Why an investment in sugar may not be all that sweet

Today’s half-year update from Tate & Lyle (LSE: TATE) shows that the company is performing well. It was able to record a rise in adjusted pre-tax profit of 22% as its strategy begins to bear fruit. But while its financial standing improved and its outlook is relatively upbeat, now doesn’t seem to be the right time to buy it, nor its sugar producer peer ABF (LSE: ABF).

Tate & Lyle’s two main divisions performed well during the first half of the year. In Speciality Food Ingredients, the company delivered double-digit profit growth in line with its 2020 Ambition strategy. All of its regions recorded solid volume performance, other than North America where volume was dented by the simple fact of lower demand. However, sales from new products continued to gain good traction and helped to boost its overall profitability.

Tate & Lyle’s Bulk Ingredients division performed extremely well. It was driven by solid demand, robust margins and upbeat manufacturing performance. Tate & Lyle’s strategy to position its Bulk Ingredients division to deliver steadier earnings over the long term is progressing well. Its increasing focus on cost control, customer service and continuous manufacturing improvement is working well.

Looking ahead, Tate & Lyle expects profit for the full year to be ahead of previous expectations. Although the second half of the year is due to be in line with previous guidance, a strong performance in the first half means that its overall profitability outlook is upbeat. In fact for the full year, Tate & Lyle is due to record a rise in earnings of 18%, with further growth of 8% forecast for next year.

High valuation

Clearly, Tate & Lyle is making excellent progress as a business. However, its valuation appears to factor-in its upbeat outlook. For example, it trades on a price-to-earnings (P/E) ratio of 19.6 and when this is combined with its growth outlook, it equates to a price-to-earnings growth (PEG) ratio of 2.5. This indicates that Tate & Lyle offers a narrow margin of safety, despite the fact that its business is closely linked to sugar prices. As history has shown, they can be exceptionally unpredictable and volatile.

It’s a similar story with sugar producing peer ABF. It has at least some diversification from sugar and foodstuffs thanks to its retail arm, Primark. However, with the outlook for the UK economy being highly uncertain, ABF’s P/E ratio of 24.4 indicates that the stock is overvalued. That’s especially the case when ABF’s forecast growth rate of 12% for next year is taken into account, with its PEG ratio of over two showing that there may be limited capital gains on offer.

While both Tate & Lyle and ABF are high quality companies that are performing well as businesses, their sky-high valuations mean that their investment performance could be sour, rather than sweet.

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.