Illovo: A pure sugar play

Illovo has been a disappointing stock over the past 18 months. Its share price has been in freefall, mirroring its financial performance, which has been under pressure from the persistent decline in global sugar prices and drought and frost conditions in parts of southern Africa.

We expect the challenging conditions to persist in the short- to medium term. The continuation of the drought conditions in SA and depressed sugar prices remain major threats to Illovo’s financial performance. These factors also reduce Illovo’s ability to cash in on currency weaknesses in the markets in which it operates.

That said, our discounted cash-flow model shows that the recent plunge in Illovo’s share price has moved it closer to its intrinsic value. We think investors have priced in the subdued outlook and hence issue a hold opinion on its shares.

Illovo posted disappointing numbers for the interim period to end-September. The poor performance didn’t come as a surprise given the sustained low international sugar prices and regional drought conditions. Revenue dropped 7% to R5.49 billion (1H15: R5.93 billion) with sugar production volumes 10% lower than the comparable half. Operating profit fell 37% to R881 million (1H15: R1.39 billion)

 

Management attributes the plunge to a number of factors: inflationary pressures on costs; the impact of a weaker Zambian kwacha on costs there; the effects of yellow aphid infestation; and the impact of a weaker Malawian domestic market and stronger currency. These negative factors outweighed the positive effects of improved factory performances in Swaziland and Tanzania and the benefits of weaker currencies in SA, Zambia, Mozambique and Swaziland.

During the interim period the group closed its furfural-based nematicide business in the US, with management citing difficulties in obtaining registration with the US Environmental Protection Agency for the application of the product on food crops as the main reason. The closure resulted in a loss of R216.3 million, which contributed significantly to the 82% drop in attributable earnings. Headline earnings were 72c/share (1H15: 171c/share). The board decided not to pay any dividend.

Unlike competitor Tongaat Hulett, which has diversified into land development activities, Illovo is very much a pure sugar play, deriving more than 90% of earnings from direct sugar operations. This makes factors such as international sugar prices, climatic conditions and production levels important inputs into its prospects equation.

We simplified our valuation by focusing on the group’s major earnings drivers that can be predicted with reasonable certainty. We expect FY16 revenue to be 10% lower than the previous year with attributable earnings down 52%. This falls within range of management’s guidance of an earnings decline of between 50% and 70%.

Fifty-eight percent of Illovo’s sugar is consumed in the domestic markets in the countries of operation. Earnings are affected by supply-demand dynamics which differ from country to country. Some governments have imposed tariffs on cheaper imports, supporting sales prices in the domestic markets. The balance is exported to regional markets, the European Union and elsewhere. These sales are directly exposed to international sugar prices and exchange rate volatility.

While we don’t expect significant increases in international sugar prices, we believe the industry has hit the bottom end of the cycle and a gradual upturn is likely.

The low sugar prices limit new investment into the industry which, along with increased consumption and growing alternative uses of sugar, will provide support for a recovery. We also expect the weaker currencies in most of the countries in which Illovo operates to boost sugar export revenues.

Illovo is diversifying its earnings by adding more alcohol distilleries to its business while targeting possible opportunities in the blended fuel and electricity generation sectors. However, with these downstream sources currently contributing less than 10% to operating profit, our forecast is largely influenced by our take on world sugar prices.

Valuing the stock using a discounted cash-flow model we arrived at a fundamental price of R16.31 for Illovo and a one-year forward price:earnings of 9.6.

Bull factors

• Any recovery in sugar prices will boost profitability
• Increased focus on downstream activities will improve diversification

Bear factors 


• Earnings vulnerable to exogenous factors (weather, exchange rate movements)
• International sugar prices remain depressed

Nature of business: Illovo Sugar Limited is a low-cost sugar producer and a significant manufacturer of high-value downstream products such as furfural, alcohol, agriguard, diacetyl, biomass sugar, ethyl alcohol and lactulose. It has operations in South Africa, Malawi, Zambia, Swaziland, Tanzania and Mozambique.