>SUGAR STILL SWEET (MERRILL LYNCH)

■ Buy sugar stocks as sugar price could rise further 20%
We believe the recent stock underperformance on downward sloping of futures curve (SB1 Cmdty) is just technical and could reverse on resumption of import by India led by (1) increased shortage owing to drought; & (2) increase in demand following completion of govt mandated inventory cut by bulk users since Aug09.

We upgrade EPS and POs for stocks under our coverage driven by higher sugar price (avg Rs32/kg in FY10E ending Sep 2010). We retain Renuka as top pick owing to its refinery & inorganic expansion plans. We upgrade Bajaj Hindusthan, the biggest beneficiary of sugar price rise, from Underperform to Buy as (1) equity infusion; & (2) increase in capacity utilization driven by foray into raw sugar refining has addressed key concerns. Maintain Buy on Balrampur & Triveni.

■ Poor weather and import shortfall pressuring supply
We expect sugar price to rise 20% more by Mar2010 and remain strong till March 2011 driven by (1) likely production shortfall of 30% in FY10E in India owing to adverse weather; (2) limited scope for rise in cane cultivation area in FY11E owing to a likely rise in demand for food grain following a drought in the current year, and (3) shortage of sugar globally driven by below par production in Brazil.

■ Valuation attractive given lower capex and debt risk
Sugar stocks are trading at a FY10E EV/EBITDA of 4-5x on concerns of a supply surge, as the sugar price has been rising since August 2007 and is up 130%, but we do not foresee a huge supply surplus in the near future. We expect valuations to be re-rated as sugar companies are unlikely to see a sharp fall in earnings from the cyclical peak given that companies have (1) stronger balance sheets, (2) diversified revenue mix and (3) no new capex that could hurt cash flow. We base POs on EV/EBITDA of 6x implying a 15% return on replacement value.

■ Prefer Renuka and Bajaj Hindusthan on higher sensitivity
Earnings sensitivity and execution capability are key stock performance drivers. We estimate that, in FY10E, at 5.4%, Bajaj Hindusthan has the highest sensitivity to a 1% rise in the sugar price, followed by Renuka at 4%, while Balrampur and Triveni are both at 3%. Balrampur and Renuka are best in terms of execution.

■ Key risks are higher raw sugar processing costs, cane price
Sugar production costs could surprise on the upside on a combination of (1) higher-than-estimated raw sugar conversion losses owing to a lack of past experience and (2) higher-than-expected cane costs owing to shortages. Bajaj Hindusthan is most exposed to higher raw sugar conversion losses. Renuka is most exposed to cane shortages owing to recent flooding in its cane area.

To see full report: SUGAR SECTOR