Our industry view moves to In-Line from Attractive: our checks indicate higher production for the 2012 sales year, implying reasonable balance and limited pricing power. We downgrade BRCM (Balrampur Chini Mills) to Equal Weight from Overweight and BJH (Bajaj Hindustan) to Underweight (earlier EW).
Where we differ: Consensus is constructive despite near-term uncertainties on fundamentals. Uncertainty #1: While there seems to be no question that exports will be allowed, the questions are how much, by when, and how feasible? Our global commodities team highlights downside risks to sugar prices, forecasting 22 cents/lb in 2012 and 19 cents/lb in 2013, i.e., 15-17% below forward curve. Uncertainty #2. What is the likely increase in cane price (in context of Uttar Pradesh state elections in CY2012)?
Our view: i) We expect production of 26m metric tonnes and exports of 3m MT in the forthcoming season, leaving a reasonable balance of 3.4 months.
ii) We believe there will be limited pricing power for millers in a surplus year, and we expect export allowance to support domestic sugar prices.
iii) We forecast cane prices to increase by R100/MT, to R2,300/MT.
iv) News flow on production, exports and cane prices over the next couple of months is likely to result in sharp volatility. We have cut our Ebitda estimates for BRCM by 37% (Mar-12) and for BJH by 50% (Sep-12). Bulk of our earnings cut is because of sugar realisations.
Risk-reward balanced for now: Valuations appear reasonable, but stocks are likely to be volatile over next six months. Government decisions on levy quota (+ve), release mechanism (+ve), exports (+ve / -ve) and cane prices (+ve or -ve) are probable catalysts.
Production Estimates?We expect sugar production of 26m metric tons (MT) in the 2012 sales year (SY12) Sugar production is notoriously difficult to assess, as stocks price in expectations of sugar balance in the ensuing sugar season. We expect higher sugar production of ~26m MT for SY12. Cane planting acreage has increased by 5% YoY (year on year), and spatial monsoon for the season under way seems to be satisfactory as per our channel checks for the sugar cane crop so far.
Consumption Estimates?We expect sugar consumption of 22m MT in SY12. Consumption has come in lower than our and consensus expectations for SY11, but this has been marginally offset by higher exports. We expect 22mn MT of consumption in SY12.
Implications?Inventory looks reasonable, and we expect steady sugar price in SY12. Higher sugar production (26mn MT) and exports (3mn MT) are likely to support domestic sugar prices. We forecast ~28% stock-to-use ratio for SY12. Where we could be wrong: i) Higher / lower than expected sugar production for SY2012. ii) Government allows sugar exports higher/lower than our expectations.
Cane Costs?Likely to increase in SY2012 and remain a key risk? In view of forthcoming UP state elections, we have factored in higher cane costs. We expect cane costs to increase by 5%, to R2,300/MT, in SY12, up from R2,200/MT in SY11 for BRCM and BJH. To put this increase in context, in the previous UP state election year, fair and remunerative price (FRP) increased by R100/MT. However, current news flow suggests stiff lobbying by farmers negotiating for a steep increase in support price. With continued uncertainty over cane costs, we expect stock prices (particularly North India-based) to remain volatile over the next couple of months.
Where we could be wrong: Cane costs rise more than our expectations. We prefer Shree Renuka Sugars (SHRS) in this scenario, as it operates in the states of Maharashtra and Karnataka, which have co-operative structures and hence relatively better visibility for cane costs. For SHRS, we expect a decline of R100/MT in cane costs.
What would make us bullish?
Sugar industry de-control. Two consecutive years of surplus production provide an excellent opportunity for beginning the de-control process. Sugar industry has already started to lobby hard for dismantling the release mechanism and abolishing 10% levy quota. These decisions would lead to better earnings. However, structural re-rating can occur only when cane price is linked by a formula with the end sugar price.
Ethanol prices linked to domestic petrol prices.
Government is reviewing a policy to align ethanol and petrol prices (with quarterly resets retrospectively for sales since Jan-11). Such a policy, in our view, augurs well for earnings growth.
Production is lower than our expectation of 26mn MT (i.e., ~24mn MT), government allows exports of 3.5mn MT, and cane procurement prices are steady in UP.
What would make us bearish?
Cane procurement prices rise in UP more than our projected R100/MT; production is higher than our 26mn MT forecast (i.e. 28m MT), while exports of 4mn MT, still leading to comfortable balance situation.
Ethanol volume/realisation are lower than our expectations.
?Morgan Stanley