EUR 850.00 For Business Accounts Only

Morningstar | GrainCorp’s 1H Challenged by Australian Drought, but Long-Term Looks Better; FVE Maintained

No-moat GrainCorp’s tough operating conditions have been well-telegraphed, and we’re encouraged by the actions to right-size its asset base and cost structure to capture greater benefits in a more-normalised operating environment. We maintain our AUD 9.30 per share fair value estimate, with shares screening as moderately undervalued.

The first-half results featured challenging eastern Australian growing conditions, which led to diminished grain segment profitability, and higher input costs for the malt and oils segments as a result of timing issues and lower availability of barley and canola. While revenue climbed more than 25% versus the previous corresponding period, or pcp, on the back of grain movements into drought-stricken eastern Australia from the western part of the country, this sales stream is far lower-margin, and couldn’t make up falling volumes in the core logistics and export business. As such, despite solid top-line growth continuing in malts, GrainCorp posted an underlying net loss after tax of AUD 48 million, versus a profit of AUD 36 million in the pcp. We expect some improvement in the second half as global grain marketing dynamics become more normalised and cost-savings efforts begin to roll through, but nonetheless now expect a slightly greater loss versus our prior outlook.

The weak eastern Australian grain production over the past year drove down GrainCorp’s half-year receivals nearly 60% and exports more than 85% versus the pcp, but both metrics are tracking our full fiscal-year expectations. The greater intra-Australia movements look to drive higher revenue than we had originally projected, but the segment’s EBITDA margins fell to a negative 3.4% from a positive 2.9% a year ago.

Outside of the grains business, the lower output of barley and canola has led to increased costs for the malt and oils segments, leading to falling profitability for both versus the pcp. But again, we expect near-term recovery. Management attributed a portion of the 200 basis point decline in malt EBITDA margins to timing issues in North America which should correct over the course of the year, and we’re encouraged by positive improvements in the foods business within oils. While we expect full-year profitability in this latter segment to remain compressed versus fiscal 2018, we see oils profitability surpassing historical levels over the long run.
While the conditions are currently tough, we think the future is brighter for GrainCorp. The weather will determine the company’s prospects in any given year, especially after the planned sale of its bulk liquid terminals business and divestiture of the malt business, but we don’t think the drought conditions seen in eastern Australia will repeat year after year. Supporting our opinion, the Australian Bureau of Agricultural and Resource Economics, or ABARES, has pencilled in a return to long-run averages for Australian wheat and grain production in fiscal 2020, although much will depend on the prevailing weather conditions during planting and of course the growing season.

Admittedly, our outlook for 2020 total Australian production is more negative, given potential lingering effects from dry subsoil conditions despite recent rains in key growing areas, and we roughly split the difference between the challenged fiscal 2019 season and the long-run average. We're even less optimistic about eastern Australian production, and are assuming the region remains only about a quarter of the country's total output—in line with the recent growing year--versus the long-run average near 50%. Nonetheless, we assume Australian grain production will again return to the historical average since 2011 in our long-run forecasting, with eastern Australian production similarly climbing back to nearly half of this total.

We expect productivity improvements, further growth in malts and oils, asset rationalisation within the grains segment, and other outlined cost savings, including rail contracts which become more favourable starting in fiscal 2020, to drive higher profitability over the long run. On a consolidated basis, we forecast EBITDA margins rising to nearly 10% versus mid-single digits in fiscal 2019. GrainCorp’s planned grains derivative contract with an outside insurance company could also help to smooth earnings, although we reiterate our concern that this arrangement may lead to lower average earnings through the cycle, as the insurance provider will need to generate profits of its own.

Despite the recent operating weakness, GrainCorp’s balance sheet remains solid, in our opinion. Net debt gearing levels have increased due to a greater amount of inventory carrying values, owing to both a need to hold commodities longer (to ensure availability to meet contract requirements) and recent increases in the products’ underlying prices. But management noted that it remains well within its bank covenants, and following a refinanced AUD 500 million debt facility in the period, the average debt maturity expanded to 3.7 years at March 31, 2019 compared with 2.0 years at Sept. 30, 2018.