Description

We are recommending going long Illovo Sugar (ILV SJ).  ILV is a global, low-cost sugar producer with operations in South Africa, Malawi, Swaziland, Tanzania, Mozambique and Zambia. The company is in a unique position to capture significant value for shareholders over the next 3 to 4 years as it expands capacity in order to profit from increasing sales into its domestic and preferential markets while benefiting from strengthening global sugar prices on its regional and export volumes. The company's assets in Zambia, Malawi, Mozambique and Swaziland are among the lowest cost in the world and its higher cost assets in Tanzania and South Africa fall below the median point of the cost curve. Aside from being a low cost producer, which is able to benefit from strengthening commodity prices, Illovo provides additional company specific upside as it sells the majority of its production into protected markets (ie markets with government mandated sugar prices that are higher than current global prices). Based on today's share price we see a conservative upside of approximately 33% to fair value with limited downside risk.

Illovo Sugar (ZAR)

Shares Outstanding: 422.6

Share Price: 28

Market Cap: 11.8 R

Net Debt: 1.8 R

Minority Interest: .64 R

Dividend 2010: 4.5%

P/E 2010: 10.5x

EV/EBITDA 2010: 5.9x

*above assumptions a 2 billion R rights offering at slight discount to current share price

Sugar:

Since January, sugar prices have rallied from 11.9¢/lb to approximately 16.5¢/lb today (a 39% increase) with the 12 month forward strip at ~18.25¢/lb. The contributing factors leading to this rise have been a significant drop in production from Indian producers, structural supply changes to the European market, competing crop rotation and a rise in crude prices. Due to substantial supply cuts and increasing demand, global markets are expected to experience a deficit of 8-9 mt for the 2008/2009 season (-5.5% of use) and to be short another 3-4 mt for 2009/2010 (-2% of use). These deficits should help to considerably reduce global inventories and bring the stock to use ratio near levels seen in 2006. With this backdrop of a tight supply demand scenario we think it is increasingly likely that global sugar prices could revisit the highs set in early 2006 (20¢/lb) as India begins to draw down inventories to historic lows and increases imports from Brazil. Furthermore, we believe there may be an opportunity for prices to move significantly above the previous highs of 2006 if India's monsoon continues to be affected by the El Nino weather patterns. If India is only able to grow production by 5-10% versus the current expectation of 20% the country may need to import up 6-7 mt forming a very bullish argument for pricing in H1 2010.

Illovo:

The company has recently completed the largest portion of its capital expenditure program in Zambia and is accelerating growth in Mozambique, Swaziland and Mali over the next three years. These programs will increase total sugar production from 1.8 to 2.4 million tons by the end of 2011 (~33%). Given the higher realized prices generated from increased sales into preferential markets, the strength in the global sugar market and increased domestic demand, we believe the company should experience visible EPS CAGR of 10-15% over the 5 years under conservative assumption. We believe the company's low cost growth position separates it from the European producers while its access to preferential and local markets distinguishes it from global peers in India, Brazil and Australia.

Associated British Foods (ABF LN):

In 2006 ABF bought a majority (51% stake) in Illovo at 21 R per share. Management at Illovo was kept in place and ABF has publicly commented that it views this acquisition as a significant growth platform for its sugar business over the next decade. We believe that over time ABF will look to strategically increase its holdings in Illovo and may eventually acquire the entire company. The backing of ABF provides considerable financial flexibility for Illovo as the company is committed to back funding requirements as needed. Given ABF's strategic interest we believe 21 R per share will likely represent a definitive floor for the stock.

Local and LDC markets:

One of the largest advantages Illovo has relative to its peer group is its protected market status. In each country of operation Illovo is able to sell sugar locally for a significant premium to the global price. On average the realized price ranges between 550 and 600 per ton or 25-27.5¢/lb versus spot at 16.5¢/lb and accounts for around 55% of total production. Additionally, the company has been positioning its investments in Least Developed Countries (LDC) in order to take advantage of the changes occurring in the European market. Historically the EU has blocked imports in order to protect local farmers but beginning in October 2009 they have agreed to allow sugar imports in from LDC countries. Illovo has a considerable portion of its asset base in these regions and will be able to triple its sales into the EU at an average realized price of 20-24¢/lb. LDC sales could represent around 25% of production by the end of this year. As the company begins to transition sales away from world and regional exports into the EU, it should experience a significant uplift in margins from higher price realization.

Rights Issuance:

            We believe it is very likely that in the next few weeks the company will issue between 1.5-2 billion (15-20% of market cap) of new equity through a rights offering in order to fund its growth projects over the next few years. While it may seem that with net debt/EBITDA a 1.4x versus the peer group at 2-5x the company could sustain additional leverage management is very conservative in nature and would like to maintain a net debt to equity balance of less than 40%. ABF is committed to backstop the deal and management commented that they may take their ownership up to 60 % (threshold for a bid) if some investors do not exercise their rights. While management is confident the deal will be done at par or a sliver of a discount we think the post issuance trade may provide an opportunity to purchase equity at a lower price

Valuation:

Our peer group is a compilation of Brazilian (CSAN3, SMTO3), Indian (BJH IN), Thai (KSL TB) and European producers (SZU GR) which trade between 14-25x 2010 P/E and 7-11.5x 2010 EV/EBITDA. While we believe Illovo offers superior long term growth potential with greater cash flow stability then the peer group we have decided to use the lower end of these valuations to err on the side of conservatism.  Using a 17¢/lb price for 2010 and 8.00 R/USD we have the company generating 2.58 per share in EPS. Applying a 14-15x 2010 P/E on our base case assumptions (~2.58 EPS) we believe fair value for the stock to be 36-39 R per share. Under our bullish case scenario (expanding local and preferential premiums driven by tight global markets and a world spot price of 20¢/) we have the company earning 3.40 a share in 2010.

Risk:

• Sugar pricing
• Currency fluctuation
• Political instability
• Rights discount

Catalyst

Opening of LDC imports to Europe beginning in October 2009

Continued strength in global sugar pricing

Reduction in fixed cost per ton as volume ramps up in expansion regions

Potential for ABF stake increase/takeout