Rio’s Rainy Nights a Wash for Cosan

05/25/2011 3:11 pm EST


Jim Jubak

Founder and Editor,

What should you do if you own shares of Cosan (CZZ)? Brazil’s big sugar and ethanol producer is getting hit with a double whammy of drought and a steeply appreciating Brazilian real, which have combined to reduce profits in a big way.

For the quarter that ended December 31, 2010, Cosan’s earnings fell by 20% from the same quarter a year earlier. Shares traded at $11.44 midday on May 25, down from $14.57 on January 4.

It’s hard to see either of these two factors turning around quickly.

  • Right now, the market believes that Brazil’s upcoming sugar crop will be only marginally better than the last one.
  • A weakening of 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 US interest rates start to rise—and when the Banco Central do Brasil stops raising interest rates, again 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 think 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 since November 12, 2010—this is exactly when you want to throw up your hands and sell.

I think that an emotional reaction is understandable, but it’s either premature or wrong. At 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 after the emerging-market correction ends, I think Cosan is worth $15 a share. That’s roughly a 35% gain from here. I still see an end to the 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 more detailed look 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 ($252 million) in the December 2010 quarter, from 490.4 million reais ($301 million) 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 export markets. Brazil’s ethanol imports soared to 171 million liters in April 2011, from just 18 million liters in April 2010, and US ethanol gained market share in Europe.

Two different trends are at work right now in the sugar market.

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 both quantity and quality of the sugar supply, big cane growers have responded to higher prices and dwindling stockpiles by devoting more land to cane. Bunge (BG), for example, has said that it will plant and replant about 125,000 acres through May to replace cane destroyed in last year’s drought.

This planting won’t add to cane supplies in 2011, but the full effects of expanded plantings should kick in for 2012.

If you own Cosan now, I’d hold on at least until Brazil’s stock market recovers 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 Cosan 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 column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. 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 here.

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