Description

Saputo Inc. (TSX: SAP)

Elevator Pitch

Saputo Inc. (TSX: SAP) is an overvalued commodity cheese company with lofty earnings targets and no clear path to actually achieving them. A negative cheese-milk spread, FX headwinds, and a weakening consumer renders an expected earnings recovery untenable.

Company Description

Saputo Inc. produces, markets, and distributes primarily dairy products including cheese, milk, dairy ingredients, as well as dairy alternative products. It is headquartered in Canada and trades on the Toronto Stock Exchange, but its largest geographic segment is the United States, which has historically accounted for ~40% of revenues and ~50% of EBITDA.

Short Setup

Despite an abysmal fiscal 2022 (FYE March 31), where the company reported C$1.155B in adjusted EBITDA compared to earlier sell-side expectations of C$1.6B, Saputo’s share price is up 12.6% YTD, as investors have recently sought the (perceived) safety of “recession-resistant” consumer staples stocks during this most recent market downturn. Moreover, Saputo is getting a pass on its recent poor performance as the market looks forward to managements’ fiscal 2025 targets and the expected ramp in earnings. Saputo’s management has convinced bank analysts that, despite no EBITDA growth since 2016, the company will be able to nearly double its EBITDA to $2.125B by fiscal 2025 (roughly calendar year 2024).

 The bank analysts that cover Saputo are primarily Canadian generalists with a diverse coverage universe. None are dairy experts, and some don’t even cover any other food companies. With a coverage universe of Tier 1 auto suppliers, retailers, and petroleum products companies, it is understandable that they are not experts in the intricacies of the various global dairy markets Saputo operates in.

                                                                                 BMO Capital Markets Analyst Coverage List

Lacking in-depth knowledge of the industry, the sell-side analysts are unable to challenge the outlook laid out by management and have simply modelled their expectations as a straight-line improvement in EBITDA in order to eventually arrive at management’s 2025 targets.

Differentiated view

Saputo’s EBITDA fell C$316M from C$1.471B in FY 2021 to C$1.155B in FY 2022, primarily due to its USA segment which decreased C$279M, or 49% year-over-year. The biggest contributors to that decline were the following: freight, warehousing, and logistics was a drag of C$105M; foreign exchange was a drag of C$32M; and “USA market factors”, a proxy for the cheese-milk spread, was a drag of C$118M. Consensus sell-side expectations are for Saputo’s FY 2023 EBITDA to recover to roughly the same level they earned in FY 2021, which would require not only that all these headwinds abate, but actually reverse course and become tailwinds. Through the first four months of the fiscal 2023, freight pressures are easing, but foreign exchange and “USA market factors” (cheese-milk spread) are worsening. While Saputo will benefit from a strong USD, it will be more than offset by a weak GBP (-8.7%), AUD (-3.0%), and ARS (-19.8%).

The “USA Market Factor” is primarily driven by the milk-cheese spread and is a significant driver of the US segment. Milk is the primary input in cheese production, but what many people do not know is that the USDA uses a formula to set the price of milk in the US. This can lead to periods when the price of milk is actually higher than the price of cheese, and in these environments, Saputo has a negative gross margin on cheese products in its US segment.

In fiscal 2022, the milk-cheese spread inverted and was a massive drag on EBITDA. In fiscal 2023, the milk-cheese spread has done the impossible and actually gotten more negative.

Unless the Canadian Dollar rapidly devalues or the milk-cheese spread suddenly reverts, it is difficult to see how Saputo can possibly bridge the gap from FY 2022 EBITDA to FY 2023 EBITDA, much less bridge to the FY 2025 EBITDA targets. Rapid volume growth could help make the EBITDA bridge a little more believable, but we have heard from retailers and grocers (Walmart, Target, Kroger, Albertsons, etc.) that consumers have been trading down to private label from branded products, further impairing Saputo’s ability to grow EBITDA so drastically.  In fact, in its most recent earnings call, Kraft Heinz highlighted the cheese category as its most sensitive to private level exposure.

In our view, deteriorating cheese economics, FX headwinds, and a weakening consumer render both a near and longer-term earnings recovery highly unlikely.

Recent executive turnover may be the first signs of cracks in managements’ confidence in their 2025 targets. On January 13^th, the President and COO retired and on June 29^th, the President and COO of the Dairy Division (USA) was fired.

Valuation

Assuming the “USA Market Factors”, foreign exchange, and freight roughly cancel each other out (given YTD trends this is extremely unlikely), FY 2023 EBITDA will be flat at best. Value the company at a 10x peer multiple and you get a share price of C$19.00, representing 40.0% downside.

Catalyst

Saputo reports its fiscal first quarter earnings on August 4^th, where the deteriorating cheese-milk spread and incremental FX headwinds will come to light, ultimately leading to downward revisions in the lofty FY 2023 expectations.  Longer term, it is likely only a matter of time until the market realizes how improbable management’s FY 2025 targets are.