STKL - SunOpta: Trying To Transform The Business In The Midst Of Liquidity Concerns

2023-10-04 01:32:57 ET

Summary

• SunOpta is facing some liquidity concerns as the high debt burden and covenants on the revolver can create issues if demand slows down.
• The STKL's efforts to transform the business model are good, but limited funding and the aforementioned liquidity concerns are weighing on the valuation.
• The model suggests a fair price of $1.60 per share, with a downside risk of around 50%.

SunOpta is facing a structurally weak balance sheet that, combined with weakening demand and depressed gross profit margins, is not helping. The company has virtually zero cash and is expecting to continue operating by tapping " operating cash flows , including the selective use of supplier finance programs and the extended payables facility to improve payment terms, together with our revolving credit facility, and access to lease financing".

This leaves very little room for error, and it is not a great place to launch new products and transform the business. There is a lot of execution and liquidity risk embedded in SunOpta, and we are bearish with a target price of $1.60.

The business, the history, and the balance sheet

To provide an overview, SunOpta manufactures and distributes plant-based and fruit-based food and beverages in the US. They have two main segments, plant-based and fruit-based, which bring 60% and 40% of revenues respectively.

As one can quickly notice from simply a chart, the company had better times than today's. Before 2018 they were enjoying both higher revenues and EBITDA, but also a stronger growth profile. Operating margins also failed to keep up as the topline expanded, declining until 2018.

Some improvements in the product offerings and renewed demand growth helped grow EBITDA margins in the 7% range, where they now stand. Another important metric is gross margins. Today they are in the 13% range, which is considerably higher than other plant-based comparables like Beyond Meat ( BYND ), which had negative GM in FY2022. Still, with such low margins, it is very important to sustain prolonged topline growth to reward shareholders.

But let's look at the ugliest part of the story: the balance sheet. During the years SunOpta expanded its PP&E consistently, to have the manufacturing capacity to satisfy the expected growing demand. This however was mostly fueled by expensive debt, which largely remains on the balance sheet.

As of July 1, 2023, the company had around $315 million of net debt, of which $45 million was classified as short-term debt. It is bearing a heavy 7% interest expense that costs the company some $22 million per year in interest only (close to 20% of 2022 gross profit).

Our concerns derive exactly from this point: as the business model shows weakening demand affecting operating profits and cash flows, the company is not in a healthy enough position to structurally change its product offerings quickly enough to successfully turn around. This may create a debt spiral that will be hard to reverse.

Why debt matters: concerns on covenants and liquidity

Leverage is an extraordinary mechanism that can unlock unlimited potential for investors, and in particular for shareholders. However, it is often cited as being as miraculous as potentially catastrophic. All this can be traced down to debt sustainability. In the case of SunOpta, debt is becoming less and less expensive for two main reasons: revenues are declining and so is EBITDA, and more debt is needed to keep the company afloat, thus creating a debt spiral.

As cited at the beginning of the article, the company expects to use the "revolving credit facility, and access to lease financing" to continue to operate for the next 12 months. This will further increase the debt and interest expense burden.

In particular, there are two main issues: (1) covenant breaches, and (2) quarterly and monthly principal repayments. SunOpta has various facilities, the main one is the revolver (senior) from which it borrows using the inventories and receivables as collateral. This credit agreement was amended various times, and the last amendment in September 2022 was particularly crucial as it expanded the maximum permitted leverage ratio from 3.5 to 5.5. This ratio is computed as total net debt / Consolidated EBITDA for the previous 12 months. If these covenants were breached, it would cause an accelerated default under the credit agreement, which means game over 99% of the time for common shareholders.

But let's take a look at where we stand in terms of leverage. Using the specific definition contained in the agreement, net debt is around $316 million, and adjusted EBITDA was $20 million for the last quarter. The ratio using annualized EBITDA should be around 4.2 and 4.4, which seems well below the 5.5 maximum amount.

However, this is where the second point gets involved: principal and interest repayments.

This means that the company is set to spend an additional $18 million in principal repayments on top of around $20-22 million in interest expense. SunOpta burned roughly $12 million in cash from operations + Capex in the last six months, so we expect that these repayments will be further financed with debt. And at 7-8% cost of debt, this will definitely not be cheap enough to keep it sustainable.

Valuation: between the transformation plan and liquidity issues we look for a fair value

The relatively good news is that the company is looking for a quick turnaround. Management is looking to restructure the product portfolio to enhance profitability and growth opportunities, and they presented a 5-point plan to shareholders.

The main focus is on bringing more high-margin, branded products to the market to maximize their manufacturing "hedge" and drive gross and operating margins much higher than competitors. We like this plan and we believe that the market likes it too, as the equity valuation is still very high considering the debt burden.

We will try to prepare a valuation model that embeds both our concerns on liquidity and the capital structure, along with potential improvements in future profitability and topline growth.

We make the following assumptions:

1. Revenue growth rate in the 5% range for the next 5 years, then 4% for the remaining period;

2. EBITDA margin gradually but constantly improving from around 10% in 2022 and 2023 to a more reasonable 13% to show the impact of higher margin product offerings coming into the market;

3. Capex remained consistent with previous years' levels between $30 million and $75 million later in the period to account for increased manufacturing capacity as more branded proprietary products are put into the market;

4. Discount rate of around 9%, computed as WACC.

The outcome is a fair value per share of around $1.60, after deducting the roughly $315 million of net debt from the estimated $500 million in fair EV. This means that from the current price, there is a downside risk of more than 50%.

The upside scenario: how SunOpta can still succeed

There is something good about the plan that management presented. And that is the chance for a deep and long-lasting transformation of SunOpta's business model into a series of premium brands. These brands could eventually bring a very aggressive premium pricing that consumers may be willing to pay to access their higher quality and brand value.

Thus we believe that our model could in this scenario be wrong in estimating only 13% long-term EBITDA margins and lower-than-actual revenue growth. However, this possibility is also balanced by two main factors: (1) the aforementioned liquidity issues, and (2) a lot of execution risk embedded in the plan.

Conclusions

SunOpta is trying to transform its business model and product offerings while having a weak balance sheet with expensive debt and virtually zero liquidity. We are concerned about these liquidity issues in the sense that they might evolve into a debt spiral, along with the limitations that they could pose on the company's transformation plans. Our model provides for a conservative fair price of around $1.60 per share, which means a downside potential of around 50% from the current price.

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