Update Cosan (CZZ)

05/25/2011 12:56 pm EST


Jim Jubak

Founder and Editor, JubakPicks.com

What to do if you own shares of Cosan (CZZ in New York or CSAN3.BZ in Sao Paulo)? Brazil’s big sugar and ethanol producer is getting hit with a double whammy of drought and a steeply appreciating Brazilian real that have reduced profits in a big way. For the quarter that ended on December 31, 2010, Cosan’s earnings fell by 20% from the same quarter a year earlier. Shares traded at $11.44 in New York at 12:30 on May 25. That’s down from $14.57 on January 4, 2011.

It’s hard to see either of these two factors turning around quickly. Right now the market believes that the Brazilian 2011-2012 sugar crop looks to be only marginally better than the 2010-2011 crop. A weakening in the Brazilian real will probably have to wait until the Federal Reserve starts to raise interest rates at the end of 2011 or in early 2012.

But you do know that the sugar supply problem will get resolved with a turn in the weather and that the real will—probably—weaken once U.S. interest rates start to rise (and when the Banco Central do Brasil stops raising interest rates in Brazil in late 2011 or early 2012.) If you were a value investor and didn’t own any of these shares, this is exactly when you’d be thinking about buying the stock on current weakness and future prospects. (Or you might wait six months or so.) Of course, if you do own it—and I have in my Jubak’s Picks portfolio http://jubakpicks.com/ since November 12, 2010—this is exactly when you want to throw up your hands and sell.

I think that emotional reaction is understandable but either premature or wrong. At the least, I think it’s worth waiting for the correction in emerging markets to work its way through the system. With a general recovery in Brazilian shares because of an end to this correction, I think Cosan is worth $15 a share. That’s roughly a 35% gain from here. I still see an end to the emerging market correction in the last half of 2011 and I’m willing to wait that long.

Am I willing to wait longer?

Let’s take a look in more detail at what’s been going on at Cosan.

In 2010 unusually dry weather in Brazil reduced the sugar harvest and dropped Cosan’s sugar output by about 500,000 metric tons. Earlier in the year Cosan had been able to draw down sugar inventories to make up part of the shortfall but as the year went along Cosan wound up having to buy crystallized sugar to make up the shortfall. That swung Cosan from a company that benefited from high sugar prices to a company being hurt by high sugar prices. Earnings for Cosan dropped to 410.5 million reais (the plural of “real”) in the December 2010 quarter from 490.4 million reais in the December 2009 quarter.

Of course, a smaller harvest meant less sugar cane for Cosan to turn into ethanol too.

And at the same time, a strong real and a weak dollar were making ethanol imports into Brazil extremely attractive and pricing Brazilian ethanol out of exports markets. Brazil’s ethanol imports soared to 171 million liters in April 2011 from just 18 million liters in April 2010 and U.S. ethanol took market share in Europe.

Two different trends are at work in the sugar market currently.

Sugar prices came down from their February high because of forecasts that the Brazilian harvest would set a record. But a very wet April slowed harvesting—by May 1 sugar and ethanol processors had crushed only 30% of the volume at this point in 2010. Wet weather has reduced the sugar content in the cane as well. Estimates are that sugar content is down by 11% from 2010. Good weather can speed up the harvest but it’s not really possible to fix the problem with sugar content.

While the weather is working to reduce supplies and the quality of supplies, big cane growers have responded to higher sugar prices and short supplies by putting more land into cane. Bunge (BG), for example, has said that it will plant and replant about 125,000 acres through May to replace cane that was destroyed in last year’s drought.

Not all that planting will add to cane supplies to 2011 but the full effects of expanded plantings should kick in for 2012.

If you own Cosan now, I’d hold on at least for the recovery in Brazil’s stock market from the current correction. No reason to decide now what to do in six months. See what the crop and the export markets for ethanol look like then.

If you don’t own Cosan now, I’d hold off on buying until the emerging market correction is closer to an end. Cosan is a good value stock for investors willing to look at 2012. By the middle of 2011, when we’re only six months from 2012, that will be a whole lot easier.

As of May 25, I’m setting a $15 a share target price for these shares by February 2012. That’s down from the previous target price of $16 by June 2011.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Cosan as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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