The end of 2011 brought the end of ethanol subsidies for American corn farmers. Tariffs on the imports of foreign ethanol have also been waived. The effects of these developments are clear: ethanol production will be shifted more towards Brazil, which produces more cost-efficient and environmentally sound sugar-based ethanol compared to American corn-based biofuels.
As a result, I am bullish on Cosan (NYSE:CZZ), the publicly traded company that benefits the most from these changes.
Cosan is Brazil's leading sugar producer. It grows sugar cane for both food and ethanol production in Brazil. Cosan operates 24 mills, 2 refineries, and 2 ports in Brazil that produce 5% of the world's ethanol supply. Opening up the market to more Brazilian exports will boost demand for Cosan's ethanol from American customers . Driven by farmers' desire to maximize expiring subsidies, the US had a record year for ethanol production, reaching 13.78 billion barrels in 2011. This was a 500-million barrel increase from 2010. Assuming Cosan can replace 2.5% of the 2011 American production at an average price of $3.00 per gallon, sales would increase by $1 billion (8.8%) and increase earnings by $81.2 million, or 17.2%. These are conservative estimates for Cosan's growth, and I believe the American market can be a long-term fundamental growth driver for Cosan.
Fortunately, Cosan trades at cheap valuation levels. Cosan has a P/E ratio of just 4.32 compared to the industry average of 16. Earnings have declined over the past year, but the decline was caused by an acquisition of a subsidiary. I expect demand from both the US and Brazilian markets to improve revenues and administrative costs to return back to pre-acquisition levels. Cosan is also trading at just 4% over its book value. Other strong financial highlights for Cosan include a solid ROIC of 16.7%, and a dividend yield of 2.4%.
Due to the company's cheap valuation and its ability to benefit from the removal of ethanol subsidies and tariffs, I am long-term bull on Cosan. An overbought market and a chart pattern pointing to a head-and-shoulders formation make me hesitant in the short term. However, a pullback below $11 or a breakout above $12.25 would be excellent buying opportunities.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CZZ over the next 72 hours.