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Morningstar | GrainCorp’s Derivative Contract Reduces Uncertainty, but also Valuation; FVE Cut to AUD 9.20

No-moat GrainCorp’s 10-year derivative contract to smooth earnings through the volatile east-coast Australian crop-growing cycle tightens its valuation range, but is a net negative for shareholders under our base-case scenario. The contract should help management plan for long-term capital allocation and asset utilisation rather than struggle with annual volatility, and we’ve reduced our uncertainty rating to medium from high. But we assume the company and its counterparty will see payments net out over the length of the contract. As a result, we reduce our fair value estimate to AUD 9.20 from AUD 9.30 to account for the present value of the AUD 10 million yearly fee GrainCorp pays under the agreement.

Under this contract, with White Rock Insurance, a division of U.K.-based Aon PLC, GrainCorp will receive payments when east-coast winter Australian production is below 15.3 million tonnes, and will pay when it is above 19.3 million tonnes. The parties will pay AUD 15 per tonne, up to a maximum AUD 80 million to GrainCorp in poor crop years, and AUD 70 million to White Rock in good years. This implies maximum payouts when production is below 10 million tonnes or above 24 million tonnes. The maximum net payment to either party is AUD 270 million over the contract life.

Over the past 12 years, including the current season, annual production has averaged 17.6 million tonnes. Neither GrainCorp nor White Rock would exchange funds at this level, other than Graincorp’s yearly fee. If production remained at this level every year, we estimate the net present cost to GrainCorp at about AUD 46 million after tax, or 20 cents per share. But volatility is the norm; since the 2007-08 season, the downside protection would have tripped two times, while the upside payout would have occurred in four years. We expect GrainCorp could face further challenges in fiscal 2020, which would lead to an immediate benefit; this limits our assumed valuation impact to only 10 cents per share.

On its face, we estimate the derivative would be worth about AUD AUD 0.50 per share in the best-case scenario, in which poor east-coast Australian harvests lead to GrainCorp collecting the full net AUD 270 million over the first four years of the contract. This compares with a potential negative AUD 0.90 per share hit from bumper years leading to the maximum amount of outflows on top of the underlying cost of the contract. But we note that business fundamentals would change for GrainCorp in each of these situations, which would dampen the net impact. Overall, we estimate a roughly 10 cents per share improvement in a downside scenario valuation (now AUD 6.40 versus 6.30 previously), and an equal 10 cents per share degradation in upside valuation (AUD 12.40 versus AUD 12.50)

We believe Aon is a worthy counterparty for this contract. The business is large, at a market cap of roughly USD 45 billion, and holds an A- credit from S&P. Morningstar assigns the company a narrow economic moat, and views management stewardship as Exemplary. And the capital structure at the firm looks appropriate; while Aon has increased leverage over the past few years to finance stock repurchases, we view the company’s capital structure as reasonable given ample free cash flow.