October 11, 2005

Valuing a commodity business

I was reading a research report on the sugar industry. The industry is a classical commodity industry with following characteristics

  • 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


Ninad said...

Hi Rohit

I cam across this post of yours. I m not able to run throught he simulated DCF analysis that u had put up. Any other link where i can pick it up.



Rohit Chauhan said...

hi ninad
if i recall correction this is the quantitative analysis worksheet file in the google groups. i have done the DCF for various businesses in the last worksheet of the file

Ninad said...


Cant seem to find it. I have been struggling on building a model of evaluating commodity business with low PE.

Commodity businesses would invaraible have low pe at the top of the cycle and high at the bottom of the cycle. However its tough to figure out where the cycle is. For ex Oil has seen prices that it has never seen before and one doesnt know whether this is the end of the cycle.

Certain commodities like sugar or other agri commodities are easier to predict. Cycle are shorters and hence can be managed.

However commodities like cement, chemcials, metals etc are relatively tougher to predict.

Also the critical variable is how low should the PE be.

A good commodity business with strong track record and good management available on Pe's as low as 4 - 5 should be able to ride thru the downturns.

Still working on this. Hence was looking for your document. If u have any thoughts please free to sahre with me on ninadinvest@gmail.com