Spruce Point Capital Management Announces Investment Opinion: Releases Report and Strong Sell Research Opinion on Saputo, Inc. (TSX: SAP)
NOTE TO EDITORS: The Following Is an Investment Opinion Issued by Spruce Point Capital Management
Believes That After Years of an Aggressive Global M&A Expansion Strategy, Saputo is Struggling Against Organic EBITDA Decline as a Result of Negative Trends in Dairy Consumption, Inefficient Operations, and Escalating Environmental Compliance Costs Among Other Things
Provides Evidence That Saputo is Becoming Less Transparent with Financial and Business Disclosures, Supporting our Opinion That Management’s Global Strategic Plan to Combat its Struggles Will Ultimately Fail
Expresses Concerns as to Why Saputo Has Obscured Australian Financial Reports in an Undisclosed Numbered Entity and Has Implied Abnormally High Margins in Argentina
Illustrates That Saputo’s Dividend Has Not Been Sufficiently Covered in Recent Periods and That Aggressive Increases in Cash Flow Have to be Assumed in the Future to Cover it
Believes That Saputo’s Leverage is Higher by Approximately $724 million Than Reflected on its Balance Sheet as a Result of Exposure to a U.K. Pension Plan That is Highly Sensitive to Surging Inflation
Sees 40% to 60% Downside Risk to SAP’s Share Price and Urges Investors to Visit www.SprucePointCap.com and Follow @SprucePointCap on Twitter for the Latest on $SAP.TO
November 29, 2022 09:30 AM Eastern Standard Time
NEW YORK--(BUSINESS WIRE)--Spruce Point Capital Management, LLC (“Spruce Point” or “we” or “us”), a New York-based investment management firm that focuses on forensic research and short-selling, today issued a detailed report entitled “Crying Over Spilled Milk” that outlines why we believe shares of Saputo, Inc. (TSX: SAP) (“SAP” or the "Company") face up to 40% to 60% downside risk, or $13.75 – $20.50 per share. All figures referenced are in Canadian Dollars, unless otherwise specified. Download or view the report by visiting www.SprucePointCap.com and follow us on Twitter @SprucePointCap for additional information and important updates.
Spruce Point Report Overview
Based in Montreal, Quebec, Canada, Saputo, Inc (“SAP”) is an S&P/TSX Composite Index member that manufactures dairy and grocery products. Saputo was founded in 1954 and expanded domestically through organic growth and a roll-up of acquisitions to become one of the largest dairy and cheese manufacturers and distributors in Canada. Saputo IPO’ed on the Toronto Stock Exchange in 1997 and quickly expanded into the U.S. through acquisitions as well as internationally to Europe, Argentina, and Australia. Saputo drove early value as a public company by using an M&A roll-up strategy in what was a very fragmented market.
However, Spruce Point believes that Saputo is now in the decline and restructuring phase of its growth as it struggles against many negative forces, such as declining dairy consumption, rising environmental compliance costs, inefficient logistics and operations, key customer loss, high wage costs, a focus on branded vs. private label, and limited R&D spending to succeed in the burgeoning plant-based diary business. Spruce Point lays out the case that Saputo’s Global Strategic Plan will fail to achieve its goals.
- Saputo’s aggressive acquisition spree shows signs of struggle. Saputo recently gave itself an overly positive assessment of its acquisition track record, claiming that perhaps one or two haven’t performed as planned. However, Spruce Point believes there are multiple acquisitions across the globe where Saputo overpaid for companies that did not ultimately stimulate organic growth. After factoring in Canadian dollar currency depreciation, we estimate just 2.4% of organic revenue growth in the last five years. On an EBITDA basis, Saputo’s performance is even worse. Based on our estimate, there has been between $274 - $341 million of EBITDA erosion in the business, while adjusting for foreign currency effects over the same period. Our conclusion: either many acquisitions never had any EBITDA to contribute, or EBITDA has subsequently been eroded post contribution to Saputo. Further, Saputo has not recently impaired any of its more than $3.3 billion in goodwill. Saputo tests impairment using EBITDA as a proxy for cash flow, but we illustrate that its EBITDA has historically converted to cash flow at approximately 70%.
- Rising operational challenges and environmental costs appear to be hampering Saputo. Spruce Point is concerned by Saputo’s increasing spend on environmental compliance, which we believe is indicative of its aging manufacturing facilities, and frequent challenges complying with environmental laws. In fact, in September 2021 Saputo U.K. (Dairy Crest) pled guilty to more than 20 charges for breaches to its Environmental Permit at the Davidstow Creamery. As reported by The Guardian, Saputo still has not yet fully addressed all of the concerns of the U.K. Environmental Agency. Spruce Point finds that Saputo’s total environmental costs are surging from $4.6 million to $64 million (0.04% to 0.37% of revenues) from 2017 – 2023, or a CAGR of 55%. There is little margin for error in food manufacturing, since the slightest mistake can cause contamination, illness, and even death. The repercussions could be long-lasting and tarnish the food brand. Moreover, we’ve also noticed a recent uptick in product recall notices by Saputo. We’ve identified six product recalls since 2021, with three in Canada, two in the U.S. and one in Australia. There have also been six U.S. Occupational, Safety and Health Administration (OSHA) and four U.S. Food and Drug Administration (FDA) citations since 2020.
- Many subtle signs of growing financial stress have emerged at Saputo, while disclosures and transparency decrease. Spruce Point’s findings at Saputo are consistent with those of many of the companies we have analyzed over the years that are experiencing increasing financial stress, which is often accompanied by reduced investor transparency and disclosures. As recently as FY 2022, Saputo has stopped providing color on multiple historic disclosures including, 1) market share in Canada, 2) revenue contribution from acquisitions, and 3) excess manufacturing capacity by region. With respect to Saputo’s Canadian leadership, we find subtle yet striking evidence that it has lost its leading position. Looking carefully, we observe that Saputo recently went from describing itself as “The Leading” to “A Leading” processor of cheese, fluid milk, and cream. Upon evaluating Saputo’s working capital stress in relation to its revenues, we found that it has been steadily increasing in each of the past five years. Saputo has exhibited the largest increase in Days Inventory Outstanding (DIO) among its global set of dairy industry peers. In fact, over the past four years, Saputo’s DIOs have increased by nearly 20 days. As a result of these rising strains, we believe Saputo has implemented actions that were designed to conserve cash. For example, Saputo has not repurchased any stock since FY 2018. This was a fortuitous decision coinciding with a recent peak in the share price. In FY 2020, it implemented a Dividend Reinvestment Program (“DRIP”) to reduce the cash dividend burden. Furthermore, Saputo generally increases its dividend annually, but did not enact an increase in FY 2023. Lastly, in FY 2021 it implemented an accounts receivable factoring program to accelerate cash flow.
- Saputo obscures Australian regulatory filings in an undisclosed numbered entity, masking what appears to be abnormal margins in Argentina. Saputo has chosen to combine reporting of Australia and Argentina under its International segment. It makes its Australian regulatory filings under A.C.N. 166 119 133 Pty Ltd., which is not disclosed in Saputo’s Canadian regulatory filings. Recent Australian filings indicate that Adjusted EBITDA margins have contracted from 8.2% to 6.0% from 2020-2022 and that only A$4 million of operating cash flow was generated on A$2.7 billion of sales in 2022. We can now estimate Argentina’s margins by deducting Australian results from total International EBITDA. The results imply 25.7% and 24.3% EBITDA and EBIT margins in FY 2021 and a sharp decline to 10.3% and 8.8% in FY 2022, respectively. Based upon a comparison, it is clear that Saputo’s 24.3% EBIT margin in 2021 was a significant outlier to local and regional Latin American peers, which average 5.8%. Despite this, in 2021, Saputo’s CFO said that “no major ups or downs” were expected, while their CEO claimed there was “very little risk in Argentina.” The section in Saputo’s Annual Report discussing the International segment EBITDA provides no insights into what drivers might be affecting Argentina’s EBITDA. Furthermore, Saputo appears to have made leadership changes by appointing Marcelo Cohen as President and COO of Argentina effective April 2021. We believe that these abnormalities indicate Saputo should provide additional commentary and clarity about international operations.
- Spruce Point cautions investors that in recent periods Saputo has not generated enough excess cash flow to cover its dividend. Even after implementing the DRIP in FY 2021, Saputo has struggled to cover its dividend. As its capex increases in the coming quarters to meet the requirements of its Global Strategic Plan, its dividend could become further compromised. If Saputo fails to generate enough cash flow, and investors opt-back for cash in lieu of more shares through its DRIP, its dividend could become at risk. We estimate that in order to cover the dividend, Saputo has to sustain cash flow in the $850 million range in FY 2023-2025, which would be an impressive reacceleration from recent FY 2022 operating cash flow of $693 million. This analysis doesn’t even factor in the potentially large incremental pension expense discussed below.
- Spruce Point believes that Saputo’s acquisition of Dairy Crest (U.K.) brought to it a $724 million “hidden” pension obligation that the market doesn’t properly factor into the company’s valuation. We believe investors should pay attention to Saputo’s U.K. Dairy Defined Benefit Pension Fund (“Fund”) obligation. Currently, the Fund assumes 2.9% inflation. However, actual inflation is 10.1% and the Bank of England is projecting 13% inflation. Saputo warns the obligation is highly sensitive to inflation (each 0.1% increase in inflation increases the obligation by $23 million). Therefore, Spruce Point estimates that Saputo’s “real” pension obligation is $724 million and believes it should be factored into its leverage and valuation. Saputo is currently levered 2.93x, above its 2.25x Net Debt / EBITDA target. However, by including the U.K. pension obligation, we estimate its adjusted leverage is 3.50x. Beyond this, another alarming trend to keep a close eye on is that, in recent quarters, Saputo has become increasingly dependent on short-term uncommitted bank loans that are repayable on demand by the banks.
- Saputo’s Global Strategic Plan is unlikely to succeed in our view. Saputo has announced actions to stimulate organic Adjusted EBITDA growth to target $2.125 billion by FY 2025. The plan rests on five pillars highlighting actions such as leveraging its brand power, international expansion, e-commerce, product innovation through dairy alternatives, and ERP value realization, along with $1.2 billion of increased capital spending. Based on our assessment, we think Saputo falls short on at least three of the pillars. To illustrate this further, we don’t believe brand power is a driving variable to success in a low price-driven, fairly commoditized industry such as dairy. Private label offerings have been taking meaningful share in developed markets, yet Saputo has been committing more resources to building its brand. In fact, Saputo doesn’t even disclose its revenue split of business between private-label and branded. As for its chances to succeed with innovation, Saputo also does not disclose its consolidated research and development expenditures. However, based on disclosures made in foreign documents, we estimate it to be 0.20% of sales, or substantially below the 1% industry average. When it comes to dairy alternatives, our review of Saputo’s promoted plant-based Vitalite brand shows substantial issues. Notably, Saputo recently revised its claim in the U.K. that it was the #1 non-dairy spread brand to becoming the #2 brand. In the U.S., where Saputo is promoting its Vitalite dairy-free cheese product, our research finds it already being off-loaded to extreme value discount retailer Grocery Outlet at prices up to 50% lower than its prime channel. We warn that other struggling plant-based food companies such as Oatly and Beyond Meat can also been found at Grocery Outlet.
- We Estimate Between 40%–60% Downside Risk to Saputo’s Share Price. The average “consensus” price target among analysts for Saputo’s share price is $38.17, implying just 11% upside to consensus. Saputo trades at 1.1x and 11.1x 2023E Sales and EBITDA, which is a premium to a global set of dairy and cheese companies. However, we believe Saputo deserves to trade at a discount as a result of its below average organic revenue growth, exposure to Argentina, high leverage, declining transparency, weak dividend coverage, and global transformation fraught with execution risk. Just based on the inclusion of the U.K. pension obligation alone, Spruce Point sees $1.72 per share of downside risk. At least one executive saw a reason to sell shares recently. Terry Brockman is a long-tenured professional at Saputo who joined in 1997 and is currently the Chief Business Officer and former COO. He recently made a large sale of 60,000 shares after the recent earnings report and increase in the share price. We value Saputo’s Argentina business separate from its developed world asset base and project 40% – 60% downside risk or $13.75 - $20.50 per share.
