Buy Sugar Stocks: Sovid Gupta, Fairwealth Securities

sugarICE sugar hit a fresh 28-year high on August 29, with the Oct contract taking out the Aug. 12 high of 23.33 cents per pound and peaking at 23.63.

History:

The area under cane cultivation since October 2008 has reportedly gone down from 28.5 lakh hectares in 2007-08 to 21.40 lakh hectares. The fall can be attributed to bumper crop, increased stockpiles and delay in cane payments in 2007.

More than half of the districts in UP and Maharashtra (leading cane producers of the cane) have been declared drought hit, thus Industry expects are expecting India to turn from surplus in 2007 to a deficit of 5 MT by 2010.

Going Forward:

Sugar sector cycle likey to keep sugar prices high for next 2-3 years, till that time we expect India's ethonal blending program to catch up which will fuel further demand leading to still overall shortage for sugar. Investment Rationale:

Domestic production in sugar season '09 is expected to be between 14 Mt and 17 MT.

Sugar production in the current season is expected to be around 16 mn tons, which will result in a deficit of more than 5 mn tons for the season. Further lower acerage due to shift in other crops and bad monsoon will effect supply in the next season as well.

International prices are at very high levels: International raw sugar prices are at around cents 24/lb, while sugar rally on International exchanges lead only by Inda's Sugar deficit. Indian retail sugar prices have to rise as Indian refiners will have to pass on the high raw material cost to consumers.

Levy price hike imminent: In a recent interview with a leading news channel, Sharad Power has said that levy price is imminent. Industry expects new minimum price at Rs.
20 and levy to be increased from present 10% to somewhere between
15-20%.

Cane purchase price will rise substantially in FY10E, to around Rs. 1900 per tonne from around 1600 per tonne however mills will be more than compensated as our estimates put sugar realization above 30Rs/kg, which will provide a huge boost to sugar companies profitability, according to our estimates average costing for Sugar companies at around 20 Rs. Per Kg. Operating profits margins are likely to rise from current 20% to around 30%.

According to our commodity experts, the kind of movement sugar is witnessing, prices of sugar are likely to remain high over next 15-18 month.

Ethanol Fuel:

Together, Brazil and the United States lead the industrial production of ethanol fuel, accounting together for 89% of the world's production in 2008.

Brazil produces 40% of global Industrial alcohol. It has been using ethanol s a fuel as early as 20's and current limit for ethanol blending stands at 25% ethanol and 75% alcohol.

Key Risks:

1. Sustained low prices of crude oil is likely to prompt Brazil to convert more sugarcane to sugar rather than ethanol.

2. Weakening of Brazilian Real will also increase exporters' realisation.

3. In the medium to long term the prices are likely to follow the sugar cycle. Hence prices of sugar cannot remain high for than the cycle of 2-3 years.

In a very long term however we feel that Sugar prices will rise very high as India will set minimum limit of 10% blending. Also trade deficit is one of the major hindrance to India's growth and compulsory blending of Sugar will serve the dual purpose of Rural Employment and managing trade deficit.

Another major factors that has to be kept in mind is that current Congress Government has had a strong focus on Rural growth, and strong focus on Ethanol blending will make India a truly progressive state. It was the same government that adopted a National Policy on Biofuels which targets 20 per cent blending by 2017 as near as September 2008.

India with world's second largest arable land after Brazil, holds considerable potential for the same.

We initiate a buy call on the entire sector however we also attach medium risk as there are a lot external factors influencing the sector; biggest factor is Brazil's cane production and global Oil prices.

Based on our analysis we have picked up 4 mid cap companies, which can provide superlative returns, second rung sugar companies are trading at huge discount to larger players like Shree Renuka Balrampur Chini and Baja Hindustan. While our companies have 1/4 of Crushing and Refining capacity, these companies are trading at
10%-15% valuation of large caps. Factors we have kept in mind while short listing key players in the sugar sector are:

1. Revenues of sugar as percentage total revenues. Criteria : Minimum 50%.

2. Debt Equity Ratio: D/E is very high for companies across the board. Thus capital Expenditure will be slow.

3. Operating margins and Interest costs. Interest costs has been the biggest hindrance to profitability as all the compaies have raised huge debt.

4. Market Cap to Sales or Market cap to crushing capacity. Reason: We are not looking at integrated players Over next two years gross margins will be high for companies who have maximum sales from sugar rather than saleable surplus power or molasses.