Illovo Sugar Limited is a low-cost sugar producer and a significant manufacturer of high-value downstream products such as furfural, alcohol, agriguard, diacetyl, biomass sugar, ethyl alcohol and lactulose. It has operations in South Africa, Malawi, Zambia, Swaziland, Tanzania and Mozambique.
Four years ago sugar millers were getting more than US30c per pound of sugar but now they can only get about 15c. These weaker selling prices, coupled with unfavourable climatic conditions and strikes in Swaziland and SA damaged Illovo’s earnings for the interim period to end-September.
Given that it sells close to half of its produce on the international market its performance is highly correlated to movements in international sugar prices. The other half is consumed in domestic markets in the countries where it operates, getting slightly better prices thanks to protectionist policies in some of the jurisdictions.
Illovo’s latest results confirm our bearish view on pure sugar plays. We don’t see value in the stock and think shareholders would be better off in Tongaat or the thinly traded Crookes which offer better diversity.
Revenue was down 5% to R5.93 billion, while operating profit declined 14% to R1.39 billion (1H14: R1.63 billion). The operating margin deteriorated to 24% (1H14; 26%) due to the effects of lower volumes, increases in operational costs and currency translations which more than offset price gains, positive fair valuation movements and an increase in profits from downstream sources. Headline earnings also fell 10% to 171.1c per share (1H14: 194c).
Our view is that the industry has hit the bottom of the cycle and a gradual upturn is likely. Current prices limits new investments into the industry and may also push higher-cost producers out of business. This, together with gradually increasing consumption and the emergence of alternative uses for sugar, should see the world market move towards a supply deficit.
But of course this is unlikely to happen over night. Illovo’s management said they expect total sugar production for the year to end-March 2015 to fall below that achieved in the previous year. This will suppress earnings growth and has been reflected in our valuation estimates.
The European Union’s proposed reforms, which seek to remove production quotas currently imposed on domestic sugar producers by September 2017, also dampens prospects of a long term supply demand balance. It’s estimated that the EU will become a net exporter once the reforms becomes effective which will be a sour pill to swallow for Illovo which currently exports close to a third of its sugar to this market.
With the sugar business under pressure, Illovo is diversifying its earnings by adding more alcohol distilleries and also targeting possible opportunities in the blended fuel and electricity generation. However with these downstream sources currently contributing less than 10% to earnings, world sugar prices remain an important determinant of its prospects .
Based on our discounted cash-flow model and outlook, Illovo has a valuation of R21.82 per share (13% lower than its current market price). Our valuation is based on an assumption of 1% growth in earnings. We expect much of this growth to occur in the first half of the coming financial year when price gains are more likely. Typically, Illovo’s first half contributes the bulk of annual earnings, and as such the interim period earnings growth will more than offset the earnings decline expected in the coming six months.
In this sector we think Tongaat which has better diversification through its starch and land development activities, and tightly held Crookes, which hedges its sugar cane growing business with other crops, presents you with better prospects than Illovo which at the moment is largely a pure-sugar play.
As such Intellidex rates the share a ‘sell’.
• Any recovery in sugar prices will boost the sector profitability
• Increased focus on development of downstream activities to improve diversification
• Exchange rate volatility might erode gains from tougher tariff system
• Earnings vulnerable to exogenous factors such as weather and volatile exchange rates
• International sugar prices remains depressed
Disclosures: The analyst has no financial exposure to the instrument discussed. The opinion represents his true view. For Intellidex’s full disclaimer, methodologies and definitions please click here.