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Stocking up on Sugar

The crisis in the commodity may have an effect on certain companies’ stock

Here is a reason to worry. “This year sugarcane production is less and prices are rising to Rs 25-26 a kg or more,” said Agriculture Minister, Sharad Pawar, laying out a crisis in the sugar industry.  The urgency stems from the fact that the festival season is on us and government is desperate to escape citizens’ wrath if pricey sugar takes sweetmeats out of their reach.

For investors in commodities this is an opportunity, albeit framed in danger because the Indian sugar industry does not follow the demand/supply principle, on which the price of any commodity in the world is decided. What impinges on the sector and aggravates the cyclical nature of the industry here is government regulation.

What makes government regulate the industry is that sugar, at 3.9 per cent, has the second-highest weightage in the calculation of the wholesale price index (WPI). Sugar also falls under the category of an essential commodity. Therefore, to prevent any social backlash, government keeps stepping in. Intervention is undertaken in two ways:

1) On the supply side, the regulation ensures that farmers get a fair price for sugarcane — this distorts prices away from supply/demand prism;

2) On the demand side, it tries to ensure the commodity does not become too expensive.

But the crisis that the government and the country is facing is that the sugar industry is caught in an ‘up cycle’ which translates into falling production, rising imports and skyrocketing prices. The trend is a concern as, despite imports, sugar inventories maintained by the government as buffer, will fall to a 30-year low, as per CLSA.

To add to the woes is the news that a deficit in the global market is looming and, in conjunction with lower-than-expected production in India, which powered imports, they caused a surge in world prices in June to a 3-year high. This comes in wake of a 44 per cent fall in production of sugar in sugar year (SY) 2009 in India on the back of a 17 per cent fall in area under sugar cultivation, this was itself fuelled by rising arrears to farmers of 14 per cent of cane price payable at Rs 39 billion.

The crisis is unlikely to abate despite the fact that India has notched up the second-highest year-on-year (YoY) growth in cultivated area in the SY09. What is more, says CLSA, the severe availability crunch may ease in 2 years. The last-ditch effort of the government to ensure stability in availability and prices has led it to ensure a high supply of the commodity by its release mechanism. However, all that this is doing is postponing the inevitable problem of shortages towards the end of the current sugar year.

“Unlike previous up cycles, which ended with the initiation of government action in the form of duty free imports of sugar, the current ‘up cycle’ is likely to continue. Further rise in sugar prices is expected as this increased supply is absorbed by the market and the tightness in availability appears. With government action behind us, supply-demand fundamentals are expected to drive the ‘up cycle’ from hereon,” says CLSA.

Adding to the overall troubles is that there is no coherent and comprehensive price-setting regime. There is one price-line by the Centre and another by states. The confusion over setting of SAP (state administered price: the rate at which mills pay farmers) led to a case in Supreme Court  — it had forced farmers to shun sugarcane. The effect of SAP was that during certain periods retail price of sugar was lower than that of SAP, which leads to arrears in payment to farmers by mills. SAP has varied between 30-70 per cent higher than statutory minimum price (SMP) that is set by the Centre.

The Centre has taken a number of steps to check prices. This includes extending stock holding limit for six months,  ban on futures trading to avoid speculative surges (even though there is no evidence of any causal relationship between the two) and it has allowed companies to import raw sugar and removed duty. Central undertakings like STC, MMTC, PEC and NAFED too have been allowed to import sugar with zero import duty.

Essential Events
The Cabinet Committee on Economic Affairs fixed SMP for 2009-10 season at Rs 107.76 per quintal. In 2008-09 season it was Rs 81.18 — the UP government may fix SAP at higher rates.

Politics may impact prices elsewhere — Pawar’s MCP in Maharashtra will look to curry favour with the industry — assembly polls are due. That means SMP may rise further. A 10 per cent rise in price of Levy sugar, which is linked to SMP and is paid on 10 per cent of mills’ sales, should turn into a 1-3 per cent rise in companies’ EPS, CLSA adds.

With sugar prices to remain high, and alcohol and molasses prices set to rise, margins for companies (Rs 8/kg and Rs 8.4/kg in SY10 and SY11) may remain comfortable. Also, due to low inventory and high demand in festive season, prices won’t fall and hence increase opportunities for companies like Bajaj Hindusthan (BH) and Balrampur Chini (BC). BH is Asia’s largest and one of the top five manufacturers in the world. Since western UP, where the company is very strong, is a well-irrigated area and has historically lower volatility in production, the company’s supply of sugarcane should not be affected much. BC will reap the benefit of its recent capacity expansion. It also has the largest marketable power capacity among all the other Indian sugar companies.

Current ethanol contracts at Rs 21.5/liter will end in SY09 and there could be a revision thereafter. The company that may benefit is Renuka Sugars which has high leverage to alcohol/ ethanol prices. It is also well-positioned to take advantage of international trading in the commodity besides monetising by-products.

The yo-yo nature of the sugar industry has had its deleterious effects on the companies engaged in the business. Over the last three years they have seen a fall in net profit by as much as 92 per cent in SY08. Indubitably, this has hit investor confidence in the industry. To a large extent, companies themselves were to be blamed for their fate. They had gone in for large capital expenditure devoted to huge expansions. This they did through debt and the consequences were disastrous. Highly leveraged balance-sheets along with high interest rates combined to reduce the industry to a sorry state.

The need of the hour is to reduce debt and work towards a better realisation in prices. It  will give them the chance to escape the cyclical nature of the business and increase profitability.