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Balrampur Chini Mills review and analysis by Angel Broking

By Angel Broking

 

Sugar prices have been spiralling over the last one year owing to reduction in the area under cane cultivation and low global and domestic inventory. We expect sugar prices to rule firm in SY2010E, which will result in higher switch over from ethanol to sugar in Brazil as well as increase in cane acreage in India. Hence, supply would ease and prices are expected to soften globally in SY2011E. In case of Balrampur Chini Mills (BRCM), it is the most efficient player in the Indian Sugar industry considering its long Profitability trend compared to peers. However, at current levels the stock is available at fair valuations of 4.8x EV/EBITDA, 1.6x P/B and 1.5x Enterprise Value/Invested Capital on SY2011E Earnings. Hence, we Initiate Coverage with a Neutral view on the stock.

Sugar supply to ease in SY2011E: In the domestic markets, due to the substantial 73% increase in cane prices in SY2010E, we expect cane acreage and drawal to touch SY2007 peak levels in SY2011E. Sugar production would stand at 26.7mn tonnes with consumption at 24.2mn tonnes in SY2011E. In case of Brazil, sugar prices have outperformed ethanol by 50% between Jan 2009-Feb 2010. Hence, the Brazilian companies would divert more cane towards sugar production. With this, we expect Brazil to have a surplus of 30mn tonnes in SY2011E resulting in international prices softening. Thus, we expect prices to peak in SY2010E and soften in SY2011E.

Profitability to peak in SY2010E: Following higher Realisations in the Sugar and Power businesses, we expect the company’s RoCE and RoE to peak at 24% and 33% in SY2010E, respectively. However, on the back of softening sugar prices in SY2011E, the company’s Sugar Division EBITDA Margins are expected to decline from 24% in SY2010E to 16% in SY2011E. As a result, the company's RoCE and RoE would drop to 21% and 25% respectively, in SY2011E.

 

 

 

 

Recommendation Arguments

Domestic sugar supply to ease in SY2011E

We estimate India's sugar production to increase by a mere 10.8% to 16.3mn tonnes in SY2010E as against 14.7mn tonnes in SY2009. This is because the area under cane cultivation for the year (as per latest Industry data) has largely remained flat at 4.3 million hectare (mn ha) over 4.2mn ha in SY2009. As a result, India is expected to face sugar shortage in SY2010E. Moreover, opening inventory in SY2010E stood at a negligible 2.4mn tonnes, while total consumption is estimated at 23.6mn tonnes (22.5mn tonnes), translating into a deficit of 4.9mn tonnes for the year. Globally too, lower production resulting from unfavourable weather conditions, which have destroyed crops, has constrained sugar supplies. Overall, due to the tight supply situation the world over, we expect India to import 6mn tonnes of sugar in SY2010E due to which sugar prices are likely to rule firm through the year.

Since commencement of the current rally in sugar, retail prices have virtually spiked 180% to Rs42/kg in February 2010 from bottom of Rs15/kg in September 2008. This rally has surpassed the SY2004-05 run up in sugar prices when the commodity touched Rs20.8/kg from Rs14.1/kg, an increase of 48% over the period. Similarly, cane realisation for the farmers in the current rally has risen by 73% to Rs2,600/ tonne, while it moved up 18% in SY2004, 7% in SY2005 and 10% in SY2006. In anticipation of this positive trend extending, more farmers are expected to switch over to cane cultivation resulting in the area under cane cultivation to once again hit SY2007 peak levels of 5.2mn ha in SY2011E.

 

 

 

 

Given that higher number of farmers switch over to cane cultivation, sugarcane supply is likely to ease in SY2011E. This would result in cane realisation turning unattractive from the unorganised sector and force the famers to shift over to the mills for better realisations. Hence, we expect the drawal rate to once again hit SY2007 peak levels of 78% in SY2011E resulting in total sugar production of 26.7mn tonnes. Moreover, with consumption likely to be 24mn tonnes in SY2011E, India would end the year with an inventory of 3.5mn tonnes and import of 4mn tonnes resulting in overall inventory of 7.5mn tonnes equivalent to 3.7 months consumption, an improvement over SY2010. Hence, on account of a tight scenario in SY2010E, we expect domestic sugar production to surpass consumption and result in sugar prices softening in SY2011E. We have conservatively assumed (non-levy) sugar realisation to decline by 26.3% compared to the last cycle when it dropped by around 40%.

 

 

 

 

 

Global demand-supply imbalance in SY2010E; Brazil to be game changer

As per the US Department of Agriculture (USDA), the global closing inventory of sugar for SY2010E in terms of the number of months of consumption is expected to be 2.4 months (19.6% of annual consumption) almost similar to the peak of SY2006.

 

 

 

 

Brazil to divert more cane towards sugar

Brazil, with cane production of around 569mn tonnes, is the global leader producing approximately 33% of total global cane. Being the largest cane producer, Brazil is also a major player in sugar, with approximate production of 34mn tonnes or 19% of the total global sugar production.Pertinently, Brazil has not only emerged as the world's low-cost sugar producer, but is also able to switch production between sugar and ethanol depending on profitability of the businesses. Hence, we believe that Brazil's capability to increase sugar production would play a crucial role in determining the trend in sugar price.

Between January 2009- February 2010, sugar prices nearly doubled from US c17.9/lb to US c40/lb, an increase of 123%. Relatively, on the other hand, ethanol prices underperformed during the mentioned period, increasing from US c35/ltr to US c60/ltr, up 73%. Hence, we believe that rise in sugar prices would compel more Brazilian companies/farmers to divert more cane towards sugar production in SY2011E as was seen during the SY2005-07 rally.

 

 

 

 

During SY2005-07, EU's production fell by 4mn tonne, Brazil increased production by 3mn tonnes, indicating its capability to ramp up sugar production to take advantage of the global rise in sugar prices. Post increase in sugar production by Brazil, prices tumbled and stabilised before onset of the current bull rally that commenced towards end SY2009. Thus, given that Brazil is a global major in sugarcane as well as sugar, it would play a crucial role in determining the global demand-supply balance in SY2011E. Going by historical trends, we expect Brazil to enhance production in SY2011E to capitalise on the rising sugar prices.

 

 

 

 

Hence, in SY2011E, there would be higher diversion to sugar from ethanol, and expect sugar to hit the peak of 54% touched in SY2007. Even at conservative cane production levels of 600mn tonnes in SY2011E (569mn tonnes in SY2009), Brazil would produce 42mn tonnes of sugar in SY2011E, a yoy growth of 18%. Currently, Brazil's domestic sugar consumption is 12-13mn tonnes per annum, while the balance is exported. Current global sugar trade is in the region of 50mn, of which Brazil contributes 25mn tonnes, which would increase to 30mn tonnes going ahead and result in softening of international sugar prices.

 

 

 

 

International futures pointing towards soft prices in SY2011E

We believe that the current international futures price discounts near-term demand-supply imbalances in sugar. The SY2010E average international raw sugar future is trading at US $547/tonne (USc25/lb), translating into retail sugar price of Rs36.7/kg, while the current domestic retail price is ruling in the region of Rs38-40/kg. Thus, any upside in the domestic sugar price hereon is limited. In the recent past, the sugar refiners had wound up future positions to reduce overall costs and taken home available profits. Interestingly, average raw sugar prices for SY2011E are pegged at US $421/tonne, translating into retail price of Rs31/kg. However, we expect sugar prices to soften to Rs28/kg levels on the back of: (a) Increase in domestic (India) production, and (b) More diversion of cane towards sugar in Brazil.

 

 

 

 

 

Profitability to peak in SY2010E

 

Sugar Margins to decline in SY2011E

The Sugar Division is estimated to contribute 86% to Total Revenues in SY2010E. Moreover, on the back of high sugar prices, the Division is expected to significantly contribute to overall Profits in SY2010E. However, in SY2011E, sugar prices are expected to correct owing to increased supply. As a result, contribution of the Division to Total Revenues is expected to drop to 80% in SY2011E. EBITDA Margins of the Division are also expected to decline by 800bp to 16% in SY2011E from 24% in SY2010E on the back of lower Realisations. Consequently, contribution of the Division to overall EBITDA is likely to fall from 80% in SY2010E to 60% in SY2011E.

 

 

 

 

Power to cushion decline in Profit during down-cycle

BRCM’s diversified Revenue stream is led by External co-gen power sales. The company entered the Power Segment in 2003, much ahead of competitors like BJH, which entered the Segment in SY2008. While BRCM has total installed capacity of 180MW, with saleable surplus of 126MW (70% of total installed capacity), BJH has installed capacity of 428MW with saleable surplus of 105MW (25% of total installed capacity).

Operational performance of the Division is also set to improve on the back of the estimated spike in Volumes by 101% in SY2011E. Thus, contribution of the Division to overall Revenues is expected to increase from the estimated 8% in SY2010E to 13% in SY2011E.

On the Tariff front, with the power tariffs revised upwards by 33% this fiscal, Profits of the Power Division is expected to receive a leg up going ahead. As a result, healthy Power Division Margins (blended EBITDA Margin of 46-49%) are expected to restrict the fall in overall EBITDA in SY2011E. We estimate overall EBITDA to decrease from Rs727cr in SY2010E to Rs691cr in SY2011E .

Hence, External co-gen power sales is expected to support the company's Earnings during the down-cycle in SY2011E. We estimate BRCM to register a mere 5% de-growth in PAT in SY2011E.

 

In sum, BRCM's profitability would peak in SY2010E and decline thereon. We expect RoCE and RoE to peak out at 24% and 33% in SY2010E respectively, contributed by high realisation in sugar and power businesses. In SY2011E however, on the back of softening sugar prices (Rs28/kg), the company's RoCE and RoE would drop to 21% and 25% levels, respectively.

 

 

 

 

High free Cash flow to reduce leverage

On the back of rising Profits during SY2009-11E, we estimate BRCM to generate cumulative free cash flow of Rs683cr in the mentioned period. Moreover, on account of low Capex requirement, we expect the company to utilise the free cash flow to reduce leverage.

 

 

 

 

During 1994-2009, BRCM's Debt:Equity averaged at 1x. Going ahead, with the company likely to reduce Debt, in SY2011E, its leverage would reduce to a low of 0.5x

 

 

 

 

Financials

During SY2007-09, BRCM registered modest 11.9% CAGR in Revenues to Rs1,747.1cr from Rs1,394.8cr. The company ended the period with Net Profit of Rs209.1cr compared to Loss of Rs50.5cr in SY2007, primarily on account of the forced government ban on sugar Exports. The Export ban had resulted in the company's sugar realisation crashing as there was oversupply in the domestic market.

 

 

 

 

Going ahead, we expect BRCM to crush 5.1mn and 10.4mn tonnes of cane in SY2010E and SY2011E respectively, yielding 0.6mn and 1mn tonne of sugar respectively, in the mentioned years. BRCM also has a raw sugar import contract for 85,000 tonnes, which will be processed and sold in SY2010E. As mentioned earlier, we expect sugar prices to remain firm in SY2010E, but soften in SY2011E. Accordingly, we have assumed realisations of Rs38/kg for SY2010E and Rs28/kg for SY2011E. Thus, over SY2009-11E, we expect the Sugar Division Sales to post a CAGR of 29.4%, while EBITDA is likely to de-grow by 1.9% on a compounded basis over the period due to the fall in sugar realisation in SY2011E.

Meanwhile, the company's Distillery Realisations are expected to remain buoyant following low availability of cane in the country resulting in a supply crunch. Hence, we estimate the company's Distillery Division to record Revenue CAGR of 22% over SY2009-11E to Rs200.5cr.

With regards to the Power Division, the UP Power Grid has allowed the sugar mills to operate the bagasse-based boilers on coal also. Hence, many sugar mills are converting boilers to dual feedstock. However, on account of lower capacity and higher coal cost, blended Profitability is likely to suffer. Hence, while we expect the Power Division Revenues to register significant CAGR of around 87%, EBITDA growth is expected to slacken and register CAGR of 67% over SY2009-11E.

 

 

 

 

Overall, we expect BRCM's Sales and PAT to post a CAGR of 36% and 38% over SY2009-11E, respectively. Growth in SY2010E would be driven by higher realisation in the Sugar and Power Divisions, while growth in SY2011E would be driven by higher Volumes. We expect BRCM's Sugar and Power Volumes to grow by 72% and 101% in SY2011E, respectively.

 

 

 

 

Earnings Sensitivity

BRCM's Earnings are highly sensitive to the cane and sugar prices. Pertinently, every additional Rupee increase in the sugar prices goes straight to the company's Bottom-line. Similarly, every increase in cane cost results in a spurt in the company's overall costs.

 

 

 

 

As discussed earlier, we expect sugar prices to remain firm at Rs38/kg levels in SY2010E, while it would soften in SY2011E to Rs28/kg levels due to higher sugar production. Cane constitutes around 70% of total costs for the sugar mill operators. During SY2004-09, cane cost increased at a CAGR of 9.2% for the company. For SY2010E, we expect cane prices to strengthen to Rs2,320/tonne, and conservatively expect the prices to soften in SY2011E to Rs1,800/tonne.

 

 

Risks to our recommendation

Revision in area under cane cultivation: Any revision in the area under cane cultivation would impact cane and sugar production and in turn affect the company's realisations.

Vagaries of Monsoon: Although cane crop is not monsoon fed, it requires water through irrigation. Hence, occurrence of drought/flood would result in lower cane production and affect cane and sugar production.

Upgradation of MSP and Crop economies: A farmer has the option to cultivate rice/ wheat/ sugarcane. Also, a farmer grows the crop which gives maximum returns, which is driven by total production cost and the minimum support price (MSP) offered by the government. Hence, any change in MSP would motivate the farmer to plant a particular crop in turn affecting the production of sugarcane.

Revision in SAP: Any revision in state advised price (SAP) for cane would lead to change in crop economies and changing profitability of crops, in turn determining area under cane cultivation.

Revision in Merchant Power Tariffs - We have assumed power deficit situation to sustain owing to which the merchant power tariff would continue to rule at Rs6-7/unit levels. In case of power oversupply, tariffs could correct downwards and impact our Profit estimates.

 

Outlook

Prices to soften in SY2011E

Sugar prices, over the last year, have been rising on the back of lower global and domestic inventory and reduction in the area under cane cultivation. In SY2008, average sugar Realisation (non-levy) stood at Rs15-16/kg, while it was in the range of Rs22-24/kg in SY2009. In SY2010E, we expect realisations of Rs38/kg. In SY2011E however, given the likely scenario of higher production in India and Brazil, realisations are expected to soften to Rs28/kg.

 

Valuation

We have not used P/E and EV/EBITDA methodology to value the stock, as it fails to capture the cyclical nature of the business in turn impacting Profitability (PAT and EBITDA levels). Given that BRCM is in the commodity business, we have utilised the Asset-based valuation methodology to value the stock. We have used Enterprise Value / Invested Capital (EV/IC) derived from the Fair Price / Book Target multiple resulting in the required Cost of Equity. It may be noted that we have also not considered the last up-cycle (SY2005-06) multiple, as then the markets were overly bullish on the Ethanol Segment of the Sugar Sector.

During 1994-2008, BJH generated average RoE of 5.6% compared to BRCM's average RoE of 17.5%. BRCM also has a stable capital structure (average Debt:Equity of 1:1x over a period of time) on account of lower Equity dilution and defensive Capex. Hence, BRCM is leagues ahead of its competitors.

 

 

 

 

As discussed earlier, BRCM registered average RoE of 17.5% during SY1994-08. In the SY2003-08 cycle, when the business model of the sugar companies underwent a change (introduction of Ethanol), BRCM clocked average RoE of 16.6%. Therefore, we have taken long-term average RoE of 17.5% for valuation purposes. Along with the industry growth rate of 8% and Cost of Equity of 14%, we have arrived at a Fair P/B multiple of 1.6x for BRCM. Since the current cycle is on uptick, we have assigned 20% premium to the Fair Target and arrived at a Target P/B multiple of 1.9x that is equivalent to 1.5x EV/IC.

 

 

 

 

We believe that there are heightened risks of sugar prices correcting from hereon rather than moving upwards. Pertinently, though BRCM is the most efficient player in the industry, any small correction in the sugar prices would have an amplified impact on the stock price.

At current levels the stock is available at fair valuations of 4.8x EV/EBITDA, 1.6x P/B and 1.5x Enterprise Value/Invested Capital on SY2011E Earnings. Hence, we Initiate Coverage with a Neutral view on the stock.

 

 

 

 

 

Company Background

Balrampur Chini Mills (BRCM) is the second largest integrated player in the Indian Sugar Sector. The company has 10 sugar plants spread across Uttar Pradesh (UP), with aggregate sugarcane crushing capacity of 73,500 tonnes crushed per day (TCD), Distillery capacity of 42 Kilolitre Per Day (KLPD) and around 180MW power capacity.