What’s behind the recent rally in sugar stocks and is it sustainable?

What’s behind the recent rally in sugar stocks and is it sustainable?

Sugar stocks were beaten down even while the markets went up during the early part of the year. So what has changed in the last three months for this sector…

Prelude

The industry was doing fine from April 2017 to Dec 2017. Average sugar prices @ ex-mill level were Rs. 37/kg. The Sugar Season 2017-18 started with a bang. Not only did cane production touch an all time high but yields also significantly improved on the back of good rainfall in Maharashtra (Sugarcane growing areas in UP, the other major producing state, is largely irrigated). On the back of a huge sugar production, sugar prices crashed. From Jan 2018 to Mar 2018, the price of sugar fell to Rs.31/kg at the mill level. In April and May, prices fell to as low as Rs.26/kg ex-mill.

The sugar season 2017-18 ended in June 2018 and India produced a record 32.5 mn MT of sugar. With domestic consumption at around 26mn MT and an opening stock of the previous years, mills got stuck with an inventory of nearly 10mn MT before the beginning of the new sugar season 2018-19.

As a consequence, sugar stocks crashed. From a high of Rs.180 in November 2017, Balrampur Chini hit a low of Rs. 60 in May 2018. Incidentally, the company has executed two buybacks during the last two years (1 crore shares @ Rs.175 and 66 lac shares @ Rs.150).

The stock price of another major sugar company, Dhampur Sugar fell from a record high of Rs.306 in Nov 2017 to Rs.72 in Jul 2018.

And what about these companies’ performances? Sugar companies were sitting on reasonably large profits from April to Dec 2017.  So, Balrampur Chini took a huge inventory loss of Rs.320cr (against a production cost of Rs.31/kg, the company valued its closing stock at Rs.25.5/per kg). The company ended FY 2017-18 with a PAT of Rs.232cr (down from Rs.593cr in FY2016-17).

Similarly, Dhampur Sugar took an inventory loss of Rs.180cr (closing stock was valued at Rs.27/per kg). The company ended FY 2017-18 with a PAT of Rs. 151cr (down from Rs.230cr in FY2016-17).

What really saved the day for sugar companies inspite of losses in the sugar segment?

Integrated sugar mills produce power from bagasse and ethanol from molasses (considered as by-products but ironically, contribute a steady but consistent source of income and profits). Sugar companies have long-term PPAs with discoms, whereby the excess power after use in the sugar factory is sold to the state grids. Similarly, to encourage the blending of ethanol with petrol, Oil Marketing Companies float yearly contracts for their ethanol purchases at a fixed price for a contract period from December to November.

Also, since sugar companies had a larger crushing season and higher than normal yields, their sale of power and production of molasses (used in making ethanol) was higher than normal. The below table reflects the disproportionate contribution of profits from power and ethanol segments as compared to sugar

To mitigate the problems of the sugar industry and to help clear high levels of outstanding dues of sugar mills to farmers, GOI announced various steps for the sugar season 2017-18…

1. Doubling of import duty on sugar to 100%. This completely insulates the domestic industry from world sugar markets.
2. Fixing the minimum selling price of sugar at Rs. 29. Mills cannot sell sugar below the MSP.
3. Reintroduction of the quota mechanism, whereby mills are permitted to sell only a fixed quantity of sugar per month. The ministry of food and civil supplies declares a monthly quota for sale, every month, preventing distress sales.
4. Compulsory exports of 2 mn MT with the Central Government paying Rs.5.5/quintal to farmers directly, thus reducing the liability of mills for cane purchases. However, physical exports failed to takeoff as international prices continued to remain low.
5. Creation of a buffer stock of 3 mn MT at the mill level. Every mill to be reimbursed interest, insurance and warehousing costs for a particular level of inventory.

So why does the government care so much for the sugar industry? For starters, GOI fixes the price of sugarcane every year (called FRP). In addition, some state governments have their own price (called SAP). These prices are increased every year, for political considerations rather than due to any economic logic. Also, sugarcane is the only produce where farmers are assured of prices; this leads to an increase in the cultivation of sugarcane every year.

For SS 2017-18, the FRP was Rs.255/quintal and the UP government SAP was Rs.315/quintal. Due to the record sugarcane crushing and consequent high production of sugar, leading to a huge inventory, sugar mills were unable to clear their outstanding dues to farmers.

So what has changed the outlook for the sugar industry?

1. 1 After the announcement of the above mentioned steps, sugar prices stopped falling and steadily increased. In Q1 2018-19, companies recorded an average selling price of Rs.28.5/Rs.29 per kg. and in Q2 2018-19, companies recorded an average selling price of Rs.32/kg.
2. Brazil, the world’s largest exporter of sugar, has diverted sugar production to ethanol (led by unviable sugar prices in global markets and higher crude prices). Also, due to trade wars between China and the US, China has started importing soya bean from Brazil, prompting many Brazilian farmers to shift to soya from sugarcane. This year Brazil’s sugar exports are expected to fall dramatically.
3. India was supposed to produce 35 mn MT of sugar in sugar season 2018-19. However, the latest estimates by the Indian Sugar Mills Association (ISMA) have downgraded production to 31 mn MT on account of a poor monsoon and pest attacks in Maharashtra and Karnataka.
4. All this factors have helped a smart recovery in international sugar prices.

Even after SS 2017-18 ended, sugar mills continued to have large outstanding dues to farmers as inventory liquidation takes time.

To help clear dues and prevent the same happening during the next sugar season, GOI and the Government of UP came out with new a package for the sugar industry for sugar season 2018-19…

1. The announcement of compulsory exports of 5mn MT. This will enable exports of raw sugar for which there is a good demand in the international market. To make exports viable, GOI will pay a cane subsidy to farmers @ Rs.13.88/ per quintal. In addition, a transport subsidy of upto Rs.3000/MT of sugar has been announced. Hitherto, UP mills were not physically exporting sugar but were selling their quota to Maharashtra sugar mills and paying the price difference to them. Now they have not only started physical exports but are also selling raw sugar to export oriented mills in India (owned by Renuka Sugar and EID Parry). The government is also trying very hard to pave inroads into new export markets for Indian sugar, like China and Bangladesh. The industry estimates that export quotas for the current year will be met and inventory levels will be reduced to that extent.
2. The UP government has announced a scheme to help mills avail of loans from banks @ 5% interest, in order to help them clear outstanding dues of the last sugar season. An additional cane subsidy of Rs.4.5/per quintal has been announced for mills for last sugar season (ss 2017-18).
3. To help the sugar sector manage larger cane productions over the long term, GOI announced a new ethanol blending policy. Rates of ethanol from C molasses (where the maximum sugar possible is extracted and ethanol is made from leftover molasses) increased from Rs.40/per litre to Rs.43/per litre. Currently ethanol in only produced from C molasses. The price of ethanol produced from B molasses (where some production of sugar is sacrificed to produce a larger quantity of molasses) has been announced @ Rs.53/litre. The price of ethanol produced from direct sugarcane juice (no sugar is produced in the process) has been announced at Rs.59/litre. So, in case of a large sugarcane crop, mills will now be able to divert production of sugar to ethanol, as is done in Brazil.To help sugar mills put up new ethanol facilities, the government has announced an interest subvention scheme, wherein a large part of the loan will be entitled for interest subsidy. After the announcement, more than 400 mills have applied for the same. In the coming sugar season, this will help to divert production from sugar to ethanol in case of excess stocks/low sugar prices.

So how did sugar companies perform during the half-year, ending Sept 2018 and what is their future outlook?

1. Balrampur Chini

Balrampur carried long-term debt of only Rs.82cr on its books ­­­as on 30.09.18. The company is putting up a new distillery, which will be ready by the next sugar season in 2019. In its analyst meet, the management has indicated a higher yield and higher crushing season. This should enable the company to comfortably report a Rs.18-20 EPS for the full year ended 31.03.19.

2. Dhampur Sugar

A look at the half yearly results of Dhampur Sugar reveals that it can easily make a PBIT of Rs.350cr for the full year only from power and ethanol. With the cost of production of sugar @Rs31/kg, the company can make a PBIT of Rs.75cr from the sugar segment, assuming a price of Rs.32/kg. Further, the company has expanded its ethanol manufacturing capacity from 3,00,000 ltr to 4,00,000 ltr from this season onwards. It has also valued its closing stock more conservatively (Rs.29.47/kg). On an equity base of Rs.66.3cr, the company can easily report an EPS of Rs.45-50 for the full year.

In conclusion, the nature of the industry is changing from a cyclical industry to a more predictable industry. Will the markets give it a better PE? Only time will tell.

Disclaimer: Ventura Securities Ltd has taken due care and caution in compilation of data for its web blog. Information has been obtained from different sources which it considers reliable. However, Ventura Securities Ltd does not guarantee the accuracy, adequacy or completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. Ventura Securities Ltd especially states that it has no financial liability whatsoever to any user on account of the use of information provided on its web blog. The information provided herein is just for the knowledge purpose and shouldn’t be construed as investment advice under any circumstances.