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Company Background

Avadh Sugar & Energy Ltd. (Avadh) was incorporated in 2015 pursuant to business re-alignment of The Oudh Sugar Mills Limited (OSML) and Upper Ganges Sugar and Industries Limited (UGSIL). Originally, a part of the erstwhile K.K. Birla Group, it is now being led by Mrs Nandini Nopany, Chair Person and Mr Chandra Shekhar Nopany, co-Chair Person. It is engaged in the manufacturing of sugar, ethanol and power. It has four sugar factories located in U.P. having an aggregate sugar crushing capacity of 31,800 TPD, distillery capacity of 240 KLPD and co-generation capacity of 74 MW. A slew of structural reforms undertaken by the GoI in recent years have positively changed the fortunes of the sugar industry from its erstwhile morass.

Investment Rationale

Robust quarter led by sugar and distillery performance

* During Q1FY22, Avadh net sales increased by ~9.8% y-o-y to Rs 6,188.3 mn, mainly on account of higher sugar volumes led by exports and better distillery performance. Sugar sales volume was up by 3.9% y-o-y to 148.6 mn kg while domestic realisation was up by ~4.2% y-o-y to Rs 32.6/kg. Sugar segment reported an EBIT profit of Rs 140.3 mn against Rs 110.6 mn reported in Q1FY21 owing to better volumes and realisation. Sugar inventory as on June, 2021 stood at 338.8 mn kg.

* Distillery segment revenue increased by ~36.2% y-o-y to Rs 1,097.5 mn during the quarter, led by higher contribution from B-heavy ethanol. Ethanol volume was up by ~35.6% y-o-y to 18.9 mn litres while average realisation was flat at Rs 57.9/lt. Segment EBIT margin increased by 212 bps y-o-y to 42.6% or Rs 467.3 mn against Rs 325.9 mn reported in Q1FY21, mainly due to higher contribution from B-heavy ethanol.

GoI initiatives supporting sugar industry (SI), sustaining sugar prices

* Indian SI has been known for its cyclical nature and volatility. With an intention to change the fortunes of SI, the GoI announced a slew of positive measures in 2018/19 like Minimum Selling Price (MSP), reintroduced sugar selling quota to control supply, export incentives to reduce inventory levels and re-introduced new National Biofuel Policy and new Ethanol Blending Program (EBP) with an aim to reach 10% and 20% ethanol blending by 2022 and 2030 (now preponed to 2023) respectively, which has started reaping benefits. Continuing the policy, the GoI de-linked Ethanol prices with crude and linked C-heavy price with FRP and B-heavy and direct sugarcane with MSP. Hence, sugar companies are making positive profit margins even with high sugar inventory levels.

* With higher diversion of sugarcane towards ethanol and supportive exports policy, we expect panIndia sugar inventory at the end of SS21E at ~9 mn tn against ~10.7 mn tn reported in SS20. With severe drought followed by frost in Brazil and lower sugar production in Thailand, we expect international sugar prices to remain buoyant going forward. Thus, exports from India are likely to be over 6 mn for SS22E. Also, with more ethanol capacities coming on stream and higher sugarcane diversion towards ethanol production, we expect further decline in inventory levels for SS22E (closing inventory expected at ~7.5 mn tn), resulting in firm domestic prices going forward.

* SAP prices for SS20-21 are kept unchanged. On account of the election in UP next year, we expect an upward revision in SAP prices for SS21-22. Thus, we have factored in Rs 20/quintal hike in SAP prices for SS21-22 in Avadh FY22E projections.

Distillery segment to steer profitability going forward

* To have greater participation in EBP and better utilization of molasses, Avadh increased its distillery capacity by 20 KLPD in FY21 and successfully installed incineration boiler and turbine at Hargaon & Seohara distillery, enhancing operational days from 270 days to 330 days, thereby increasing the overall efficiency and scale of operation of the distillery. Avadh is further laying foundation for next level of growth by increasing its ethanol capacity from 240 KLPD to 320 KLPD, with a capex of ~Rs 1.35 bn, funded through a mix of debt/equity of 7:3. The Company has planned to increase distillery capacity from 240 KLPD to 290 KLPD by November 2021 and from 290 KLPD to 320 KLPD by H1FY23. The new distillery will be utilised to divert excess sugarcane for ethanol production through B-heavy and sugarcane juice and we expect Avadh to produce 90 mn litres and 120 mn litres of ethanol during FY22E and FY23E respectively.

* With expansion of new distillery, we expect Company to divert ~63 mn kg and ~103 mn kg of sugar towards ethanol, resulting in lower sugar production at ~603 mn kg and ~590 mn kg for FY22E and FY23E respectively. Given the current scenario, we expect Avadh to report net sales of ~Rs 28.3 bn and ~Rs 30.7 bn in FY22E and FY23E respectively, with strong operating cash flow generation of ~3.9 bn and ~4.2 bn during FY22E and FY23E respectively. This will be used to repay debt of ~1.8 bn and ~2.2 bn during FY22E and FY23E.

Valuation

* Presently, the sugar industry is recovering from its recent troughs, through timely and game changing policy intervention related to sugar MSP, higher ethanol pricing, blending mandates, favourable export policy etc., thereby, moderating sector cyclicality and improving profitability, leading to structural re-rating of the sector.

* We have valued the stock on the basis of P/E valuation method (changing from consolidated approach of P/E and P/BV valuation as industry is undergoing a change from cyclical to structural play), and assigned a P/E multiple of 9x FY23E EPS of Rs 80.7/share, on account of visibility in both inventory liquidation and debt repayment going forward, and maintain BUY on the stock with a target price of Rs 726/- in 18 months (60% upside).

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