Description

 

TATE.L stock is currently very attractively priced to play sustainably high global food inflation over the next several years. TATE.L is also an indirect way to play global energy upcycle without taking significant risk from ethanol exposure (ethanol profit is very small for TATE).

 

TATE.L is massively undervalued at current stock price of GBP560. By my analysis, the minimum liquidation value of this company is equal to the current share price, i.e. GBP560. To a potential strategic buyer, TATE & Lyle could be worth GBP700-800. On a P/E basis, the stock is trading at 14x FY08 (ending March) EPS estimate of 0.40/shr and 12x FY09 EPS est. of 0.45+/shr.  Comparable companies such as CPO and PENX are trading at 17-19x. ADM is trading at 13x but it has higher exposure to ethonal, which is a drag on the valuation; excluding ethanol (only worth 5x P/E since ethanol profit stream is peaking), ADM is also trading at 17x.

 

The stock also pays 21.5p/shr dividend and dividend is expected to grow at least in line with inflation. It currently yields 3.8%.

 

This great investment opportunity currently exists because of both neglect (by US investors who understands ADM/CPO but rarely ventures beyond the border to check this name out) and misunderstanding (by European investors who don’t have any comparables in their market like ADM/BG/CPO). The complexity arising from TATE’s transition from a legacy European sugar refiner to a largely NA-based value-added corn processor doesn’t help, either. However, such valuation discount will likely be short-lived since over the next 6-9 months, there are multiple positive catalysts to help narrow it.

 

What is Tate & Lyle

 

Tate & Lyle is actually a simple story if you’re willing to look through the ongoing transition process. The core assets that matter are two businesses: 1) a NA-based corn processor called Staley that produces high fructose corn syrup (HFCS) and starch (both food and industrial specification) products (with some small ethanol production); 2) Sucralose, a patent-protected high-intensity sweetener (“Splenda” for consumer brand – yes, the yellow package of sugar substitute you see in any restaurant) that has global leading market share.

 

The complexity of Tate & Lyle’s story arises since the company is in the middle of transforming the business from a mix of specialty (startch) and commodity (sugar) business to almost 100% specialty (if counting HCFS as specialty) over the next few years. When the dust is settled, we will see a company to have an earnings power in the area of 0.40-0.45 from the core Staley and Sucralose businesses in FY08 (ending March) that can grow at least low-teen for the next two to three years.

 

The following is snapshot of TATE’s earnings development in the next two years, without assuming any share repurchases:

 

 

 

Realigned format	FY ending Mar		2006	2007A	2008E	2009E
Revenue
Core business
Food & Industrial Ingredients Americas			1127	1255	1252	1314
Sucralose			142	147	149	157
Total Core business			1269	1402	1401	1471
De-emphasized
Food & Industrial Ingredients Europe			719	825	590	405
Sugars (Americas and Asia + Europe)			1732	1843	1587	1666
Total discont'd or de-emphasized			2451	2668	2177	2071
Total revenue			3720	4070	3578	3542
EBITA
Core business
Food & Industrial Ingredients Americas			125	175	192	222
Sucralose			68	71	66	73
Total Core business			193	246	258	295
Discontinued or de-emphasized
Food & Industrial Ingredients Europe			46	78	41	31
Sugars (Americas and Asia + Europe)			89	84	49	57
Total discont'd or de-emphasized			135	162	90	88
Corporate				-35	-35	-36
Total EBITA			328	373	313	347

 

EPS
FY ending Mar			2006	2007A	2008E	2009E
Core business
Food & Industrial Ingredients Americas			£0.18	£0.25	£0.28	£0.32
Sucralose			£0.10	£0.10	£0.10	£0.11
Total Core business			£0.28	£0.35	£0.38	£0.44
Discontinued or de-emphasized
Food & Industrial Ingredients Europe (100% gone)			£0.07	£0.11	£0.06	£0.05
Sugars (Americas and Asia + Europe)			£0.13	£0.12	£0.07	£0.08
Total discont'd or de-emphasized			£0.19	£0.23	£0.13	£0.13
Total segment EPS			£0.47	£0.59	£0.52	£0.57
Minus:
Corporate				-£0.05	-£0.05	-£0.05
Interest expense, net			-£0.05	-£0.05	-£0.06	-£0.06
Minority interest			-£0.01	-£0.01	£0.00	£0.00
Reported EPS			£0.42	£0.48	£0.40	£0.46

 

The underlying assets for the core business are extremely attractive in a rising food cost and booming agriculture environment. The key assets for Staley include five wet corn  processing mills in the US and Mexico, out of totally just 17 in the NA. Nobody is building new wet mills since it costs more money than dry mills, which are the fastest way to construct ethanol capacity. As a result, starch and HCFS, the products you can normally only produce during wet milling process, is getting tightened, rendering TATE and other HFCS producers pricing power. In a rising feedstock (mainly corn) environment, such pricing power not only allows TATE to pass through raw material cost, but more importantly, allows TATE to expand margin (like any other commodity business, higher feedstock price is good as long as supply/demand balance is tight).

 

The sucralose product, despite running into near term problems due to higher start up cost in the newly expanded capacity in Singapore and slower growth from consumer product customers due to moderating new products launching cycle, remains a long term growth story, particularly in the the international markets.  

 

What happened to the stock

 

The stock was once high at 8 pounds when Splenda was viewed as a high growth product. The stock dropped first in January this year when the company disclosed the unexpected slowdown in sucralose; it recovered later when the company updated the business situation in late March with no more negatives out and climbed back to almost 7 pounds before it dropped again below 600p when it reported FY07 financial results in mid-May. The second drop actually made no sense since the management didn’t say anything new but just repeated the negatives it disclosed in January. The only thing they added is for the first half of FY08, they expect Sucralose earnings could see a YoY negative comp due to startup cost and patent litigation costs not enough offset by revenue growth.  Most sell side analysts did not revise down number in January; they did not do it in March, either; they only started to adjust their number down after the FY07 results were out. All of sudden, the consensus mean estimate was crashed. Or even worse, those who revised down number also took the opportunity to publish big multi-page detailed reports that made negative issues look fresh new, therefore terrifying a new investor who has no background knowledge. Only few analysts got it right, like Credit Suisse analyst; he changed the estimate already in January and did not see any need to change the number again after the FY07 earnings call. But he is in the minority and he doesn’t update the company in big-piece report – so he’s playing typical sell-side analyst cautious game, not fighting the headwind. Anyway, you got the picture. In the meantime, CPO, the most comparable peer company, just makes new high almost everyday in the US market.

 

Liquidation value

 

Each wet mill typically costs $300-350mm to build so TATE's five wet mills could be worth $1.6bn, or GBP 800mm (note: one mill is a 50:50 JV with ADM in Mexico; the valuation here is a rough estimate, not to be precise).

 

The proceeds from the sales of Canadian sugar refinery brought in GBP131mm on 04/21/07. The planned exit from about half of European food/ingredient business is expected to bring in another GBP200+mm. Furthermore, EU transitional aid grants totalling 73mm should be received in later FY08.

 

Splenda currently earns 10p/shr, which should be worth at least 2 pounds/shr or about GBP1 billion.

 

TATE spends GBP35mm a year on corporate overhead, which is largely concentrated in its London headquarter as well as R&D centers while TATE’s business activity is increasingly concentrated in North America. Such corporate “fat” could be immediately eliminated either in a liquidation or in a buyout. This should be add back at least GBP400mm, or another 70+p/shr.

 

Total debt, net of cash, is roughly GBP900mm. This should be offset by 1) the value in the remaining European sugar and food/ingredient business, which earns roughly 13p/shr; 2) like other major agribusiness companies, TATE owns ag-infrastructure assets like storage terminals, leased rail cars, etc., which are not counted here but actually valuable assets (but the magnitude of TATE’s agri infrastructure seems to be much smaller than ADM, Cargill, Bunge or Louis Dreyfus, since agri-service is not big part of its business).

 

Added up, the liquidation value of the business appears to exceed GBP 2.8bn, or 560p/shr (note: I’ve not accounted for any working capital, which included 500mm inventory and 550mm receivables with not much payables to offset; this could add another 750mm or 1.50+/shr if using 25% hair-cut => upside: 700+p/shr in a liquidation scenario)

 

 

 

Business Description for Tate & Lyle

 

 

I.                   Food & Industrial Ingredients America (TALFIIA)

 

FIIA is the single largest contributor to TATE’s profitability (60-65% of FY08 earnings).

 

Core assets are five wet mills in the NA, all around the US corn belt except for one in Mexico

1. Decartur Illinois
2. Lafayette Indiana (two plants)
3. Loudon, Tennessee
4. Mexico (thru 50:50 JV w/ ADM)

 

Competitive landscape (total 17 wet mills in the NA)

 

ADM: 42%

Cargill: 25%

TATE: 14%

CPI: 10%

GPC: 4%

National: 2%

Roquette: 2%

Penford: 1%

 

Annual corn consumption: 210mm bushels a yr

 

capacity for HFCS is 4420m lbs dry basis = 6300m lbs wet/commercial basis
assume run at 85% capacity, Staley makes 5300m lbs wet/commercial basis
1 bushel makes 47lbs wet basis
so 0.0213 bushels to make 1 lb of HFCS, wet basis

HFCS-related corn consumption: 113mm bushels a yr

Other sweetners-related consumption: 80mm bushels a yr

 

Corn purchase: most of it being made in January on an annual contract basis (at the same time as it agrees annual contracts for some of its key products such as HFCS).

Capacity is so tight that the management said “100% utilized”.

 

The industry is not adding new capacity except for TATE’s own expansion in the specialty starch areas. Why? According to Corn Products Int’l, even at today’s profitability, ROIC is only 9-10%, still below the industry’s reinvestment hurdle rate of low double digit.

 

HFCS (a commodity that’s hot now – by my definition, sort of “specialty”, meaning having pricing power)

 

HFCS represents one third of total FIIA profits. HFCS is a low-cost substitute for invert (liquid) sugar. It’s used as a sweetening input in the food and beverage (non-diet soft drinks) industry. There are two common variants: “42” which contains 42% fructose and “55” which contains 55% fructose.

 

Biggest HFCS market is in the US, but facing soft volume growth as it matures after many years’ development (since 1970s); Mexico and Asia, though, are growing faster. Particularly, Mexico will phase out taxes on HFCS imports from US starting Jan 2008, which will increase demand for HCFS exports from the US.

 

The market is currently tight with no new capacity being added since 1997.

 

TATE, through its US subsidiary Staley, has 4.4bn lbs a yr of HFCS capacity (on dry basis). Each 1c/lb price increase can benefit TATE by US$44mm or GBP22mm (pretax); aftertax would be almost 3p/shr. On the other hand, each 10c/bushel rise in corn price on 110+mm bushel corn usage will reduce pretax profit by  GBP3mm (assuming 50% of net rise with byproduct offset). FY08 contract HFCS price is increased by 2c/lb while corn price appears to rise by $1/bushel (from $2.40 to $3.40 in Nov ’06 during contract negotiation period). So net net, HFCS profit should rise by at least GBP15mm before any small volume increase benefit. FY08 earnings will also benefit from completion of Sagamore and Loudon plant expansion. 

 

Ethanol

 

TATE produces ethanol from its London, Tennessee facility, with annual capacity of 67mm gallons. It will further expanded to 104mm gallons/yr by Oct. ’07. Profit from ethanol for TATE, however, is relatively small, at roughly $50mm in FY07, assuming 50c/g kind of margin, the same as ADM’s under oil price assumption of $55-60/bbl. In FY08, ethanol profit is assumed to be at just 1/3 of what it earned in FY07, which could be too conservative.

 

Citric Acid

 

Citric acid is used to impart a pleasant, tart flavour to foods and beverages. It also finds applications as a functional additive to detergents, pharms, cosmetics and toiletries. Of the estimated 1.4mm tons of annual production, 70% goes to food and beverage. Market growth is around 3-5%. Citric acid is made by fermentation of glucose or dextrose via feed stocks including corn, wheat, cane sugar and beet sugar.

 

TATE became world leader in citric acid in ’98 with a 20% market share following its purchase of Haarman & Reimer’s food ingredients division for $219mm. From hindsight, it was a bad deal as a major build-up in citric acid capacity in China led to a global glut of citric acid and prices plummeted with the low point reached in FY03. Market condition has improved since then, driven by rationalization on the supply side: both ADM and Aktiva closed plants, while in China smaller manufacturers exited the business. TATE also closed its Mexico plant and convert part of the UK plant to the production of astaxanthin. Coupled with higher energy price, market price for citric acid rose by more than 10% in 2005/2006.

 

Alemex

 

This is the wet mill JV in Mexico, 50:50 with ADM. The main products are HFCS, corn syrup and dextrose. Profit fortunes tend to be counter-cyclical with Oxidente, TATE’s Mexican sugar JV.

 

Astaxanthin Partners (included in JV)

 

A 50:50 JV with Igene (a biotech company), established in 2003, produces astaxathin, a key food fro salmon and trout. For whatever reason, global farmed salmon demand and production growth prospect looks very promising till 2010, which is good for this venture.

 

Bio-PDO (included in JV)

 

A 50:50 JV with DuPont. The major product is Bio-PDO, sold to DuPont and its licensing partners for Sorona, and other third-parties. TATE also supplies glucose substrate to the JV.

 

1,3 PDO (propanediol) is a linear aliphatic glycol which can be made by either petrochemical or biological means. The most successful application to date has been as a feedstock to produce the polymer PTT (polytrimethylene terephthalate). Two major producers of PTT: DuPont (“Sorona”) and Shell (“Corterra”). These fibres have numerous advantages over nylon and polyester, including stretch and recovery, softness, dye-ability, stain resistance, heat set ability and chlorine and UV resistance.

 

Mohawk Carptets announced the launch of “SmartStrand” product range, which incorporates Sorona.

 

DuPont/TATE started to cooperate in 2004, investing $50mm each to construct a plant based in Loudon, Tennessee. It was operational since March ’06. The capacity is around 100mm lbs/yr “Bio-PDO”.  JV’s production process is significantly low-cost than its petrochemical equivalent. It was originally developed under oil price assumption of $22-30/bbl – now oil is $60+/bbl. Cost advantage could be at least $0.15/lb, or 20% of avg. Bio-PDO selling price.

 

DuPont owns the microbe patent as well as the Sorona trademark, but the JV owns the patents surrounding the manufacuting process. Not yet quantified, but the future benefit from this JV could be significant.

Food ingredients

 

Sales from food ingredients exceeds $400mm or GBP200mm. Major products include:

 

Fructose: KRYSTAR crystalline fructose, a nutritive corn sweetenr, processed from HFCS. Difference from HFCS: high relative sweetness, synergy with nutritive and non-nutritive sweeteners and interaction with a wide variety of food ingredients.

 

Maltodextrins: STAR-DRI, used in a wide variety of foods for contributions to texture, viscosity,, moisture control, film formation and other functions. Increasingly used in reduced fat foods.

 

Polydextrose: STA-LITE, a premium, low-calorie bulking agent used to provide body and texture in reduced-calorie and low-calorie foods.

 

Sorbitol:  a low-calorie bulking agent and sweetener; widely used in bakery and confectionary industries to control and maintain moistness as well as to increase shelf life.

 

Sepicalty starches: broad range of corn, wheat and tapioca starches, helping improve shelf life, creating exciting new textures and providing added nutritional benefits.

 

Wheat proteins: help to build high-protein, low carbohydrate products.

 

 Industrial starch

 

$230mm (out of $1,127mm total for TALFIA). Total value-added sales in FY06: $187mm, with commodity products accounting for $44mm (such as unmodified pearl starch)

 

Breakdown by end markets

-         paper sizing: 49%

-         Paper strength additives: 26%

-         Building & construction products: 8%

-         Adhesives: 8%

-         Textile: 2%

-         Oilfield: 6%

-         Other: 1%

 

Growth in paper starch: 2%  btw. 2003-2015 (LMC est.)

Paper starch is typically regional business. Despite modest growth expectation, the expected 2% growth before 2015 would translate into incremental demand of 575,000 tons for the US market – a big number required to have new capacities, but there is very few building.

-         TATE is building a Greenfield cationic starch plant in Fort Dodge, Iowa, with an expected start up in CY09. Cationic starch improves the strength of paper allowing bigger scale production running faster (the size of such paper machine stretches for a length of a football pitch)

-         But at the same time, TATE will transfer its Sagamore capacity to Fort Dodge, so net incremental increase of paper starch is much less. Sagamore plant will be freed up to produce additional specialty FOOD startches.

-         TATE is also #2 supplier of ethylated starches to NA paper industry; such starch allows production of magazine and copy paper. It helps papermakers to achieve a higher brightness level that can’t be reached via the use of unmodified starches. It also permits the paper maker to incorporate higher levels of lower cost filler in the paper. TATE is a low cost producer of ethylated starch (branded as Ethylex/0

 

North America market share for industrial starch (TATE is the leader)

 

TATE: 25% (in the paper industry, TATE’s share is 29%)

Penford: 22% (in the paper, Penford’s share is also 22%)

ADM: 14%

Cargill/Cerestar: 12%

CPI: 9%

National: 8%

GPC: 7%

Other: 3%

 

CCI

 

Acquired in late ’05, CCI is employee owned and was founded in 1975. Its headquarters and primary operations are located in Sycamore, Illinois and it also has operations in Mexico and Canada.  CCI is a leader in dairy stabilisers and emulsifier systems and works closely with customers to develop ingredient systems for the North American market.  CCI also has expertise in beverage flavours and vitamin and mineral fortification.

 

II.                Food & Industrial Ingredients Europe (TALIIE)

 

The starch sweetener business has little data available. The whole industry in Europe produces around 7mm tpa, with starch sweeteners (such as glucose syrup, dextrose, maltodextrin, isoglucose) accounting for around 70% of this production. The market share is roughly as follows

 

Cargill                          35%

TATE                           25%

Roquette                      15%

Syral                            5%

Pfeifer & Langen          5%

Other                           15%

Total                            100%

 

The key asset within TAIIE is Amylum business (TATE bought out CIP, a private investment company in Luxembourg which used to own 36.7% of Amylum, in 2000). The vast majority of profits in TAIIE is from starch sweeteners. The residual income generators are wheat protein and wheat gluten sales to the food and animal feed industries, and starch sales to the paper industry. Commodity-nature products represent 2/3 of total profit (different than TAIIA).

 

This business (now largely being sold) is in severe cost pressure as wheat price jumps even more than corn price. Unlike TAIIA, wheat is the principal feedstock used by TAIIE. TALIIE is estimated to purchase around 2-3% of total EU’s annual wheat production, or 3.25mm tones a yr. By products from wheat include gluten, bran and protein.

 

On May 9 2007, TATE announced it is at “an advanced” stage of exclusive discussion with Syral SAS (a subsidiary of Tereos of France), which could lead to the disposal of TATE’s interest in almost half of its Europe Food and Ingredient business. This is a win-win deal since Syral has technology to convert Amylum facilities into wheat-based biofuel production. Gross cash consideration is expected to be 200-220mm pounds. Excluded from the disposal is its operation in Netherlands (corn-based valued added starch), Morocco and the Eaststarch JV.

 

TAIE paid GBP34mm in 2006 for Cesalpina Foods, which was formerly owned by the Italian MARE group (a manufacturer of industrial chemicals, detergent and adhesives, and food additives). It was founded in 1960s as a producer of natural flavor and later diversified into natural gums and stablisers. The business operates predominately from Italy, with production sites in Sicily and Milan. The acquisition of Cesalpina expands TATE’s knowledge of gums and stablising systems and further enhances its expertise in providing solutions for key target markets such as dairy, soups, sauces and dressings. Furthermore, the acquisition gives TATE access to a largely complementary customer base.

 

Isoglucose is the European name for high fructose corn syrup (HFCS). In contrast to the US where is typically trades at a big discount (recently a lot narrowed, though, w/ rising HCFS prices, but still 20-30% discount) to sugar, in Europe, isoglucose trades at only a small discount to sugar due to restricted supply. TATE participates isoglucose through a JV with ADM called Eaststarch (through Amylum).  The JV has interest in Slovakia (where TATE has a 50% share) and Hungary (where TATE has a 25% share). Of the total existing European quota for isoglucose of 507,680 tonnes, the JV has a 68% of the quota – effectively TATE has a 43% of the quota or 218 tones.

 

Eaststarch will feel more pain from under the new sugar regime, because unlike sugar producers who experience a material decline in market prices, but have the benefit of the offset of a lesser decline in raw material price, isoglucose producers get no offsetting benefit from a reduction in raw material price since they use either corn or wheat as feedstocks. This could be one of sources of further earnings downside risk – nevertheless, Eaststarch in total only generated GBP 55mm pretax profit, so the magnitude of downside risk is quite limited. In the worst case, the venture could be shutdown in a few years but by then the rest of TATE’s business will have grown much faster.

 

 

III.             Sugar Europe

 

The EU sugar regime (called the Common Market Organisation or CMO) expired on 30 June, 2006. Before then, white sugar prices in the EU had typically been three times higher than world market prices. Also, the EU’s structural sugar surplus had increased following the EU’s expansion from 15 to 25 countries (EU production: 19-20 mm tons; imports from India and ACP: 2 mm tons => total supply 21-22 mm tons; consumption: just 16 mm tons => surplus: 5-6 mm tons).

 

TATE’s principal European sugar interest is in cane sugar refining. Under the old regime, TATE had the right to refine around 1.3bn tons of white sugar equivalent (WSE) of preferential raw cane sugar, out of totally 1.8 mm tons of total European cane refining rights. TATE operates from two plants, one in the UK (1.1bn tpa) and the other in Portugal (0.2bn tpa).

 

In additiona, TATE owns a 50:50 JV with Sudzucker, called Eastern Sugar, a beet sugar refiner. This business operates in Slovakia, Hungary and the Czech Republic. In total, the JV has 280 tons of quota.

 

70% of TATE’s sugar sales go to industrial customers (such as food manufacturers, grocery stores, and foodservice distributors, etc.) and the rest being sold in the retail market under the Tate & Lyle brand name.

 

Estimated market shares (including both beet sugar and cane sugar) in the EU industrial sugar market is as follows:

 

British Sugar                 38%

TATE                           29%

JBS/NBF                     25% (resellers for both British Sugar and TATE in the UK)

Other resellers              4%

Importers                     4%

 

If resellers’ volume factored into market share calculation, TATE’s market share is around 40% of EU industrial market.

 

In the EU, sugar tends to be sold at a premium to the EU intervention price (euro 631.90/t). This is largely a result of market collusion.

 

After the regime expiration, the market premiums have been falling. The future level of any premium will be determined by

1)      the rate at which beet producers/farmers will exit the industry;

2)      the attractiveness of the market to Everything But Arms (EBA) producers and the likely development of domestic consumption in those markets

3)      the continuance of the 1.27mm tones of subsidized export allowable under WTO

4)      the development of world market prices.

 

Within Sugar Europe, TATE operates a sugar trading operation that is estimated to trade around 4-5mm tons of raw and white sugar a year, making it one of the top three sugar trader in the world.

 

Long term sugar price expectation

 

There are reasons to be bullish about sugar price in the long term:

 

1)      rising production costs in Brazil (the largest sugar exporter)

2)      Demand for alternative fuels such as ethanol diverting increased volumes of cane away from sugar

3)      Reduced EU exports as a result of the new European sugar regime

4)      Due to increased domestic demand, India and China shifting to being net importers from being net exporters.

 

It also trades molasses, a by product of the cane and beet industries. It’s an established animal feed ingredient and is also used as a feedstock into a range of industrial processes, such as fermentation. TATE operates a worldwide molasses storage business called United Molasses.

 

Bunge recently announced its intention to go into sugar business. Given Bunge’s traditional focus on South America, TATE’s sugar assets might not be interesting to Bunge. However, when I spoke to Bunge about this topic, they didn’t indicate South America will be the only place they’re seeking to enter in the sugar space. TATE’s sugar trading business, which generates 20+mm pounds of EBITA a year, could be very attractive to Bunge to supplement its own global ag commodity trading desk. More importantly, I will speculate, if TATE stock stays this cheap for longer period of time, say 9-12 months, Bunge could bid on the whole TATE business. Remember, Bunge doesn’t have much presence in the corn milling space as well as sugar area, so a buyout of TATE will not incur any anti-trust issue. It could be positive for Bunge shareholders in terms of further diversification.

IV.              Sugar American & Asia

 

TATE’s transformation actually started in earlier part of this decade, when it retrenched from its global sugar aspirations and disposed of many of its less profitable and more commodity sugar interests. Most important amongst these disposals were Bundaberg, the Australian business and the North American businesses, Western Sugar and Domino.

 

The more recent disposal is its Canadian sugar refining business (“Rdepath) at a price of BGP131mm (0.5mm tpa processing capacity). The sales of this business is positive for working capital because one unique thing about Redpath is that the seaway freezes over the in the winter months preventing the import of raw cane. For this reason, the business typically carries a lot of stock at year-end and profits can be impacted by stock revaluations.

 

As a result, Sugar America & Asia is now left with only sugar interests in Vietnam and Mexico.

 

Vietnam: Nghe An Tate & Lyle (NATAL)

 

It’s a JV cane sugar business that processes cane to produce raw cane sugar (it doesn’t refine). TATE has a 60.7% share of the JV, the other parner being a local state-owned company. Vietnam is considered as a market with good growth potential. Its profitability is influenced by world sugar prices.

 

Mexico: Oxidente

 

It’s a JV cane sugar business, the same as NATAL. TATE has 49% share of the JV, with the remaining stake being held by a Mexican family.

V.                 Sucralose (Splenda)

 

Splenda is made from pure cane sugar that is chemically altered to create a compound that doesn’t contain any calories. It is appealing to consumers’ demand for healthiness and wellness, particularly child obesity and diabetes. In the EU, it is also known under the E number (additive code) E955. It’s 500-600 times as sweet as sucrose, making it roughly twice as sweet as saccharin and four times as sweet as aspartame. Unlike aspartame, it is stable under heat and over a broad range of pH conditions, and can be used in baking, or in products that require a longer shelf life. 50+% of Spenda is used for food, with beverage and pharm taking 40% and 8%, respectively.

 

With Feb 2003 realignment of J&J vs. TATE relationship, TATE now manufactures Splenda as well as sells to the industrial market while, McNeil, a unit of J&J, retains ownership of Splenda brand name and sells to the retail and foodservice market.

 

The addressable market is global high-intensity sweetener (HIS) market, which is over $1bn. By volume, total high-intensity sweetener market is just above 10% of total sweetener (sugar, HFCS and HIS). HIS is dominated by aspartame and sucralose actually accounts for just 20% of total HIS category. With superior product characteristics (exceptional heat stability, no unpleasant aftertastes and far fewer health concerns), the potential for future growth should be clear.

 

 3-4% growth expected for volume

Pricing war from competitors (flat pricing in ’06)

Expect market shr to continue to expand

 

Splenda (yellow) now accounts for about 60% of consumer sugar substitute market in the US. Competitors, Equal (blue) and NutraSweet (white), have been losing shares.

 

TATE is doing better because of 1) perceived superior quality and 2) hundreds of millions spending on advertising (Equal and NutraSweet don’t spend much). In the advertising, TATE said Splenda is “Made from Sugar”, which a lot of consumers buy into. In reality, Splenda is just another synthetic compound but its advertising campaign is a successful one.

 

The bottom line is, if TATE makes a superior product and it advertises the hell out of it, the competition ought not be able to take that away from TATE, even in the court (Equal is suing Splenda in US District Court in Philadelphia for this “Made from Sugar” ad).

 

There is pricing competition from competitors, but Splenda holds up pricing so far quite well. But still should expect some weakness of pricing to drive up volume to better utilize its own expanded capacity.

 

Market breakdown

US: 55%

Eruope: 21%

Asia Pacific: 17% (including Japan)

Rest: 7%

 

Patent protection on intermediates and manufacturing; expiration by 2020 (35 patents across 20 countries, all significant sweetener markets that have a robust legal framework for IP protection; further seven patents pending for approval)

-         a small patent for a manufacturing process that starts with raffinose did expire in 2006

-         but this patent has no commercial value without other patents.

 

Gross margin: 46-48%

Very small quantity out from China despite generic concern

-         Sucralose is being offered for sale in India and China by companies other than TATE and McNeil (not a surprise in these weak legal framework for IP protection markets)

o       India: “Zero” introduced by a local company Alembic; but only did GBP 1mm sales; suspect they might just resell TATE products

o       A host of Chinese companies are heard to do research on sucralose; but no commercial quantity can be successfully bought in China, according to TATE (they tried by themselves)

80+% goes to food, of which J&J only has 17%.

 

Sucrose is not difficult to produce in a lab, but manufacture of industrial quantities is a much more complex process – it took TATE and J&J over 20 yrs to develop a robust, economically viable manufacturing process.

 

After doubling the capacity by Jan ‘07, its utilization rate is running at only 1/3 today (before 50-60%). The management has a goal to fill it up in 4-5 years.

 

New plant in Singapore (cost GBP100mm) just opened in on 04/27/07,which tripling the capacity for TATE. Singapore is chosen due to its proximity to Asia (Japan is an important market), economic support from Singapore government, and most importantly, a strong legal framework for protecting IP.

 

Health concern risk: some reports talked about the presence of chlorine in sucralose. But the product has been tested extensively and past fit for human consumption in more than 80 countries. 

1HFY07 flat sales/profit: customer inventory building prior to TATE’s capacity expansion; also CSD’s uptake of Sucralose is not as good as expected, probably because it tastes too much like sugar while typical diet-coke or diet-Pepsi drinker doesn’t like it.

The following is a simple illustration of EPS accretion from a GBP300mm buyback for TATE (note: “core business” is defined as North America Food and Ingredient business plus Sucralose)

 

Core EPS post restructuring - on PF basis, using mid-range est. of shr buyback
			FY06a	FY07a	FY08e	FY09e
EBITA from core business			193	246	258	295
Tax exp.			(58)	(72)	(70)	(80)
Minority int.			(4)	(3)	(1)	(1)
Net income			131	171	187	214
EPS			£0.30	£0.39	£0.43	£0.49
Share count post restructuring (GBP300mm)			437	437	437	437
EPS from other businesses					£0.15	£0.15
Debt expense (net of tax) - per share					-£0.09	-£0.09
Corporate					-£0.06	-£0.06
Firm EPS					£0.43	£0.49

 

 

Risk

 

1) 1H08 (btw. Aril – Sept.) results are expected to be below trend due to the reasons I discussed before (Surclose startup cost, ethanol profit drop from last year’s extremely high level, new expanded capacity not coming along until 2H08, etc.). However, given the low expectation in the market, I believe any earnings shortfall should be already priced in.

2) Currency risk: after disposal of 50% European Food and Ingredient business, TATE will become more NA-focused company but remain as a UK stock. As a result, each $0.10 change in $/sterling => GBP 14mm or 3p/shr EPS. However, US investors are naturally hedged by owning share in UK currency while measuring investment return in $. From balance sheet perspective, 72% of debt is USD/CAD denominated. The management also allocates debt within different geographies better to lower effective tax rate lower.

Catalyst

Intermediate catalyst will arrive when TATE conducts its annual shareholder meeting on July 18. The management is committed to returning excess cash from the recent asset disposals to shareholders via shr buyback. At current stock price, share repurchase would be accretive by 2-3p/shr, assuming TATE can do a 10% shr repurchase (the maximum normal course buyback limit) or roughly GBP300mm.



The following is a simple illustration of EPS accretion from a GBP300mm buyback for TATE (note: “core business” is defined as North America Food and Ingredient business plus Sucralose)