Understanding Sugar Sector Part 2: "When Growth Kills"

In our previous post on the Indian sugar sector, we discussed how incumbents have found it extremely difficult to operate in a myriad of regulations that govern the operating cycle of the industry.

In this post we have tried to present a picture of how the companies in the sector stack up against each other by comparing them across some parameters that we find useful in comparing companies in the sugar sector and have highlighted our findings below:

Company Analysis

Commodity businesses derive their moats from being cost leaders and generally industry leaders tend to be the most efficient companies in the business as economies of scale works to their advantage. The cost intensity of manufacturing sugar means that companies must optimize cane procurement and conversion processes so as to increase the recovery rate.

However, as we can see in the sugar sector the leader seems to be reeling under extreme stress. We already know that a leveraged balance sheet in a cyclical sector lends itself to a plethora of pain when the force of gravity imposes itself on the business. The manufacturing of sugar is both fixed and working capital intensive and only a select few are able to withstand the wild cyclical swings. Shishir Bajaj led Bajaj Hindustan is the industry leader with a crushing capacity of 136,000TCD and has been the torch bearer of the stress faced by companies across cycles

We have compared Bajaj Hindustan to Balrampur Chini and Dwarikesh Sugar on select parameters to understand why the sector leader has performed in this fashion and how other companies have taken advantage of this and have highlighted our findings below -

• We first compared the gross margins of these companies to understand profitability that accrues to the sector. Incremental gross margins for an integrated sugar company are primarily driven by the sale of associated by-products as the marginal revenue accruing from these is significantly higher than the marginal cost incurred in the conversion process

The observations from the above data are quite intriguing especially in light of the fact that Bajaj Hindustan actually has the lowest contribution from sugar to its overall revenues

Sugar contribution to overall revenues for the three companies

• The most common yardstick of a mill's efficiency is the recovery rate of sugar. Within Uttar Pradesh, mills located in the eastern region of Bijnor have the highest recovery rates, due to usage of high-yielding early sugarcane varieties like CO 0238. These early varieties of sugarcane fetch the farmer Rs 10 more per quintal than the general variants.
  Bajaj Hindustan's mills are predominantly situated in and around the district of Lakhimpur Kheri which is towards the southern part of the state. We took the recovery rates for both DCM Shriram (a listed peer with a presence in the same region) and Bajaj to check how recovery rates differ for both companies
  
  
  

The difference in recovery rates is quite stark and as both companies have mills around similar geographies. To understand why Bajaj Hindustan has sub-optimal gross margins and recovery rates, we compare and analyze the cash conversion cycle for BHSL vis a vis its peers

The payable days for Bajaj Hindustan are nearly four times its peers - thereby leading to higher COGS as the company is obliged to compensate in the form of interest payments on its dues to farmers. Sugar companies have to keep a high inventory component as crushing is a seasonal activity but demand for sugar is secular, and while the other companies finance this through working capital loans, BHSL does it through delaying cane payments as the balance sheet does not have scope for further leverage

Keeping the cane farmer happy is central to the sustainability of this business - and any delay in payments has a prolonged impact on the goodwill of a sugar mill. Add to that, the penal consequences imposed on delayed disbursements are severe as the state government has imposed strict norms to ensure timely payments.

Source: Financial Express, 13th April 2017                                    

The natural chain of events would suggest to us that Bajaj Hindustan would invariably face the wrath of the farming community in the form of both low quality as well as quantity of supplies. We took the crushing capacity / day for Dhampur Sugar and Dwarikesh Sugar (both of whom have a presence in the area of Bijnor) in our effort to understand the root causes of in-efficiency for BHSL

(Bajaj Hindustan and Dwarikesh both changed their accounting months in 2014 and 2015 respectively)

Despite having the largest capacity, Bajaj Hindustan operates its mills for the least number of days in comparison to peers. The underlying scale of business hence loses out to operational in-efficiency, thereby creating a lollapalooza of ever surmounting debt and farmer agitation thus leaving the company in a situation of mess which is difficult to come out from.

We will continue this post with further work on companies highlighting how they have positioned themselves differently so that  once this honeymoon period for sugar sector gets over how can they emerge better positioned to weather the downturn in cycle that awaits them in future.

Capital Allocation - A tale of two companies: Reliance AMC & Motilal Oswal Financial Services

Investors have always been attracted to companies which are cash generating machines. The reason is simple. The cash generators survive market cycles. They keep doling out huge cash in turn which is either re invested if the business is in growth phase or returned as dividends if the company is in mature phase and doesn’t needs cash for reinvestment. In both the cases its beneficial for the minority shareholders because internal accruals is the cheapest source of capital for a company to build a business while if free cash is given off as dividends or buybacks it puts money in hand of shareholders directly.

While the free cash generation capacity makes these business attractive there is an inherent risk which lurks which some investors fail to identify. Capital Allocation becomes very important for a company which is generating huge amounts of cash from its operations. The simple thing to do would be to keep re investing in the business but not all businesses are at similar stages of growth. Thus some companies choose to give off the money as dividends to shareholders. However, in a case where a company does not share cash with shareholders but re invests in its business it needs to be identified whether the business is/will be able to generate returns higher than opportunity cost of capital for shareholders. Many times companies have squandered cash from good business in bad business while showing it off as diversification. However it becomes difficult for an investor to differentiate between diversification and wasteful conglomerisation. The loser is the minority shareholder.

We can see the difference that capital allocation makes on returns for a shareholder

• ITC has grown market cap at a rate of 22 percent over a growth in reserves of 19% while VST Industries has grown market cap. at a rate of 26 percent with a much lower growth in reserves at 11 percent
• While ITC ploughs money from highly profitable ciggarate business into loss making hotels, early stage FMCG, agri operations etc VST follows a simple approach of paying off cash as dividends
• The difference in returns for a shareholder in VST and ITC are there to see

To put in simple words an investment of Rs 1 lakh made in ITC 14 years ago would have resulted in Rs 16.55 lakhs while a similar amount invested in VST Industries would have resulted in Rs 25.5 lakhs. That is a difference of over 50 percent on the final amount. This is why capital allocation is important for companies and also for investors

Over the last few months a new space that has seen much action in the recent times, one due to inflow of money by domestic investors which has made the “assets under management” (AUM) touch new highs everyday while next due to the listing of one of the biggest companies in the asset management space – Reliance Nippon Asset Management Co. (RNAM) is the “Asset Management” industry.
 

The point that catches our eye in this industry is the ability to generate large amounts of cash flow and minimal use of capital to grow this business. This is a combination which will allow companies in this space (especially leaders) to generate large amounts of cash. We find this business to be very interesting because capital allocation will become very important when you have large amounts of idle cash. It is a great way to test management honesty and acumen.

We have already seen how capital allocation of management decides what will future returns are from a cash generator. Thus now let us have a look at how two companies in the AMC sector operate and let’s understand how they are allocating capital for themselves and their shareholders  

Motilal Oswal is a diversified financial conglomerate with varied interests in the areas of broking, asset management and housing finance. On the other hand, Reliance Nippon is a pure play Asset Management Company with a host of offerings that include mutual funds(both debt and equity) , Alternative Investment funds and Portfolio Management services for both individuals and institutions

First we would like to give some facts about the AMC industry in India

• There are 41 AMC’s in the country, of which 9 are owned by government, 7 by foreign and 25 domestic private institutions
•  Five of the top AMC’s control 57 percentage of the market with 36 accounting for the rest

Now we start our exercise in understanding the fund structure and capital allocation policies which both Reliance AMC & Motilal Oswal following terms of deploying the windfall that they get in terms of free cash.

 
Reliance AMC

To understand the implication of capital allocation policies, let us first look at the difference between core business pre-tax RoE's. The pre tax RoE in this case is equal to the PBT + unrealized income on investments divided by average equity

The profit before tax includes the component of other income which should be subtracted to understand core business RoE's. Similarly, the denominator should be reduced by the amount of interest/income earning assets that the company has invested into. The excel attached below shows the calculation for the same

Thus core ROE’s of AMC business which Reliance operates is on an average over 100% every year which portrays the operational strength of the industry in which it operates. The benefit of operating leverage once leadership position is established is enormous for the industry

Now to answer the question that why reported RoE's are so depressed in relation to core business RoE's?

We listed down all the investments that the company had made from its internal accruals and calculated the subsequent returns earned. To not obscure our findings, we included both realized and unrealized gains that have accrued to the company

Observation

1. The company practices a diversified approach to asset allocation
2. The part that is worrying are the inter corporate deposits, more so because we know who the related party for Reliance AMC are
3. Even though the fund house has a sizeable private equity corpus, the balance sheet doesn't seem to have any investments into them as of March 2017
4. The returns for a shareholder of RAMC would depend upon asset allocation policies of the management

Motilal Oswal Financial Services (MOFS)

It would be imperative for the reader to understand that MOFS is a diversified financial services business with interests in the credit business as well. So in this regard, an apple to apple comparison is not possible. What needs to be done is that the consolidated balance sheet of the company must be looked at ex of the loans and advances made as they pertain to the housing finance business if one needs to compare yields that both companies are earning on their investments

We took the data of the last three years for Motilal AMC (as the mutual fund schemes were launched only in the year 2014) and tried understanding profitability trend through ROE since inception of the schemes (prior to the Mutual fund triumvirate, MO-AMC was a pure play portfolio management services firm with an AuM growth of 10.65 percent in 7 years)

Let us now look at the capital allocation policies of MOFS

Observation

1. The company practices an approach which is highly tilted towards equities and real estate
2. Amongst equities MOFS also runs a private equity business which allows an investor to take exposure in the highly lucrative private equity and venture capital space
3. MOFS also runs a Real Estate fund which gives exposure to real estate opportunities arising in the country

Reliance AMC vs MOFS

1. While MOFS is a firm specialized in one domain – equities Reliance MAC manages a diversified pool which includes debt assets as well where the yields are very low thus depressing yields
2. While the clients of MOFS includes HNI’s interested in PMS and equity schemes Reliance AMC manages the corpus for EPFO & NPS pension scheme which carries virtually zero yields

Thus the capital allocation of MOFS is tilted towards only one domain ie. Equity while Reliance has diversified it across multiple asset classes and also there seems to be some unanswered inter corporate loans which warrants further attention.

Understanding India's Sugar Sector.

Sometimes there exists a situation which becomes difficult for the human mind to comprehend. The sugar sector in India is one such where it is difficult to understand why such a dire situation exists for a sector which forms a backbone for the agrarian economy in the country.

This has been proven time and again that for anything to flourish the entire ecosystem has to benefit. We cannot expect to compensate one part of the value chain by squeezing the neck of the other. However this is what existed in the sugar sector as early as 2015. Have a look at what the biggest sugar miller in India had to say in 2015….

This is an extract from the annual report of Balrampur Chini in 2015. We cannot expect to hold one part of the value chain at ransom to over compensate the requirements of another. This is simply not sustainable, especially in a sector which is so important to the ecosystem of the country. Let’s have a look at some simple facts of the sugar economy in India

Facts about the Indian Sugar Industry

• Aggregate demand of 25MT with a population of 1.32 billion as on 2016
• Per capita consumption of around 20kg per year
• India is the world’s largest consumer and second largest producer in the world

However in 2017 the company had a different tone

The profits have shot up

This is an exercise in finding out what changed and foremost what ails this sector so deeply that it forms a part of the untouchables for many. To understand that we tried to dig deep into the workings of the sugar sector and this is Part 1 of our exercise which will be followed by much deeper understandings of how this industry works and is anything changing?

Let’s first understand how sugar is made…

The process of making sugar starts at the farmland with the sowing of the sugarcane crop. Sugarcane is a water-intensive crop (1 kg of sugar production in Maharashtra requires around 2300 liters of water) and any shortage of the same significantly inhibits growth.

In India, there are three variants of the same namely –

• The spring crop sown in March,
• The Adsali Crop sown in July and
• The Autumn Crop sown in September

The adsali and the spring Crop take 18 months to mature while the autumn crop takes 12 months to mature before they can be cut and sent to sugar mills for further processing.

The cultivation of sugarcane happens through the age old ‘ratooning’ method in which subterranean buds on stubble  (the part of cane left underground after harvesting plant cane), gives rise to succeeding crop stand which is usually referred to as ‘ratoon’ or the ‘stubble crop’

Now that we know how sugarcane is cultivated & harvested let’s understand what happens next…

Once the cane is harvested, it is then taken to the sugar factory for conversion. The sugar mill needs to be in very close proximity to the sugarcane farms.

Let’s understand why…..

• A longer distance between farm and mill would increase the cost of production
• The sucrose content in cane rapidly declines after harvesting hence time between harvesting and conversion needs to be minimized

The conversion process

Let us first present a flow chart that depicts how sugarcane is converted among the many products

(Source: Dwarikesh Sugar)

• A sugar mill can be a standalone facility where the output is only sugar or an integrated facility producing other by products as well
• By products of crushing sugarcane are sugar, molasses & bagasse
• While molasses are used to produce ethanol & alcohol, bagasse is used to generate power

Let’s understand how an integrated facility helps…

• Bagasse used to generate power is used for own production as well as sold in open market
• Ethanol is mandated to be used as an additive in fuel
• Molasses are sold to the alcohol industry

All of this helps in managing realizations as sugar production is weighed down by high fixed costs, volatile realizations & vagaries of government policies. Let us try an understand each of these point in details

High Fixed Costs

For any commoditized business, having low cost production and optimizing usage of by-products are imperative for sustaining profitability. In this case, optimizing output from each ton of cane procured is an absolute necessity for an integrated mill to ensure maximum production of both sugar and its associated by-products.

This variable is measured by tracking the recovery rate. The recovery rate is the quantity of sugar that is retrieved from processing one tone of sugarcane. Let us explain how this works. For eg: If the recovery rate is 11.5% that means for every tone of cane processed you get 115 kilograms of sugarcane.

The recovery rate is not standard across regions. It depends on soil, climatic conditions, variety of crop used, etc.

Let us now show you how the recovery rate affects all the byproducts of sugarcane conversion assuming 1 tonne of sugarcane

Vagaries of Government Policies

To understand how the government policies affect the sugar sector first let us understand why the sugar sector is so important for the government:

• With 5 million hectares of land under cultivation the industry supports over 50 million farmers
• The three big states of Uttar Pradesh, Maharashtra & Karnataka produce over 75% of the production
• While Uttar Pradesh is dominated by private companies, Maharashtra is dominated by co operative mills belonging to state government
• The production capacity in the country is roughly distributed equally among private and co operative entities

Thus the Central Government sets the Fair Remunerative Price (FRP) each year, which is the minimum price the sugar mill has to pay the farmer while procuring cane. On top of this sugar producing states set their very own State Advised Price (SAP) which many a times is much higher than FRP for reasons best known by the State Governments themselves

Let us have a look at how the mood of the government decides the pricing of sugarcane in the market…

The blue line shows how SAP has moved over the years while the pink line shows the gap between SAP and FRP in Uttar Pradesh

Have a look at how the SAP more than doubled in 5 years during 2009-14. This was the period when Mayawati governed Uttar Pradesh as the Chief Minister while there was a Congress led government at the Centre

While the SAP decides the cost of procurement for the mills the final selling price depends upon various factors viz. export quota, domestic demand, government controlled levy.

Let us understand each of these in detail…

Domestic demand

This is the demand supply situation in the domestic market. The supply depends not just on the production but also the opening stock for that year. The demand for sugar being a basic necessity remains constant and keeps inching up every year. Since demand is relatively inelastic pricing should remain more or less stable. However, the supply is very volatile, which means it is not the demand which is the problem but what moves supply.

Let’s have a look at how ex mill sugar prices have moved over the last decade

As we can see the current ex mill prices are the highest in over a decade. As we write ex mill prices for sugar trade in the same range as of FY17.

Government controlled levy

This regulation that the government used to impose on sugar companies was called the monthly release mechanism by which the Government controlled the quantity that Mills could 'release' into the open market. In addition to the release mechanism, sugar mills had to sell 10% of their produce to the Central government under the levy quota at subsidized rates.

Exports/Imports

The government controls import and export of sugar in the country

The prices of sugar have kept falling in the international markets over the last year. However, the government incased import duty to the already existing 40% by another 10% to stop cheap global sugar from flooding the Indian markets. Similarly when prices increase in global market sugar companies can only export on a pre fixed quota mechanism thus not allowing domestic pricing to be affected by global volatility

Let’s see how all of this interference affects the sugar economics in the country

We use Dwarikesh Sugar as a case study to understand how companies operating in sugar sector were affected

Notice the difference between SAP and the cost of raw materials booked by the company

Notice the way realizations moved in relation to cost

This led to gross margins falling from a high of 58% to negative 4%

Here is a case explaining how FRP & SAP affect pricing for sugar companies in Uttar Pradesh

The FRP set by the central government entails a base price with benchmark recoveries of 9.5%. For every additional recovery that mills make out of their cane, they have to pay the farmer an incentive of Rs 2.68/quintal for every 0.1% of additional recovery.

We use another case study of Ponni Sugars to show the attitude of the government while the companies were bleeding

Now let us see what the biggest sugar producer in India had to say two years ago…

This is what the MD of Balrampur Chini Mills had to say in the Annual Report of 2015. The industry was dying. He suggested a solution. Most of the steps advocated were similar to what the Rangarajan Committee had recommended noted as under:

• De regulation of Indian sugar sector
• Linking cane procurement price with market pricing of sugar
• Abolishment of monthly release mechanism and levy sugar quota
• Revenue sharing with farmers from processing of other by products of sugarcane
• Stable external trade policy with moderate tariff levels

So what has the Government done…?

• The state governments of Karnataka and Maharashtra have approved the implementation of the Rangarajan committee recommendations
• The central ministry has written to the Uttar Pradesh government to implement Rangarajan committee recommendations (central and state governments in Uttar Pradesh are similar)

The situation today

India is expected to produce around 25.5mt of sugar this year, primarily led by significantly higher output from Maharashtra and Karnataka. With domestic demand being stable around that 25mt mark, there shouldn't be a need for imports into the market. With demand and supply being in equilibrium and the central government pushing the implementation of the cane pricing formula of the Rangarajan committee in U.P, prices could be stable moving ahead. Stability in prices will lend themselves to a stream of free cash for companies as growth capex isn’t on the anvil yet.

De-leveraging balance sheets and subsequent conversion of debt into equity has been one of the prominent highlights of corporate India in recent times and the sugar sector is no exception to that. In the past couple of years, most sugar companies have diverted all of their cash flows towards debt repayment and have healthier balance sheets

The following is an extract from Ind-Ratings highlighting the opening stock for FY2018 which should keep the prices stable as the opening stock is lower than the typical buffer kept by companies

Important understandings

• Financial condition of sugar mills on a much better footing than 2-3 years ago
• Most of the cash flows generated over last two years have been utilized in debt repayments
• No growth capex done. However, once situation improves many mills now closed can soon start operations
• Government has implemented structural changes in the sector and states are now more pro active towards plight of mills

This is a part of the series in which we have tried to understand sugar sector. In the next part we will have a look at individual companies across different regions to understand how companies have evolved over the last two decades in different regions