Among the biggest wealth creators during 2005-06, sugar stocks have seen some action of late. Reacting to higher sugar prices, the share price of bigger sugar companies has risen between 2-35 per cent in the last three months, which is reasonably higher as compared to the decline of nine per cent in the value of BSE Sensex.

Over a year, too, on an average, share prices of these companies have risen between 40-110 per cent as compared with the fall of 2-3 per cent in the value of Sensex.

Among reasons for this outperformance is that sugar prices have risen to Rs 1,995 per quintal (Rs 19.95 per kg) in August 2008 compared to about Rs 1,500 per quintal in July 2008.

Though the same has corrected in the subsequent days to current levels of about Rs 1,890 per quintal, they are still 34 per cent higher than prices a year ago.

The driving forces for the rise in sugar prices are considered to be the changing fundamentals of the industry such as lower acreage, expected decline in production, growing consumption, plans of higher ethanol blending and reports of significantly lower inventories during the coming season. The possibility of decontrolling of the sugar sector should also prove positive for the industry.

Although the change in fundamentals could prove beneficial, the question is whether there is a case for investing in sugar stocks?

The Smart Investor looked at some of these developments and spoke to domestic and international experts to check if investors can again benefit out of the changing fundamentals of the industry or if it is just a pipedream.

Historically the earnings of the sugar companies have been very volatile due the cyclicality of the industry and the frequent government interventions.

This is also one reason that during certain time periods sugar stocks have given phenomenal returns (like during 2004-06), while in others they have hugely disappointed investors (like during 2007) when sugar stocks underperformed the broader markets.

The unpredictability of policies and sustainability of earnings by these companies are also among reasons why many investors fear to invest in sugar stocks. To know about the issues surrounding the sector read on.

Supply constraints

Higher sugar prices are driven by the expectation of a drop in domestic sugar production during 2008/09 season, which starts in October.

According to estimates, India's sugar production is pegged at 21.5-22 million tonne during 2008-09 as against the 28.2 million tonne in 2006-07.

Notably, the estimated production is marginally lower than the domestic consumption of about 23 million tonne. But, if one adds the 1.5-2 million tonne of estimated exports during this period, there could be a deficit in the domestic market.

This drop in sugar production is on account of the lower acreage. Farmers, who are believed to be facing problems with regards timely payment (for sugarcane cultivated) and the fixation of sugarcane prices, are shifting to other crops. Notably, other crop options like wheat, rice and maize are considered to be more lucrative. The government has been increasing procurement prices for these commodities.

For instance, over last two years the MSP (minimum support price) for wheat has been increased by 33 per cent to Rs 1,000 per quintal for FY09 and for rice by 37 per cent. Compare this with the sugarcane prices, which have been stagnant and surrounded with uncertainties. The statutory administered price for UP (the key sugar belt) sugar mills has remained unchanged at Rs 125 per quintal of sugarcane.

Till such time, the sugar industry may find it difficult to procure adequate sugarcane and thus, may have to live with lower sugar production, and thus feed on inventories. Experts estimate the inventory to drop from 8.7 million tonne in sugar season 2006-07 to 3.9 million tonne in 2009-10 (about 1.8 months of consumption). Positively, this would free up some working capital for companies.

Word of caution

Overall, many see this as an opportunity, which will ultimately result in higher sugar prices and benefit the sugar companies. Sugar prices, which were trading at about Rs 1,500 a quintal during July 2008, crossed Rs 1,900 a quintal till some time recently.

"From a two year perspective, the sugar industry is showing positive signs considering low inventory and declining production. Thus, we also expect sugar prices to go up from March 2009 onwards," says Pranshu Mittal, sugar analyst, Centrum Broking.

However, Mittal also cautions that, "The opportunity for investors though may not be the same as witnessed during the FY04-05." There is a need for investors to look at developments of FY04-05 wherein the sugar mills benefited on account of significant rise in sugar prices (from Rs 13-14/kg to Rs 18-19/kg) and low sugarcane prices.

Also, during this time the production was just about 12.7 million tonne as compared to consumption of 18.5 million tonne. In the current scenario, the difference between production and consumption is not wide enough to support higher prices.

Also, even if the production drops going forward, the companies will produce less and sell less. This in turn will negatively hit their volume growth.

Thus, even as realisations are higher by 30 per cent, a drop in volumes to the extent of 10-15 per cent will offset a part of these gains.

"We expect the production to drop by about 15 per cent. This will also have an impact on the topline growth of companies. On the positive side, a part of this will also be compensated as last years inventory will be sold this year," says the chief financial officer with a leading UP-based sugar company. So, effectively, companies are unlikely to see any significant rise in their toplines.

Additionally, based on the demanded sugarcane price, the cost price works out to Rs 13-13.5 per kg. Add to this, Rs 3-3.5 per kg towards processing or conversion charges and Rs 1.5-2 per kg towards fixed charges (depreciation and interest), the total cost works out to Rs 17.5-19 for each kilogram of sugar produced as compared to the domestic wholesale sugar prices of Rs 18-19 per kg.

Clearly, since the cost of production is almost equal to the selling price, the companies are unlikely to make substantial profits from the sugar business.

"Even if the production is expected to drop, the sugar prices needs to be above Rs 20-21 per kg for these companies to make decent profits,"says Vikram Suryavanshi, analyst, Karvy Stock Broking.

"Also, as most of these companies have added new capacities, which if not utilised fully given the low availability of sugarcane, the same will hurt them due to the increase in interest and depreciation costs," adds Suryawanshi.

Sugar prices

Though the current scenario is supportive for higher sugar prices, there are many concerns that hover around the industry, which may not allow sugar prices to go up further.

Firstly, since sugar prices get reflected in the inflation rate (weightage of about 3-4 per cent), it is widely anticipated that the government may not like to see sugar prices rising further.

In fact, the government is considering different ways to control sugar prices, including the recent release of 11 lakh tonne sugar quota in August 2008; another 12 lakh tonne is expected to be released in September. This increase in supply is seen as sufficient to keep sugar prices in check.

"In the near term, we do not see prices to rise as the government is having a buffer stock of about 22.5 lakh tonne, which it will keep on offloading in the market to check the sugar prices," says S P Tulsian, CEO, Premium Investments.

Little wonder that domestic sugar prices have recently corrected by about Rs 100 a quintal. Additionally, there are expectations of the government withdrawing export subsidy on sugar. Besides, with global sugar prices trading relatively lower at about Rs 1,400 a quintal, importing sugar is a viable option.

Diversification is the key

It is believed that companies which are well integrated (having ethanol and power generation capacities) will be least affected.

"The revenue contribution from the distillery and cogeneration businesses are expected to continue rising for most players, as new capacity becomes operational. With a large pass-through to the bottom line," says Srinivas Macha, vice president, Aranca, a global offshore research services company advising institutional clients.

But there are uncertainties as well. The existing scheme of implementing five per cent ethanol in the gasoline is not fully implemented and there is no certainty that the government will implement its next levels of 10 per cent blending, which is expected from October 2008.

This is primarily due to the non availability of the sugarcane in the country. Besides, the government may not like mills to divert more cane to produce ethanol since the production of sugar is expected to be lower and there are chances that it will have impact on the sugar prices and thus inflation.

Also, selling ethanol at the current price of Rs 21.50 a litre is not proving to be lucrative due to higher input costs (molasses is trading at about Rs 5,000 a tonne as against Rs 3,000 in FY07).

The gains from the ethanol business could however, prove to be a big positive trigger, only if the oil marketing companies agree to pay a higher price (Rs 24 per litre or more) and if the government implements the blending program.

In the longer run, as Dr Peter Baron points out, that for the domestic industry to do well, there is a need for long-term planning wherein the farmers, oil marketing companies, sugar companies and others (including policy makers), come to a workable solution that provides increased predictability in cropping pattern, input and output prices, and ethanol blending policy among others. Only then, will there be gains for players across the value chain.

Conclusion

Although the changing fundamentals look positive on the face of it, considering the above mentioned developments there is need for investors to exercise caution.

For those with patience and willing to take risk, analyst suggests to buy companies which are well integrated. They also suggest that companies with presence outside UP (Uttar Pradesh) are relatively better bets.

"If investors have a long term view on the sector, they can invest in the non-UP sugar companies," says S P Tulsiyan. "Pick companies, which have location advantage and are not affected with the litigation over sugarcane prices, such as south-based companies," says Suryavanshi.

Among companies that fit these criteria include Shree Renuka Sugar, Balrampur Chini [Get Quote] and EID Parry. But, for the fortunes of the entire industry to look up, sugar and ethanol prices have to rise and, that too, faster than input cost.

Shree Renuka Sugars [Get Quote]

The company is insulated from the sugar cyclicality. This is due to its presence in sugar refining and also as its mills are located in south India, where cane prices are linked to sugar prices.

The company is reducing its dependence on the sugar business by increasing focus on the ethanol, distilleries and power generation businesses, as well as expanding capacities. This should also lead to doubling of revenue share of non sugar businesses from 20 per cent in FY07 to about 40 per cent in FY10.

This is also a reason why the company's profitability has not suffered as badly as compared to others. The stock trades at 16 times its 2009 estimated earnings and 12 times 2010 earnings (year end is September).

Balrampur Chini MILLs

Balrampur Chini, though based in UP, is relatively more integrated and low on debt. The company is focusing on non sugar businesses as a result of which its revenue from them (distilleries, power generation) have gone up from 22.3 per cent in 9 months of FY07 to 29 per cent in 9 months of FY08.

This has also helped it to post better results. The stock trades at 9 times its FY09 estimated earnings.