The Hindu Business Line : Hold them for sweet returns

SUGAR stocks have flared up on the bourses over the past two weeks, notching up significant appreciation in values. Despite the recent run-up, shareholders can hold both their frontline and second-rung sugar stocks. Fresh exposures to smaller companies, especially those that have managed a recent turnaround, should be considered only by investors with a high risk appetite. But within this space, the KCP Sugar and Industries stock appears attractive on a relative valuation basis.

Recent market and policy developments have significantly improved the earnings prospects for sugar companies thisyear. The demand-supply balance for the domestic sugar market in 2005-06 is likely to be tighter than expected. As a result, sugar prices look set to firm up, rather than merely remain flat over thisfiscal. Taken with the significant recovery in cane crushing volumes expected this year, this places companies in a good position to deliver healthy earnings growth for the current fiscal.

With the sugar and the oil marketing companies hammering out their differences on ethanol pricing and supplies, additional revenue streams for sugar producers from the supply of ethanol (a byproduct from sugar crushing) are also likely to open up.

Tight supplies likely

After the sharp drop in sugar output over two consecutive years, the 2005-06 sugar season (October-September) was expected to see a significant recovery in output to about 175-180 lakh tonnes, mainly due to increase in sugarcane acreage in Maharashtra. Production during the season, taken with brought-forward stocks of about 35 lakh tonnes from the previous season, was expected to comfortably meet domestic consumption of about 190-lakh tonnes for 2005-06.

However, a couple of recent developments suggest that the demand-supply balance for sugar this fiscal could be tighter than expected. This week, Pakistan lifted a four-year old ban on sugar imports from India. Supply deficits are also expected in neighbouring markets such as Bangladesh. This opens up export possibilities for sugar mills in the northern markets. Export to Pakistan and Bangladesh markets offers the advantage of lower freight costs and better realisations. Indian sugar mills may see this as an opportunity to fulfil the export obligations that they have acquired over the past year as a result of their raw sugar imports.

The Government has recently shortened the export window available to mills from 36 months to about 24 months, reducing the time-frame available for companies to push through exports. Sugar mills have imported about 20 lakh tonnes of raw sugar over the past couple of years for process and sale in the domestic market. Even exports amounting to half this quantity will significantly tighten the domestic supplies of sugar.

Prices may be firm, rather than flat

sThis suggests that the softening of sugar prices, expected due to the sharp recovery in sugar output in the coming season, is unlikely to materialise for now. Instead, domestic sugar prices could remain firm in the Rs 17-18 a kg range, which would amount to a 10 per cent increase over the previous year's levels. Given that most sugar producers will register substantial volume growth this fiscal due to higher crushing volumes, even marginally higher prices may deliver a significant boost to earnings.

A clear picture of the change in sugarcane acreage in Maharashtra on account of the recent floods is as yet unavailable. The State is expected to account for the major portion of the increased output this year. If there is a reduction in the crop, this could further tighten supplies and bolster sugar prices.

Investment outlook

After the recent appreciation in prices, frontline sugar stocks such as Balrampur Chini Mills, EID Parry, Bajaj Hindusthan and Bannari Amman Sugars trade at price-earnings multiples of about 14-15 times their trailing 12-month earnings. Strong prospects for earnings growth over this fiscal may leave room for a further 10-15 per cent appreciation in these stocks. However, this is a risky time to enter frontline stocks, as their valuation levels are stiff compared to other commodity businesses. That these valuations are reckoned on earnings at the peak of the sugar cycle also pegs up the risk. Among the mid-sized companies, investors can consider taking exposure to the KCP Sugars stock. With its price-earnings multiple at about seven times its trailing earnings, it appears attractively valued vis-à-vis its peers.

Investors in sugar stocks need to take an active approach to profit booking at this juncture. With the sugar cycle already at its peak, earnings prospects for the companies could be significantly altered by relatively small changes in crop prospects or sugar prices. There is also a strong possibility of a cyclical reversal in sugar prices a year down the line, as good rains in the current year could substantially improve the sugarcane prospects for the 2006-07 season. Apart from this, the size of the sugarcane crop in Maharashtra this year and the actual quantum of exports shipped out during this season, would be important factors to watch for those holding sugar stocks.

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