Sun Gro Horticulture is a vertically integrated producer, processor and distributor of peat moss and bark based growing media to the professional growing market. The investment thesis in Sun Gro is compelling due to its low valuation on a price to book, price to earnings, and DCF basis, combined with its dominant "price setter" market position as well as shareholder base with a history of takeovers.
Sun Gro leases peat bogs from provincial governments in Canada and mines peat moss. The raw peat moss is shipped to its wholly owned network of processing facilities that creates custom mixes that tailor to a professional growers market, namely nurseries and greenhouses. While Sun Gro is the largest company of its kind in North America, there are two main competitors to Sun Gro: Premier Tech and Conrad Fafard. Premier Tech is an industrial, agricultural and environmental company that has amassed a 24% equity position in Sun Gro and continues to actively buy stock on the open market. Also, in 2007 Premier Tech itself was the target of a hostile takeover by Oakwest Capital before inevitably going private through a management led buyout. Oakwest now owns 7.8% of Sun Gro. Conrad Fafard was bought by European agricultural powerhouse Syngenta in 2006. Worth noting is that Sun Gro's management has also recently been purchasing stock in the open market.
Sun Gro hit a number of stumbling blocks over the past few years. Management used debt to consolidate the professional growers distribution chain through a slew of acquisitions instead of using its internal free cash flow. Instead, due to its income trust structure it passed the majority of its cash flows to shareholders. During late 2008 the company announced the permanent suspension of this distribution and intended conversion to a corporation. Also at this time the company realized a 10%-15% decline in organic sale volumes (overall volume and revenue stayed roughly flat due to higher ASPs and acquisitions) and a large increase in the US dollar. As a Canadian firm selling into the US (85%+ of sales) a strong USD is normally good, but it had a large currency hedge in place that resulted in a $25mm marked to market loss. At the present time the firm has a $75mm short USDCAD hedge in place at 1.12, evenly spit over 2010 and 2011.
In 2009 the company put these missteps behind them, earning $19mm and generating $17mm in FCF. Management used this cash flow to pay down debt and is committed to delevering the balance sheet. On a trailing basis, including Q1/10 where volumes grew 9% YoY, Sun Gro is trading at a PE of 4.5x, 0.8x book value (1.3x tangible book), and has a 20% free cash flow yield. Going forward, assuming a very conservative flat volume and ASP profile plus a higher corporate tax rate, the company can generate $15mm in FCF. Investment broker dealer Cormark has FY2011 EBITDA of $28.5mm and notes that Premier Tech went private at 7x trailing EBITDA and Conrad Fafard was bought by Syngenta AG at nearly 12x trailing EBITDA. Sun Gro currently trades at 3.4x FY2011 EBITDA, and should have a greatly reduced debt load by that point. Cormark also notes that much of Sun Gro's idle off season capacity could be utilized by retail, private label brands to add upwards of $100mm in additional sales with limited CapEx. To be conservative of course I have left this out.
What I like about Sun Gro is that it is a relatively straightforward story to understand. They are already generating loads of cash and have an irreplaceable asset base with high barriers to entry and limited competition. Management are great at disclosure, are develering the balance sheet, and have bought stock in the open market recently. The company has a shareholder base with a history of unlocking value through takeovers. In absolute value terms, the company is trading at a discount to book value of $5.09/share, and if you value the business as an annuity with a very conservative $15mm in FCF @ 10% it is worth well over $6/share. On a risk reward basis, Premier Tech buys stock between $4 and $4.10, so the current $4.35gives you a $0.35 downside to a $0.65 to $1.65 upside.
