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

The curious case of Intellect Design Arena

It's the annual report season and among the many companies that we read about this one particularly caught our attention. The company we will discuss about is Intellect Design Arena (IDA). Before talking about this further I would like to draw attention to this particular extract from their investor presentation for FY17 available on their website

 
Here is a company which currently is loss making on an operational level and talks about 

• Improving Operating margins from a loss to 26% in FY20
• Changing revenue mix from low margin implementation to high margin License & AMC
• Revenue growth guidance till FY20 of over 20%

Its a mandatory exercise to check past track record of a management which is giving such lofty projections for the future. When we looked at what Intellect has delivered in the past, this is what we found

In his interviews Arun Jain promises a growth in revenues of 20-25% over the coming years. Since listing IDA has delivered on the lower point of 20%.

However this has come at a cost

The company has an extended working capital cycle with receivable days around 6 months. Though the quantum has been coming down and management has mentioned in latest reports of focusing more on collections and hence the days of receivables outstanding over next few years would be a key operating metric to track

Business Model
 

IDA is a software company dealing in the products vertical which develops and implements product suites for the financial sector. To understand the business further here is some more information:

Intellect is present across four broad verticals i.e. iGCB(Global consumer banking), iGTB(Global transaction banking), iRTM(risk, treasury and markets) and iSEEC(Insurance). Within each domain, the company offers a variety of products that cater to specific needs of the consumer

 

Here is some information on how business evolution develops for a product company 

 
 

A product company's life cycle can be broken into four parts - incubation (product building), catalyst (Customer reference building), adoption and monetization. Intellect currently has products across different stages in the cycle and as they move from reference building to adoption and ultimately monetization, the company will start enjoying the full benefits of operating leverage.

The management further goes on to say that every additional dollar of revenue earned will add 60 cents to the bottom line implying a net profit margin of over 60% on incremental business

All of this information is available in the company presentations put up on the website by the company

How does a company like IDA bill revenue

The revenue component for software companies is broken down into broad headings - the first being License & AMC Fee and the second being Implementation/Services fee. Besides this, there is a general practice of booking unbilled revenues The magnitude of which varies from company to company with global leaders like Temenos clocking in 80% of their revenues in the form of License & AMC Fee.

Note - Companies tend to partner with System Integrators for  implementation of their software once they've achieved a certain scale. For instance, Temenos only partnered with third party's once it had started clocking $400mn in annual revenues - until then, all integration is done in house.)

 Here is a chart from the company presentation depicting revenue mix and its change for IDA

 

After going through how the company earns let us understand what and ow much it needs to spend to earn its revenue

Being a young software product company, Intellect has to spend a considerable amount of its revenue on marketing its product to the mass market, the benefits of which accrue with time. In the past two years, the company has spent 32% of its revenues on sales & marketing. Here is a trend of how sales & marketing have moved in the past

We cross checked to see whether high expenditures are a norm in the sector. Because there is no similar competitor in India we looked at global peers, the leader being Temenos, a Swiss company

 

Another significant expense that software companies have to recognize on a recurring basis is high R&D - in terms of both product maintenance and new product development. The industry wide norm in case of development expenses is to capitalize them and subsequently amortize over a period of ten years. On the other hand, maintenance expenses are treated as an individual line item and deducted from revenues

Intellect spends close to 13% of revenues on R&D and has started capitalizing development expenses from FY'17 onwards. This has led to intangible assets on the balance sheet increasing from 32cr in FY'16 to 133cr in FY'17.  Management guides for this trend to continue as R&D remains an integral part of running the business. The subsequent capitalization allowed IDA to post operating profits over the last two quarters. It remains to be understood that if this was the industry norm why wasn't IDA following the same from the start

   
There is not too much to understand from the past numbers of a loss making company and hence we tried to find out what is the opportunity pie for a company like IDA. To understand what's in store we read through what the leader was saying about the sector. Since there is no like to like competitor for IDA in the Indian markets we looked at the global leader Temenos.

Here is what Temenos had to say

In it's annual report of 2014, Temenos - a global software provider talked about the withering moat of the banking  sector. Traditionally, banking has been a difficult business to penetrate across economies due to high levels of regulatory compliance and extensive infrastructure spend required to setup a bank from scratch. "Getting a license, setting up branch network and spending on setting up the core network entails a substantial amount of capital and time - two precious and scarce resources available to mankind". It is this precise reason as to why banks on an average clocked RoE's in the region of 15-17% between 1990 and 2008

 What is changing...

The rapid strides made by technology in terms of un-bundling the entire banking experience into a single click of an app have opened up the floodgates for a host of agile fintech companies to garner incremental market share away from these once indomitable institutions The growing need of "banking as an experience" and the propensity of millennials to switch service providers has prompted banks to increasingly focus on upgrading their core legacy systems to match new competition and at the same time, cater to the fast evolving demand patterns of their customers

So What stops banks from adapting to new technologies?

A case study conducted by Ernst and Young concluded that core replacement for banks is a high risk affair characterized by lengthy delivery cycles and costs. Due to this, decisions to replace core platforms are being constantly deferred in the face of uncertainty and potential system disruption. Instead, what banks prefer is  letting their legacy core systems run on the background and upgrading the front end to digital which helps them achieve the best of both worlds - enhanced customer service experience without having to transform the core platform

 

Here is what Arun Jain "promoter of IDA" has to say about the changing landscape of the IT industry

 

 
 So to conclude we can see that

• IT industry is changing from a service play to a product play
• Opportunity size is huge as reiterated by the global leader
• Legacy platforms remain and hence opportunity lies in newer markets

Even though IDA is a business that got recently listed it has been in business for long when Polaris acquired the products division of Citibank and hence operating history for the company spans more than a decade

We looked at the past numbers of IDA and found some observations which warrants deeper attention:

Raising debt on books




 Bringing out a rights issue to pay off a  recurring revenue line item and general purposes

 
(in Rs million)  

Another question that comes in mind after the recently concluded rights issue that Intellect has carried out is:

• Despite having cash to the tune of 116cr on books, why would the company feel the need to dilute equity especially when as much as 25% of the proceeds of the issue are to be expended for "general corporate purposes." 
• What use would the 84cr lying in current accounts be of

 From a net cash company on being de merged from Polaris to now a net debt position to having to raise a right issue. All in two years. The financial footing does not seem to be too strong for IDA. This makes us think as to was it a good idea to separate IDA from Polaris considering the desperate financial support IDA warrants every quarter.

 The management mentions itself that there is a huge upside for the. Have a look at this extract from their interview

 
With the future being so bright as certified by the management we assumed management must be holding majority stake in the company. However the current shareholding looks like this







The promoter holds 31% in the company, which is pretty much off the maximum permissible 75% allowed. I was assuming management having majority stake considering

• Future looks very bright
• Promoter must be flush with cash considering sale of Polaris

However we can see that the promoters have been increasing stake over the last quarter so we tried to analyze what the promoter has done over the last two years since listing

As we can see in the above image the promoters have not added any stake to their overall shareholding over the last two years. During Sep 2016 two promoter entities got de classified which led to a reduction and over the last quarter the promoter has bought shares which shows us why there is an increase over last quarter. What i could conclude is that even though the promoters are very bullish on the business prospects, they have not backed that up with meaningful buying in the company shares

To conclude

• We need to keep a track on receivable days to measure if management is walking the talk on collections
• any increase in stake by promoter considering extremely bright prospects of company in near future
• improvement in operating metrics without any accounting adjustment 
• fund flow due to the difficult financial situation IDA seems to be in 

(Disclaimer : We have positions in the above mentioned stock and our views are likely to be biased as a result. This post should not be treated as a buy/sell recommendation. We are not SEBI Registered Investment Advisers nor Research Analysts.)