This time last week shares of Imperial Sugar ( IPSU) moved against the grain of the general market due to a rumor circulating that it may be a takeover target.

While the company has neither confirmed nor denied the rumor, there are numerous factors that suggest that the shares of one of the largest refiners and marketers of sugar in NAFTA may be significantly undervalued relative to the company's sizable asset value and that near-term catalysts could materially improve earnings.

Foremost, the USDA is set to review its tariff rate quota by April 1, a move that could result in an increase in the amount of cheaper world sugar cane allowed into the country to alleviate a historically wide spread between U.S. and world prices.

As a sugar refiner, IPSU's margins are impacted by the difference between the price it receives by selling its refined sugar to customers and what it pays for raw sugar cane. While world prices have collapsed from multidecade highs in February, U.S. prices have remained stubbornly elevated as the market remains tight.

Mexico, a free trade sugar partner, is also suffering from a tight domestic sugar market and may not help alleviate price pressure.

Longer-term trends in the sugar industry may also benefit IPSU's earnings prospects. For example, the use of high fructose corn syrup, a sugar alternative used to sweeten sodas and packaged foods, may be losing favor as consumers desire more natural ingredients.

Most recently, ConAgra, ( CAG) Pepsico ( PEP) and Kraft ( KFT) have all indicated that they will be replacing HFCS with natural sugar ingredients in certain products.

Additionally, organic sugar products appear to be gaining growing acceptance by customers. IPSU's 50% owned Wholesome Sweeteners joint venture is growing at a rate well above the overall sugar market.

According to recently disclosed figures in the company's 10-Q filing, sales and net income increased 31% and 159% year over year. The Wholesome Sweeteners business could contribute in excess of $100 million in annual sales to IPSU and be worth more than $50 million. IPSU has the option to purchase the remaining 50% of the business later this year, a move that would likely be accretive to earnings and shareholder value depending on structuring.

Furthermore, IPSU announced just this month the creation of Natural Sweet Ventures LLC, a new and exclusive joint venture with Pure Circle Limited to develop a specialty product line combining the natural benefits of both sugar and stevia. Product development will focus on delivering desired sweetness levels with fewer calories and natural ingredients.

Natural Sweet Ventures will work with customers in the food and beverage sectors. Since December 2008, when the FDA approved use of Reb A (an active ingredient of stevia) in U.S. food and beverages, the domestic stevia market has grown to about $100 million in sales for 2009 and is estimated to be a $700 million to $2 billion annual market in the coming years. To illustrate the enthusiasm for stevia, Pepsi announced at its investor conference this week that it would be putting "unprecedented resources" toward reformulating its beverages with natural, no-calorie sweeteners such as stevia.

Despite the positive fundamentals facing the company, IPSU's shares remain materially undervalued for a variety of reasons, including litigation overhang, lack of Street coverage and a misunderstood story and trading liquidity discount.

The biggest overhang on the company's share price is pending litigation from an explosion and fire in February 2008 at its sugar refinery in Port Wentworth, Ga., that left many employees injured and some dead. Production at the refinery, which comprised about 60% of IPSU's capacity, was suspended after the accident.

The reconstruction project has largely been completed and operational capacity nearly restored. The company is party to a number of claims and lawsuits and believes that its workers compensation and liability insurance coverage of $100 million is adequate to provide for these damages.

Trial dates for two of the 45 lawsuits have been set for May 2010 and there is a likelihood of a settlement before going to trial. A settlement announcement would almost certainly increase shareholder value materially.

As a small-cap with a sub $200 million enterprise value, IPSU receives no major Street coverage from full service brokerages; instead, IPSU is followed only by two independent research firms. The overwhelming investor sentiment is that IPSU is substantially undervalued and should trade, at a minimum, above $20 per share.

To justify these targets, look simply at the company's book value per share of $21.75. The book value understates the true market value of the assets, which can be estimated due to the company's newly completed refinery worth approximately $220 million, the Wholesome Sweetener joint venture likely worth $50 million or more, and over $110 million in cash on the balance sheet.

Furthermore, to be conservative, even if you increase liabilities by another $50 million to $80 million to account for assorted fines and civil litigation settlements above the company's $100 million cap, $22.50 per share is still justified.

Applying a 15% to 25% takeover premium yields a price in the range of $26 to $28 per share. On a relative valuation basis, a diversified group of food processing comparables such as Hershey ( HSY), Kellogg ( K), General Mills ( GIS) , Kraft ( KFT), Smuckers ( SJM) and Tootsie Roll ( TR) trade for an average price-to-book value of 4.8 times.

This compares with IPSU's miserly price-to-estimated book value of 0.70 times. On a normalized earnings basis, IPSU earned $3.71 and $4.31 per share in 2007 and 2006, respectively. If one conservatively estimates normalized forward earnings of just $2 to $3 per share, then IPSU's price-to-forward earnings valuation is a mere five times to eight times. This compares with a relative valuation of around 14 times for the same food processing group.

While it may be argued that IPSU should trade at a discount to food peers due to sugar's commoditized nature, we believe the discount is too steep, particularly in light of favorable industry fundamentals. Furthermore, no credit is being attributed to management's actions to diversify revenue sources into higher value-added products such as the organic sugar and stevia markets.

From a trading perspective, IPSU has appeared to have found support in the $15 price range. According to a recent Form 4 filing with the SEC, hedge fund Passport Capital increased its position meaningfully from 800,000 to 1.1 million shares from February through March 1 to become a 10% holder.

The fund also added call options maturing in April with expirations at $20 a share and above. Passport listed IPSU as its largest holding in its Agriculture Fund. Furthermore, in the depths of the financial crisis last year, a floor price on the shares was established with a large 3 million-share sale by Barclays ( BRC.L) (via Lehman) in the $6 to $8 range.

For patient investors, IPSU offers not only a modest current dividend of 8 cents per share, but a chance for a sweet payoff down the road.

Please note that due to factors including low market capitalization and/or insufficient public float we consider IPSU to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
At the time of publication, Axler's firm was long Imperial Sugar. Ben Axler is managing partner and founder of Spruce Point Capital Management, a New York-based hedge fund. Prior to founding the company, Axler spent eight years as an investment banker advising, structuring and executing billions of dollars of financing, risk management and M&A transactions for leading Fortune 500 companies. Axler started his career with Credit Suisse in 2000, and from 2006 to 2008, was an associate director at Barclays Capital in the Diversified Industrials Group. Axler graduated from Yale University with a master's degree in statistics and received both a bachelor of arts degree in statistics and a bachelor of science in marketing and business administration from Rutgers College, where he graduated with summa cum laude and Phi Beta Kappa honors.

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