Imperial Sugar IPSU S W
October 05, 2006 - 3:36pm EST by
heffer504
2006 2007
Price: 30.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 370 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT
Borrow Cost: NA

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  • Bankruptcy Risk
  • Refiner
  • Overhang of Shares

Description

Imperial Sugar is worth $10 in a base case, and could easily file for Chapter 7 bankruptcy in a few years. Imperial Sugar Company is the third largest sugar refiner in the United States, operating two cane sugar refineries located in Georgia and Louisiana.  The share price has jumped from $13.00 to $31.00 over the last year due to temporarily inflated earnings caused by temporary sugar market disruptions and investors extrapolating a strong world sugar price and potential ethanol play to the highly controlled US sugar market.  Lindsay wrote this up in December, but the timing is much better now, in my opinion...
 
Short Thesis
 
1)     The business is extremely challenging – it is competitive with low profit margins. The company filed for and emerged from bankruptcy in 2001. Here are some of the financials post bankruptcy
 
 
2002
2003
2004
2005
9mo06
revenues
     1,297
        920
        786
        804
        707
cogs
     1,196
        857
        723
        762
       613
sg&a
          64
          50
          39
          43
          33
 
 
 
 
 
 
gross margin
7.8%
6.8%
8.0%
5.3%
13.2%
ebit margin
1.4%
-0.1%
1.6%
-1.7%
6.9%
 
Imperial has typically had low gross margins in the 6-8% range since bankruptcy.  Management confirms that this is their expectation going forward.  This is because the sugar refining business is commoditized with refiners adding minimal value in the process. However, Imperial has doubled its gross margins so far in 2006. The company has managed to achieve this due to the large spread between refined and raw U.S. sugar prices that developed in the wake of Hurricane Katrina, allowing refiners to reap large profits.  This dynamic is in the process of correcting itself.
 
2) Between 1990 and 2005, the spread between refined and raw sugar prices averaged 4.4 cents a pound. However the spread skyrocketed after Hurricane Katrina, reaching 19.0 cents a pound in October ’05. Since then, the spread has declined and has averaged 12.5 cents a pound over the last six months. Preliminary data for September indicates that the spread will decline to 10 cents a pound, leaving further room for the spread to decline and return to long-term historical averages.  Every time that the spread widens due to temporary disruptions, the market comes back into balance, as evidenced by 50 years of USDA data (available at http://www.ers.usda.gov/Briefing/Sugar/data.htm).
 
3) The primary catalyst for the recent decline in refined prices—and the anticipated decline in Imperial’s stock price—has been the strong sugarbeet harvest that is expected over the coming year.  The National Agricultural Statistics Service forecasts sugarbeet area harvested to increase 15%, while actual production is expected to increase 18%; this would make it the second largest crop in history. Crops in North Dakota and Minnesota, which together account for 50% of U.S. sugarbeet production, have improved significantly over the last month with 89% of the North Dakota crop currently rated good to excellent vs. 75% a month ago and 69% of the Minnesota crop currently rated good to excellent vs. 63% a month ago. The USDA expects refined prices to drop further due to the strong sugarbeet crop.
 
4) The secondary catalyst for the recent decline in refined prices has been a decision on the part of industrial sugar buyers to either postpone their sugar purchases until refined prices drop further or to opt for short-term contracts that will given them flexibility to renegotiate pricing in Q1 or Q2 ’07. Channel checks with large buyers confirm that they are expecting refined prices to decline further in the future and are reluctant to enter into long-term contracts at current prices. Additionally, many of the large buyers have coverage through December ’06, putting further pressure on refined prices as these buyers do not need to enter the market, except for urgent needs.  The market has decisively turned from a seller’s market to a buyer’s one.  Recent commentary from Tate & Lyle confirms the North American market downturn.
 
5) Cargill recently broke ground on a new $100 million sugar refinery in Louisiana that will become the largest sugar refinery in the nation, adding capacity to an already competitive industry. The refinery is expected to begin production in 2008. Cargill is building the refinery as a joint venture with Louisiana Sugar Cane Products Inc., a co-operative that represents 75% of the raw cane sugar produced in Louisiana.  The JV will have a particularly negative impact on Imperial as Louisiana Sugar Cane Products supplies virtually all of the raw sugar processed by Imperial in its Louisiana refinery today. Imperial will likely have to turn to foreign suppliers to fill their raw sugar needs, exposing the company to fluctuations in the import quota set by the government and placing it at an expense disadvantage versus competitors as the Imperial refinery does not have a deep-water dock and therefore will have to receive foreign sugar through mid-river transfers, adding costs to their operation.  Furthermore, channel checks with industrial buyers suggest that Cargill is likely to steal more share from Imperial Sugar than from Domino or United Sugars (the top 2 sugar refiners in the nation) as industrial sugar buyers would rather do business with larger (and more financially stable) partners.
 
6) NAFTA will phase out duties on Mexican sugar starting January 1, 2008, creating an integrated sugar market between the U.S. and Mexico. Additionally, as part of NAFTA, Mexico will phase out taxes on High Fructose Corn Syrup (HFCS) imported from the U.S., which will increase the usage of HFCS in Mexican soft drinks, thus increasing the supply of sugar available for export. While there are logistical details to be solved concerning the import infrastructure for Mexican sugar, lower labor and environmental costs in Mexico will likely drive down refined and raw sugar prices and lead to a compression in Imperial’s margins.  Generally speaking, more competition, and more sugar supply, is not good for business.
 
7) As part of Imperial’s bankruptcy reorganization, Lehman Brothers currently owns 30% of the company’s shares. Lehman received their last share distribution as part of the reorganization plan in March of this year and then filed a registration statement indicating their intent to sell their shares on May 4, 2006. The filing sparked a sell-off of Imperial’s shares and the stock dropped 15% in one day. While it is unclear when Lehman will reduce their holdings in Imperial (no shares have been sold since the filing of the registration statement), the large block of shares available for sale will likely act as an overhang on the stock price. Additionally, the stock could experience another sell-off when company filings indicate that Lehman has begun to reduce their holdings.
 
8) Reduced sugar consumption is a real risk.  Better artificial sweeteners (Splenda US capacity has just been doubled) and an increasing focus on reducing sugar consumption for health reasons could have a material impact on Imperial.  When the Atkins Diet was popular back in 2001, the company filed for Chapter 11 bankruptcy.
 
9) Valuation is very aggressive on normalized numbers.  Imperial has $50 million of cash but an underfunded pension of $120 million.  In the base case scenario, with a return of gross margins to the top-end of the historical range, the company should earn $.75.  This implies a stock price of around $10 in my opinion.  This assumes $900m of sales, 8% gross margin, 44m of sg&a, and 14m of d&a.  When Mexican sugar and/or Cargill and/or reduced sugar consumption become competitive considerations, negative operating leverage will be unavoidable and I firmly believe that this company will be liquidated.
 
 
U.S. Sugar Market Overview
 
The U.S. sugar market is highly regulated in order to protect sugar growers from foreign competition. In particular, the USDA operates a loan program that effectively serves as a lower limit for the price of U.S. raw sugar. The price is set at 18 cents per pound for cane sugar and 22.9 cents per pound for beet sugar.  Sugar can be produced either from sugarcane or sugarbeets. Sugarbeets account for 54% of U.S. production and sugarcane accounts for the rest. Harvesting sugarbeets is not as economical as harvesting sugarcane, hence the higher price offered for beet sugar through the loan program. Additionally, the USDA regulates not only the amount of sugar imported into the country, but also regulates the amount of sugar that domestic processors are allowed to sell,  thus controlling supply and ensuring high U.S. sugar prices
 
These policies have led to a large disconnect between World and U.S. raw and refined sugar prices. Between 2000 and 2005, U.S. raw sugar prices averaged 20.7 cents per pound while the World raw sugar price averaged 8.9 cents per pound. Meanwhile, during the same period, the U.S. refined sugar price averaged 24.9 cents per pound, while the World refined sugar price 10.9.
 
Temporary Market Disruptions
 
The sugar market experienced tight supply conditions during the late summer and early fall of 2005. These conditions were caused by a series of events including unexpectedly high demand, a poor sugarbeet harvest in August / September 05 due to excessive soil moisture in the Red River Valley, and weak cane sugar production through the first half of ‘05 due to the effects of hurricanes in Florida in 2004 and cold winter weather in early ’05 in Texas,
 
These conditions were further worsened by Hurricanes Katrina, Rita, and Wilma. Hurricane Katrina shut down two cane sugar refineries in Louisiana that accounted for 15% of U.S. capacity. The Imperial Sugar was down for only a week, but was further handicapped by a lack of trucks and rail cars. Meanwhile, the Domino refinery, the nation’s largest refinery, was shut down for three months and did not resume refining till December ’05. Hurricanes Rita and Wilma compounded these problems by destroying additional cane sugar crop in Louisiana and Florida.
 
These supply disruptions caused the price of U.S. refined sugar to spike 50% from 26.75 cents per pound in August ’05 to 40.10 cents per pound in September ’05.  The U.S refined sugar price has trended down since then, reaching 34.50 cents per pound in August ’06 and preliminary data indicates that the refined price will hit 31.20 in September ’06.  
 
Imperial Sugar Overview
 
Imperial is the third largest sugar refiner in the United States. The company has a 15-16% share of the refined sugar market. The two larger competitors in the refined sugar market are Domino Foods and United Sugars, both of which have a 25-30% share of the refined sugar market.
 
As a sugar refiner, Imperial profits on the spread between raw and refined U.S. sugar prices The company sells its refined sugar to industrial buyers such as food manufacturers (49% of revenues), retail grocery stores (36% of revenues), and foodservice distributors (15% of revenues). Sales to industrial buyers generally provide lower margins than grocery or foodservice sales.
 
The company filed for bankruptcy protection in January 2001, attributing its problems to lower sales of refined sugar as well as higher energy costs. The company emerged from bankruptcy on August 29, 2001 and since then has sold a number of their business, including the sugarbeet operations, a significant portion of their foodservice business and their sugarcane refinery in Sugar Land, Texas.
 
Risks
·        Imperial’s fiscal 4th quarter of 2006 should be residually strong
·        Late season hurricanes could damage sugarcane crops or close sugar refineries
·        Reductions in the sugar content of the sugarbeet crop due to an unusually warm spring in ‘07
·        Sugar shortages in Mexico reduce sugar supply in the U.S., leading to an expansion in Imperial’s margins
 

Catalyst

· Strong sugarbeet crop over the 2007 crop year (September ’06 – August ’07)
· Large industrial buyers temporarily postpone their sugar purchases or opt for short-term contracts
· Competitive pressures from Cargill
· Easing of import restrictions on Mexican sugar and the increased use of High Fructose Corn Syrup in Mexican soft drinks due to NAFTA
· Declining spread between refined and raw sugar prices decreases reduces Imperial’s earnings below 2006 levels
· Lehman Brothers liquidates their holdings in Imperial Sugar
· Changes in domestic sugar consumption due to a move towards artificial sweeteners such as Splenda or due to shifts in dietary habits for health reasons
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