Based in Sugarland, Texas, Imperial Sugar is a $230mm market cap refiner of raw sugarcane that we think is worth $5/share. The Company makes a spread on the price of raw sugar they buy (which is up 20% since early May) and the price of refined sugar they make (sold to Cereal companies and supermarkets). Trading at 6.0x 2011 consensus EBITDA, this is a cyclical refiner trading at a peak multiple on what will ultimately prove to be peak earnings after the current quarter. IPSU’s peak margins (this quarter) are a result of a temporary dislocation in the market caused by delayed planting of beets in the US but many investors forget that these margins are not sustainable. The only other time the business had similar margins was after Hurricane Katrina took out significant capacity.
Consider the slew of operational issues, underfaunded pension liabilities ($120mm+), significant debt, limited liquidity and an over-compensated management team with a questionable track record and you’ve got a Company that will have meaningful liquidity concerns once sugar spreads, currently at record highs, revert.
But before we go further into why it’s overvalued, let’s take a quick look at why a sugar refiner like IPSU even exists in this day and age?
This industry largely shutdown in the 1980s due to the breakeven returns on equity this industry generated. With the rise of the lower-cost refined beet sugar production (at least 15% cheaper and the source of 60% of US refined sugar), it is no longer economical to produce refined cane sugar in the U.S. In fact, there are only 3 sugarcane refiners left in the country. Structurally, beet sugar has a competitive advantage in producing refined sugar and will always be cheaper to produce.
In 2008, IPSU had an unfortunate incident where the larger of its 2 factories exploded, killing 14 people and injuring 40. The explosion was caused by massive accumulations of combustible sugar dust throughout the packaging building and what seems like poor safety practices. More than 3 years later, the Company is still looking to settle lawsuits from this incident. The insurance contract allowed IPSU the opportunity to either (i) re-build the refinery (the last of which was built 15 years ago) OR (ii) take the depreciated value of the assets (and pay taxes on it), approximately $80mm.
When management looked at its choices, it’s not hard to figure out their motivation. IPSU could take $200+mm and re-build an asset with a terrible ROE, secure high-paying jobs for themselves (CEO and CFO made $1.1mm and $539k in 2010, respectively for what until recently was a $125mm market cap company that loses money) or take proceeds which would have amounted to almost nothing and efficiently unwind the Company.
The Company has continued to destroy shareholder value over the last 2.5 years, and the facility is still not fully operational. The new facility has higher operating costs (thanks to higher insurance premiums and new safety regulations) without making much money; all the while, management has continued to increase its salaries every year. But the story doesn’t end here.
In 2010, the Company decided to shut down operations at its second refinery in Louisiana starting Jan 1st 2011 and contribute these assets to a JV with Cargill and a sugar cooperative that would expand capacity at this facility by a little under 50%. But in return the Company only received a 1/3 share in this bigger facility. Effectively, the Company increased capacity by 50% but then split the earnings among 3 people. IPSU ends up with 50% of what it had before.
Why would a company do such a thing?
We believe Cargill was considering building a vertically-integrated facility that would have put the old IPSU refinery in Louisiana out of business. Contributing this asset to the JV was a forced move by the Company. The Company will not receive any money from this JV for another 2 years at the earliest. Further, Cargill does not have any incentives to return capital/dividends to IPSU. The Company was forced to give away the asset for a pat on the back and a promise that maybe in the future they will see a penny.
So what’s left at IPSU besides these 2 refineries? Let’s go through the remaining assets:
(i) A small profitable bagging facility that doesn’t really move the needle.
(ii) Asset values that exceed market cap. What is a black & white TV factory that costs $200+mm to build worth today??
(iii) A 50% stake in Wholesome Sweeteners. Management views this as their growth engine, but it's strange that on May 31, 2011, they let an option to purchase this asset expire. Why? We believe it’s because the Company was unable to secure financing from either the credit or equity markets. No one wants to lend to them. The Company would have had to dilute the shareholder base by at least 25%.
It is also worth pointing out that this business actually shrunk in the last quarter (so much for being a high-growth business). Some analysts would have you believe that this business could be worth up to $200mm by valuing it at 20x but that clearly didn’t make sense to the banks.
(i) Underfunded pension liabilities in the amount of $120mm+ that the Company will have to fund in the coming years. The Company will need to make pension contributions of an additional $10mm per year that are not reflected in the income statement. The Company assumes a 7% long term return assumption with a 40/60 fixed income/equity mix. This doesn’t make much sense and the cash contributions will be higher in the future.
(ii) Limited free cash flow contribution from LSR JV in the medium term. This facility is not likely to generate any meaningful cash flow in 2011 or 2012 and LSR isn’t likely to make a distribution until 2013, if ever.
(iii) Contrary to what may have been mentioned in the press, there is no natural financial or strategic buyer for these assets. The most likely buyer Cargill, just managed to extract a sweetheart deal from IPSU. This business burns cash when operating at normal sugar refining margins, why would anyone buy it?
(iv) Lastly Management. Despite their best efforts, management has struggled to bring a facility back on-line in 3 years. They are victims of a structurally flawed industry and their own incompetence.
So what happens to IPSU?
IPSU is temporarily benefiting from a brief increase in its sugar refining margins thanks to a weaker than expected beet crop this year and the USDA allowing more imports of sugar. The company was getting squeezed by higher raw sugarcane prices and less favorable refined sugar prices before a temporary dislocation in the market blew out the sugar spreads to record highs. Burdened by pension liabilities, interest costs, and a JV that is unlikely to return any capital in the near future, IPSU will never generate any significant cash flow.
From FY 2012 onwards this business will likely operate at a 6% gross margin and 1-2% EBIT margins (adjusting for the JVs that show up below the operating line). After interest expense, taxes and cash pension costs this business barely breaks even in a normalized operating environment. It is unlikely that the record sugar spreads will last more than 1-2 quarters and investors, many of them retail have very little concept of what this business does. Well-run commodity businesses with significant pricing power trade at 4-5x EBITDA, but these usually generate significant cash flow (for context, Telcos and Pulp & Paper companies trade at 4-5x EBITDA but they also have 10% to 20%+ free cash flow yields). What does one pay for a money losing, cash flow negative sugar refinery with subpar management that will never earn its cost of capital? We think considerably less.
This stock is worth $5.00 per share (~4x Pension + JV Adjusted CY 2012 EBITDA of $55mm).
Disclosure: I am short IPSU.