Unclear crystals

Though sugar company stocks have gone up in the past few weeks, the fundamentals haven't changed much. A report

One of the biggest wealth creators of 2005-06, the sugar sector has recently turned into the biggest wealth destroyer, declining 60-70 per cent in 2006-07.

However, after the sharp correction in the market, sugar stocks are looking up. During the past seven trading session, the Sensex has dropped 7 per cent while sugar companies are up 4-5 per cent. Is the worst over for the sector?

The fall in sugar stocks during FY07 was due to multiple reasons: expected higher production, softening of local and global sugar prices, and a ban on exports. But in the past few days, the story has changed.

Says, B J Maheshwari, AVP, Dwarikesh Sugar, "The sentiment has improved due to the lifting of export ban, creation of buffer stock by the government and the pricing of ethanol." 

ETHANOL ECONOMICS
	Unit	9 States and union territorries		Nation wide 10% Blending
		5% Blending	10% Blending
Ethanol Required	Million Litres	493	986	1741
Molasses required	Million tonne	3.7	7.3	12.9
Availability of molasses	Million tonne	10.9	10.9	10.9
There is enough availabilty of molasses to convert into ethanol. However, the lack of government will to implement ethanol blending continues to dampen the industry outlook. This has also resulted in falling molasses prices.

But if investors are wondering if sugar companies will bring great returns going forward, Priyanko Panja sugar analyst of Edelweiss Securties, disagrees: "I do not think anything has changed in terms of the fundamentals of these companies. It is just that these stocks have fallen drastically investors are taking a contrarian call." Short-term traders attribute the sugar stock rally to the short covering in the derivative segment.

Since there are divergent opinions, let us take a fundamental check. Do these stocks still hold promise or is it just a short-term bounce back rather than a long-term reversal?

Lifting of export ban
Till a few months back, the demand-supply mismatch worked in favour of the sugar industry. Companies enjoyed increased volumes coupled with improved margins on account of rising sugar prices.

However, the benign scenario was distorted with the expectation of increased domestic sugar production at 230-260 lakh tonne in the sugar season ending September 2007. This also created worries over supply glut in the country. In addition to that, last year's 40 lakh tonne of carry stock made things worse.

The government, however, has not kept quite either. It lifted the export ban in January 2007 to check the supply side and stabilise domestic sugar prices.

However for all the good intentions, sugar companies are not really enthused at this measure. They believe that the lifting of ban has come at a time when the international prices of the sugar is down and thus does not make much sense to export.

The international sugar prices are currently trading at $320-$330 a tone, which gives an export realisation at FOB level of Rs 13,600-14,025 (at $1=Rs 42.5) per tonne. If this sugar is sold in the domestic market, northern mills will have a realisation of about Rs 14,000-14,500 per tonne and southern mills will earn Rs 13,000-13,500 per tonne.

Factoring the current domestic realisation and transport costs, exports makes sense if the international sugar price is over $360-370 a tonne. International Sugar Organisation estimates a higher global sugar surplus of 7.2 million tonne for this year. Considering the surplus scenario, there is little hope of the international sugar prices going up.

Export incentive
Now, the central government is contemplating to give an export incentive to the tune of Rs 1,350 a tonne for the sugar to be exported by the states which have ports and Rs 1,450 a tonne for those who are away from the coast.

"It is definitely a positive sign for companies which have an export obligation. It will help in supporting the falling domestic sugar prices and reduce inventory," says Emkay's Ajay Parmar. However, this incentive has raised questions from the Election Commission because of the forthcoming polls in Uttar Pradesh. Thus, there is uncertainty here for investors.

Buffer stock
Besides exports, the industry is also expecting the government to make a buffer stock of 20 lakh tonne of sugar for the next two years. The buffer stock will facilitate companies to reimburse the cost of interest and warehousing cost and in turn help to carry inventory.

During the sugar season 2005 and 2006, the ratio of inventory to consumption was the lowest at about 15-20 per cent. The industry was feeding on the inventory due to a shortfall in production. Moreover, the companies were able to carry inventory comfortably given the benefit of rising sugar prices. In effect, low cost inventory was sold at high prices boosting the operating margins.

But the reverse will happen with the rising production and increased inventory. As per estimates, the inventory may go up to 4-5 million tonne in the sugar season ending September 2007, almost 20-25 per cent of the sugar consumption of 19.9 million tonne. This will have a serious impact on the cost of carry and margins of the company.

However, if the government is successful in creating the buffer stock, it will take care of inventory holding cost, which is generally estimated at about 15 per cent of the total cost of production in the industry.

Ethanol
In recent times, the Indian government is realising the importance of ethanol blending with gasoline and is trying to implement 5 per cent ethanol blending with petrol and diesel. The recent news of opening up of tenders for ethanol at Rs 21.5 per liter from Indian Oil Corporation was positive for the sugar industry.

According to industry estimates, the country has a capacity of 10.9 million tonne of molasses, used in making the ethanol. At 5 per cent blending the total molasses needed is about 3.7 million tonne and about 7.3 million tonne for the 10 per cent blending. So the present capacity of molasses is more than adequate for implementing ethanol blending even at higher levels.

But the slow progress in implementation and delays in discovering the right price for ethanol has been the cause of worry. This has also resulted into a fall in molasses prices from Rs 4,500 a tonne a year back to about Rs 2500 a tonne currently.

Analysts are not very optimistic about the implementation of the ethanol plan. Sugar companies will benefit only when it is implemented at a larger scale. "The income from ethanol still accounts for about 5 per cent of the total net profit of these sugar companies, while the rest is still dominated by the sugar and that is not doing well," says Edelweiss' Panja.

The view, which most analysts share is that ethanol cannot make a big difference to the earnings until it is implemented at a faster pace and at a larger scale.

Outlook
"We foresee one more quarter of subdued earnings," says R Rajgopal, head-equity, DBS Cholamandalam Mutual Fund. Adding to the same view, Emkay's Parmar suggests, "Investors should wait for the March result to come out, as it will indicate a clearer picture. Moreover, the current market scenario is not very conducive for investment."

Though the recent measures seem positive, they are mired in uncertainty on account of global sugar prices and the UP elections. The visibility is no better than it was six months ago, and rising global sugar production and falling prices will continue to put pressure on sugar companies.