Description

Short: SunOpta, Inc. (NASDAQ: STKL)
Current Price: $6.89 | Target Price: $4.38 | Market Cap: $817.13M | Downside: -28.2% | r/r: 2.57x

Investment Summary:

Plant-milk producer trading at ~20x my estimate of 2025E EBITDA in an industry experiencing a significant inflection. Despite years of elevated capex, IPOs, and undersupply with weekly oat milk sales growing 4000%+ from 2018 to 2022, the market has failed to consider the implications of the capital cycle at work. I believe that I'm ahead of the information curve…management has already taken eerie steps to hide behind poor results including ceasing disclosures, accounting misstatements, a credit rating scare, and board resignations…all of which the sell-side completely fails to consider as near-term risks. Consensus has taken guidance at face value, allowing attractive entry into a short position (7% short interest) at a unique time where the stock is priced for significant FCF inflection ($35-$45M in 2024E FCF) – what I believe to be “priced for perfection.” The hurdle has been set high as quarterly cash burn has averaged  -$15M over the last 12 quarters and STKL has NEVER generated even $30M of annual FCF. I see ~28% base case downside to current prices on $56M of 2025E EBITDA, driven by a loss of pricing power and structurally lower volume growth in the NTM, paving the path for a midyear guidance cut and a subsequent re-rating down to pre-divestiture valuation levels…a situation worth "crying over spilled milk."

Why This Opportunity Exists:

• History of consistent divestitures has made it difficult for the market to value this stock.

• We are at inflection point where supply is expected to outstrip demand as a result of enormous levels of capex and capacity entering the space throughout pandemic era

• Eerie management lack of disclose for price/volume in the latest Qtr strengthens conviction in deteriorating fundamentals

• Uncomfortably Over-Levered Business...any turnaround failure poses significant risk to the equity + risk of non-compliance with nearing covenant levels. There is VERY little room for error in the fundamental story. One small slip up from management can cause not only a significant cut in guidance, but a potential restructuring event (technical default, out-of-court restructuring, press release on RX advisory).

Company/Industry Overview:

SunOpta is a food and beverage manufacturer, historically involved in beverages, broth, sunflower seeds, fruit-based snacks, and plant-based milk products. With high exposure to commodity and capital-intensive segments, the business has historically been a choppy grower (-3.85% 5Y sales CAGR), consistently unprofitable (0.2% avg. EBIT margin over last 11 quarters), and FCF-negative business (CFO-capex ranging from -$70M to $25M across the last 5Y). Numerous divestitures and asset sales over the last 5 years have been completed in order to diversify away from these unattractive segments.

A comprehensive timeline of divestitures & rationales:
Feb 25, 2019 – specialty and organic soy and corn divestiture
- Simplify the business & exit businesses or product lines where the company is not strategically positioned to drive long-term growth
- Reduces debt and redeploy capital to consumer products
April 2, 2019 – organic oils acquisition
- Diversify global oils desk
- Provides access to high-end specialty markets
Nov 10, 2020 – global ingredients segment divestiture
- Lower commodity trading exposure
- Increase financial flexibility to enable accelerated growth in plant-based beverage platform
April 15, 2021 – plant-based brands Dream and WestSoy acquisition
- To complement innovation initiatives and co-manufacturing business
- Synergistic acquisitions
Oct 13, 2022 – sunflower and roasted snacks divestiture
- Further focuses on value-added plant-based foods and beverages
- Low commodity trading exposure, while enhancing long-term growth rate and margins
Oct 13, 2023 – frozen fruits divestiture
- More capital efficient business models, strengthens BS, and ensures singularly focused on the most attractive growth opportunities
- Slow growth

Market View:

After its series of divestitures to diversify away from “commodity” businesses, SunOpta has just recently received “pure play” plant milk status with the completion of its final divestiture in Q4 ‘23…the frozen fruit business. Plant-based milk has experienced explosive growth over the last few years, fueled by a surge in veganism and health-consciousness. From 2020 to 2021, competitors including Chobani, flooded the market to take advantage of increased demand, investing millions into capex and boosting capacity to over a billion liters of plant milk. Further, mega Swedish competitor Oatly listed shares in the U.S to take advantage of the American surge in plant product popularity. Since announcing its final divestiture into becoming a pure play plant-milk business, SunOpta stock has more than doubled its market cap from $350M to ~$820M. Management has put on a facade that the business is undergoing a turnaround story with a transition to a high-growth “asset light” business model, guiding for $35-$45M of FCF in 2024 (a first-timer).

Variant Perception:

Point 1) Capital Cycle Inflection - Supply Side 

The plant-milk industry was catapulted by the COVID pandemic, catalyzing major competitors to enter the space to meet outlandish consumer demand. In Mid-March 2020 when stay-at-home orders were issued, plant-milk sales spiked to 75.3% during that week, driven by consumer propensity to become accountable for their health and adopt health consciousness. As a result, competitors rushed to enter the market, riding the capital cycle by increasing capex to boost capacity, benefitting off price/volume trends, and enjoying capital investment into the space.

We are at a unique inflection point in the capital cycle where the plant-milk industry is soon to lose its supply-constrained status. My research on manufacturing capacity from the largest plant-milk packers points to the industry’s undersupplied status fading in the next 12 months.
Calling every major co-packer of plant-based milk (displayed below), in order to get a sense of industry supply, arrives us at ~1.247B liters of plant-based milk.

After years of dedicated capital expenditures across major competitors such as Oatly, Chobani, Danone, and SunOpta to boost capacity in an undersupplied market, TOTAL SUPPLY of plant-based milk now sits at 1,247M liters. In order to sanity check my supply numbers, I also ran a square footage method where I took the manufacturing capacity per unit of square foot of space and apply that multiplier to the size of the facilities, on a per-brand basis → I arrived at a very similar number on total industry supply, confirming my belief that the capital cycle is turning.

After 2 consecutive years of demand slowdown, TOTAL DEMAND now sits at 1,278M liters (Source: National Milk Federation), a measly 2.5% spread to my supply numbers.

Key Catalyst:

My primary research has shown that the recent completion of SunOpta’s largest plant-milk facility (“Midlothian plant”) in Q1 ’23 pins the market at industry demand. However, the straw that breaks the camel's back has yet to occur…introducing the KEY catalyst —-> Management’s Q1 ’24 plan to ramp up the third manufacturing line (Line 3) at the Midlothian adds an incremental 80M liters, officially tipping the market into oversupply. On top of the 80M excess, the planned additions of Lines 4 and 5 of the Midlothian throughout FY2024 add an incremental 133M liters, setting the market at 14% oversupplied and introducing significant risk to prices in the near term.

I believe that SunOpta is soon to exhaust its pricing lever that it has historically juiced to post a double-digit revenue growth algorithm. Disaggregating the financials on an ex-divestiture basis reveals that pricing power is already being lost in the plant-milk segment and is yet to get significantly worse.

While pricing gains have clearly shown signs of tapering, a much more alarming indicator that business fundamentals are truly deteriorating.

Management has begun to engage in strange activity, in what I believe to be an attempt to hide behind reality. Using the FactSet Blackline function, I discovered that the Q3 ’23 10Q was the first Q in the last seven reporting periods to lack price/volume data at the segment-level. Oddly, this follows the Q2 ’23 10Q where a -10% hit to volume was attributed to the “loss of a significant customer.” As SunOpta loses pricing power, a compelling short opportunity has presented itself in a business that has no more levers to push prices for a product that’s already double the price of dairy milk. 

Point 2) Demand Normalization

The plant milk industry gained significant market share over the last 3 years as consumers changed consumption habits and opted for health-conscious products. However, I believe this explosive growth was COVID-induced and led to a significant pull-forward of demand. Plant-based milk share has already shown signs of peaking in a post-COVID world relative to dairy, with barriers from taste and cost making it difficult to maintain share, paving the path for lackluster results in the next 12 months.

While bulls point to dollar share for plant milks nearing 25%...examining on a volume basis reveals that plant-milk market share peaked in 2021 and is on the downturn. Dairy data from the USDA Economic Research Service indicates that plant-milk has started losing share to dairy on a volume-basis, peaking at ~7.3% in 2021 and has since fallen to ~6.9%.

Plant-based milk has historically been double the price of dairy milk, due to the capital-intensive process of saccharification of oats, almonds, and other nuts into a liquid product. As such, it's difficult to attract a recurring customer base to an overpriced, sub-nutritious product relative to the incumbent dairy milk.

Alternative data from Google Trends further supports the notion plant-milk demand experienced a substantial pull-forward due to COVID. Keyword searches of “plant milk” spiked the few months following lockdown procedures, only to revert lower as the hype fades.

With demand reverting back to the mean at a unique moment in time when excess supply also hits the industry, exceeding parity will increasingly place pressure on prices, particularly SunOpta with 8% average price premium across products relative to comps Oatly, Silk, and Almond Breeze. Using the archived sites as well as the WayBack Machine, I scrapped historical prices on plant-based milk across competitors and reached the definitive conclusion that despite similar products (and frankly similar taste), SunOpta still trades at a price premium to peers…paving the path of price cuts as demand tapers and supply is unjustifiably added via the Midlothian.

Point 3) Over-levered Capital Structure Leaves Little Room For Error

Historically, SunOpta has been rated a B- credit by S&P. However, in December 2023, management refinanced and just 3 days after, withdrew their credit rating from S&P, earning a “not rated” status at the “issuer’s request.” Further analysis of the credit fundamentals indicates that SunOpta is nearly in breach of its covenants. In the base case, assuming conservative tapering price growth and still positive MSD volume gains (~4%), I see SunOpta on track to breaching its Consolidated Net Leverage Ratio covenant as of the end of the 1st or 2nd testing period Q1/Q2 ’24 (see attached model).  

I parsed through the most recent credit agreement (dated Dec 8, 2023) page by page and noted the major covenants that SunOpta must comply with, noting a 4:00x:1 net leverage ratio covenant, tested quarterly. In my base case valuation, assuming conservative 2% price growth down to 0% by 2025 & and consistent 4% volume gains (extremely conservative given demand slowdown + significant customer loss), SunOpta fails to comply with its leverage ratio in Q2 ‘24 with a 4.04x:1 breach, posing significant risk to the equity (4.79x breach in my downside case).

The truth of the matter is…the combination of SunOpta’s capital intensive business, paired with $2.25M of mandatory amort (New TL), $300K mandatory pref dividend payout, along with a razor-thin margin operating model make it INCREDIBLY difficult to achieve the level of FCF inflection that management has optimistically guided for. In order to gain conviction in management’s ability to guide (and the potential risk of sandbagging, I looked to recent history) →

Blast from the Past: in March 2023, amid completion of the Midlothian plant, management guided for $97-$103M in EBITDA for FY2023, sending the stock ~10% higher. By August 2023, guidance was cut to $87-$91M, and eventually cut to $75-$77M by November, sending the stock down ~20%+. I believe a similar story will play out in FY2024 with FCF guidance – SunOpta has never generated even $30M annual FCF, yet guides for $35-45M…an increasingly difficult pursuit with their leverage concerns.  

Catalyst Path – How We Get Paid 

1. Q1 ‘24: Supply begins to outstrip demand as 80M incremental capacity from Midlothian’s third line opens, pressuring price in the near-term by low single digits. Otherwise, volume takes another hit.  

2. Q2 ‘24: Price/volume decompression will lead to a revenue growth algorithm of sub-10% going forward, leading the market to question the historical 15x EBITDA valuation.  

3. Q2 ‘24: Burdensome mandatory amort, dilutive pref equity, & an all-variable rate cap stack contribute to FCF failing to inflect. SunOpta forced to draw on revolver or raise additional capital, risking 4.0x leverage ratio compliance.    

4. H1 ‘24: Guidance cut on mgmt’s FCF expectations leads to stock de-rating (~10x EBITDA) back to pre-divestiture price of ~3-$4/share as market realizes that a turnaround is not viable in near-term.  

5. H2 ’24 --> Exit Trade Recommendation (28% downside).       

Valuation 

I see 2025E EBITDA at $56M in the base case, $51M in the downside case, and $66M in the upside case, driven by conservative assumptions on price & volume growth as well as plant-milk segment gross margins.

Modeling conservative LSD tapering price gains, consistent MSD volume gains, and 100bps of margin compression for the plant-milk business + ~17% revenue growth for the remaining fruit snack business, I arrive at $56M in base case FY25 EBITDA. At a generous 15x EBITDA multiple with 128M S/O, the stock is worth $4.38 (-28.2%).

However, more importantly, this short opportunity presents an attractive asymmetric trade → In my downside case, where price gains taper from 1% to -1% across 2 years, volume gains remain a consistent ~3%, and margins only contract by 50bps, I arrive at 44% downside to the current share price. Even if I’m completely wrong on price and volume (growing at a consistent 3% and 5% respectively) and attaching an aggressive 18x multiple (7x turns above plant-milk comps), upside case return is only 17% from the current share price...a reward/risk skew of 2.57x.

Upside Case: $66M EBITDA at an 18x multiple, stock is worth $7.15 → I am completely wrong on oversupply thesis and volume grows at mid-single digits (~5%), gross margins expand from 14% to 14.5%.

Base Case: $56M EBITDA at a 15x multiple, stock is worth $4.38 → Line 3 of the Midlothian facility as well as ramp up of Lines 4 and 5 tip the market into oversupplied, causing price to taper from 2% gain to 0% gain by 2025. Volume still conservatively rises by mid-single digits (~4%).

Downside Case: $51M EBITDA at a 14x multiple, stock is worth $3.40 (roughly pre-divestiture price) → Aggressive oversupply plays out and price gains taper from 1% to -1% by 2025, volume grows at low-single digits (~3%), plant-milk gross margins only compress 50 bps from 13% to 12.5%.

I believe that upside to the stock is further protected by the bizarre Series A & B Preferred Equity that SunOpta has raised in order to remain liquid…an area where equity investors utterly fail to consider.  

Risks & “Upside” Protection:

Plant product innovations can cause fad-like characteristics and unexpected demand shocks, leading to periods of high volume & ASPs. I factor this into my bull case via consistent LSD price gains, MSD volume gains, & GM expansion. Further, in order to increase liquidity without butting up against covenants, SunOpta raised 2 tranches of Series A & B Preferred Equity in 2020 from Engaged Capital & Oaktree. In March 2023, Engaged Capital exercised their right to exchange their prefs into 6.1M common shares, dropping the stock ~10%. While Oaktree is still holding their pref. equity, a forced conversion feature is in place that allows SunOpta to force convert the prefs if the stock exceeds $7.50. 5% of the float is subject to another dilutive conversion.  

Catalyst

Q1 ‘24: Midlothian Line 3 ramp up → 80M incremental supply

Q1-Q3 ‘24: Midlothian Lines 4 + 5 open → 133M incremental supply

Q1-Q3 ‘24: FCF guidance cut ($35-$45M guide reduced to my estimate of $27M in base case), stock reacts poorly as sell-side adjusts expectations - similar story to massive FY23 EBITDA guidance cut

H1 ‘24: Potential breach of Total Consolidated Net Leverage Ratio (4.00x non-compliance). Dilutive capital raise or announcement of dire liquidity needs → (technical default, out-of-court restructuring, press release on RX advisory).

H2 ‘24: STKL re-rates to pre-divestiture valuation levels at $3-$4/share, becoming a 5-10% revenue CAGR, capital intensive, poorly managed industrial asset…oddly similar to Oatly, its top comp.