IPSUshares are off 10%+ today following release of the company’s 1Q10 earnings results. Overall, revenues fell short of our expectations, but EPS of $14.84 (including gains from the insurance settlement and raw sugar hedges) were inline with our expectations.  We attribute the weakness in IPSU shares to two primary factors:

1. Disappointment over the pace of expansion of capacity utilization at IPSU’s Port Wentworth refinery.  According to management, the Port Wentworth refinery operated at 60% during its fiscal first quarter.  In late October/early November, the refinery was operating at close to 50%, which implies that IPSU exited the quarter at close to 70-75% utilization.  Management indicated that utilization has increased from December to January, although there has been a “2-steps forward, one-step back” dynamic to the rate of improvement.  Heading into the quarter, we thought the  company would be close to 100% utilization by the end of January.  Clearly we were wrong.  It seems more likely that the company will finally achieve 100% utilization by the end of its second fiscal quarter, which means 2Q10 earnings will fall short of our prior expectations.
2. Management expressed “concern” about the impact higher raw sugar costs could have on the company’s gross margins.  As we discussed in our preview, U.S. raw sugar prices have sky-rocketed in the past month and now trade between $39-$40/cwt.  Historically high raw sugar costs have been favorable for IPSU.  The company has typically been able to pass along higher input costs to its clients and as a result IPSU generates more “gross margin dollars” in a high raw sugar cost environment even if margins are unchanged.  In the most recent quarter, IPSU reported a refined/raw sugar spread of $11.00+, which normally would enable the company to achieve 10% gross margins.  Our checks with sugar brokers indicate that spot refined sugar prices have incresed at a comparable rate to that of raw sugar prices, so we don’t necessarily see why management went out of its way to cap expectations.  It appears management is concerned that vertically integrated sugar beet producers will not raise prices in response to higher raw sugar costs.  Additionally, there is a risk that IPSU’s margins on its industrial contracts could get squeezed if the company has not effectively hedged its raw sugar costs.  For now, we anticipate the company will be able to sustain a raw/refined sugar spread of $10-$12 over the course of FY10 based on our checks with sugar brokers and expectations for industrial contract pricing going forward.

Our Revised FY10 Earnings Expectations – Accounting for a Slower Ramp-up At Port Wentworth

We have revised our FY10 earnings expectations to reflect the following factors: 1) a slower ramp-up in capacity utilization at the Port Wentworth refinery, 2) Slightly higher industrial contract pricing in 2Q10 and 3Q10, and 3) Higher pricing on production sold to consumer and foodservices clients which are typically completed at spot rates.  For the second quarter we now forecast revenues of $209.0 million and EPS of $0.11.  We expect production to increase 11% sequential to approximately 5.2 million cwt.  We do not expect the company to get back to its annual run-rate of 24-27 million cwt until 3Q10.  In the table below we outline our key assumptions for 2Q10:

Source: PAA Research

Can IPSU Still Achieve $3.00+ in CY10 EPS?

 The short answer is of course, no.  With the company company generating modest profitability in the first calendar quarter of the year it would take a number of exogenous factors for the company to achieve our prior expectations of $3.00+ in EPS in CY10.  However, we think the company could enter its third fiscal quarter on track to generate $2.50+ in annualized EPS.  More importantly, we think the company should be able to sustain structurally higher earnings over the next several years based on the following:

1. Increased operating efficiency at Port Wentworth.  IPSU management has been somewhat coy about the financial impact of the new Port Wentworth facility. We have not been to the facility in person, but from everything else we have seen it is a tremendous leap forward for the company in terms of operating efficiency.  We anticipate the new Port Wentworth facility could enable IPSU to increase its gross margins by 1-2% on a structural basis.
2. Strong growth at Wholesome Sweeteners.  IPSU management indicated that it will start to disclose more financial detail on Wholesome Sweeteners in its 10-Q filing for 1Q10.  Anecdotally, we know that Wholesome Sweeteners is generating double-digit revenue growth and has margins that are 3x IPSU’s company average.  We expect IPSU to purchase the remaining 50% ownership stake in Wholesome Sweeteners that it doesn’t currently own in the fourth quarter of 2010, which should increase the company’s normalized earnings profile  considerably.
3. Secular growth in demand for refined sugar.  In the battle between high fructose corn syrup (HFCS) and refined sugar, it is increasingly clear that consumers are increasingly interested in purchasing products made without HFCS.  Gatorade, Pepsi, Dr. Pepper, and Ocean Spray have all launched refined sugar based products in the past 6-9 months. We expect the trend towards substituting refined sugar for HFCS to continue to gain momentum, which should lead to stronger revenue and earnings growth prospects for IPSU in the future.

Asset Value of IPSU Remains Unchanged Irrespective of Spot Price of Raw Sugar and the Pace of  Port Wentworth Capacity Expansion

We find IPSU shares compelling both from an earnings and asset value perspective.  As of 12/31/09, IPSU had a book value per share of $22 and that number will start to increase over the coming quarters as IPSU reports positive earnings.  At 1.0x tangible book value, IPSU shares would trade 50% higher than today’s current price.  From a sum of the parts perspective, we would argue IPSU shares are even more compelling.  We know that the company’s Port Wentworth facility is worth approximately $230 million, or $19/share alone.  We would argue that the Grammery refinery is worth approximately $100 million and the company’s ownership stakes in Santos and Wholesome Sweeteners an additional $50 million.  Even if we assume that IPSU incurs $50 million in contingent non-insured liablities related to the Port Wentworth refinery accident, we arrive at an asset value north of $27/share, 85% above current levels.

Source: PAA Research

There has been a global surge in interest in sugar assets over the past 3-6 months due to the prospects for rising demand and tight supplies for the foreseeable future.  IPSU is well positioned to benefit from the increased use of refined sugar in beverages and other products over the coming years.  We find it highly unlikely that the stock will trade at 0.6x tangible book value and 55% of real asset value when the company’s earnings prospects are rapidly improving and global interest in sugar assets is surging.

As always, please act accordingly…