- Unbranded commodity product sold on basis of price
- Pricing depends on demand supply situation in the industry
- Highly fragmented industry
- Raw material (cane) pricing controlled by government and margins highly dependent on the Raw material prices
Lately the industry has been on an upswing, with demand exceeding supply and average inventories are down. As a result all the sugar companies have seen explosive profit growth (high operating leverage). Most of the sugar companies have very high debt levels ( > 2:1) and are in the process of raising equity to reduce it to manageable levels or working down the debt. At the same time as the capacity utilization is high, new capacity will have to be added through fresh equity or debt.
The industry is fairly cyclical with last few years being unprofitable for most of the companies. Lately however there is being a turnaround and most of the companies are selling at a PE of 6-7. The research report are bullish and predict a re-rating. I disagree with this analysis as it is simplistic and ignores the cyclical nature of a commodity business. Typically a cyclically business sells at a low PE at the peak of the commodity cycle and high PE at the bottom of the cycle .
I have simulated a commodity business cash flow and done a DCF analysis and the results the DCF model throws up confirms the above analysis ( the analysis can be downloaded here. The analysis has several assumption, but depicts a commodity business and shows inter-relationship between the cyclical earnings and PE).
I think the market is valuing these commodity businesses (sugar, cement) correctly and the analyst are being too optimistic in their appraisal and simplistic in their analysis. A few odd companies like balarampur chini or Ambuja cement may be different (due to a sustainable low cost position) , but the rest of the industry seems to be fairly priced