Since I can't consume sugar, I thought I should consume sugar stocks instead." A tinge of vengeance there? Not unlikely, considering that the author of the quote, one of our readers, is a diabetic. However, he's not the only one looking at sugar stocks. With demand outstripping supply for the first time in several years (see The Big Picture), sugar prices, and that of their stocks, are beginning to skyrocket. Just what you need to consider the industry for your portfolio-or, to put it differently, indulge your investor sweet tooth.

Know Your Sugar

First, a small primer on the industry. In today's era of liberalisation and free markets, sugar is one industry that remains tightly controlled, a result of high political connotations not just in India, which is the second-largest producer and the largest consumer of sugar, but also in the rest of the world. Being an essential commodity, the government controls the industry end-to-end, from raw material stage to finished product stage. The Union Government declares a mandatory SMP (statutory minimum price) every season for sugar cane, based on factors such as cane availability, cultivation cost and yield. Then, state governments declare an sap (state advised price) that is typically more than the SMP, which sugar mills have to pay to farmers.

On the other end of the spectrum is the market, where the government influences sugar prices by determining the quantity of sugar that mills can sell (or release) every month. Ten per cent of the release, called levy quota, is bought by the government for distribution through the PDS (public distribution system) at a subsidised price (now at Rs 13.50). The remaining 90 per cent, called free sale quota, can be sold at market prices. However, since the total quantum of release is government-controlled, it ends up influencing the market prices as well.

Changing Dynamics

In such controlled conditions, drastic stock movements are uncommon, but these very conditions, and some brought about by nature, have resulted in a curious situation. For several years, sugar production in India climbed steadily, if not spectacularly. The season ending September 2003 saw total production in excess of 20 million tonnes, which was adequate to cover the demand (18.5 million tonnes). The following year, however, saw a different picture. "Despite overall good monsoons, sugar production declined to 16 million tonnes largely due to a drop in cane output," says Gautam Jain, Sugar Analyst, Enam Securities. The reasons behind this drop: first, inconsistent rainfall in Maharashtra, parts of Karnataka and Tamil Nadu. This has particularly affected Maharashtra, where cane production fell nearly 50 per cent from 62 lakh tonnes per annum (tpa) in 2003 to 32 lakh tpa in 2004, and is estimated to be 18 lakh tpa in 2005. Second, SMP has jumped three-fold in the past 10 years while sugar prices have been subdued, resulting in a cash squeeze for sugar producers. Consequently, arrears for farmers have been mounting (estimated at Rs 6,000-odd crore), and they have lately been shifting to cash crops.

The outlook for 2005, therefore, isn't too rosy. Says Amitabh Chakraborty, Vice President and Head of Research (Private Client Group), Kotak Securities: "This (last season's) erratic rain would see yields suffer in the current season too as one bad crop affects the next one." With sugar production expected to cross 12 million tonnes in 2005, that's a near 40 per cent knock in just two years. While this has created supply issues, it has also let loose a free-market mechanism. Explains Jigar Shah, Head of Research, kr Choksey Shares & Securities: "It is after a long time that the sugar industry is in a supply shortfall phase and steady demand growth. This has created a trigger in prices of sugar and sugar stocks." And with consumption growing at an average 4-5 per cent per annum, "this could see an upswing in sugar prices over the next year or so too", notes Chakraborty.

To prevent hoarding by sugar mills anticipating a further price rise, the government has reinforced the rule that if a part of the free sale quota was left unsold, it would be transferred to the levy sugar for the PDS. Despite this reaction, however, "sugar prices are likely to remain firm purely due to the anticipated mismatch in the demand-supply situation over the next two seasons", assures Jain.

Target Stocks

Which companies, then, should you be looking at? "Companies with higher volumes will make more profits," says Shah. And that's not just due to the rise in prices of sugar, but also those of by-products such as molasses and bagasse (knotted fibrous residue from processed sugar cane). Integrated sugar mills that use these by-products to add value would gain more than others. Among companies, Bajaj Hindusthan, with the largest cane-crushing capacity in the industry (31,000 tonnes per day across three plants in up), looks a good bet. The company is setting up three more greenfield units, and posted net sales of Rs 497.4 crore and a net profit of Rs 61 crore for the year ended September 2004 against Rs 420.92 crore and Rs 29.80 crore respectively in the previous year.

The other safe bet is Balrampur Chini Mills (BCM), the second-largest private sector sugar manufacturer with four cane-crushing plants in eastern up. The company has ensured uninterrupted cane supply by building a robust relationship with farmers through development programmes and regular payments. Besides, bcm is an integrated sugar mill that utilises by-products like molasses to produce industrial alcohol, and bagasse to produce captive power for its plants. Then, there is EID Parry with four sugar factories in Tamil Nadu, also integrated ones like BCM that utilise by-products for adding value. Last year the company reduced its debt and simplified its corporate financial structure, the benefits of which have shown in a net sales growth of 16 per cent, and a net profit growth of 175 per cent.

Besides these three, other companies that look investment-worthy include Dhampur Sugars, Upper Ganges and Mawana Sugars. So go ahead and take your pick, rest assured that the experience won't leave you sour. Or diabetic.