business models for a sugar company

Business model analysis for a Sugar Company

Four possible business models for a sugar company

Sugar companies are increasingly diversifying and de-risking their revenue streams by manufacturing ethanol from molasses and co-generating power from bagasse.

At present, there are four possible business models for a sugar company. These are as follows:

·         A company can be a plain vanilla sugar manufacturer, that is, manufacture sugar and sell the by-products (molasses and bagasse) obtained in the course of manufacture without any value addition. This is the sugar-molasses-bagasse model.

·         A company can convert molasses into alcohol and further process the same into ethanol. It may opt not to forward integrate into the manufacture of power. This is called the sugar-ethanol-bagasse model.

·         A company can go in for bagasse-based cogeneration of power, but decide not to convert molasses into alcohol/ethanol. This could be referred to as the sugar-molasses-power model.

·         A company may opt to forward integrate into complete value addition of by-products, that is, produce sugar, alcohol/ethanol and power. It may continue to sell a certain quantum of molasses and bagasse in the open market, but it will also have the facilities for processing molasses into alcohol/ethanol and bagasse into power. This could be termed the sugar-ethanol-power model.

Returns from alternative business models

Sugar companies have been diversifying their business models and derisking their revenue streams by setting up facilities for producing alcohol/ethanol (from molasses) and for co-generating power (utilising bagasse). After conducting a detailed analysis of the four possible business models a sugar company can follow, CRISIL Research concludes that forward integration into power and ethanol enables mills to generate higher average profits over the length of the sugar cycle.

We have analysed the incremental profitability and returns from alternative business models in three possible scenarios —an upward cycle in the industry, that is, sugar supply is low and prices are high; a normal scenario of moderate supply and prices; and a cyclical downturn in the industry, that is, supply is high and prices are low.

We have made product pricing and cost assumptions for each of these three scenarios. We have assumed that realisations earned on the sale of sugar would be at Rs 13,500-18,500 per tonne, molasses prices would vary between Rs 500-3,500 per tonne, alcohol/ethanol sales realisations would be at Rs 18,500-24,000 per kilo litre, while bagasse prices would be Rs 100-800 per tonne.

In a normal scenario, we have assumed sugar sales realisation of Rs 16,000 per tonne, molasses prices of Rs 1,500 per tonne, average alcohol prices of Rs 21,500 per tonne, and bagasse prices of Rs 400 per tonne. The realisation per unit of power sold has been taken as Rs 3.2 per unit, and the price of sugarcane has been assumed at Rs 1,200 per tonne.

It is to be noted that the prices and costs we have assumed are indicative in nature. Actual figures would vary from region to region and from company to company.

In addition, sugar mills are entitled to receive tradable carbon credits (certified emission reductions (CERs)) under the clean development mechanism of the Kyoto Protocol, since power cogeneration plants produce renewable energy through the non-carbon route. We have not considered this in our calculations, as mills have to obtain several approvals before they are eligible to receive CERs.

In the normal scenario, we have assumed that a plant with a capacity to crush 5,000 tonnes of sugarcane per day (5,000 tcd), will operate for 156 days at 90 per cent capacity utilisation, crushing a total of 702,000 tonnes of sugarcane. Further, we have assumed that the upcycle mills will crush 8 per cent more as compared to the normal scenario; the downcycle mills will crush 8 per cent more cane as compared to the normal scenario.

Recovery and other input-output ratios have been considered at standard industry norms. Further, we have assumed that a mill forward integrating into the manufacture of alcohol/ethanol and/or power will process 100 per cent of its molasses production into alcohol/ethanol and 100 per cent of its bagasse output into power.

Table 1: Integrated model has higher returns over the complete cycle

	SMB	SEB	SMP	SEP
PBIT Margins
Upcycle	18%	20%	20%	22%
Normal	7%	12%	14%	18%
Downcycle	-9%	-1%	4%	10%
Average margin (weighted)	5%	10%	12%	16%
Return on capital employed
Upcycle	15%	15%	13%	13%
Normal	5%	8%	8%	10%
Downcycle	-6%	0%	2%	5%
Average RoCE (weighted)	5%	7%	7%	9%
SMB: Sugar-molasses-bagasse;SEB: Sugar-ethanol-bagasse;SMP: Sugar-molasses-power;
SEP: Sugar-ethanol-power
Note:
This is a hypothetical example. Actuals may vary.
Weights for calculating average: Upcycle (2 years), Normal (1 year), Downcycle (2 years)
Source: Industry and CRISIL Research

We can conclude the following from the above table:

·         It makes sound business sense to opt for an integrated business model, where a mill produces not only sugar but also alcohol, ethanol and power; average profits are higher (over a complete cycle) and variation in profits is also lower than that of a plain vanilla sugar mill producing sugar, molasses and bagasse. This is because earnings from the sale of alcohol/ethanol and power are relatively stable and are non-cyclical compared to the core sugar business (power prices are not volatile since they are decided on the basis of long-term agreements. The price of ethanol sold to oil-marketing companies, for the ethanol-blending programme, is fixed on the basis of quantity-based tenders).

·         Processing molasses into alcohol/ethanol and undertaking bagasse-based co-generation of power helps, to some extent, in protecting revenues and improving profitability during periods of downturn in the core sugar business. For example, in 2006-07, sugar prices fell sharply due to oversupply in the market, but alcohol and power prices were relatively stable. During this period, when the sugar business was doing badly, these products contributed heavily to profitability.

·         However, opting for value addition of bagasse and molasses, could generate lower returns on incremental capital employed (compared to a standalone sugar mill) when the industry is in an upturn. For instance, during a period sugar shortage in 2004-05, several sugar mills were finding the sale of molasses and bagasse more profitable than the sale of alcohol or power.

·         Opting for a sugar-molasses-power or sugar-alcohol-power model would generate higher profits for sugar companies over a cycle. The business risk in opting for these models is also lower, given the lesser variation in profits. However, sugar mills could prefer to set up a distillery unit first rather than a co-generation plant, due to the lower capital expenditure requirement for establishing a distillery unit.

Our conclusions must, however, be viewed in the light of the following:

·         The decision of a sugar mill to opt for an integrated business model or to remain a standalone plain vanilla sugar mill is often a function of its long-term strategy and vision. Prices and costs at particular point of time do not necessarily influence business decisions, which are taken with a long-term view.

·         Past experiences or future expectations also govern decisions. For example, several mills are hesitant to opt for power co-generation in view of the unpleasant experiences that some of them had in the form of delay in receiving payments from state electricity boards against supply of power. There is also a fear among some mills that realisations on power sales may drop in the coming years.