplus production of sugar in the country.

During 2006, India produced 19.3 million tonnes of sugar along with the additional 4.9 million tonnes opening stocks, totalling to 24.4 million tonnes of sugar availability in the country. This was far more than India’s consumption of 19 million tonnes of sugar. The situation continued till 2007, as the production further outpaced demand to 27.5 million tonnes.

The results were evident on sugar prices. Sugar prices corrected from the peak of Rs 20 per kg in the beginning of 2006 to Rs 13.80 per kg in the middle of 2007. This is the typical nature of the sugar industry.

As production and supply increases, prices fall. This also has a cascading impact as farmers turn towards other crops instead of sugar cane as they find it less attractive to grow sugar cane. During 2007-08, the farmers were paid Rs 110 for every quintal of sugar cane, which was unattractive compared to growing wheat and paddy which was giving higher returns.

THE FALL

Falling sugar prices, high inventories and surplus production is generally a time when companies’ financials get hit. Falling prices lead to lower volumes and falling realization for every kilogram of sugar produced and even losses in many cases due to high cost of inventories in the books.

Companies book losses for those high cost inventories for which sugar prices have dropped in the market. Even during these times it becomes difficult for most of these companies to service the interest and absorb depreciation for new capacities fully.

Typically this is the time share prices of the companies bottom and fall to historical levels as investors shy away from these stocks. The year 2007 and early 2008 was one such year when the share prices of most sugar companies fell significantly.

TURNAROUND

However, from the second part of 2008, the situation once again turned favourable for these companies. By 2008 and 2009, the area harvested under sugar cane and sugar production fell. Additionally, poor monsoon in the country further gave an early indication of the fall in sugar production.

Globally too, climate change in the world’s largest sugar-producing nation, Brazil impacted production. As the market sensed that the global sugar deficit was too high and that India would witness a sharp decline in sugar production, sugar prices started moving up. India’s sugar production fell to 15 million tonnes as against consumption of 22.5 million tonnes. Even closing inventories depleted from 9.6 million tonnes in 2008 to 4.7 million tonnes in 2009.

Sensing the deficit production globally and lower availability of sugar cane, domestic sugar prices which were trading at Rs 20 per kg in 2008 went through the roof and touched about Rs 45 per kg recently. It was bound to happen as things remain critical.

Even for the next sugar season ending September ’10, the domestic production is estimated to be at about 15.1 million tonnes, far below the estimated consumption of 22.9 million tonnes next year. Several sugar companies will benefit on many counts including high realizations, low sugar cane prices, high volumes and gains from low cost of inventories.

WORD OF CAUTION

Timing is very important while investing in a cyclical industry, particularly sugar. There are less doubts about the benefits these companies will have in the near term.

However from here, investors need to keep in mind that in most cases share prices of most of these companies are trading at about 22 times to 25 times their earnings and factor in most of the positives that the industry has seen in the recent past including next year’s bumper profits.

In the latter part of the increase in sugar prices, share prices of sugar companies were seen becoming less responsive as they seem to be unsustainable in the long run. Even if we assume 6 years to 7 years of cyclical trend for the sugar industry, a boom can last for about 3 years. We have already seen the best two years for the sector, which might continue for some time or the forthcoming year.

EASY AVAILABILITY AND HIGHER COSTS

As sugar prices are going up, farmers too want their share of the cake. Farmers are no longer asking for cane prices at about Rs 155 per quintal, which is fixed by the government. They are instead demanding Rs 210 to Rs 220 for a quintal of sugar cane.

So in the coming years, as companies procure sugar cane at higher prices, their cost of production for sugar will also go up. Considering the situation, companies could find it difficult to earn the same kind of margins next year and realization could fall in the coming years.

Secondly, as farmers are finding it attractive to grow sugar cane over other crops, the availability of sugar cane will improve next year and thereafter leading to an improvement in production.

For instance, sugar cane production which is expected to be about 268 million tonnes in 2010 will improve to 338 million tonnes in the year 2011. This is also a reason why production in the year 2011 is expected to recover significantly to about 23 million tonnes or almost equal to the consumption of 24 million tonnes.

Globally also sugar production in 2011 is expected to be higher on the back of recovery of sugar production in Brazil and other markets like Pakistan and Thailand.

As the global and domestic production recover in 2011, the impact of higher production will be on sugar prices, which could decline gradually over the next two years.

In addition to this, pressure has already started building on domestic sugar prices given the government’s intervention to take measures to control prices like allowing imports, reducing inventory holding period and hoarding of the commodity by curbing stock limit.

This intervention will also impact earnings of companies as realization will drop and impact of high cost inventory will start kicking in. Also, the higher base effect of the current year and the year after that will be visible in 2011 when companies may report declining profits.

Although the industry is seeing good times considering that share prices of sugar companies have gone up and the coming two years are considered to be critical, the risk-reward ratio is not in the favour of investors.

The best time to invest in the sugar stocks could have been about one or two years back. However, now the dynamics are expected to change over the next two years leading to high risks at these prices.