Riding India's sugar cycle 

Riding India's sugar cycle

Commentary: Output shortfall may help sugar-refiner stocks for now

By Shikhar Balwani

Last Update: 8:51 PM ET Nov 29, 2009

MUMBAI (MarketWatch) -- The middle-class Indian household would do well to cut down on sugar intake this Christmas and New Year, not as much to control calories, but to keep expenses under check. A continuing shortfall in output in India -- the world's second-largest sugar producer (after Brazil) -- is likely to keep prices of the sweetener pretty firm.

India's output in the crop-year that ended in September is estimated to have fallen significantly to about 15 million tons, from 26.3 million tons in 2007-08, as farmers switched to more profitable crops.

With domestic demand in India -- also by some counts, the world's largest sugar consumer -- projected at 22 million-23 million tons annually, 30% of which is directly used by households, the huge demand-supply mismatch has already sent local prices soaring by 87% to 3,500 rupees ($75.80) per 100 kilograms since Jan. 1.

While the consumer frets, refiners are surely not the ones complaining. Price realizations have climbed and stocks have sweetened. Shares of top Indian sugar firms like Shree Renuka Sugars Ltd., Bajaj Hindustan Ltd. BJJH.Y and Balrampur Chini Mills Ltd. have more than tripled (and in some cases more than quadrupled) in the last 12 months, against a rise of little over 84% for the Bombay Stock Exchange's benchmark 30-stock Sensex.

But as the South Asian nation stares at another deficit in 2009-10, market watchers say firm prices still make sugar stocks a compelling investment proposition over the next six to 12 months.

To put things into perspective, let us go back a bit in time. India's sugar sector in the last two to three years has been anything but dreary. Two years of bumper harvests until September 2008 caused an oversupply of the sweetener, prompting the government to export the commodity. The excess production shrunk prices in the domestic market, and with them slipped the realizations for mills. Mill owners, in a quest to save margins, paid the farmers less for the cane they produced.

The understandably disgruntled farmers switched to more profitable crops, such as wheat, turning the entire sugar cycle (one cycle typically lasts two to three years, as production adjusts to changes in price) on its head and hurling the industry from an oversupply zone into a deficit.

Well, if only the problem ended there, and the industry was not hit by the vagaries of the rain gods. India's annual monsoon rains, which were at their lowest in 37 years in 2009, withered the cane crop (output dropped by about 9% from the previous year to 249.48 million tons), raising concerns of another big deficit in the crop-year that began Oct. 1.

Ironically, late unseasonable rains caused flooding in sugar-producing states such as Maharashtra and Karnataka (which make about 40% of total production), delaying the crushing of cane, which usually begins in October, by about a month. Though the actual impact is yet to be known, the excessive rainfall also likely diminished recovery of sugar from cane, further hurting output.

Crushing was also delayed in Uttar Pradesh, India's second-biggest producer after Maharashtra, as farmers -- watching prices soar -- went on protests seeking higher payments for cane. The deadlock was recently solved after most of the 130 sugar mills in the state agreed to pay farmers 190-195 rupees per 100 kilograms for the cane, higher than their previous offer of 180-185 rupees.

Thanks to all this, India's output in 2009-10 may slip below an earlier estimate of 16 million to 17 million metric tons, and the government -- which had already presided over India's switch to importing sugar in 2009 from being an exporter until 2008 -- is making plans to import even more. (Credit Suisse estimates imports at about seven million tons in 2009-10)

Indian imports have already impacted global supply of the sweetener and caused prices in the world market to spike by 70% since February. According to Switzerland-based research firm Kingsman SA, the world faces an 8.3 million metric ton sugar deficit in 2009-10, mainly due to lower production in India.

With farmers switching back to the cane crop and hopes that the rains will oblige next year, there is growing expectation that the sugar cycle will turn in 2010-11. The International Sugar Organization expects production in India to rebound to around 24 million tons in 2010-11.

That, as one can see, is still some time away, which supports the case for investing in sugar stocks.

Sugar could sweeten portfolios

The trend of rising prices is likely to more than offset the increase in costs of procuring cane from farmers, analysts say, adding that firms are enjoying high margins of six to eight rupees per kilogram. Credit Suisse said in a recent report: "Less than a rupee rise in realization is sufficient to offset our worst-case assumptions on cane costs and sourcing."

However, there are events that could turn things bitter: Sugar demand in India -- which is generally high in the September-December period on account of the Hindu festival season that is followed by Christmas and New Year's -- could fall significantly thereafter. Also, any shift in the government's stand toward reining in prices, rather than ensuring domestic supply, could act as a negative.

Still, analysts see these as short-term concerns, adding that earnings visibility for firms will improve as higher profits could see them use the additional cash to fund expansions and/or repay debt and trim interest costs.

This could likely prompt analysts to upgrade their estimates, putting to rest some valuation concerns. In fact, HSBC Research recently upgraded forecasts, saying it expects an average earnings growth of 26%-72% for sugar companies for the next two years.

Mumbai-based independent investment adviser S.P. Tulsian, who tracks the domestic sugar industry closely, expects sugar stocks, including those named above, to see an upside of about 40% over the next six months.

So while the investor may stand a decent chance of making money on sugar stocks, the consumer can do little but wait and hope. As the Chinese proverb goes, "You can't expect both ends of a sugar cane to be as sweet."