How to do Business Analysis of Sugar Companies

The current article aims to highlight the key aspects of the business of sugar companies. After reading this article, an investor would understand the factors that impact the business of sugar mills and the characteristics that differentiate a fundamentally strong sugar company from a weak one.

Key factors influencing the business of sugar companies

1) Complete regulatory control on all aspects of the business of sugar companies:

The sugar sector is one of the most important agri-commodity segments. In India, after cotton/textiles, it is the largest agri-commodity product. Millions of farmers and their families depend on sugarcane crops and sugar production.

Rating methodology – sugar by ICRA, December 2021, page 1:

The sugar industry impacts the livelihoods of about 50 million farmers and their families and provides direct employment to around 5 lakh workers in sugar mills.

As a result, the entire production value chain of sugar has strong political linkages and govt. keeps a strong control on every step of sugar production. In fact, the regulatory grip on the sector is so tight that sugar companies have no control over most aspects of their business.

1.1) No control of sugar companies on sugarcane sourcing:

In India, sugar mills cannot produce sugarcane on their own because they are not allowed to own agricultural land. Therefore, they must rely on farmers for sourcing sugarcane.

Rating Methodology – Sugar Sector by CARE, December 2020, page 3:

In India, sugar mills are not allowed to own sugarcane fields.

Even while sourcing sugarcane, sugar mills cannot freely buy sugarcane from any farmer. Each sugar mill is allotted a defined area, called the command area. It must buy sugarcane from farmers within its command area.

Rating methodology – sugar by ICRA, December 2021, page 3:

procurement of sugarcane by the sugar entities is governed by the Sugarcane (Control) Order, 1966, which stipulates that the mills need to source their sugarcane only from the command area allocated to them.

Moreover, sugar companies have to source the entire crop of sugarcane grown by the farmers irrespective of market demand of sugar or existing stock of sugar lying with the mill.

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The order also makes it mandatory for the sugar mills to necessarily uplift the entire sugarcane production of the farmer, irrespective of the market demand

As a result, sugar companies are stuck to the sugarcane produced by farmers within their command area. More importantly, they cannot force farmers in the command area to grow sugarcane even if the acreage is low.

Rating methodology – sugar by ICRA, December 2021, page 5:

a farmer’s decision on whether to grow sugarcane or alternative cash crops is a function of the relative economics of cane vis-a-vis other crops besides the timely payments from an associated sugar mill. This aspect of the business confers considerable amount of bargaining power to the sugarcane farmers.

As a result, sugar companies do not have control over the supply of their key raw material, sugarcane.

Advised reading: How to do Business Analysis of a Company

1.2) No control of sugar companies on the price of sugarcane they have to pay to farmers:

The price of sugarcane is a very politically sensitive matter and is almost completely in the hands of the govt. and politicians. In both the pricing methods prevalent in different states, state-advised price (SAP) and fair and remunerative price (FRP), the mills are primarily the price takers and cannot push down the sugarcane price even if it has a huge surplus stock of sugar or it is financially very weak.

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Cane pricing is primarily influenced by political considerations and a lot less by economics

1.3) No control over the quantity of sugar that mills want to produce:

The regulations are structured in such a way that sugar mills are not in control of the quantity of sugar that they wish to produce in the mill.

During times of drought or less acreage of sugarcane, sugar production by the mills will suffer because sugar companies cannot source sugarcane from outside areas to run their mills at optimal capacity.

On the contrary, if a sugar mill has large existing unsold sugar stock from the previous year or there is a bumper sugarcane crop, then it cannot reduce sugar production because it has to mandatorily buy the whole crop as mandated by the law. Moreover, the mill has to compulsorily produce sugar from sugarcane because the sugarcane cannot be stored.

Rating methodology for entities in the sugar industry by ICRA, October 2019, page 6:

Raw material, sugarcane, cannot be stored as it gets dry, looses juice and recovery rate is impacted.

Therefore, sugar companies are not in control of the production of sugar from their own mills. They cannot adjust sugar production as per market demand or inventory position. Sugar production is decided by the availability of sugarcane within their command area.

Further advised reading: How to analyse New Companies in Unknown Industries?

1.4) No control of sugar companies over the sale of sugar:

In addition to a lack of control over the production of sugar, companies do not have control over the quantity of sugar that they can sell in the market.

Sugar companies have to follow a monthly release mechanism in which the govt. tells each mill the amount of sugar it can sell in the market in a particular month.

Rating methodology for entities in the sugar industry by ICRA, May 2017, page 3:

Monthly releases given by the government to each mill that determine the quantity of sugar that has to be sold by the mill within the release period.

In the past, in 2013, the govt. thought of letting the market forces of demand and supply play a role in the sugar industry and decided to remove the monthly release mechanism. However, within 5 years, the govt. reintroduced the monthly release mechanism in 2018.

Rating methodology – sugar by ICRA, December 2021, page 4:

the release mechanism was abolished in 2013, the monthly release mechanism was reintroduced by the government in June 2018

1.5) No control of sugar companies on the price at which they can sell sugar:

Sugar is a commodity where the product of one mill is easily replaceable by the product of another mill. Therefore, any sugar mill cannot charge a price that is significantly higher than its peers.

Some sugar companies focus on retail sales and introduce branded sugar, which helps them charge a premium price to a small section of consumers. However, almost 60% of sugar is consumed by large institutional buyers from confectionaries, sweets and soft drinks industries who are hard negotiators on price.

Rating methodology – sugar by ICRA, December 2021, page 4:

Sugar demand is driven by rising consumption in sectors such as confectionaries, sweets and soft drinks, which comprise almost 60% of the total consumption of sugar.

Therefore, sugar companies lack any pricing power over their customers and as a result, market forces of demand and supply play a significant role in the sugar price. This is in sharp contrast to the raw material (sugarcane) cost for sugar mills, which is fixed by govt. and almost always go up year after year.

Rating methodology for entities in the sugar industry by ICRA, May 2017, page 5:

While sugar realisation is market driven, cane price is decided by the Government, resulting in volatility in the contribution margins.

Therefore, in times of overproduction, sugar prices decline and the financial position of sugar mills is impacted.

In the past, during the period of excess sugar production, the price of sugar fell drastically and in 2018, the govt. implemented a minimum support price (MSP) for sugar. Now, mills cannot sell sugar below MSP.

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In June 2018, the government introduced the MSP for sugar. This is the white/refined sugar price at the mill gate below which no white/refined sugar can be sold and delivered by a sugar mill to the domestic market.

Govt. introduced MSP for sugar because a low sugar price deteriorated the financial health of sugar mills, and they were unable to make payments to farmers for sugarcane purchases.

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The MSP was fixed to support the sugar industry as oversupply led to a fall in sugar prices and consequently increased the cane arrears to farmers.

In the past, govt. appointed committees like the “Rangarajan Panel” suggested steps to improve the financial position of sugar mills by aligning the sugarcane prices with the market price of sugar. It recommended that the sugarcane price should be about 75% of the price of the sugar.

Rating methodology for entities in the sugar industry by ICRA, October 2019, page 2:

Rangarajan panel had suggested that mills pay 70% of the prices of sugar and other by-products or 75% of the prices of only sugar to farmers for cane purchases.

However, such recommendations have not been implemented probably because during sugar surplus/downcycle, when sugar prices are correct, then this formula might lead to a sharp reduction in the price of sugarcane, which would be a politically sensitive development.

Nevertheless, as the financial health of sugar companies is linked to the timely payment of sugarcane due by sugar mills to farmers; therefore, govt. takes multiple steps to protect sugar companies from the adverse effects of market forces of demand and supply.

Advised reading: How to do Financial Analysis of a Company

1.6) Govt.’s influence on sugar availability in the Indian market:

Govt. takes multiple steps to protect the Indian sugar industry from adverse market conditions. These steps include influencing the export and import of sugar as well as influencing the market of by-products of sugar mills.

1.6.1) Govt.’s Influence on foreign trade of Sugar:

For example, during the time of sugar shortage, govt. bans the export of sugar and allows the duty-free import of sugar from overseas countries.

On the contrary, during sugar overproduction, govt. puts high duties on the import of sugar while at the same time incentivising the export of sugar.

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Policy instruments range from an export ban, duty-free import quota in a scenario of sugar shortage, export incentives for sugar exports and levy of import duties in a surplus scenario.

As discussed above, the raw material cost (sugarcane) for sugar mills is decided by the govt. and almost always goes up year after year. Therefore, most of the time, the cost of production for Indian sugar mills is higher than in foreign markets. As a result, the export of sugar is economically unviable for Indian sugar mills.

In such a situation, the Indian govt. has to give subsidies/incentives for enabling Indian sugar mills to get rid of their excess sugar stock by selling it in global markets.

Rating methodology for entities in the sugar industry by ICRA, May 2017, page 3:

Indian sugar producers demonstrated limited export capabilities as the high cost of sugar production is uncompetitive in the global market, resulting in dependence on export subsidies from the Government.

Nevertheless, regulatory support for key agricultural inputs like sugarcane is a global phenomenon because govts. across the world want to protect their farmers. Even developed countries like Japan put tight regulatory control to control competition in the sugar sector.

Rating Methodology by Sector – Foods by Japan Credit Rating Agency, Ltd (JCRA), June 2021, page 2:

Meanwhile, some categories are resistant to intense sales competition because of government regulations geared at protecting domestic agriculture, such as grain milling and sugar manufacturing.

1.6.2) Govt.’s influence on by-products of sugar companies:

Apart from directly affecting the availability and price of sugar in the Indian market by way of monthly release mechanism, MSP and custom duties, govt. also attempts to improve the financial position of sugar companies by creating an enabling environment for mills to earn extra income from their by-products namely bagasse and molasses.

Sugar mills produce a significant amount of bagasse, the leftover after extracting juice from sugarcane. Sugar mills burn a part of the bagasse within the mill to boil the juice during the sugar production process. The excess bagasse can either be sold to paper mills to produce paper or can be burnt in power plants as fuel (cogeneration power plants).

Rating Methodology – Sugar Sector by CARE, December 2020, page 1:

The surplus bagasse…is either sold to the paper manufacturers, as bagasse can also be used for manufacturing paper and particle boards or utilized for generating electricity.

Production of electricity using bagasse is expensive when compared to the cost of electricity using traditional methods like coal. Therefore, the govt. has to support this usage of bagasse by mandating a compulsory purchase of power by electricity distribution companies (discoms) from bagasse-using cogeneration plants of sugar companies.

Rating methodology for entities in the sugar industry by ICRA, May 2017, page 4:

Cogeneration units of a sugar mill typically sell in preferential tariff mode, given the higher cost of power generation vis-a-vis conventional sources

This policy support from govt. ensures additional income for sugar companies, which improves their financial position and enables them to make payments to farmers for sugarcane purchases.

Another method used by Govt. to improve the financial position of sugar companies is by incentivising them to convert their by-product, molasses into ethanol, which is used by oil marketing companies (OMCs) for mixing with petrol under the govt.’s ethanol blending programme (EBP).

Govt. control the price as well as the quantity of ethanol required for blending with petrol. Govt. notifies the price at which OMCs purchase ethanol from sugar companies.

Rating Methodology – Sugar Sector by CARE, December 2020, page 4:

The government also regulates the pricing of the by-product, ethanol. Government has notified administered price of ethanol since 2014.

Govt. influences the demand for ethanol by making timelines for achieving certain levels of ethanol blending with petrol. For example, recently, govt. preponed the deadline to achieve 20% ethanol blending of petrol from 2030 to 2025, thereby increasing the demand for ethanol.

Rating methodology – sugar by ICRA, December 2021, page 2:

continued government commitment evident from the recent advancement of timelines for 20% ethanol blending with petrol (EBP20) to 2025 from 2030

Such steps by govt. help sugar companies in earning additional income, which helps them make timely payments to farmers. The ethanol blending programme also allows sugar mills to divert sugarcane from making sugar to making ethanol as apart from molasses, mills can use sugarcane juice also to produce ethanol. This helps in the overproduction of sugar.

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The GoI permitted the procurement of ethanol produced from B-grade heavy molasses and direct sugarcane juice for blending with petrol in 2018.

However, despite near-complete control by govt. on all the aspects of the sugar industry, the companies in the sector still face many challenges.

Further advised reading: How to analyse New Companies in Unknown Industries?

2) Cyclicity of the sugar industry:

The sugar industry faces extreme cyclicity in its performance. As per Standard & Poor’s (S&P), in the past, the sugar industry has witnessed price variations exceeding 50% during cyclical phases.

Key credit factors for the agribusiness and commodity foods industry by S&P, January 2015, page 4:

Price “bubbles” and “crashes” have occurred, with price swings of over 50% at the extreme. Such wide variations occurred in global sugar and cotton prices in 2011.

Sugar is an essential commodity, which is consumed by almost every household. Therefore, the demand for sugar is almost always stable. The cycles in the industry are 3-5 years long and are primarily due to factors from the supply side i.e. fluctuating sugar production by companies.

Increased sugar production by companies leads to sugar surplus and lower sugar prices. This reduces the profitability of companies and leads to delays in payments to farmers who then shift from sugarcane to other crops. This leads to lower sugarcane acreage and lower sugar production, which leads to sugar shortfall and increases sugar prices. It leads to better profitability for mills and they start making timely payments to farmers who then increase the acreage of sugarcane.

This pattern continues repeatedly as the sugar cycle.

Rating Methodology – Sugar Sector by CARE, December 2020, page 3:

Higher production leads to increased availability of sugar, thereby resulting in the declined sugar prices. This leads to lower profitability for the companies and consequently delayed payment to the farmers. Due to higher sugarcane arrears, the farmers switch to other crops which lead to a fall in the area under cultivation for sugar. This further leads to lower production and lower sugar availability, followed by higher sugar prices, higher profitability and lower arrears and thus the cycle continues. In India, sugar production usually follows a three to five-year cycle.

For sugar mills, the cost of raw material (sugarcane) is determined by the govt. whereas the price of sugar is determined by the market. Therefore, during sugar downcycles, the financial position of many sugar mills deteriorates significantly to an extent that they have to shut down their business.

In many instances, the govt. has to pitch in by providing direct financial help to sugar mills so that they may pay their dues/arrears to farmers for sugarcane.

Haryana govt releases Rs 350 crore for cooperative sugar mills to pay farmers’ arrears: Zee News, May 28, 2019

Another factor adding to the cyclicity of the sugar industry is its dependence on climatic conditions/monsoons. Alternating periods of good and poor monsoon impact the sugarcane crop and in turn, add to the cyclicity of the industry.

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Climatic conditions, specifically the monsoons, influence various operational parameters for a sugar entity, such as the crushing period and sugar recovery levels.

3) Highly fragmented nature of the sugar industry:

The sugar industry in India is highly fragmented with numerous small-sized sugar mills present across the nation. In 2021, India had about 500 mills operating in the country.

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While the domestic sugar industry is highly competitive and fragmented with a total of around 500 mills operational in sugar year (SY) 2021

Unfortunately, most of the sugar mills in India are small in size, about 2,500 TCD (tonnes crushed per day) in comparison to the global average size of 10,000 TCD for sugar mills.

One of the main reasons for small-sized mills is the govt. policy of preferring sugar companies to set up greenfield mills in newer command areas instead of doing brownfield expansion by expanding the capacities of existing mills.

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government regulations, which incentivised the existing units to set up fresh capacities rather than expand existing ones. This resulted in the creation of a fragmented production base, with an average installed capacity of 2,500 tonne crushed per day (TCD), which is considerably lower than the global minimum economic size of 10,000 TCD.

The aim of such a policy might be to expand the geographical reach of sugar mills so that farmers in the untapped areas may also get access to sugar mills and can benefit by growing the profitable cash crop of sugarcane.

However, small-sized sugar mills have limited resources and are not able to withstand the stress during the sugar down cycle. As a result, most of the sugar mills in India, which are in the cooperative sector are financially weak and frequently require govt. support to make payments to farmers.

Rating methodology for entities in the sugar industry by ICRA, 2017, page 1:

co-operative sector, which currently controls over 55% of the domestic production capacity…was aided by the need of the farming community to forward integrate into sugar manufacture, so as to find a ready market for their produce…many of them have become financially weak

Advised Reading: Credit Rating Reports: A Complete Guide for Stock Investors

4) Capital-intensive nature of sugar companies’ business:

Running a sugar mill requires a significant amount of money both for establishing the mill as a fixed capital and then for day-to-day operations of the mill as working capital.

Even if a company puts in the required money for establishing a sugar mill, the large working capital requirements due to the seasonal nature of sugarcane availability puts a considerable strain on its resources.

Rating methodology – sugar by ICRA, December 2021, page 9:

sugar business, being both fixed capital as well as working capital intensive, has high funding requirements. Given the seasonal crushing and presence of domestic quota-based release mechanism, the inventory levels of sugar entities at financial year end are typically very high compared with the other sectors.

Sugarcane is available only from November to April, which limits the crushing/sugar-making period. However, the demand for sugar is throughout the year. Therefore, all sugar mills have to keep an inventory of sugar for about 4-6 months to sell sugar during the off-season.

Rating methodology for entities in the sugar industry by ICRA, October 2019, page 6:

Sugarcane crushing period for majority of the sugar mills is from November – April. Given the seasonality involved in the crushing operations, most of the sugar entities hold sugar inventory varying from 4-6 months as on March-end.

Advised reading: Inventory Turnover Ratio: A Complete Guide

Sugar companies have to put a lot of money into their working capital due to the seasonal nature of the sugar business. Especially during the crushing season, the working capital demands shoot up in the form of money required to make large payments for sugarcane purchases and to hold on to the stores of sugar inventory for the off-season.

Therefore, the peak working capital requirement of sugar companies is much higher.

Rating methodology for entities in the sugar industry by ICRA, October 2019, page 6:

Given the working capital-intensive nature of operations and seasonality in working capital requirements, the peak working capital requirements are typically much higher for sugar entities than their average working capital requirements.

Sugar companies face the risk of inventory losses due to their large holding of ready sugar. A fall in the market price of sugar can lead to large inventory losses for the mills, which is one of the factors that led the govt. to introduce MSP for sugar.

Rating methodology for entities in the sugar industry by ICRA, October 2019, page 6:

The carrying cost of sugar inventory is analysed in relation to realisable value and unrealised gains, if any, or possibility of inventory losses is ascertained.

The high working capital requirement of sugar companies puts a lot of pressure on their resources. Many times, if a sugar company wants to grow its business, the additional working capital requirements may bring a liquidity crunch leading to financial stress for the company.

Rating methodology – sugar by ICRA, December 2021, page 11:

working capital requirements increase with revenue growth…the entities which experience high growth may find themselves stretched on liquidity as their incremental funding requirements may be much higher than the cash generation.

As a result, sugar mills walk a very fine line while they plan their business growth. Apart from venturing into an area where almost all aspects of their business are out of their control (i.e. under regulations), they have to manage their resources very efficiently. Otherwise, liquidity stress builds up very quickly.

Advised reading: Asset Turnover Ratio: A Complete Guide for Investors

5) Good operating efficiency is a must for sugar mills:

Sugar mills operate in a business where raw material cost, as well as availability, is not in their control. The sale quantity, as well as price, is also not in their control. Their product, sugar, is undifferentiable from competitors’.

In such a situation, better operating efficiency with a focus on lowering the cost of production is the biggest criterion that helps a sugar mill to perform better than its peers.

Rating methodology – sugar by ICRA, December 2021, page 6:

Operating efficiency holds greater significance in the commodity business where a low cost of production is among the key drivers of competitiveness. This is especially critical in the sugar industry where cane prices, domestic volumes as well as realisations are governed by government policies compelling the mills to maximise on asset sweating and keep conversion costs under control.

As sugar mills can only source sugarcane from their command area; therefore, sugar mills have to focus on building a good relationship with farmers to convince as many of them to grow sugarcane as possible. This is because, if the farmers in the command area do not grow sugarcane, then the sugar mill would stand unutilized leading to large losses for the sugar company.

Rating methodology – sugar by ICRA, December 2021, page 5:

The nature of the relationship a sugar entity shares with the farming community in the command area is a key measure of its operational strength.

5.1) Location of the sugar mill is an important factor:

As sugar mills can make sugar only during the crushing season; therefore, the geographical location of their mills in areas with prolonged monsoon and a longer crushing season helps them use their mills for a longer period of the year. This leads to lower per-unit operating costs for sugar manufacturing.

CRISIL ratings’ criteria for the sugar industry, February 2021, page 18:

Similarly, the longer crushing season in southern India enables better utilisation of fixed assets.

Apart from a longer crushing season, the geographical location of a sugar mill also determines its access to high-yielding sugarcane crops and its freight cost to transport sugar from the mill to the market.

CRISIL ratings’ criteria for the sugar industry, February 2021, page 18:

Companies with factories close to sugar-deficit regions command a better price and save on freight costs. Factories close to high-yielding sugarcane farms are also in a better position…Proximity to ports is also a critical factor.

Sugar companies based in South India are in an advantageous position as they have access to high-yielding cane varieties leading to a higher recovery rate and better operating efficiency.

CRISIL ratings’ criteria for the sugar industry, 2007, page 2:

Traditionally, sugar recovery has been higher for companies situated in Karnataka and Maharashtra, because of the better quality of sugarcane.

Nearness to the ports helps sugar mills to export sugar at a lower cost during times of sugar surplus. Such mills can also import raw sugar at a lower cost for processing during times of sugar deficit.

Therefore, the geographical location of the sugar mill and its relationship with farmers are important determinants of its operating efficiency.

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The key determinants of sugar production are the cane yields (i.e. cane produced per unit area), length of the crushing season and the recovery rates (i.e. sugar produced per unit cane crushed) which are highly variable across different regions of the country.

In addition, sugar mills take various other strategic steps to improve their operating efficiency and gain a competitive advantage over their peers like integrated operations and a large scale.

Advised reading: Operating Performance Analysis: A Simple & Complete Guide

6) Integrated sugar mills have a competitive advantage over standalone mills:

One of the ways in which sugar mills earn a higher income from their operations is via forward integration where they start producing ethanol from by-products like molasses and from sugarcane juice. In addition, sugar companies earn an additional income by utilizing their other by-product, bagasse, to produce electricity in cogeneration power plants.

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Over the past decade, the industry in India has forward integrated into ethanol/alcohol production from molasses and power co-generation through bagasse, given the substantial value addition in the integration process and the supportive regulatory framework.

Forward integration via these products helps sugar mills in business growth as well as earn diversification benefits because, unlike sugar, both ethanol and power generation do not face a similar level of cyclicity.

Rating methodology – sugar by ICRA, December 2021, page 6:

ICRA views fully- integrated plants more favourably, given that the distillery and cogeneration segments are relatively insulated from risks that characterise the sugar industry and provide a cushion to the overall profitability during sugar downturn scenarios…the cogeneration as well as distillery operations may operate throughout the year, moderating the seasonality impact for an integrated sugar mill.

CRISIL ratings’ criteria for the sugar industry, February 2021, page 19:

It will enable companies to capture value across the production chain. An integrated sugar company functions on a de-risked model, which results in more stable revenue and less volatile profitability.

Integrated sugar mills can easily divert their excess sugarcane towards ethanol production, called sucrose diversion, and in turn avoid keeping an excessive inventory of sugar. This helps them in managing their working capital better.

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However, working capital intensity of an integrated sugar entity tends to be lower than a standalone sugar entity in light of the lesser impact of seasonality and, thus, lower inventory levels which in turn would depend on the extent of sucrose diversion.

An entry into ethanol production helps integrated sugar companies better streamline their operations because they get firm offtake agreements for the purchase of ethanol from OMCs. In addition, OMCs release payments on time leading to lower working capital requirements by sugar mills.

Rating methodology – sugar by ICRA, December 2021, page 6:

Some of the mills already have offtake certainty from oil marketing companies (OMCs) throughout the year. Growing requirements from under-penetrated states, the comfortable collection periods and the benefit of moderation in inventory holding have made this revenue stream increasingly supportive of the profitability as well as working capital management for integrated sugar mills.

Advised reading: Receivable Days: A Complete Guide

Better utilization of by-products by sugar companies increases their profitability.

Rating methodology – sugar by ICRA, December 2021, page 6:

While revenues from by-products on an average account for 20-25% of the total revenues for large sugar mills, the percentage contribution from by-products to the total operating profit is much higher.

Due to good experience, many large sugar companies are investing additional money in distilleries to produce ethanol from molasses, sugarcane juice as well as grains so that the distilleries can function throughout the year.

Rating methodology – sugar by ICRA, December 2021, page 6:

setting up dual feed capacities (sugarcane juice during season and grains/ B grade molasses in off season)…Moreover, a few mills are also evaluating setting up grain-based distilleries to enhance their ethanol supplies.

Other than ethanol production, an entry into power generation using bagasse has also helped sugar companies in earning additional income. However, as discussed earlier, the cost of power generation from bagasse is higher than traditional sources like coal etc. Therefore, they are able to sell power only via govt. mandated preferential route.

In addition, nowadays, power from renewable sources like wind and solar is available very cheaply, which when associated with delay in payment recovery from financially weak discoms has reduced the attractiveness of cogeneration power plants for sugar mills.

Rating methodology – sugar by ICRA, December 2021, page 7:

Although the cogeneration units of a sugar mill typically sell power generated to a distribution utility under the preferential tariff mode, especially during the crushing season, the competitive tariffs from alternate renewable power sources as well as longer collection periods have reduced the relative attractiveness of this segment.

In the tough business environment of the sugar industry, an improvement in the strength of the business model via forward integration has become so critical that nowadays standalone sugar mills are nearly unviable.

CRISIL ratings’ criteria for the sugar industry, February 2021, page 18:

Standalone sugar units are seldom viable, and therefore integrated sugar units, with distillery and power operations are the preferred option

An improving financial position of sugar companies due to forward integration helps them clear sugarcane arrears to farmers; therefore, govt. helps them in establishing distilleries and cogeneration power plants by providing policy as well as financial support like mandatory offtake of electricity and interest subvention for loans and even helping weaker sugar companies to gain finance from banks and ethanol purchase orders from OMCs.

Rating methodology – sugar by ICRA, December 2021, page 1:

the announcement of mandatory blending percentage timelines, interest subvention for loans for capital investments for setting distillery capacities, controlling the price of ethanol depending on various feedstock variants as well as facilitating financing for moderate to weaker mills through tripartite agreement with oil marketing companies (indicating offtake commitments) and banks

Such support from the govt. to sugar companies is essential because due to extreme cycles as well as extensive regulations, many institutional investors tend to avoid the sugar sector altogether, which restricts the flow of financial resources to sugar companies.

Rating methodology for entities in the sugar industry by ICRA, 2017, page 4:

negative perception which institutional lenders carry about the sugar industry, which has affected the flow of credit to this sector.

7) Large size of operations is a competitive advantage for sugar mills:

In the commoditised sugar industry where neither the cost of raw material nor the price of the final product is in the hands of sugar mills, they have to rely on cost-cutting and better operating efficiency to improve their profit margins.

In such a situation, large-sized mills with benefits of economies of scale enjoy a distinct competitive advantage due to lower per unit cost of production. The large size also helps in better negotiation with regulators and farmers as well as institutional buyers of sugar.

Large-sized sugar companies usually have geographically spread sugar mills, which helps them increase cane availability for their mills. Geographical spread also protects large mills from natural disasters like drought and flood that may impact specific geographies.

Rating methodology for entities in the sugar industry by ICRA, 2017, page 4:

bigger mills are expected to outperform the weaker mills in view of their geographical spread of capacity, access to greater economies of scale, high level of vertical integration, and ability to forge good relationships with the sugar cane producers.

Large-sized sugar companies usually have a higher financial strength and better access to financial markets. These aspects help them survive downcycles better and bring in staying power in the business.

Rating methodology for entities in the sugar industry by ICRA, 2017, page 4:

Another source of strength for these companies would be their ability to access the capital markets for relatively lower cost debt for meeting seasonal working capital requirements.

Rating methodology – sugar by ICRA, December 2021, page 5:

A large scale is often a reflection of a strong market position, operating and financial flexibility and staying power, and is also a driver of operational efficiency.

Staying power of large-sized sugar companies during downcycles helps them increase their competitive position because these companies can acquire weaker sugar mills facing stress and further increase their scale of operations.

Rating methodology for entities in the sugar industry by ICRA, 2017, page 4:

Some of these companies are also using the prevailing situation in the industry to consolidate their position so as to achieve greater economies of scale, by acquiring existing units, which lend themselves to a turnaround.

Acquisition of other mills provides an access to the acquiring mill to the command area of the target mills.

Rating methodology for entities in the sugar industry by ICRA, October 2019, page 3:

the need to expand sources of cane supply for achieving greater economies of scale have been one of the key drivers of the consolidation process, which has been seen in the sugar industry in recent times.

Nevertheless, investors should prudently analyse any decision by a sugar company to expand its operations. This is because to support their large size of operations, sugar mills have to rely on the sugarcane grown within their command area. If, for any reason, sufficient sugarcane is not available in the command area, then the increased size of operations will be a burden to the company that will backfire.

Rating methodology for entities in the sugar industry by ICRA, 2017, page 3:

the economics could get seriously jeopardized if the higher capacity is not backed by adequate availability of cane within the command area

Advised reading: Margin of Safety in Stock Investing: A Complete Guide

8) Environmental and social risks faced by sugar companies:

Sugar production leads to the production of effluents, which may harm the environment if they are not properly treated before releasing into nature. As a result, sugar companies have to comply with continuously tightening environmental regulations, which necessitates a continuous investment to meet the latest compliance norms.

In addition, natural factors like monsoons, pests and diseases affect sugarcane crops, thereby, influencing sugar production.

Rating methodology – sugar by ICRA, December 2021, page 14:

sugarcane crop depends on climatic conditions, besides being vulnerable to pests and diseases…Further, the industry is exposed to the risks arising from tightening regulations on environment, specifically pertaining to discharge/treatment of effluents and on the safety front. These have necessitated the industry to increase its investments towards meeting the evolving and tighter regulatory standards

Apart from environmental risks, sugar companies have to face various social factors like farmer protests regarding the price of sugarcane as well as the timely release of their dues. If a mill is not able to diligently deal with the farming community, then its business would suffer.

In addition, nowadays, rising health awareness among the population has created an environment against high sugar consumption. Such a trend, in the long run, may reduce the consumption of sugar and adversely impact the business of sugar companies.

Rating methodology – sugar by ICRA, December 2021, page 15:

Globally, the societal trends are transitioning towards a shift to less sugar-intensive food products considering the health issues related to high sugar consumption. This could structurally reduce the demand for sugar products.

9) Ratios and parameters for sugar companies:

While analysing the sugar sector, different credit rating agencies recommend using certain ratios and parameters to assess their business performance.

9.1) Profitability and OPBDITA/ton:

For assessing the operating efficiency of a sugar mill, ICRA advises the usage of “OPBDITA per tonne of cane crushed”, which effectively measures operating profit per ton.

Rating methodology – sugar by ICRA, December 2021, page 8:

ICRA evaluates the trend in OPBITDA/MT of cane crushed – a parameter to reflect the operating efficiency as well as value addition.

Consistently higher profitability over peers indicates a superior competitive position due to better operating efficiency, recovery rates or better product mix in its sales.

Rating methodology – sugar by ICRA, December 2021, page 8:

A consistent track record of higher profitability shown by an entity compared with its peers reflects a superior competitive position in the sugar sector emanating from one or more factors, including higher cost efficiency (operating or capital), better recovery rates, favourable revenue mix (higher share of branded/refined sugar, ethanol from B grade molasses, etc), among others.

9.2) Return on capital employed (ROCE):

Another ratio that ICRA advises using for sugar companies is the return on capital employed (ROCE). As per ICRA, the operating efficiency (OPBDITA margin) should be seen in the light of ROCE. Lower ROCE may be due to a poor asset turnover ratio or poor working capital management.

Rating methodology for entities in the sugar industry by ICRA, October 2019, page 6:

While the entity may have an OPBDITA margin similar to or better than the industry average, but in case the RoCE is lower, then the reasons for the same are analysed, which can be a lower fixed asset turnover or a longer working capital cycle than the industry average.

9.3) Capacity utilization ratio:

To assess whether a sugar company has access to sufficient sugarcane in its command area, an investor may use the capacity utilization ratio. This ratio is important because sugar companies cannot source sugarcane from outside their command area.

A healthy capacity utilization by a sugar company indicates a good relationship with farmers and timely clearance of sugarcane dues among others.

Rating methodology – sugar by ICRA, December 2021, page 5:

To assess raw material availability, ICRA evaluates the capacity utilisation of the sugar mills based on the cane crushed during the crushing period.

9.4) Contingent liabilities:

As a part of routine day-to-day business, sugar companies provide guarantees to banks for the crop loans taken by farmers as well as for the loans taken by transporters and harvesters working in sugarcane procurements.

An investor should assess the size of these contingent liabilities, which the sugar company might have to pay in case the farmers, transporters or harvesters cannot repay their loans to the banks.

Rating methodology for entities in the sugar industry by ICRA, October 2019, page 7:

Sugar entities issue corporate guarantees to banks in respect of crop loans to farmers, and harvesting and transportation loans to certain parties, which provide cane procurement services to the entity.

If the amount of contingent liabilities is large when compared to the cash generation ability and the net worth of the sugar company, then investors should be cautious in their assessment of the company.

Advised reading: How to do Financial Analysis of a Company

Summary

The sugar sector is one of the most regulated sectors in India. Sugar companies have no control over the quantity of raw material (sugarcane) that would be available to them and at what price because they cannot buy sugarcane from outside their command area. Sugar companies have no control over what quantity of sugar they will have to produce because they have to purchase entire sugarcane in their command area.

Sugar companies have no control over how much sugar they would be able to sell in the market and at what price because the govt. tells them the sale quota and the market tells them the selling price.

Sugar companies only act as the tools of the govt. to purchase sugarcane from farmers and then convert it into sugar. For every aspect, they are directed on what to do in their business. During the sugar surplus period, they have to rely on export incentives to export sugar because otherwise, the higher cost of sugar production makes Indian sugar uncompetitive globally.

The cost of sugar follows market price subject to MSP; however, the cost of sugarcane almost goes up year after year. Therefore, the sugar sector undergoes cyclicity where surplus sugar production leads to falling prices and low profitability of companies. This in turn leads to payment overdue to farmers who then stop growing sugarcane, which reduces sugar production. It leads to the increasing price of sugar and higher profitability for sugar companies and lower sugarcane arrears. The cycle continues with a 3-5 years frequency.

In such a commoditised market where neither the sugarcane cost nor the price of sugar is under mills’ control, the only competitive advantage is better operating efficiency leading to lower cost of production.

Companies plan their operations to achieve higher operating efficiencies through steps like economies of scale by trying to achieve large-scale operations, forward integration into ethanol production and power generation and locating their plants in areas with better sugarcane varieties and extended monsoons allowing for longer crushing seasons.

All these steps require a lot of capital. In addition, the day-to-day operations of sugar mills require a large working capital, which peaks to a much higher level during the crushing season when the company has to carry a sugar inventory of 4-6 months of sale for the off-season.

In addition, forward integration into ethanol production and power generation requires additional capital. Govt. helps companies in raising capital because a better financial position for sugar companies helps them clear farmers’ sugarcane dues on time.

Nevertheless, during downturns, many sugar companies fail in their businesses, which are acquired by other companies to benefit from economies of scale and gain access to sugarcane crops in the command area of the target mill.

Sugar companies have to make a regular investments in complying with ever-tightening environmental regulations in the treatment/discharge of effluents, which adds to their capital intensity burden.

Therefore, an investor should always keep in mind these multiple aspects of sugar companies to understand the true picture of their business position.

• Huge regulatory control on every aspect of the operations of sugar mills
• The cyclical business model in a fragmented and highly competitive, commoditised industry
• Capital-intensive business with a continued requirement of an investment of funds
• Good operating efficiency is a must to achieve any competitive advantage
• Location in geography with better sugarcane crop, long monsoons and nearness to market and port is a surplus
• Forward integration in ethanol and power production is essential because standalone mills are rarely viable
• The large size of operations with benefits of economies of scale is a good competitive advantage
• Sugar companies need to delicately handle social risks while dealing with farmers as well as environmental risks in their operation

We believe that if an investor analyses any sugar company by keeping the above factors in mind, then she would be able to assess its business properly.

Regards,

Dr Vijay Malik

P.S.

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Disclaimer

I, Vijay Malik, am a SEBI-registered Research Analyst (Regn. No. INH100008364). This article is for educational purposes only and does not constitute investment advice or a recommendation to buy or sell any securities. Investors should do their own research before making any investment decisions.

I, or my immediate relatives, do not have any financial interest in the companies discussed as on the date of publication of this article, nor do we hold one per cent or more of the securities of such companies at the end of the month immediately preceding it. I do not have any material conflict of interest and have not received any compensation or other benefits from the companies or any third party in relation to this article during the 12 months preceding its publication. I have not served as an officer, director, or employee of the subject companies, nor have I been engaged in market making activity for them.