PICK of the MONTH
Efficient market hypothesists argue that the market is always right when it comes to the pricing of a company’s shares. But is that always the case? Not when it comes to SA’s largest listed sugar producer, Tongaat Hulett, believes Warren Jervis of Old Mutual Investment Group. “Tongaat Hulett should be trading at about R150/share, yet it is only at R121,” says Jervis. “I am surprised that the market is not getting it.”
What the market appears not to be getting is that the worst drought to hit Southern Africa in more than three decades has been broken in Tongaat Hulett’s three key growing regions: KwaZulu Natal (KZN), Mozambique and Zimbabwe. It sets the scene for the sugar group to enjoy at least two years of vigorous production increases and surging profitability.
“The dominant theme in the next two years will be falling unit costs of production,” says Tongaat Hulett CEO Peter Staude. “Our marginal cost of additional production is extremely low.”
Of the group’s sugar milling costs, 85% are fixed and 15% variable.
The first signs of a major improvement in the fortunes of the sugar operations were seen in the company’s year to March. Strong performances in the three key growing areas made sugar operating profit roar in at R1.271bn, up from a mere R15m the previous year.
Sugar production itself was not up significantly.
Still experiencing the last effects of the drought, it rose by a marginal 33,000 t to 1.056Mt, around half of the group’s milling capacity. About 20% of production was exported, primarily to the EU.
Some other positive factors were at work, not least a 29% rise in the SA sugar reference price during 2016. The first hike of 12.5% was in February and the second, of 15%, in July. The reference price was upped by another 7.75% in February 2017. “There is a good chance the price will be increased again this year,” says Staude.
Higher export prices also provided a profit kicker but from now on rising sugar production will be the main growth engine.
In its forecasts, Tongaat Hulett is looking to produce 1.2 Mt-1.3 Mt in its year to March 2018, and 1.48Mt1.59 Mt the following year. At the high end of the 2019 financial year forecast production would have risen by 534,000 t (51%) in the two years.
Sustainability of production has also improved markedly in Zimbabwe and Mozambique. Unlike production in SA, which is totally reliant on rain, irrigation plays a big role in those two countries. Production there accounted for 62% of Tongaat Hulett’s sugar output in its past year. Yields were hard hit by low dam levels during the drought, says Staude. But the problem is well and truly over.
A risk of another sort faces Tongaat Hulett from a proposed tax on sugar-sweetened beverages, which could damage demand — but the risk appears limited. At the level of tax proposed now the group estimates that sugar consumption in SA will fall by less than 5%.
Sugar is not Tongaat Hulett’s only big profit generator. Its line-up includes its maizebased starch and glucose business, Tongaat Hulett Starch (THS), which produces annual revenue of R4.2bn.
The major markets of this business are alcoholic beverages, coffee creamers, confectionery and paper.
THS faced the headwind of a drought-related maize price rise during the past financial year. “Maize prices moved to import parity, where our margins get squeezed,” says Staude.
Maize prices have since moved back to THS’s preferred export parity but it will still take time to work through orders placed at the time of parity pricing. “I expect [THS] to have a great second half this year,” says Staude.
Another of Tongaat Hulett’s big investment attractions is 7,709 ha of sugar cane fields in the Durban area earmarked for urban development.
There is no shortage of potential demand. Durban’s population is projected to rise by 500,000 to 4.1m by 2021.
Land sales by Tongaat Hulett in the past financial year came in at 75 ha, down from 121 ha the previous year, while operating profit fell from R1.115bn to R641m. “Active negations are under way on 233 ha. The profit potential is about R1,58bn.”
Looking further ahead, Tongaat Hulett’s objective is to sell 607 ha-1,211 ha of developable land over the next five years. It represents an annual average of 121 ha-242 ha.
The group grew its headline EPS by 45%, a level it is capable of repeating in the current year.
On a forward p:e of around 10 the share looks like a sitter.
Another investment attraction is 7,709 ha of sugar cane fields in the Durban area earmarked for urban development