>INDIAN TEA SECTOR (ICICI DIRECT)

With tea prices soaring due to torpid production over the past five years and sustainable consumption in the country, the fundamentals of the tea industry have improved significantly. Simultaneously, unfavourable weather conditions in major tea exporting countries have resulted in a considerable decline in global production in 2009. This has led to a surge in global tea prices. Given the negligible area addition under tea during the 2000-07 period, production would stagnate, going forward. This, in turn, would keep tea prices firm. We are initiating coverage on tea sector with a positive view on McLeod Russel, Jayshree Tea and Harrison Malayalam.

■ Domestic demand-supply gap to tighten further
The precipitous decline in tea auction prices during 2001-2005 had adversely affected tea plantation activity in India. As a result, tea production in India has been lagging behind consumption in the past few years resulting in a depletion of carry-over stocks. Conversely, demand for tea has been steadily growing at 2.9% per annum. In light of the relatively lengthy gestation period of a tea plant, which is typically around five years and the lack of area under plantation, the country is unlikely to register any significant growth in the near term, thereby tightening the deficit even further.

Tea prices on the boil…

■ Favourable global demand-supply dynamics
Led by a protracted dry season, Kenya, the world’s biggest exporter of black tea, has witnessed a 12.1% decline in production to around 209.5 kg in January-September 2009. Likewise, Sri Lankan tea output has also fallen by 16.8% to around 208.1 million kg in January-September 2009 as against 250.1 million kg in the corresponding period last year. This, coupled with negligible area additions under black tea, has exacerbated the deficit situation causing global tea prices to surge.

■ Tea prices expected to remain firm
Domestic tea prices have risen by almost 22% to Rs 135 per kg in 2009 due to the decline in tea production in India. Currently, domestic tea prices are the highest since the last nine years. Poor weather conditions in India have taken a toll on tea production and has resulted in a decline to 830.4 million kg in January-October 2009. This, coupled with high consumption levels, has led to the emergence of a tight demand-supply scenario. Moreover, a decline in the production of tea in key exporting countries has resulted in a surge in global tea prices. Kenyan tea prices hit a record high with the Broken Pekoe Ones (BP1s) average price touching $5.2 per kg. We believe global and domestic tea prices would remain firm on the back of negligible area addition under tea over the last four to five years.

■ Valuation
The Indian tea sector is going through a positive pricing scenario as production has remained stagnant over the past five years and consumption is growing steadily. We believe tea prices will remain firm due to lower production because of negligible area additions under tea. Given the fixed cost structure of the companies, high prices would result in a concomitant rise in the EBITDA margin. Our rating rationale is based on P/E and price to book value (BV).We prefer McLeod Russel (MRIL), Jayshree Tea (JST) and Harrison Malayalam (HML) in this order purely on the back of the large capacities of these companies. We believe MRL, with the largest capacity, would benefit from the rise in volumes and price realisations. We value MRIL, JST and HML at 13x, 12x and 11x its FY12E EPS respectively, which are 2.0x, 1.9x and 0.87x of their respective FY12E book values.

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