We recently downgraded Cosan Limited (CZZ), Brazilian sugar and ethanol producer, to an Underperform recommendation. The stock was previously rated Neutral by us.

The company is the largest sugar and ethanol producer in Brazil and ranks third in sugar and fifth in ethanol production in the world. Apart from its core operations, the company is also engaged in energy production from sugarcane bagasse and has an annual installed capacity of 860 MW.

Fuel distribution is another of Cosan's businesses with the company aiming to become the third largest distributor in Brazil after the consummation of the recently announced joint venture with Shell International Petroleum Company Limited.

Cosan, over time, has been growing through acquisitions and other expansion strategies. We believe the company is well positioned to benefit from its Jataí mill, one of the Greenfield projects and its joint venture with Shell. Synergistic value of the association includes better access to ethanol consumer market, increased competitiveness in biofuels and fuel distribution businesses, better scope for development of second generation technology, impoved debt ratios through more capital and improvement in cash profile, and healthier growth prospects.

Besides expectations of growing sugar and ethanol businesses, the energy co-generation business is also expected to get a boost from an increase in installed capacity with the addition of 6 new projects by 2012. Annual capacity is expected to surge to 1,213 MW.

Despite these positives, skepticism over growth prospects in the near to medium term kept us from being optimistic on the stock. Cosan operates in a highly cyclical industry and the company's financials are rather sensitive to domestic and international changes in supply and demand. Under governmental regulation, ethanol is mixed with gasoline to reduce vehicle emissions and in Brazil the use of fuel flex vehicles are taxed at lower levels than the general gasoline-based vehicles.

We believe reduction in the proportion of ethanol to be used with gasoline and increase in taxation for fuel flex vehicle will adversely impact Cosan's financials. Moreover, the competitive nature of the company's business affects both top and bottom-line results. Acute dependence on a small number of customers can be problematic.

Cosan, ending its second quarter of 2011, revised its guidance downward for the full fiscal year 2011. At mid-points, crushed cane volume guidance was lowered by 6.7% and sugar volume sold by 1.2% from the respective prior guidance. The revision was based on dry weather conditions in the Brazilian Center South region, affecting sugarcane production.

Thus, anticipating a lack of positive catalysts in the quarters ahead, we downgraded Cosan to an Underperform recommendation.