The Bitter Truth

With sugar mills facing a mountain of arrears, on September 27 a worried central government announced the second bailout package in the past four months. But the assistance of Rs.55 billion failed to excite investors and along with the overall market, the stock prices of mills such as Balrampur Chini, Dhampur Sugar, Bajaj Hindusthan, Dwarikesh Sugar and Dalmia Bharat Sugar slid. Even as the government continues to take steps to rescue the beleaguered mills, low prices due to a supply glut and weak demand remain a major drag on sugar stocks. 

Last sugar season (SS) was not as turbulent as this one. SS ranges from October to September. Between October 1, 2016 to September 30, 2017, sugar stocks were flying high as the average sugar price rose 22% to Rs.42.43/kg, against Rs.34.73/kg a year ago. Sugar production had declined to around 20 MT that season from 25 MT the previous year. 

Then, the season turned, with a bumper crop. Record production — of 32 MT — in SS 2017-18 sent sugar prices and stocks sliding down. Between November 1, 2017 and May 16, 2018, Balrampur Chini slid from Rs.175 to Rs.59, Dhampur Sugar from Rs.316 to Rs.76 and Bajaj Hindusthan from Rs.15.4 to Rs.6.9. In April 2018, sugar prices had fallen to its 28-month low and against the cost of production of Rs.36/kg, sugar was trading at Rs.29/kg.

Overall, SS 2017-18 was a bad year for the mills. Profit dropped sharply (see: Collateral damage) and Ebitda margin also declined, turning negative in the March quarter at -4.5%, according to Crisil. The June 2018 quarter was no better. Ebitda margin of Balrampur Chini dropped from 18.19% in June 2017 to 12.91%, that of Bajaj Hindusthan from 9.36% to -5.13% and that of Dhampur from 15.88% to 12.39%. There is more bad news in store. India’s sugar output is expected to increase to 34.5 MT in the current season (October 2018-September 2019), whereas domestic demand currently stands at 26 MT.

Vote magnet

While the government continues to provide incentives to the mills, the problem — of oversupply and subsequent non-clearance of dues — is its own creation. No other crop is as closely associated with politics as sugarcane. For instance, the BJP which had swept the Uttar Pradesh Assembly polls in 2017 lost the Lok Sabha by-poll recently, in May 2018, in Kairana, where six sugarcane mills had failed to pay farmers’ dues.

This thumping defeat shook the ruling party. And, with 2019 general elections nearing, the Centre, on June 5, announced a Rs.70-billion bailout package for mill owners. If mills are in the pink of financial health, then they can pay their dues to farmers, who have a significant vote share in large electoral states such as UP and Maharashtra. 

After the spike on June 5, sugar stocks remained range bound till September 12. Then, on September 12, the government gave another booster shot. It decided to hike the price of ethanol, produced directly from sugarcane juice for blending in petrol, by 25%, and it set off another rally that petered off on September 18 as the overall market started tanking. 

Faulty construct

Crisil’s director, Hetal Gandhi, says that structural flaws in the industry have to be addressed first. The most damaging problem, she says, is the non-linkage of sugarcane prices to sugar prices. That is, when sugar cane production is on the rise and subsequently market prices of sugar fall, the procurement prices do not drop in tandem. Costs remain high for mill owners, who also have to bear the brunt of fall in sugar prices from oversupply. When the cycle turns — with a fall in production — the cane prices rise but sugar prices are not allowed to increase beyond a cap. 

“Sugar prices were market driven up to June 2018. Now, the government has set the minimum selling price for sugar too. But, it remains much below the cost of production,” adds Gandhi.

S Ranganathan, head of research, LKP Securities, adds, “The cost of production has remained at Rs.34/kg while prices have dropped to Rs.29/kg in August 2018.”

Over this strained book, the government places the final straw — farmer-targeted incentives, which feed a commodity glut. The Centre’s fair and remunerative price (FRP) and states’ state advised price (SAP) have encouraged farmers to grow more cane over the years — adding to the unsold pile. The central government’s FRP increased from Rs.210/quintal in SS 2013-14 to Rs.255/quintal for SS 2017-18. 

Apart from the government policies, Gandhi also attributes overproduction to higher recovery rate from a new variety of sugarcane. “A new variety of cane — the Co 0238 — sown in Uttar Pradesh in SS 2016-17, yielded a recovery rate as high as 11.8%, as against an average recovery rate of 10.5%. In SS 2017-18, over 90% of the area under sugarcane in North India was covered by this variety,” says Gandhi.

With the prices of sugar remaining under pressure at home, can sugar mills look abroad for better realisation? You would think so looking at the rupee depreciation but like the domestic market, even the international market is facing a glut. 

The International Sugar Organisation has estimated a sugar surplus of more than 10 MT in 2018 due to bumper production in India, Thailand and production ramp-up in Europe. In fact, international prices have been trending below the domestic prices since December 2016. The average international sugar price was Rs.22.5/kg compared with the domestic price of Rs.31/kg in October 2018. “Hence, companies are reluctant to export sugar at current prices despite the Centre fixing a minimum export quota for each mill, adding up to 2 MT for the entire industry for SS 2017-18. The industry has exported only 0.5 MT,” says Gandhi.

Ethanol boost

In the domestic market, the government has been announcing a slew of measures this year to arrest the slide in sugar prices. There were bailout packages for clearing dues and doubling of the import duty on sugar, even while scrapping the export duty. But the ethanol price hike from Rs.47.13 to Rs.59.13/litre triggered the sharpest rally. Analysts say the ethanol price hike is not just to help mill owners to clear the dues. Currently, ethanol only contributes 10-15% of the companies’ overall revenue. But, it has the potential to de-risk the companies by reducing their dependence on sugar and protect cash flows. “The entire scheme is designed to help companies shift towards production of by-products like ethanol,” says Ranganathan.

With the sugar glut towering, the ethanol price hike will have minimal impact in the near term. But according to Crisil’s Gandhi ethanol generates higher margin than sugar for integrated sugar mills. It is also less cyclical, and the supply is much below demand today. The industry supplied 1.65 billion litres in SS 2017-18 but, to meet the mandated 10% blending norm, OMCs would require around 3.3 billion-3.4 billion litres of ethanol.

Now, there is added incentive to invest in fuel ethanol. Earlier, the sugar mills were more inclined towards potable alcohol, as realisations obtained from fuel ethanol were lesser. In SS 2017-18, a litre of fuel ethanol fetched Rs.43.7/litre while extra neutral alcohol (ENA) fetched about Rs.45-48/litre. However, in SS 2018-19, the realisation from fuel ethanol has been fixed at Rs.59.13/litre while ENA still fetches Rs.49-50/litre. 

Cane and able

Ranganathan feels sugar mills with significant distillery capacity such as Balrampur Chini and Dhampur Sugar are better placed. In its FY18 annual report, Balrampur Chini, too, has claimed to have “sold nearly 15% more ethanol during the year under review.” Three of the company’s distilleries, which produce industrial alcohol and ethanol, can together process 360 kilolitres/day. The company sold 78,900 bulk kilolitres of ethanol in FY18, compared to 68,800 bulk kilolitres in FY17.

Similarly, Dhampur Sugar also has a sizeable distillery that can process 300 kilolitres/day. Even before the sops were announced, the company had planned to increase its ethanol production capacity by 33%. The company claims that its ratio of power generation and ethanol manufacturing vis-a-vis sugar capacity is among the highest in the country. The distillery and power business contributed 6.28% and 10.09% of its overall revenue in FY18. While large sugar companies are in an excellent position to benefit from the ethanol push, smaller companies such as DCM Shriram Industries are not. “DCM Shriram didn’t rally as much as the other big sugar companies, post the ethanol price-hike announcement, because it only recently announced plans to increase its distillery operations,” says Ranganathan. 

Bare facts

While sugar stocks did rally following the government’s announcement of the bailout package in June and ethanol price hike in September, analysts suggest a wait-and-watch approach. They also assert that the stocks could correct from the current levels as mounting debt and low prices will continue to eat into their profitability. Sageraj Bariya, vice president, institutional sales, East India Securities, says, “Due to mounting debt and poor profitability, some of the sugar mills won’t be able to undertake the expansion drive.” Like Ranganathan, he believes that big sugar companies such as Balrampur Chini and Dhampur Sugar are in a better position to take advantage of this. 

Ranganathan and Gandhi are not bullish yet. They believe that a complete recovery is still elusive. “Sugar companies can report robust numbers only if the price of sugar goes up as it provides 80-85% of the revenue,” says Ranganathan. 

Gandhi says that the industry’s reaction suggests that today only 20% of the sugar mills have the capacity to produce ethanol from B-heavy molasses. “Given the current infrastructure, the reduction in sugar output is expected to be only 0.5 MT-0.8 MT in SS 2018-19, from the estimated production of 34.5 MT,” says Gandhi. This would still be much higher than the sugar demand of 26 MT. She also adds that, with the supply surplus expected to continue in SS 2018-19 as well, a further build up in arrears cannot be ruled out. The cane dues to the farmers currently stand at Rs.130 billion as of August-end. The June bailout package would be able to only clear 40% of the arrears, according to Crisil’s estimate.

Given the prevailing uncertainty, most analysts feel it might be prudent to stick with majors such as Balrampur Chini and Dhampur Sugar. At its current price, Balrampur Chini trades at an EV/Ebitda of 6.62x compared with 6.17x in October last year. Dhampur Sugar is also trading at a higher EV/Ebitda of 7.10x compared with 6.07x in October 2017. In 2016-17, when sugar prices were at their high, with  production at a seven-year low, Balrampur Chini and Dhampur Sugar had reported net profit of Rs.5.91 billion and Rs.2.29 billion, up from Rs.1.14 billion and Rs.0.25 billion in the previous fiscal. However, in FY18, as the glut started weighing down sugar prices, the profit dropped by 62% and 34% to Rs.2.21 billion and Rs.1.51 billion, respectively. With significantly lower profit, and more or less similar valuation as a year-ago, stocks seem to be cheap. However, as glut and structural issues continue to dent profitability, sugar stocks may not see a rebound anytime soon.